A Note on Derivatives
Warren Buffet, the iconic American investor has referred to derivatives as “financial weapons of mass destruction,” while Joseph Stiglitz, the recipient of the 2001 Nobel Peace Prize for economics has called for outright outlawing of their use by banks. Derivatives have been derided and impugned as the source of the recent financial crisis they continue to be used by over 95% of Fortune 500 companies for the purposes of hedging and risk management.
Simply put, a derivative is a financial contract the value of which is determined by reference to one or more underlying assets or indices; derivatives “derive” their value from other assets and come in various forms: futures, forwards, swaps and options.
Futures are perhaps the simplest form of a derivative and are agreements to trade commodities, securities or currencies at a set price at a given date in the future. Forwards are similar to futures but are privately negotiated and not traded on an exchange like futures. Swaps are agreements to exchange sequences of cash flows for a set period of time. An interest rate swap, for example, involves a counterparty agreeing to pay either a fixed or floating interest rate denominated in a particular currency to the other counterparty at specific times in the future. Options are contracts under which buyers have the right but not the obligation to sell or buy a particular asset at a particular price at or before a given date.
Derivatives have their roots in antiquity. In fact, they pre-date Jesus Christ. Chapter 29 of Genesis narrates the story of Jacob who, around 1700 B.C., purchased an option (costing him seven years of labour) that granted him the right to marry Rachel, Laban’s daughter. Thales of Milesian is said to have enriched himself around 580 B.C. by purchasing options on olive presses prior to a bumper olive harvest. ‘Rice futures’ were traded in 17th century Japan.
Trading in financial derivatives, however, took off in the 1970s. The abolition of fixed exchange rates in 1973 with the Bretton Woods Agreement led to volatility in exchange rates around the world. Advances in information technology and “real-time” communication ushered in a new era of derivatives with 24 hour trading across the globe.
In 1981, IBM and the World Bank entered into the first ever currency swap whereby the World Bank borrowed dollars in the U.S. market and swapped the dollar payment obligations to IBM in exchange for taking over IBM’s Swiss franc and Deutsche mark payment obligations.
Largely unregulated, derivatives began to grow at a dizzying pace, both in numbers and complexity, with many experienced corporations such as Procter & Gamble losing significant amounts in trading in the 1990s. In the absence of regulatory scrutiny, an arrogance and recklessness emerged in financial institutions, corporations and hedge funds that culminated in the hubris of Enron: an “energy” company that had newsprint and weather derivatives on its books! (1)
In September 2008, the insurance giant American International Group (AIG) teethered on the brink of collapse after entering into credit default swaps (CDSs) (a derivative insuring lenders against a borrowers’ bankruptcy) worth $400 billion and had to be bailed out by the US government out with $180 billion of tax payer’s money.
The jargon and complexity of derivatives eludes many lawyers. At a financial law course at Oxford University this writer was reassured that he was not the only one. A team of experienced banking and financial legal counsels from across the globe were, to varying degrees, perplexed by the multifarious nuances of derivatives. Schuyler K. Henderson (2), an American derivatives lawyer (the godfather of derivatives, no less) shed light on the abstruse subject.
Broadly speaking there are two distinct types of derivative contracts that are distinguished by the way they are traded. The most common are “over-the-counter” (OTC) derivatives that are privately negotiated contracts whereas ‘exchange-traded’ derivatives are contracts that are entered into through an exchange that acts as an intermediary.
The International Swaps and Derivatives Association (commonly known as ‘ISDA’) is the trade association for derivatives dealers. ISDA’s greatest achievement has been the standardization of the documentation used in derivatives transactions: the ISDA Master Agreement with its ancillary documents and definitions. This has created clairty, uniformity and reduced legal expenses in the business of derivatives.
ISDA was formed in 1985 and “represents participants in the privately negotiated derivatives industry and is among the world’s largest global financial trade associations as measured by number of member firms. It has over 820 member institutions from 57 countries on six continents which include most of the world’s major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on over-the-counter derivatives to manage efficiently the financial market risks inherent in their core economic activities.” (3)
Once an ISDA agreement has been signed, deals between counterparties are usually made on the telephone, which are then confirmed through long or short ‘Confirmations’. The ISDA, Schedule, Confirmations and the relevant Definitions form a single legal agreement between the counterparties and cover all trades concluded between them.
The business of financial derivatives is nascent to the Pakistani economy and is regulated by the State Bank of Pakistan (SBP) Financial Derivatives Business Regulations (FDBR). Derivative transactions currently permitted under the FDBR are Foreign Currency Options, Forward Rate Agreements and Interest Rate Swaps. No derivative transactions other than these are to be undertaken except with the express prior approval of the SBP. Initially under the FDBR, derivatives transactions were not to be entered into by a Financial Institution unless an ISDA Agreement had been exchanged with the counterparty. Since an amendment in 2005, however, for FX Options, Long-form Confirmations in place of ISDA Master Agreements can be used in certain circumstances.
As of today, there are five Financial Institutions in Pakistan that have been licensed as Authorized Derivatives Dealers. Under the FDBR, these Dealers owe their derivatives customers a duty of care to disclose potential risks and provide relevant information relating to the proposed derivatives transactions.
Five suits are currently pending against an Authorized Derivatives Dealer relating to cross currency swap transactions in the banking jurisdiction of the High Court of Sindh. These suits are fascinating in the legal questions they raise. These are, inter alia, whether a derivatives transaction can actually be defined as a “finance” as defined by the Financial Institutions (Recovery of Finances) Ordinance, 2001 and consequently whether the banking courts have jurisdiction over ISDA related matters.
These are primae impressionis cases or cases of first impression and judgments/orders in them will be epochal for the country’s legal and financial system.