OTC derivatives played important role in Asian crisis

In a contribution to a leading economics journal, Prof. Jan
Kregel highlights the role played by derivatives, particularly
over-the-counter (OTC) derivatives, in the Asian financial
crisis. OTC derivatives, which are structured to clients'
particular needs by banks which themselves assume little risk,
hamper efficient capital allocation and prudent risk
assessment. The volatility generated by the use of such
instruments necessitates the need for financial-sector reform.

by Chakravarthi Raghavan

GENEVA: While not all the difficulties created by volatile
capital flows in Asia were due to the increased use of
derivative instruments or structured derivative packages by
foreign banks, they did play an important role in the
unexpected declines and excessive volatility of currency and
asset markets in Asia during the crisis, according to Prof. Jan
In an article on derivatives and global capital flows in the
Oxford Journal of Economics November 1998 issue devoted to the
Asian crisis, Kregel (who at that time was teaching at Bologna
University, but is now on the staff of UNCTAD) points to four
puzzles in the East Asia crisis that have caused surprise, and
suggests that the understanding or explanation lies in the
widespread use of structured over-the-counter (OTC)

Puzzling elements

There are at least four puzzling elements in the Asian crisis,
he says:

First, after the Latin America debt crisis of 1982,
developing countries were encouraged to increase reliance on
non-bank lending, in particular FDI, and the instance of such
flows to a number of Asian economies was used as an example of
the greater stability of such lending. Yet the Asian crisis
seems to have been precipitated by the reversal of short-term
private bank lending which had come to dominate capital flows
to the region.
Second, capital flows to Asia have been used as an example
of the benefits of international capital markets in directing
resources to the most productive uses. Yet in the aftermath of
the crisis, it appears that total returns on equity investments
in Asia have been lower than in most other regions throughout
the 1990s.
Third, in a number of Asian countries, the majority of
international lending was between foreign and domestic banks.
It has been suggested that the major cause of the crisis is
unsafe lending practices by Asian banks, due to inadequate
national prudential supervision.
But the developed-country lenders were large global banks,
employing highly sophisticated risk-assessment procedures,
which continued to lend well after the increased risks in the
region had become apparent.
This shows that even the most sophisticated operators in the
global financial markets have difficulties in assessing risk,
and that the Asian country regulators were no more successful
in imposing prudent limits than those in most advanced
Finally, private portfolio and FDI flows were considered
to be preferable to syndicated bank lending because they were
thought to segregate the problem of foreign exchange
instability from asset market instability.... Yet, the linkage
between the collapse in exchange rates and that in equity
markets appears to have been even closer in Asia than in other
experiences of financial crises.
One explanation offered for the crisis in foreign markets,
Kregel notes, is that a large proportion of foreign borrowing
by corporations was unhedged because of expectations of stable
currency rates, and when these were disappointed, there was a
scramble for foreign currency to repay the debts and this
created the massive market imbalance and collapse of foreign
exchange markets.
And the absence of generalized hedging in foreign exchange
markets has been interpreted to mean that financial derivatives
contracts played no role in the crisis - a view reinforced by
references to the IMF study that global hedge funds were not
active catalysts in the Asian crisis.
However, points out Kregel, the quarterly reports (fourth
quarter of 1997 and first quarter of 1998) of US money centre
banks suggest that most of their initial losses have been
related to derivative-based credit swap contracts. And at least
in the case of US banks, such derivative contracts played some
role in the flow of funds to Asia and thus in the instability
of such flows. There is also evidence that the German and
French banks were also involved in derivatives trading in the

Over-the-counter derivatives

The standard derivative contracts - such as forwards, futures
and options - are used for hedging risks. Foreign currency
forwards remain the province of bank foreign exchange dealers.
Most basic futures and options contracts are standardized and
traded in organized, regulated markets. But banks also offer
derivative contracts to their clients in the "over-the-counter"
market. These are not derivatives on organized markets, but
rather individually tailored, often highly complex,
combinations of standard financial instruments, packaged
together with derivative contracts designed to meet particular
needs of clients. Such contracts involve very little direct
lending by banks to clients, and generate little net interest
income to the banks. They are often executed through special
purpose vehicles - specialized investment firms that are
separately capitalized and thus, in terms of the Basle capital
adequacy requirements, need little or no capital or are
classified as off-balance-sheet items, involving no direct risk
exposure of the bank. They generate, though, substantial fee
and commission income - with the bank committing none of its
own capital, but serving as an intermediary matching borrowers
and lenders.
The major objective of active, global financial institutions
is thus no longer the maximization of profits by seeking the
lowest-cost funds and channelling them to areas of highest
risk-adjusted return, but rather maximizing the amount of
funds intermediated to maximize fees and commissions, thus
maximizing the rate of return on bank capital. This means a
shift from continuous risk assessment and risk monitoring of
funded investment projects that produce recurring flows of
interest payments over time to the identification of riskless
"trades" that produce large, single payments, with as much of
the residual risks as possible carried by purchasers of such
packages. This process has been accelerated by the introduction
of risk-weighted capital requirements.
This has resulted in banks coming to play a declining role
in the process of efficient international allocation of
investment funds, but serving to facilitate this process by
linking primary lenders and final borrowers. This means that
the efficient allocation of funds to the highest risk-adjusted
rate of returns depends on an assessment of risks and returns
by the lender.
But the role of most derivative packages is to mask the
actual risk involved in an investment, and to increase the
difficulty in assessing the final return on funds provided.
As a result, certain types of derivatives may increase the
difficulties faced by private capital markets in effecting the
efficient allocation of resources. And by making investment
evaluation more difficult for primary lenders, they create also
difficulties for financial market regulators and supervisors.

Circumventing prudential restrictions

Most institutional investors in the US do not face unlimited
investment choices, but are limited to investing in assets with
a minimum of risk represented by the investment-grade credit
rating on the issue. They are precluded from risks such as
foreign exchange risks or foreign credit risks.
This means that a large proportion of professionally managed
institutional investment funds cannot invest in emerging
markets or in particular asset classes such as foreign
"Structured derivative packages, created by global
investment banks, have often provided the means to circumvent
these restrictions."
Some of these packages, Kregel explains, might involve US
government agency dollar-denominated structured notes with the
interest payments, or the principal value, linked to an index
representing some foreign asset, such as the Thai baht/dollar
exchange rate, and derivative contracts enabling a Thai bank to
get below-market-rate funds, US investors above-market returns,
and the banks fees and commissions for arranging the trade, but
with no commitment of capital.
Kregel points out that it is virtually impossible (in such
contracts) for the US investor to evaluate the use of funds by
the Thai bank, and there is little incentive for the US bank to
do so: for, once the structured note issue is sold, the foreign
credit and exchange risks are borne by the US investor, who is
not only subverting prudential controls, but in all probability
evaluating the return without any adjustment for foreign
exchange risk, even if that risk is recognized as such.
"There is thus little economic interest or possibility for
the market to assess either the risk or the returns of the
investment, and thus no incentive for market agents to act so
as to ensure that capital is allocated globally to those uses
providing the highest risk-adjusted rates of return."
Kregel explains the use of OTCs for "credit enhancement" in
lending and investing in Mexico for Brady bonds and J P
Morgan's use of them for the issuance of Aztec bonds in 1988,
and more recently investment banks applying this principle to
other types of developing-country debt to enable US
institutional investor funds to invest in emerging-market debt,
earning above-market interest rates, with no risk to the
intermediary "unless the bank was required to guarantee to
convert interest payments (in local currency) into dollars, and
a risk only if the foreign currency were to become
inconvertible - not a devaluation risk but a risk that the
currency could not be sold at any price."
Kregel comments that this provides one possible explanation
why so much effort was made to prevent Mexico from suspending
convertibility in 1994, and notes that structures similar to
that used in Mexico were used in Asia as well as Latin America.
The structured note and the credit-enhanced Brady structures
were used to move funds from developed to developing countries,
despite the existence of prudential regulatory barriers.
Kregel notes that information about the various derivatives
is not easy to come by, but some of the litigations between US
centre banks like JP Morgan and some Korean counter-parties
throw some light.
And in the case of Thailand, the profits from derivatives
and current revaluations far exceed the total amounts owed for
traditional lending. This suggests that a majority of the
funds that entered Thailand were linked to derivative
contracts. For Korea, the profit figures were well over half
the amount of total lending, leading to a similar conclusion.
And in Indonesia, they are roughly two-thirds.
Thus, in all the three countries that had to seek IMF
support, derivatives sold by US banks to domestic institutions
appear to have played as large a part as traditional financing
The Kregel article was contributed in April 1998, and thus
makes no reference to the evolution of the financial crisis
after that date - its spread to Russia and Latin America, and
the scandal in the US itself of the Long-Term Capital
Management Fund (LTCM) and its operations and collapse, and the
New York Federal Reserve-engineered rescue of the LTCM.
But some of Kregel's views on OTC derivatives and their role
in Asia, and banks assuming no real risks except when a
currency becomes inconvertible, may perhaps explain the howls
raised in Washington and elsewhere against Malaysia and its
decision in September to make the ringgit non-convertible and
impose capital controls.
The strong criticism of Malaysian controls possibly reflects
worries and fears that Indonesia and other developing countries
might follow the Malaysian example, if there is no quick
turnaround in their economies under the IMF conditioned

Capital controls

In the OJE, in other articles, Prof. Robert Wade and others
in fact advocate capital controls and restrictions.
Wade argues that capital account convertibility brings
economic policy in developing countries under the influence of
international capital markets - and a small number of country
analysts and fund managers in New York, London, Frankfurt and
Even if free movement of capital leads to efficiency in
allocation of capital and as such maximizes returns to capital
worldwide, "governments have much more than the interests of
the owners of capital in view - or ought to have.... They want
to maximize the returns to labour, to entrepreneurship, to
technical progress and to maximize them within their own
territory rather than somewhere else; they want to provide
public goods that contribute to the good life."
"Only blind faith in the virtues of capital markets could
lead one to think that maximizing the returns to capital and
promoting development goals generally coincide," Wade adds.
But regional economists like Prof. Jomo Sundaram of the
University of Malaya believe that capital controls can avert a
crisis but not overcome it. Currency measures in Malaysia were
necessary to regain control over monetary policy and kill the
overseas market in ringgit (especially in Singapore). But
capital controls are a means and not an end in itself, and
could be messy and discourage FDI as well, he adds.
The full contours of the LTCM and its operations in the US
are yet to come out fully - the involvements of various banks
and bank regulators (in the US and Europe, and their failures),
and the LTCM rescue, justified by the Federal Reserve as
necessary to safeguard the financial system but viewed by many
others as US crony capitalism and an attempt to bury the
mistakes of the regulators.
The LTCM has forced regulators, under prodding from
Congress, to sit up and take note of such funds and their
operations. But even when trying to respond to Congress, the US
regulators are fighting their own turf battles: there are three
of them - the US Federal Reserve, the Securities and Exchange
Commission and the Commodities and Futures Trading Commission -
and each has a constituency that uses its campaign financing
to line up Congressional support too.
But many of the arguments of the US and of the IMF against
over-regulation and controls, and why hedge funds cannot be
controlled or regulated (since they will shift their operations
to offshore centres, like the Cayman Islands, and thus escape
supervision) don't really stand up to much scrutiny.
After all, Mr. George Soros or Mr. Meriwether of the LTCM
and his like may locate their funds in offshore centres, but
they and their staff won't go and live in these places with
their families and send their children to school there. The
offshore centres will only be "name-plate" funds and
enterprises, in fact run from desks in the US, UK and so on.

Two schools of thought

There are two schools of thought in the US: one that advocates
that derivatives traded on regular markets, and OTCs (whose
daily turnover is not over a trillion dollars), need to be
regulated and controlled in the same way new drugs are by the
US Food and Drug Administration: each one needs prior approval
and clearance before being put on the market.
The other approach is for regulators to give clear
instructions to the banks on the extent of risks they will be
allowed and not allowed, and rely on their internal oversight
systems. If these systems are found to have failed, then the
banks will be forced to set aside heavy capital adequacy
But either way, it will only safeguard the interests of the
financial and money centres, not the host developing countries.
For the latter to be served, any reform or any new financial
architecture must be seen not in separate compartments, dealing
with financial and trading systems, but together in one piece.
The starting point for this, to ensure that their voices are
heard and accommodated, is not to treat "trading in widgets as
the same as trading in dollars", adapting the title of a recent
article by Prof. Jagdish Bhagwati.
Developing countries may not be able to block changes at the
IMF, but they can do so at the WTO (and use the consensus
process to reject accords). They might regain some bargaining
leverage at the WTO by not ratifying the 1997 financial
services accord, and insisting on changes in the financial
services agreements or, at the minimum, their being enabled to
rewrite their schedules with new conditions under which the
dictum for foreign financial services operators would be that
they can do only what they are specifically permitted to do,
and anything not allowed would be illegal.
This would not be an issue of market vs. command economy -
but rather one of following the Anglo-Saxon or Napoleonic law.
In the financial sector at least, the market theology needs to
be modified to the effect that any new activity not
specifically authorized would need specific approval, and the
operators would face penalties if they try to get around the
regulations or help local enterprises to do so.
And the home countries of these banking and financial
services enterprises should be able to raise disputes on behalf
of their enterprises at the WTO only if they undertake
supervisory and regulatory obligations to ensure that their
main offices will obey host-country rules and regulations - in
the same way the US wants countries of origin to track and
control production and exports of narcotic drugs. (Third World
Economics No. 202, 1-15 February 1999)

This article was originally published in the South-North Development
Monitor (SUNS) No.4348, of which Chakravarthi Raghavan is the
Chief Editor.