Open Review of Management, Banking and Finance

«They say things are happening at the border, but nobody knows which border» (Mark Strand)

Enhancing information disclosure to strengthen derivative counterparties

by Martin Berkeley

Abstract: This article explores whether better information disclosure would improve outcomes for the counterparties of derivative transactions. Derivatives have two principal roles: hedging and speculation however the boundary between these elements can be indistinct and for the unwary a derivative trade can be dangerous exposing a counterparty to potentially unlimited losses and multiple risks. Derivatives play a significant role in the stability of the financial system as a whole. The growth of the derivatives market has led to the dispersion of risks through financial markets and when a crisis occurs this can lead to risk being rapidly transmitted and contagion. This article also considers a type of often non-disclosed risk and argues that better disclosure may ameliorate the risks of derivatives and led to improved outcomes for all counterparties. However this is likely to be resisted by banks who are the principal vendors of derivatives.

Summary: 1. Introduction. – 2. The role of counterparties. – 3. The risks of derivatives and disclosure. – 4. Fostering the outcomes of derivative transactions.

1. Derivatives are fundamental building blocks of the financial system and underlie various aspects of the global economy. We are all exposed to derivatives either directly or indirectly, and an incomplete understanding of their function, impact and significance appears to be a root cause of many financial disputes and contribute to financial instability. This article explores the information disclosure requirements in respect of derivatives and argues that better disclosure would have a positive impact on both financial stability and investor protection. Specific risks are considered as the knowledge of them would then would be of direct benefit to all counterparties and by extension contribute to financial stability.

Derivatives are often for used hedging purposes but their primary use is speculative [1]. Derivatives are classified as complex investments under MiFID2 [2], and as a result of their complexities and the risks attached to them; they are subject to various regulatory controls – particularly when used by non-expert private customers [3]. Derivatives are some of the most complex financial transactions frequently entered into in the financial markets, with a market size of over $544 trillion [4]. Not only are the component parts of a trade complex, but there is a multiplying and compounding effect as a ‘simple’ derivative trade may be combined with other constituents to form an highly complex, or ‘exotic’ trade [5].

A derivative is an investment that derives its value from an underlying market, for example forwards, options and swaps are forms of derivative and they, derive their value from tradable (and hence quantifiable) markets, such as the stock, commodity or currency markets. At its simplest a derivative can be considered to be a choice; it is effectively a contract giving the holder the ability to make a choice at a future point in time.

As an example, a farmer may wish to lock in the price of their wheat crop (perhaps because he is concerned about future low prices due to a good harvest and market oversupply), so the farmer agrees a future price per tonne with the mill, which he must deliver on the agreed terms (e.g. date, amount quality etc.). This is a forward contract and both the farmer and the miller have an obligation to honour the contract as deliverer and receiver. Both parties know their products and markets so can assess the risks of entering into such an agreement. The problem with this type of arrangement arises when one party no longer wishes to be bound by the agreement or is unable to fulfil the terms of the contract; a devastating storm may have destroyed the crop or the mill may have closed. No doubt the contract will have provisions for such eventualities, but the question at stake is whether one party simply no longer wished to be bound as they can achieve a more advantageous price elsewhere. This is where the forward contract has limitations.

Let us assume a similar scenario but where each party is not tied to contractual obligations but rather has a choice. This would mean upon contract maturity each party could decide whether to exercise their rights under the contract. Had the grain price collapsed the farmer had a guaranteed price – effectively a hedged position. For this to function effectively one of the parties has to give up rights. By guaranteeing a price the mill is granting an option to the farmer and farmer receives the benefit of this option. This is effectively how options and derivatives function. For the benefit of a having the option the mill will wish to be recompensed for the risk they are taking on. This could be through the charging of an upfront premium or embedding the premium price in the agreed future price with the farmer. Essentially the farmer would have to be prepared to accept a lower guaranteed price in order to have the option to exercise it (or not on) maturity.

An interest rate swap is one of the most widely used derivatives [6], the concept being an exchange of cash flows to achieve either a fixed rate of interest from a floating rate, or alternatively a floating rate of interest from a fixed-rate. They are commonly used as a method of managing interest rate risk in loan portfolios. However, this simple concept belies an extremely complicated structure with profound implications. In British law the leading definition of a swap was given by Wolff LJ in Hazell v. Hammersmith & Fulham L.B.C 1990 [7], this gives an indication of the complexities in explaining and understanding how comparatively simple derivative such as a swap functions:

An interest rate swap is ‘an agreement between two parties by which each agrees to pay the other on a specified date or dates an amount calculated by reference to the interest which would have accrued over a given period on the same notional principal sum assuming different rates of interest are payable in each case….normally neither party will in fact pay the sums which it has agreed to pay over the period of the swap but instead will make a settlement on a “net payment basis” under which the party owing the greater amount on any day simply pays the difference between the two amounts due to the other’ [8].

As can be seen, a comparatively simple swap requires an agreement between two contracted counterparties. This agreement will cover the obligations and responsibilities of each party but also more mundane mechanistic parts of the swap such as dates and a reference to an interest rate. Most commonly this is LIBOR or another tradable interest rate such as Euribor. It is also possible to use a non-tradable interest rate such as Bank of England Base Rate, though this can incur further complexities such as ‘basis risk’, which is where there is a mismatch between indices being used, for example hedging Base Rate debt with a LIBOR hedge [9].

Additionally, the period or duration of a swap must be agreed, as well as the amount or ‘notional’ of the swap. The notional is reference to a sum of money on which the derivative is based, for example a debt that is being hedged; this is not the same as the actual amount of the debt. The consequence of this is any sum that is being used paid down any debt may become potentially disconnected from the swap which is used to hedge the original notional position. This can result in customers finding themselves in an over-hedged or under-hedged position as there is potentially a mismatch between the notional amount of the derivative and the original loan which was being hedged. The terms of payment or cash flow will also need to be agreed; these could be on a monthly, quarterly or semi-annual basis. Cash flows are exchanged on a net basis so only the party that owes money under the contract on a given date may actually suffer any negative cash flow impact. However, the exchange of cash flows may not only be on maturity of a derivative, but also possibly on a periodic basis, which will have been agreed under the contract. There may also be decision points within a swap structure on a unilateral or bilateral basis; for example, the bank may have the choice on a quarterly basis whether to cancel or to continue using the swap (these are a type of binary option) [10].

These complexities and subtleties in terms of construction and operation of derivatives gives rise to potential risks for both counterparties, especially if either is unaware of the risk and their significance. The difference in levels of knowledge between the parties to the derivative contract will depend on who the counterparties are.

2. Most derivatives are bilateral agreements between counterparties are known as Over the Counter (OTC) transactions [11]. In OTC transactions banks are often the market making counterparty and the other party may range from a large or small business, individuals or other financial institutions. The result is an enormous range of knowledge and experience between the counterparties, which can give rise to issues as are explored later in this article. By contrast, the listed derivative market is made up of standardised contracts traded via regulated exchanges. These listed derivative trades are facilitated and cleared by Central Clearing Counterparties (CCPs) who also become the counterparty to each trade.

One of the problems of the OTC derivative markets was maintaining and distributing knowledge of derivative contract existence and ownership. Derivatives may be novated to new parties and the counterparties themselves may merge, restructure or be liquidated. This is true for banks as well as non-bank counterparties. The result is not only a lack of clarity as to ownership, but also confusion as to where the derivative risks have been transferred to. This could have profound impacts on financial stability as was seen in the Global Financial Crisis (GFC). The introduction of European Market Infrastructure Regulation (EMIR) in 2012, in light of the risks highlighted by derivatives during the GFC, aims to increase transparency and reduce the risks of OTC derivatives [12]. A key element of EMIR is the introduction of the Trade Repositories (TR) scheme where detailed information is stored on OTC derivative contracts and their ownership with the European Securities and Markets Authority (ESMA) being responsible for scrutiny of trade repositories and for their accreditation [13]. The use of CCP has a number of advantages, these principally being contract standardisation, liquidity and stability.

Derivatives by their interconnected nature were a key element contributing to instability during the GFC [14], and hence even entities that may not have direct derivative exposure may effectively be indirect counterparties to derivative trades. They are not direct counterparties in terms of having entered freely into a derivative position but may be affected by the outcome of external derivative positions. Additionally, several investments have derivatives embedded within them. For example, structured products use derivatives to increase leverage or provide levels of protection and as a result the investor has derivative exposure though is not a direct counterparty to the original derivative trade. Some fixed rate loans also provide another example of indirect derivative exposure. The bank hedges the loan itself and the borrower is not a counterparty to the derivative. This has led to unsatisfactory outcomes for customers where they have still had to bear the mark to market break costs (as they typically indemnify the bank for costs), but do not have the same regulatory protections as a derivative investor [15]. This raises the question of whether an investor would have entered into a fixed rate loan had they known of all the risks, when they alternatively could have entered into a floating rate position and used an independent hedge – though this is also not a risk free approach.

3. Derivatives are fundamentally for managing or transferring risk between counterparties. However, they also entail a number of risks in themselves with some of the principle risks being default or breakage costs. They also entail other less obvious risks [16].

In respect of breakage costs, when a derivative is liquidated before maturity the derivative holder (effectively the person who ‘buys’ the derivative) will have to pay the derivative seller (or granter) the market cost of a replacement product if the market price so demands (the derivative is said to be ‘out of the money’). This is because before maturity the derivative seller must enter into an equal and opposite trade to synthetically cancel the original derivative trade position. It is possible that the situation may be reversed, and a derivative position is ‘in the money’ and a payment will be made from the derivative seller to the customer. Recently the decline in interest rates has led to many holders of interest rate hedging products to discover the break costs of their hedging products are substantial [17]. Not only is the magnitude of the break cost uncertain, but also the calculation methods are opaque and beyond the expertise of the non-expert, and even their existence can be unclear for non-expert counterparties [18].

The UK regulator the Financial Services Authority (as it was at the time), was very clear on disclosure of break costs and stated that ‘the nature of IRHPs [19] means the scale of any break costs is inherently uncertain as, depending on market conditions, the customer may have to make a payment to the bank or the bank may have to make a payment to the customer and for the disclosure of break costs to comply with our regulatory requirements, the bank should be able to demonstrate that: in good time before the sale, the bank provided the customer with an appropriate, comprehensible and fair, clear and not misleading disclosure of any potential break costs’ [20]. This is a clear indication that this most obvious of derivative risks should be disclosed in good time to counterparties.

However, not all derivative risks as well as their significance and consequences will be obvious to a non-expert customer. An example is the derivative risk known as Potential Future Exposure (PFE) or Credit Limit Utilisation (CLU) which forms part of derivative counterparty risk and can have significant consequences [21] [22]. The PFE risk is defined as ‘the risk that the counterparty will not pay the amount due in the future’ [23], effectively the potential loss in the event a counterparty does not honour their obligations under a derivative contract.

The value produced by the calculation of the PFE risk is used to quantify the risk in a worst-case scenario that a bank may be exposed to in respect of a future potential derivative default by a counterparty. It is also required for regulatory capital reporting and allocation purposes. Historically banks have used their own bespoke methodologies to calculate the PFE risk, this typically is seen as representing with 95% confidence the most a bank may expect to lose in the event of a customer default on a trade [24]. The bank will then make a provision for the risk [25].

Recent cases in the UK courts have considered PFE risk and in general have concluded that it is not a bank’s duty to disclose this risk to a customer [26], though notably in Parmar 2018, HHJ Hochhauser QC noted there may be factual situations where because of the consequences of PFE, it may be beholden on the bank to disclose this in order to comply with the COBs rules [27]. However the non-disclosure of PFE or a counterparties lack of knowledge of even its existence may have significant consequences. For example, if a customer was aware that a particular derivative carried a very considerable PFE risk he or she may question why that particular derivative was riskier than another. PFE risk can vary with derivative types, for example interest rate caps typically carry no PFE risk as for these a premium is paid up front and hence the bank is not exposed to any counterparty risk. The knowledge that one type of derivative carries no PFE risk, whereas others carry considerable PFE risk, may raise a question in a non-expert customers mind as to the significance of the comparative risk levels between two derivative types. Should the customer be aware of this risk and use it as a method of comparing derivative types, a better and more fully informed decision can be made at the outset by the customer. This is obviously a benefit to the customer in obtaining a potentially more appropriate derivative structure, but also to the bank in not having to potentially deal with a dissatisfied customer’s complaints and perhaps even a compensation claim.

Disclosure of PFE risk can also have a profound impact on financial stability in terms of the risks that banks are carrying. Banks that are deemed to be Globally Systemically Important Financial Institutions (G-SIFIs) are required under the Basel Accords to hold sufficient regulatory capital to act as a buffer to absorb unexpected losses and to promote stability of the financial system [28]. The capital buffer that a bank has to put aside in order to satisfy regulatory capital requirements cannot be further utilised by the bank for lending or speculative purposes, hence there is a conflict of interest as the bank not only wishes (and is required) to manage risk, but there may be also pressure to downplay this risk as the bank is unable to use capital put aside for risk management purposes for more profitable activities. This has led to disputes between banks and regulators as to what constitutes components of regulatory capital, with banks wishing to maximise their profitable activities, thereby increasing the risks in the financial system as regulatory capital levels may be diminished [29].

Risk Weighted Assets (RWA) are used in defining asset risk types for regulatory capital purposes and RWA ‘are computed by adjusting each asset class for risk in order to determine a bank’s real-world exposure to potential losses. Regulators then use the risk-weighted total to calculate how much loss-absorbing capital a bank needs to sustain it through difficult markets’ [30]. PFE is classified as RWA and hence affects the banks regulatory capital and potentially may have an impact on global financial stability [31]. In recognition of the importance of PFE and other risk factors, the Bank of International Settlements (BIS) since 2014 has mandated a standardised methodology for measurement of counterparty credit exposures including PFE, due to inadequacies in the previous models [32] [33].

The PFE credit limit increases the overall credit exposure of the customer to the bank, as this credit limit ‘utilises’ some of the overall credit capacity or credit appetite a bank has for exposure to a particular customer. This credit capacity can also be thought of as the ‘equity headroom’ which a customer may have available for a given level of security to the bank [34]. In practice, this means a bank will assess its total exposure to a customer when looking at its overall credit appetite for a customer. The PFE is not be an actual amount of additional debt that a customer can borrow but it utilises some of the overall credit ‘capacity’ of a customer. This means that this could reduce the amount a customer could borrow both at the prevailing time and in the future. Furthermore, once a derivative has matured (or has been liquidated), the PFE in respect of that derivative would no longer apply to the customer and would liberate more credit capacity. The utilisation of credit capacity can have adverse consequences for a customer where they may erroneously believe they have headroom to borrow further funds (for a given amount of security), but latterly discover they are unable to so due when the total credit utilisation including the PFE and other non-lending limits that are taken into account [35].

In terms of bank security, if interest rates fall by a greater amount than the bank had accounted for, a bank may have the right to request customers to provide additional collateral or security to cover the additional liability. If a customer is unable to provide extra collateral, there is a risk that any covenants with a bank may be breached. There may also be consequences in terms of the bank taking of security for credit risk. For example, where a loan has been repaid and the bank has a charge over assets as security, the borrower may erroneously believe the charge will be lifted after repayment. However, if there is continuing derivative exposure (which is not unusual for customers with multiple loans), there may still be a requirement for a charge over customer assets by the bank in order to secure itself against any liabilities – as the bank will not wish to have substantial unsecured credit exposures. Hence the customer may not be free to do with his chattels as he wishes until the bank releases the charge over assets.

Derivatives can also entail other risks that may bring hazards for the unwary. Though loans and interest rate derivatives are typically separate legal constructs (the exception being fixed rate loans as noted), they may in their extensive documentation contain cross default clauses. The effect of these can be that once a loan is liquidated or even over paid, it may trigger the automatic breakage of an associated derivative that is hedging a loan. Without knowledge of this, a borrower who is taking a portfolio approach to hedging (using derivatives to hedge multiple loans – not an uncommon approach in larger loan portfolios), may find themselves unhedged and/or exposed to adverse break costs through the simple act of over paying their loan. The counterargument to this is perhaps that their legal advisors should have warned them of this risk – if indeed any advice was taken before the transactions were entered into. However, there is often a reliance on the bank counterparty for advice and information given the informational asymmetries. In this case, the advice is not independent.

4. Derivatives are a specialised area of finance and hence non-bank counterparties typically rely heavily on the bank counterparty for information and advice in respect of derivatives. This knowledge asymmetry and difficulty in knowing the risks and their consequences in derivative transactions has been shown to be a major concern for many companies [36].

The UK Supreme Court judge Lord Sumpton in Plevin v Paragon Personal Finance Limited 2014 recognised the dangers of information asymmetry, though commenting on Payment Protection Insurance (PPI), the point is equally valid for complex instruments such as derivatives: ‘the provision to a financially unsophisticated debtor of bad advice or no advice about the suitability of a relatively complex product like PPI will commonly result in a one- sided relationship substantially limiting the debtor’s ability to choose’ [37]. Most counterparties to derivative trades can be considered to be ‘unsophisticated’ customers, in that they are not derivative experts.

As mentioned, most derivative transactions take place between unequal counterparties. Would enhanced information disclosure improve outcomes? If we take a straightforward case where a derivative is used for hedging purposes and the hedge performs well or alternatively for speculation and a profit is made. At face value it may seem that enhanced information disclosure would add little in these circumstances. However, this is to ignore the benefits of a more equal balance of information. If a customer understands a transaction better (through disclosure, advice or education), even if the investment performs well, they may make the same choice – but it will be a fully informed choice. Secondly, a customer armed with improved knowledge may make a different and hopefully better choice. This is not necessarily of benefit to both parties – for example where a customer chooses a different course of action based on enhanced knowledge, the bank would perhaps be giving up profit by the customer having the knowledge to make a better choice [38].

The investor Warren Buffet described derivatives as ‘financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal’ [39]. Buffett also said he would ‘deal with derivatives by requiring every CEO to affirm in his annual report that he understands each derivatives contract his company has entered into….and I suspect you’ll fix up just about every problem that exists’ [40]. Buffet identifies many of the problems of derivatives and knowledge of their risks. The risks may be latent, not obvious or even hidden from the unwary. However, the consequences of when they ‘blow up’ can be significant. Mr Buffet by suggesting that CEO’s effectively underwrite derivative positions graphically illustrates other problems of derivatives. Knowledge of their existence and exposure to them may be imperfect due to indirect effects of derivatives. Additionally, it is unlikely that a CEO will understand all the risks of derivatives sufficiently – perhaps he or she should be taking expert independent advice before agreeing to them. Buffet is effectively saying that derivative positions should not entered into unless absolutely necessary, as he recognises their hazards.

More recently the criticism of derivatives and their risks has also come from more spiritual quarters – the Vatican. The current Pope Francis has called derivatives markets a ‘Ticking Time Bomb’ [41].  The Vatican has said that in certain areas of the derivatives markets there’s an ‘ethical void which becomes more serious as these products are negotiated on the so-called markets with less regulation (over the counter) and are exposed more to the markets regulated by chance, if not by fraud, and thus take away vital life-lines and investments to the real economy’ [42]. Again this is a recognition of the risks of derivatives, particularly in OTC transactions, which as noted are often between parties with significant informational asymmetries, but also that the risks are of consequence beyond the direct counterparties, but to the whole economy. Herein is the crux of the issue with derivatives: despite their risks they are useful and significant components of the financial system, but when they do not function as expected they can have catastrophic consequences – not only for the direct parties but also the wider financial system. However, the requirement to disclose risks is partial and incomplete. It also raises the question as to whether counterparties should be responsible for discovering the risks themselves and if there is a wider capacity question of whether a non-expert would be able to fully comprehend all the risks.

Naturally, banks will not want the additional burden (and potential) liability for explaining derivative risks in full. However, for some financial products (for example mortgages), banks are required in addition to explaining key risks, to ensure customers seek independent legal advice [43]. If this were also the case for derivatives, this would have the effect of deflecting some of this risk away from banks. It may also be beneficial for derivative sellers (who are principally banks) to not disclose all risks. If customers had perfect knowledge and the benefit of price transparency, derivatives would not be as profitable. Despite the potential advantages to customers and financial stability of improved disclosure in respect of derivatives, the aphorism scientia potentia est (i.e. knowledge is power) appears also to be the case in respect of derivatives [44]. If your counterparty has full knowledge, your ability to profit will be diminished, hence the motivation for removing or reducing informational asymmetries between counterparties is lacking on behalf of banks.

Author

Martin Berkeley is Director of Corvinus Capital, guest lecturer in financial regulation at the University of Reading, Law School and invited MBA financial markets course lecturer at Alliance Business School Manchester; email: martin.berkeley@corvinuscapital.com

[1] Sergey Chernenko; Michael Faulkender. The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps. (December 2011) The Journal of Financial and Quantitative Analysis. 46 (6).

[2] MiFID2, Art 19.

[3] See the Financial Conduct Authority, Conduct of Business Rules (COBS), particularly COBS 14.

[4] $544 trillion notional outstanding at June 2016, source International Swaps and Derivatives Association, Facts and Figures, June 2016.

[5] For helpful illustration of the potential complexity of derivative trades, see The European Structured Investment Products Association (EUSIPA) See their Derivatives Map at: https://eusipa.org/governance/#EusipaDMap.

[6] Bank of International Settlements, OTC derivatives statistics at end June 2017, https://www.bis.org/publ/otc_hy1711.htm.

[7] Hazell v. Hammersmith & Fulham L.B.C (1990) 2 QB 697.

[8] Ibid Wolff LJ at 739.

[9] Basis Risk is price dislocations occur where different reference indices are used, see Basel Committee on Banking Supervision, Consultative Document Interest rate risk in the banking book, 4.3, p31, 11 September 2015.

[10] Alistair Hudson, The Law of Financial Derivatives, 3rd edn, 38, 2002.

[11] OTC derivative truncations make up nearly 95% of the derivatives market, Source: European Commission, European Market Infrastructure Regulation definitions, https://ec.europa.eu/info/business-economy-euro/banking-and-finance/financial-markets/post-trade-services/derivatives-emir_en.

[12] European Commission, Derivatives (EMIR) Regulation (EU) No 648/2012, https://ec.europa.eu/info/law/derivatives-emir-regulation-eu-no-648-2012_en.

[13] ESMA Trade Repositories, https://www.esma.europa.eu/supervision/trade-repositories.

[14] Christopher Whalen, Yield to Commission: Is an OTC Market Model to Blame for Growing Systemic Risk? (2008) 14.2 Journal of Structured Finance 8, 11.

[15] Historically in the UK loans (including fixed rate loans) have not been considered investments and hence not subject to the same regulatory provisions as designated investments such as derivatives. This has led to considerable confusion as the fixed rate loan has effectively the same features and risks as a swap. This confusion and ambiguity was expressed by the House of Commons Treasury Select Committee when hearing Oral Evidence on SME Lending , 17 June 2014, questions 392-656, Q435 between Mr Brooks Newmark MP and Mr David Thorburn, CEO of Clydesdale bank: ’Mr Newmark: David, I may be flogging a dead horse here but I am really fascinated by this. What is the difference between the break­ cost calculation of a standalone fixed­ rate interest­ rate hedging product and a fixed­ rate tailored business loan because there seems to be some sort of difference between the two? David Thorburn: No, there is no difference. They are one and the same’.

[16] Khader Shaik in Managing Derivatives Contracts, Apress 2014, Ch 3, 68-72, identifies the following principle types of derivative risk: Market, Credit, Counterparty, Concentration, Operational, Liquidity, Legal, Model, Settlement, Systemic, Compliance, Reputational.

[17] It may be seen counterintuitive to the non-expert, but as interest rates fall, break costs increase in interest rate derivatives where used for hedging.

[18] FSA, Interest Rate Hedging Products – pilot findings, March 2013.

[19] IRHPs stand for Interest Rate Hedging Products.

[20] FSA, Interest Rate Hedging Products – pilot findings, March 2013. The FSA made similar submissions in the matter of Green and Rowley v RBS 2012 EWHC 3661 (QB).

[21] PFE (Potential Future Exposure) is known variously as Potential Credit Risk (PCR), Credit Limit Utilisation (CLU), Credit Equivalent Liability (CEL), Credit Equivalent Exposure (CEE) and/or Contingent Liability (CL). Different banks use different terminology to describe the same risk.

[22] In addition to PFE, the major components of counterparty risk are Current Credit Risk, also known as current exposure, which is the risk that a counterparty will not pay what is already currently due. There is a risk that a counterparty may declare bankruptcy in the future because of the current liabilities owed to other parties.

[23] Khader Shaik, Managing Derivatives Contracts, Ch3. Derivatives and Risk Management, 69, (2014).

[24] See London Executive Aviation v RBS 2018 EWHC 74 (Ch), para 34.

[25] For an example of bank provisions see http://lexicon.ft.com/Term?term=loan_loss-provision.

[26] For example, see Property Alliance Group Limited v. The Royal Bank of Scotland PLC 2018 EWCA Civ 355 and Ramesh Jadavji Parmar and Rama Ramesh Parmar v. Barclays Bank PLC 2018 EWHC 1027 (Ch), see Paul Marshall, Disclosure of risk in SME swap transactions: the Court of Appeal wreaks havoc with accepted principles, Butterworth Journal of International Banking and Financial Law, Vol 33, 5 May 2018, 282-287, for analysis of the current legal position.

[27] Dentons, Barclays successfully defends first swap mis-selling claim involving a claim by individuals for breach of statutory duty, 16 May 2018, https://www.dentons.com/en/insights/alerts/2018/may/16/barclays-successfully-defends-first-swap-misselling-claim-involving-a-claim.

[28] Financial Stability Board, List of global systemically important banks (G-SIFs) http://www.financialstabilityboard.org/wp- content/uploads/r_141106b.pdf.

[29] The Economist, Whose model is it anyway? 19 September 2015 http://www.economist.com/news/finance-and- economics/21665039-regulators-are-taking-firmer-stand-how-banks-gauge-risk-whose-model-it.

[30] Financial Times Lexicon: Risk Weighted Assets. http://lexicon.ft.com/Term?term=risk_weighted-assets.

[31] Bank of International Settlements: Basel Committee on Banking Supervision, An Explanatory Note on the Basel II IRB Risk Weight Functions, July 2005.

[32] For a comprehensive overview of the complex processes involved with PFE and regulatory capital: Bank of International Settlements: Basel Committee on Banking Supervision, The Standardised approach to measuring counterparty credit risk exposures 2014.

[33] RWA as a methodology is not without its critics and a major weakness of the new Basel III standards is its failure to address the weaknesses of RWA exposed by Basel II, see Rogoff K, Ending the Financial Arms Race 6 September 2012.

[34] This why some banks, for example the Royal Bank of Scotland describes the PFE as ‘CLU’ (Credit Limit Utilisation).

[35] Other non-lending limits would include where the bank still has a risk exposure, which it must manage but are not strict ‘lending’ limits as such, for example trade finance lines or card back risk in merchant credit cards.

[36] Of 800 UK based companies surveyed the lack of ability to assess risks and fundamental knowledge of derivatives were cited as chief concerns: Chris Mallin, Kean Ow-Yong, and Martin Reynolds, Derivatives usage in UK non-financial listed companies (2001) 7.1 The European Journal of Finance 63, 77.

[37] Plevin v Paragon Personal Finance Limited 2014 UKSC 25.

[38] An example would be where a customer perhaps chooses a premium paid interest rate cap. As the premium is paid upfront by the customer it is harder for a bank to ‘hide’ profit. In a non-premium derivative, such as a swap no premium is typically paid, but the profit is embedded within the structure. Without detailed knowledge of how the structure works, the pricing and access to the underlying market data it will be difficult for a customer to learn the true level of profit being earned by the bank.

[39] Warren Buffet, Letter to Investors 17 March 2003.

[40] Warren Buffet, Letter to Investors 20 March 1995.

[41] Sridhar Natarajan, Bloomberg Markets, Pope Calls Derivatives Market a ‘Ticking Time Bomb’, 17 May 2018.

[42] The Vatican, Oeconomicae et pecuniariae quaestiones’. Considerations for an ethical discernment regarding some aspects of the present economic-financial system of the Congregation for the Doctrine of the Faith and the Dicastery for Promoting Integral Human Development, 17 May 2018.

[43] These are regulated and advised financial products and failure to advise clients to seek independent legal advice has been a cause of criticism for banks in respect of misrepresentation or undue influence There is extensive case law in respect of undue influence in regulated mortgage contracts, for example Barclays Bank Plc v O’Brien 1993 UKHL 6, CIBC Mortgages Plc v Pitt 1993 UKHL 7, Royal Bank of Scotland Plc v Etridge (No 2) 2001 UKHL 44.

[44] Attributed to Thomas Hobbes, The Leviathan, Volume III, 69 (1668).

References

[[1]] Sergey Chernenko; Michael Faulkender. The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps. (December 2011) The Journal of Financial and Quantitative Analysis. 46 (6).

[[2]] MiFID2, Art 19.

[[3]] See the Financial Conduct Authority, Conduct of Business Rules (COBS), particularly COBS 14.

[[4]] $544 trillion notional outstanding at June 2016, source International Swaps and Derivatives Association, Facts and Figures, June 2016.

[[5]] For helpful illustration of the potential complexity of derivative trades, see The European Structured Investment Products Association (EUSIPA) See their Derivatives Map at: https://eusipa.org/governance/#EusipaDMap.

[[6]] Bank of International Settlements, OTC derivatives statistics at end June 2017, https://www.bis.org/publ/otc_hy1711.htm.

[[7]] Hazell v. Hammersmith & Fulham L.B.C (1990) 2 QB 697.

[[8]] Ibid Wolff LJ at 739.

[[9]] Basis Risk is price dislocations occur where different reference indices are used, see Basel Committee on Banking Supervision, Consultative Document Interest rate risk in the banking book, 4.3, p31, 11 September 2015.

[[10]] Alistair Hudson, The Law of Financial Derivatives, 3rd edn, 38, 2002.

[[11]] OTC derivative truncations make up nearly 95% of the derivatives market, Source: European Commission, European Market Infrastructure Regulation definitions, https://ec.europa.eu/info/business-economy-euro/banking-and-finance/financial-markets/post-trade-services/derivatives-emir_en.

[[12]] European Commission, Derivatives (EMIR) Regulation (EU) No 648/2012, https://ec.europa.eu/info/law/derivatives-emir-regulation-eu-no-648-2012_en.

[[13]] ESMA Trade Repositories, https://www.esma.europa.eu/supervision/trade-repositories.

[[14]] Christopher Whalen, Yield to Commission: Is an OTC Market Model to Blame for Growing Systemic Risk? (2008) 14.2 Journal of Structured Finance 8, 11.

[[15]] Historically in the UK loans (including fixed rate loans) have not been considered investments and hence not subject to the same regulatory provisions as designated investments such as derivatives. This has led to considerable confusion as the fixed rate loan has effectively the same features and risks as a swap. This confusion and ambiguity was expressed by the House of Commons Treasury Select Committee when hearing Oral Evidence on SME Lending , 17 June 2014, questions 392-656, Q435 between Mr Brooks Newmark MP and Mr David Thorburn, CEO of Clydesdale bank: ’Mr Newmark: David, I may be flogging a dead horse here but I am really fascinated by this. What is the difference between the break­ cost calculation of a standalone fixed­ rate interest­ rate hedging product and a fixed­ rate tailored business loan because there seems to be some sort of difference between the two? David Thorburn: No, there is no difference. They are one and the same’.

[[16]] Khader Shaik in Managing Derivatives Contracts, Apress 2014, Ch 3, 68-72, identifies the following principle types of derivative risk: Market, Credit, Counterparty, Concentration, Operational, Liquidity, Legal, Model, Settlement, Systemic, Compliance, Reputational.

[[17]] It may be seen counterintuitive to the non-expert, but as interest rates fall, break costs increase in interest rate derivatives where used for hedging.

[[18]] FSA, Interest Rate Hedging Products – pilot findings, March 2013.

[[19]] IRHPs stand for Interest Rate Hedging Products.

[[20]] FSA, Interest Rate Hedging Products – pilot findings, March 2013. The FSA made similar submissions in the matter of Green and Rowley v RBS [2012] EWHC 3661 (QB).

[[21]] PFE (Potential Future Exposure) is known variously as Potential Credit Risk (PCR), Credit Limit Utilisation (CLU), Credit Equivalent Liability (CEL), Credit Equivalent Exposure (CEE) and/or Contingent Liability (CL). Different banks use different terminology to describe the same risk.

[[22]] In addition to PFE, the major components of counterparty risk are Current Credit Risk, also known as current exposure, which is the risk that a counterparty will not pay what is already currently due. There is a risk that a counterparty may declare bankruptcy in the future because of the current liabilities owed to other parties.

[[23]] Khader Shaik, Managing Derivatives Contracts, Ch3. Derivatives and Risk Management, 69, (2014).

[[24]] See London Executive Aviation v RBS [2018] EWHC 74 (Ch), para 34.

[[25]] For an example of bank provisions see http://lexicon.ft.com/Term?term=loan_loss-provision.

[[26]] For example, see Property Alliance Group Limited v. The Royal Bank of Scotland PLC [2018] EWCA Civ 355 and Ramesh Jadavji Parmar and Rama Ramesh Parmar v. Barclays Bank PLC [2018] EWHC 1027 (Ch), see Paul Marshall, Disclosure of risk in SME swap transactions: the Court of Appeal wreaks havoc with accepted principles, Butterworth Journal of International Banking and Financial Law, Vol 33, 5 May 2018, 282-287, for analysis of the current legal position.

[[27]] Dentons, Barclays successfully defends first swap mis-selling claim involving a claim by individuals for breach of statutory duty, 16 May 2018, https://www.dentons.com/en/insights/alerts/2018/may/16/barclays-successfully-defends-first-swap-misselling-claim-involving-a-claim.

[[28]] Financial Stability Board, List of global systemically important banks (G-SIFs) http://www.financialstabilityboard.org/wp- content/uploads/r_141106b.pdf.

[[29]] The Economist, Whose model is it anyway? 19 September 2015 http://www.economist.com/news/finance-and- economics/21665039-regulators-are-taking-firmer-stand-how-banks-gauge-risk-whose-model-it.

[[30]] Financial Times Lexicon: Risk Weighted Assets. http://lexicon.ft.com/Term?term=risk_weighted-assets.

[[31]] Bank of International Settlements: Basel Committee on Banking Supervision, An Explanatory Note on the Basel II IRB Risk Weight Functions, July 2005.

[[32]] For a comprehensive overview of the complex processes involved with PFE and regulatory capital: Bank of International Settlements: Basel Committee on Banking Supervision, The Standardised approach to measuring counterparty credit risk exposures 2014.

[[33]] RWA as a methodology is not without its critics and a major weakness of the new Basel III standards is its failure to address the weaknesses of RWA exposed by Basel II, see Rogoff K, Ending the Financial Arms Race 6 September 2012.

[[34]] This why some banks, for example the Royal Bank of Scotland describes the PFE as ‘CLU’ (Credit Limit Utilisation).

[[35]] Other non-lending limits would include where the bank still has a risk exposure, which it must manage but are not strict ‘lending’ limits as such, for example trade finance lines or card back risk in merchant credit cards.

[[36]] Of 800 UK based companies surveyed the lack of ability to assess risks and fundamental knowledge of derivatives were cited as chief concerns: Chris Mallin, Kean Ow-Yong, and Martin Reynolds, Derivatives usage in UK non-financial listed companies (2001) 7.1 The European Journal of Finance 63, 77.

[[37]] Plevin v Paragon Personal Finance Limited [2014] UKSC 25.

[[38]] An example would be where a customer perhaps chooses a premium paid interest rate cap. As the premium is paid upfront by the customer it is harder for a bank to ‘hide’ profit. In a non-premium derivative, such as a swap no premium is typically paid, but the profit is embedded within the structure. Without detailed knowledge of how the structure works, the pricing and access to the underlying market data it will be difficult for a customer to learn the true level of profit being earned by the bank.

[[39]] Warren Buffet, Letter to Investors 17 March 2003.

[[40]] Warren Buffet, Letter to Investors 20 March 1995.

[[41]] Sridhar Natarajan, Bloomberg Markets, Pope Calls Derivatives Market a ‘Ticking Time Bomb’, 17 May 2018.

[[42]] The Vatican, Oeconomicae et pecuniariae quaestiones’. Considerations for an ethical discernment regarding some aspects of the present economic-financial system of the Congregation for the Doctrine of the Faith and the Dicastery for Promoting Integral Human Development, 17 May 2018.

[[43]] These are regulated and advised financial products and failure to advise clients to seek independent legal advice has been a cause of criticism for banks in respect of misrepresentation or undue influence There is extensive case law in respect of undue influence in regulated mortgage contracts, for example Barclays Bank Plc v O’Brien [1993] UKHL 6, CIBC Mortgages Plc v Pitt [1993] UKHL 7, Royal Bank of Scotland Plc v Etridge (No 2) [2001] UKHL 44.

[[44]] Attributed to Thomas Hobbes, The Leviathan, Volume III, 69 (1668).

Advertisements
%d bloggers like this: