Testimony, Senate Agriculture Committee, 12/16/98
 
 

My name is Martin Mayer. I am a guest scholar at The Brookings Institution, and I have written multiple books about, among other things, banking and finance. I am now engaged on a study for the Levy Institute of Bard College on risk reduction in the new financial architecture while I continue to work on a book about the Federal Reserve System, to be published by The Free Press. I speak only for myself, of course, and I am not a shill for the CFTC. I recognize that in the current dispute there is a considerable element of bureaucratic turf-grabbing. But the law gives CFTC jurisdiction over commoditized financial derivatives--many of which would otherwise, let me note, be illegal under the gaming and anti-bucket-shop laws of some states, including New York, which provides the governing law for most international swap contracts.⁽¹⁾ And our current situation demands at the least that the CFTC study reassertion of its role in the creation and sale of these instruments, which properly emplaced can make significant contributions to financial structures, but improperly applied can blow up with severe damage to the foundations of economic activity.

The simplest example of the folly of our current procedures is the creation of nondeliverable forwards--contracts which represent bets on the relative future value of two currencies. Last spring, various financial houses, not only hedge funds, bought short-term Russian government notes that paid annualized interest in rubles at rates of 25% to 50%. They financed these purchases by borrowing dollars at 6% and then sought to lock in their profits by entering into contracts that directly or indirectly would give them compensation for any decline in the relative value of the ruble over a period of 60 or 90 or 180 days. These contracts were written and sold by some of the world's largest banks--we know for sure that the list includes Deutsche Bank, Credit Suisse First Boston, Paribas, Credit Lyonnais and our own Lehman Brothers, Chase, Citigroup and Bankers Trust. And there were clearly others, some American. Those banks then entered into offsetting contracts with the big Russian banks, making a markup on the difference between what the Russian banks charged them and what they charged their customers.

Under the inadequate rules governing bank supervision in this country and elsewhere, the banks were then permitted to say that they had no exposure to changes in the value of the ruble. For each contract they had with an American entity--or Cayman Islands or Guernsey entity--that left them exposed to losses if the ruble lost value, they had an offsetting contract with a Russian entity that covered those potential losses. Without objection from their supervisors, they simply netted out the pairs of contracts on their books. To this day, nobody really knows the volume of these contracts, though the number appears to be somewhere north of $5 billion.

Most of these contracts have been defaulted on both sides. Some of our big international banks have said that the Russian actions of August 17^th, when the currency was floated and servicing stopped on government notes, constitute an Act of God which releases them from their contractual obligations. This means, incidentally, that at least some of them have not reported their losses under these instruments. A few banks have negotiated private deals with Russian state banks. To my knowledge, at least one group of nondeliverable forwards was quietly settled two weeks ago with Sperbank, the Russian government savings bank, paying 47c on the dollar. But the private Russian counterparties simply don't have access to the dollars--or, rather, the crooks who own them won't release the dollars they have secreted from their creditors.

Before we leave these instruments, let us note that they are not exclusively Russian. One of the things that has made the Korean situation so intractable is the existence of undeliverable forwards involving the won, the dollar, the yen and (in the case J. P. Morgan has brought under the laws of New York State, for $186 million, against a Korean bank which plausibly claims that Morgan swindled it) the Thai bhat.

If the banking regulators refused to permit the banks to net out these contracts, moved the goal lines in the Value At Risk calculations bank make on these instruments to increase the risk banks must carry with their own capital--and boosted the risk weighting of such instruments to something closer to the real risks involved--the banks and the hedge funds and the other financial houses would be forced to do their business in public, through exchange-traded currency futures and options. Instead of resting with derivatives traders eager for some extra bucks on their bonus, decisions about the creditworthiness of participants in the market would be made by the clearing house that became the counterparty in every trade. Daily open interest numbers would reveal the extent of the creation of such instruments, and large trader reports would keep supervisors informed of dangers both to the market and to the trader. And management attention would be flagged by changing prices in the market, published in the newspapers and available to everyone.

My article in the January-February issue of The International Economy goes into the relationship of nondeliverable forwards and the Long Term Capital Management fiasco. I have asked the publishers to send copies to members of this committee as soon as they become available.

To the extent that such instruments are indeed used to hedge other positions, exchange-traded contracts can do virtually anything custom-designed contracts can do, and in an emergency they will be more effective because they can be sold in a more liquid market. Finding a hedge for an exotic derivative can often be a trap. Nassim Taleb, whose Dynamic Hedging has become a key textbook for traders, tells a "war story" about a trader who hedged a discontinuous exposure with a continuous one, lost money on both as Long Term lost on both ends of its convergence trades, and "concluded with the following wisdom: Hedging increases your risks."⁽²⁾ This is roughly half a joke, but only half.

On the international scene, custom-made derivatives that rely on analyses of covariance among different currencies and interest rates in different countries become the vectors of contagion in time of trouble. To quote David Folkerts-Landau, formerly chief of capital markets research for the International Monetary Fund and now managing director of Emerging Markets Research for Deutsche Bank, "State of the art risk management methodology--endorsed by and imposed by industrial country regulators--is a primary source for the contagion effects of a crisis. . .[A]pparently bizarre operations that connect otherwise disconnected securities markets are not the responses of panicked green screen traders arbitrarily driving economies from a good to a bad equilibrium. Rather, they work with relentless predictability and under the seal of approval of supervisors in the main financial centers." The omitted sentences are a list of examples, which I commend to you as Paul Volcker commended them in October to the annual conference of the Group of Thirty; indeed, the entire document is fascinating.⁽³⁾

Again, the danger is greater because these are bilateral, secret contracts. And because they are carried off-balance-sheet, they can be almost infinitely leveraged. Even before the Thai, Korean, Indonesian and Russian experiences illustrated his point, Andrew Sheng, deputy c.e.o. of the Hong Kong Monetary Authority, argued that "bankers must be concerned not only with their net exposure, but also with their gross exposure. The current lack of transparency in derivatives trading means that many regulators are not aware of the true size of the risks being assumed by their banking systems. This blind spot, caused by financial innovation and liberalization, may be the biggest problem for regulators in the post-liberalization era. . . In the rush to liberalize as a correction to central planning and excessive regulation, many policymakers and their advisers lost themselves in the herd instinct, assuming that markets will always correct themselves. There was universal underestimation of the volatility of markets in a global world."⁽⁴⁾

Four years ago, Folkerts-Landau and Alfred Steinherr won the American Express brilliancy prize for an essay urging bank supervisors to guide their wards toward exchange-traded rather than custom-made derivatives.⁽⁵⁾ Their arguments are even more convincing today. Given our experiences in this decade and the weight of the argument that promiscuous creation of o-t-c derivatives can imperil the world financial structure, it is preposterous, even sinister, that the CFTC, charged with regulating this area, should be prohibited from undertaking a study of its reponsibilities.

One sympathizes with the banking and securities regulators. They are concerned that changes in information technology are reducing the value of the franchises they award, and that an ever-increasing proportion of the potential profits of their clients lies in exploiting the information advantages they retain in the area of o-t-c derivatives. But the externalities of this activity are clearly costly, arguably too costly. Surely the time has come to hear what case can be made by the one agency of government that has clients who will gain by restricting most derivatives activity to the standardized, publicized, transparent world of exchange trading.

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1. New York General Business Law, Article 23--Bucket Shops, Section 351, Acts Prohibited

2. Nassim Taleb, Dynamic Hedging: Managing Vanilla and Exotic Options. John Wiley & Sons, New York, 1997, p. 311

3. Global Emerging Markets, Deutsche Bank Research, October 1998, p. 79

4. Andrew Sheng, Bank Restructuring: Lessons from the 1980s, World Bank, Washington, D.C. 1996, pp. 178, 179

5. David Folkerts-Landau and Alfred Steinherr, "Derivatives: Taming the Beast," The Amex Bank Review, November 16, 1994