International Financial Law - Article Example

International Financial Law Introduction Global finance is one of the most globalised and at the same time the most mysterious spheres in the world economy. Amongst global finance, maybe no activity is more mystical and more complex to comprehend than the trading in derivatives. The terms – options, futures, swaps, forwards – used in the world of derivatives are some what familiar but their temperament is vague. Thus we can define derivatives as financial instruments which are used to hedge risk. If a Corporation knows that it will need to purchase 50 million dollars on foreign exchange markets within a span of three months, then in that case it can organise a fixed price for that leverage with the help of a financial contract known as derivative. This results in the lowering of the risk in the cost of the currency altering significantly before it buys the amounts it requires. Thus derivatives are significant because they have turned out to be a very big business in global finance. Grant and Marshall (1997) in the UK executed a survey on derivatives utilisation in big UK companies and established that most big companies use derivatives which are most frequently utilised to deal with foreign exchange and interest rate risks. What are Derivatives? Derivatives are normally used to hypothesize, keep transactions off-balance sheet and surreptitiously, boost leverage, arbitrage rigid and tax rules and produce unusual risk cocktails. “Derivatives are usually valued according to their ‘notional amount’ meaning the market value of the assets or debt balance on which payments are based” (Brealey and Meyers, 1996). Warren Buffett, who is the American investment guru, stated that derivatives are "financial weapons of mass destruction". These were currency that facilitated banks, hedge funds and other speculators to create billions when once the Wall Street was good. Thus it can be inferred that anything which has a price can generate a derivatives market because they are instruments which has the capacity of financial contracts and can be sold so that the risk involved can be passed on to others. One such example is the credit or bond derivatives market. It is believed that speculation in this field alone is valued at more than $56 trillion (£33 trillion). This estimation may seem to be underestimated because the real figure since lax ordinance exploded the market over the preceding two years. In a way, derivatives personify globalization because they allow individuals and firms to be in charge of price regardless of time and place that to for an acknowledged fixed cost. Derivatives have thus become targets of speculation, contributing to trillions of dollars splashing about the globe on a weekly basis. During the 1980s and 1990s, the derivative instruments markets have evolved and grown at a tremendous pace, and numerous corporations have taken active participation in derivatives markets. Since then, the variety and value of both exchange-swapped and OTC derivatives, collectively with the intensity of the market for such tools, have enlarged intensively (Allen and Santomero, 1998). For instance, Schering-Plough a Pharmaceuticals industry with its headquarters at Kenilworth in New Jersey, in its 1995 yearly report (page 25) contends that: “To date, management has not deemed it cost-effective to engage in a formula-based program of hedging the profitability of these operations using derivative financial instruments. Some of the reasons for this conclusion are: The Company operates in a large number of foreign countries; the currencies of these countries generally do not move in the same direction at the same time". Thus a derivative security is a financial tool whose economic value reckons on the measures of other tangible or intangible assets. In current years, derivatives have developed and become progressively vital in the domain of finance. The argument on derivatives went on for a decade. In 1998, Brooksley Born, the then head of the Commodity Futures Trading Commission, foretold derivatives as unsafe and desired to control the industry. There are a lot of original derivative instruments utilised by companies to deal with their vulnerabilities to foreign exchange risks like forward contract, swaps, futures contracts and options. Each of these techniques disagrees in the way they are enforced in each company’s situation. Evan Davies one of BBC’s former economic editor and presenter, stated in a documentary - The City Uncovered with Evan Davis: “Banks and How to Break Them (January 14, 2008), rating agencies were paid to rate these products (risking a conflict of interest) and invariably got good ratings, encouraging people to take them up.” The recent financial meltdown was not actually because of the derivatives market but it did step up the meltdown once the sub prime mortgage collapsed. Derivatives inspired the financial markets and will probably stay here for years to come since there is a huge demand for insurance and palliating risk. The dispute now, as summarised by Davis is to control in the riskier nimiety of derivatives to shun those exceedingly costly tragedies and put off more economic depression happening again. Speculation in Derivatives Market Quigley (1966) had commented in those days that "the powers of financial capitalism had another far-reaching aim, nothing less than to create a world system of financial control in private hands able to dominate the political system of each country and the economy of the world as a whole. This system was to be controlled in a feudalist fashion by the central banks of the world acting in concert, by secret agreements arrived at in frequent private meetings and conferences. The apex of the system was to be the Bank for International Settlements in Basel, Switzerland; a private bank owned and controlled by the worlds central banks which were themselves private corporations." A speculator may enter into a contract to purchase 100 shares in a company six months from now at $50 each. This means that he is making a bet that in six months the price of each share will be more than $50/share. This will help him to buy the stock at the $50 price now and then instantaneously sell it at a higher price, thus realising a profit. The economic theory of Bourgeois states that it is logical and acceptable to permit this sort of gambling on the basis that a wise use of derivatives can function as a kind of insurance to guard those who presently own, or who in the future may require to purchase goods or other real assets, from unanticipated price variations. But this theory is not flaw less and it can be argued that while this type of gambling can certainly reduce the risks of market for that company but at the same time it is also possible that the altered risks may be transferred to other speculators. Actually the stock market is a colossal Ponzi1 scheme, which allows for derivatives to be based on stock prices and acts as a means and serves to exaggerate this Ponzi aspect. This is the reason that derivatives greatly increase the speculative and unstable quality of modern financial capitalism. But since huge profits are also made it can be said that derivatives will never be did away with or cannot even be totally controlled. They will remain till capitalism exists. Regulations in the European Derivatives Market According to the United Nations Conference on Trade and Development (2009) “Financial regulation should be aimed at reducing the proliferation of such instruments which seem to be more efficient at masking the risk to investors than in minimizing it”. The huge degree of thick derivatives dealings was a key cause of the financial crisis. Derivatives markets have made goods and other prices more fickle, and have produced huge deprivations, destabilising economies. The regulative standards that the European Union and other powers are presently studying on certain kinds of derivatives are poor. They should be substituted by bolder standards to govern finance for the welfare of citizens in Europe and throughout the world. The problem for regulators is because most derivatives trades are inconspicuous because they are dealt “Over the Counter” (OTC). This means that the trade takes place between two companies without any exchange. This is the reason that OTC derivatives have developed very much over the past years. The lofty level of derivatives trading, particularly in OTC markets last year, produced vast departures and destabilised the complete financial markets. This resulted in multiple organisations unwinding their situations at the same time, thus forcing down prices.2 Credit default swaps are a type of derivative which are utilised as insurance against the danger of companies defaulting and this has demonstrated to be very harmful. Derivatives may be divided into 5 types - contracts: Swap, Forward, Future, Option and Repo which is the forward contract applied by the ECB to deal with liquidity in the European inter-bank market (Hull, 2002). Bryan and Rafferty (2006) suggest that “derivatives are conceived as keystones of “capital’s own system of regulation, as “they are transforming the system of calculation under capitalism, intensifying the process of competition between capitals, with direct pressure on labour. They also agree that Furthermore, derivatives enhance capital’s ability to dominate and expand on the global scale: They blend together all possible forms of yield and thus make possible the direct comparison of profitability between different assets or ‘investments’ on a global scale.” They further add that “Assets that do not meet profit-making benchmarks must be depreciated, restructured and/or sold” Former practical works on derivative usage in UK companies centralised on big companies (Grant and Marshall 1997). Previous experimental works which were carried out to inspect the management of foreign exchange risk of UK companies also focussed on the management of precise vulnerabilities like transaction and translation exposure (Collier and Davies 1985, Belk and Glaum 1990) or economic disclosure. Graph: Size of the derivatives market, in trillion $US Source: Marta Ruiz, 2010 European Union derivatives regulation: Too little too late? A Eurodad briefing. Financial models before the collapse of the financial market and after Source: David Haas, 2008. The “Stable Model” supra depicts that there is space for derivatives on the macroeconomic scene. This is possible only till they are kept for a very short period and applied only with intensions to support producers. This would help them to deal the risks of vivid changes in markets on which they reckon for raw materials to be used in production. Source: David Haas, 2008. Donmez and Yilmaz (1999) examined many striking disruptions regarding derivatives markets and they concluded that “they do not seem to create new risks, but only change the type, structure and nature of the existing”. Hunter and Smith (2002) stated that “with derivatives the lender of last resort function is not changed in its scope, but in its concrete management. The needs for the use of derivatives have been extensively examined by investigators, with the direction on whether firms used derivatives for hedging uses to capitalize on shareholder wealth or for speculation. According to Bartram et al (2003) there is very strong evidence to the use of derivatives for risk management rather than not only speculation. Thus derivatives serve two way purposes. For instance “firms that use Foreign exchange derivatives have higher proportions of foreign assets, sales, and income and firms that use interest rate derivatives have higher leverage” Bartram et al (2003). Of course the use of Interest rate swaps has come to a lot of criticisms as well. In the case of Hazell v Hammersmith and Fulham London Borough Council3 it was held by the House of Lords that “interest rate swaps entered into by local authorities (a popular method of circumventing statutory restrictions on local authorities borrowing money at that time) were all ultra vires and void, sparking a raft of satellite litigation.” In the case of Kenilworth BENSON LTD v south Tyneside Metropolitan Borough Council4 the contemporary systematisation of restitution law has been corroborated by the principle that “unjust enrichment” should be countermanded. The House of Lords discerned an autonomous law of restitution established on this principle and not on connoted contract. The House of Lords in this case held that, “The enrichment must have been at the expense of the claimant. This simply means that it was obtained directly from the claimant. It is in this context that defendants have tried unsuccessfully to raise a defence that the claimant has “passed on” his expense to a third party. In some of the “swaps” cases10 the defendant argued that the claimant had suffered no loss because it had entered into parallel, hedging contracts with third parties, offsetting losses arising from its contract with the defendant. The defence was rejected, on grounds that such individual hedging contracts were too remote to be taken into account; and because the law of restitution is concerned with the defendant’s gain and not the claimant’s loss.” At the same time in the case of Westdeutsche Landesbank Girozentrale v Islington London Borough Council5 Lord Browne-Wilkinson said: “[I]n order to show that the local authority became a trustee, the bank must demonstrate circumstances which raised a trust for the first time either at the date on which the local authority received the money or at the date on which payment into the mixed account was made.” This remains an area of powerful disagreement. What still requires to be done to forbid harm to economies and citizens? EU regulators have begun to obtain measures to control derivatives but in reality these lack all the prerequisites to what is actually required to fend off lawless speculative behaviour. Much more wide-ranging measures are required. Many of the present measures are dealt with particular types of derivatives, mostly credit default swaps (CDS), leaving alone others and, more disturbingly, leaving the option for new kinds of derivatives to break away from regulation. OTC markets permit the creation of over complex intersections that admit powerful and risky speculation and cannot be regulated. Thus it has to be ruled that all derivatives hence forward have to be traded in the exchanges market and that too under the severe power of publicly monitored clearing houses. This has by now been effectively enforced in the yesteryears in some US markets.6 It has to be noted that many institutions which deal in derivatives must be openly regulated. Additionally, ordinances should also be able to deal with any other firms occupied in derivatives whose actions in these markets can produce great vulnerabilities to counterparties. The recent financial disaster should be taken seriously and that the derivatives trading actions of a single firm can jeopardise the full financial system. Thus all such firms should be focused to vigorous regulation. By completely governing the institutions that deal or hold themselves out to the public as derivative dealers regulating the complete derivatives market becomes a possibility. The laws should be rectified to allow for the enrolment and regulation of all derivative dealers. The complete, obligatory directive of all derivatives dealers would signify a vivid alteration from the present statutory organisation in which some dealers can control with fixed or no effective oversight. Many kinds of derivatives must not any more be permitted. Every country should establish a financial products safety commission and such commission will decide whether certain deals or credits are allowable. This would work in the same way as the determinations by the US Food and Drug Administration which resolves whether medicinal and food productions can be sold.7 This must, for instance, enforce to suggested new derivatives like those on carbon, which endangers to be a new bubble.8 Conclusion We can conclude by saying that the law for the speculators does not have any ethics. Regulations have to be changed in order to bring speculation in the derivatives market under control. Differences in the concentration of regulatory oversight might end up preferring one market over another. This will also most likely trigger noteworthy economic losses and gains for individual nation states. Differences in regulative approaches might also cooperate, if not fully challenge, nation-states’ capability to comprehend degrees of risk in the global financial system. As Albrow (1997) suggests, “globalization theory puts on the agenda a whole set of concepts and of ways of thinking and theorizing that were forged for a period when nation-state authority was much more dominant and monopolistic in the international system than it is today.” The banks that control the OTC derivative markets are presently struggling to keep at bay many of the EC’s (European Commission) propositions. They seem to be very active in media reach. But the European Commission along with the decision-makers from Member States has to be strong and defend against this force. As an alternative they can achieve control on financial derivatives market by enacting measures which safeguards the public interest, and not just cater to a slender private one. Clearing houses also can support by increasing substantially the obligatory assurance deposit that traders have to deposit when making a trade9. The EC should establish deposit prerequisites on pragmatic confirmation and base on the defensive principle, instead of relying on the industry to come up with suitable figures. Reference and Bibliography 1. Albrow, Martin. 1997. “Travelling Beyond Local Cultures”. In John Eade, ed. Living the Global City: Globalization as a Local Process. London: Routledge. 2. Allen, Franklin and Anthony M. Santomero. 1998. “The Theory of Financial Intermediation,” Journal of Banking & Finance, Vol. 21, pp. 1461-85. 3. Bartram, S. M., Brown, G. W., Fehle, F. R. (2003) International evidence on financial derivatives usage, Economics Working Paper at WUSTL 4. Belk, P. A. Glaum, (1990) The Management of Foreign Exchange Risk in UK Multinationals; an Empirical Investigation, Accounting and Business Research Vol 21, pp.3-13 5. Bryan. D. and M. Rafferty. M. 2006. “Capitalism with Derivatives- A Political Economy of Financial Derivatives, Capital and Class”. New York: Palgrave-MacMillan 2006. pp. 8-66 6. Carroll Quigley. 1966 Tragedy and Hope: A History of the World in Our Time. New York, The Macmillan Company 7. Carbone. A., Castelli. G. and Stanley. H. E., 2004 "Time-Dependent Hurst Exponent in Financial Time Series," Physica A 344 p. 267-27. 8. Chen, S.-H., Lux. T. and Marchesi. M.2001. Testing for non-linear structure in an artificial financial market," Journal of Economic Behaviour & Organization 46(3), pp. 327-342. 9. Collier, P. and Davies, E. (1985). The management of currency transaction risk by UK multinational companies. Accounting and Business Research, 15, pp.327-334. 10. David Haas. 2008. “The Crushing Potential of Financial Derivatives.” Retrieved from http://www.haasfinancial.com on 9th April 2010 11. Donmez, C.A. and Yilmaz, M.K. 1999. “Do derivatives markets constitute a potential threat to the stability of the global financial system?” ISE Review, Vol. 3, No. 11, pp. 51-82. 12. Grant, K. and Marshall, A. P. (1997) Large UK companies and derivatives, European Financial Management, 3, pp.194-208. 13. Hull, J. 2002, “Options, futures and other derivatives.” fifth edition, Prentice Hall. 14. Hunter, W.C. and Smith, S.D. 2002. “Risk management in the global economy: a review essay”, Journal of Banking and Finance, No. 26, pp. 205-221. 15. Jr. Kelly. J. L. 1956. "A new interpretation of the Information Rate", Bell Syst. Tech. J. 35 p. 917 16. Kaizoji. T., and Kaizoji. M. 2003 “Exponential laws of a stock price index and a stochastic model,” Advances in Complex Systems 6 (3) p. 1-10, 17. Marta Ruiz. 2010 European Union derivatives regulation: Too little too late? A Eurodad briefing. 18. Richard A. Brealey & Stewart C. Meyers. 1996. “Principles of Corporate Finance” pp.711-729 19. Slanina. F., 1999. "On the possibility of optimal investment," Physica A 269, pp.554-563. 20. Wang. F., et al., 2005 "Scaling and Memory of Intraday Volatility Return Intervals in Stock Market," Phys. Rev. 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