Chapter

Innovative Financial Instruments and Capital Flow Discrepancies

Author(s):
International Monetary Fund
Published Date:
June 1992
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Author(s)
Russ Krueger

This paper reviews the measurement of international capital flows and investment positions, and the problems that stem from the rapid innovations in financial derivatives and hedging instruments during the 1980s. These innovations created gaps in statistical coverage and may have significantly increased the uncertainty involved in estimating international capital transactions and investment positions.

Within a short time—mostly since 1984—a variety of financial instruments and techniques have been introduced that have grown to major importance in capital markets: interest rate and foreign currency swaps, floating-rate agreements, numerous forms of exchange-traded and over-the-counter options, warrants, swap options, strips, zero-coupon bonds, high- income subordinated debt (junk bonds), and asset-backed securities. Some of the innovations created serious measurement problems because statistical systems often mismeasure transactions involving these instruments, or miss them entirely. When the newer financial instruments are combined with more traditional ones, the economic behavior of the traditional instruments may change in ways that make existing statistical methodologies inaccurate or misleading.

The first section of this paper discusses some of the most important innovations in derivatives and hedging instruments—their origins, markets, and economic functions. The second section discusses specific problems in the measurement of these transactions and investment positions. The final section deals with possible remedies and areas of future research.

Instruments and Their Economic Functions

As expressed in the draft fifth edition of the Fund’s Balance of Payments Manual, “financial derivatives are secondary-market instruments that give the holder the right to receive an economic benefit” at some future date. The benefit may take the form of cash, a primary financial instrument, or some other financial product.

Rights for some instruments are qualified by, or contingent upon, a specified event. Derivatives are secondary instruments in that they are either linked to a primary instrument or a commodity (or some related indicator or index), which can be purchased or sold at a future date, or linked to the future exchange of one asset for another, according to a contractual arrangement.

Derivative instruments can be used to hedge risk exposure for investment or trading purposes. The instrument may be tradable and have a current-market value, and if so, “its characteristics as a contingent asset or liability. . .change, giving way to its treatment as an actual financial asset or liability in the current period, as evidenced by its current resale value.”1 Tradable derivative investments include options (on currencies, interest rates, commodities, and indexes), traded financial futures, warrants, and currency swaps. See Box 1 for definitions and descriptions of these instruments.

Markets in derivatives and hedges started slowly during the 1970s but began to grow rapidly around 1984. In part, rapid growth occurred because the instruments served three distinct economic purposes effectively. First, they provided hedges against interest rate, exchange rate, and other exposures. Second, many were suitable for speculation and arbitrage, resulting in large speculative markets both in public exchanges and in over-the-counter (OTC) markets. And third, the new instruments often piggy-backed on standard equity and debt instruments. In several instances, derivatives used in conjunction with standard instruments contributed, perhaps strongly, to an increased issuance of the standard instrument. For example, most of the surge in U.S. Eurobonds in 1984 and 1985 happened in conjunction with interest rate swaps.

Two key elements in the new instruments are that the functions of financial instruments can be unbundled, separately traded, and recombined in novel ways and that they are often off-balance-sheet transactions. Both features can create serious problems for statistical reporting. Unbundling refers to the decomposition of economic instruments into components, each of which can be separately priced and marketed. For example, a Eurobond may include an option guaranteeing redemption at a stated exchange rate. Often, that guarantee can be stripped from the underlying bond, separately priced, then resold to another party, such as an importer or exporter, wanting to hedge exchange rate risk. The stream of interest earnings on bonds can be stripped and separately marketed, creating two distinct financial instruments. Once elements are unbundled, they can be rebundled in innovative or customized ways that may fundamentally alter the instruments. For example, a fixed-rate Eurodollar bond can be transformed using an interest rate swap into a floating-rate obligation, which subsequently can be modified by purchasing a cap option that protects against rises in interest rates. Unbundled-rebundled instruments can behave much differently from the original instrument, and frequently no paper trail is left of the transformations. Existing international (or domestic) statistical compilation programs generally lack information on such innovations; if the repackaging is sufficiently large and not mutually offsetting, significant errors in recording capital flows can result.

Russ Krueger is an economist at the Board of Governors of the Federal Reserve System in Washington. The views expressed are the author’s own and do not necessarily reflect those of the Federal Reserve.

Box 1.Definitions of Derivatives

The following descriptions of derivatives and their proper statistical treatment are contained in the draft Balance of Payments Manual (italics below are added).

  • —Swaps are contractual arrangements between two parties who agree to exchange streams of payments on the same amount of indebtedness.

  • —Balance of payments entries for streams of interest payments associated with swaps should be recorded in the current account, and principal repayments should be counted in the capital account. Principal repayments are generally associated with currency swaps. Any fees to brokers or agents in a swap arrangement are to be recorded in ‘financial services’.

  • —Options are contracts that give the purchaser the right to buy or sell a particular financial instrument or commodity “at a predetermined price within a given time span or at a specified date.” Some leading types of options are those on foreign currencies, interest rates, equities, commodities, and specified indexes. The buyer of an option pays a premium to the seller for the latter’s commitment to sell or purchase the underlying instrument on demand of the buyer. That commitment should be regarded as a current liability of the seller.

  • —Payment of options premiums should be entered as a capital account transaction, reflecting the purchase price of a financial asset. Subsequent trading of options should also be recorded in the capital account. If an option actually proceeds to delivery—which is not usual—the sale of the underlying commodity or instrument should be entered as a separate transaction in the appropriate current or capital account item.

  • —Traded financial futures (on interest rates, currencies, commodities, and share or other indexes) should be recorded in the capital account in a similar manner to options. Other financial futures should not be recorded in the balance of payments as they remain contingent assets and liabilities.

  • —Warrants are tradable options that give the holder the right to buy from the issuer of the warrant (usually a corporation) a certain number of shares or bonds. Warrants can be traded apart from the underlying securities, and thus have a market value. The commitment of a corporation to issue new securities should be regarded as a current liability.

  • —Another variety of the tradable warrant (usually issued by investment intermediaries) is a currency warrant, which is valued by the amount of one currency that it takes to purchase another, at or before the expiration date of the warrant. This variety, and more complicated cross-currency warrants with payment denominated in a third currency, should be treated like other warrants, and settlement should be classified under currency and deposits in ‘other capital’.

  • —Forward rate agreements (FRAs) are arrangements between two parties, who in order to protect themselves against interest rate changes agree on an interest rate to be paid on an amount of principal that is never exchanged. At the time of settlement, only the payment resulting from the difference between the agreed FRA interest rate and the then-prevailing rate should be recorded as interest income in the current account of the balance of payments.

Many of the new instruments are off balance sheet, generally because accounting rules state that they have contingent or future values only. As off-balance-sheet instruments, they are often obscured from public view and frequently fall outside standard statistical reporting programs. It has been noted that “one outgrowth of such innovations ... is the growing inability to glean from financial statements what financing strategies are in fact being employed. Off-balance-sheet instruments transform on-balance-sheet exposures: therefore, their use has reduced the information content of standard financial statements.”2 Thus, data sources on business transactions in derivatives, both domestic and foreign, may be lacking. Because trading in derivatives tends to be highly concentrated (in Chicago, London, NewYork, and Tokyo, to a large degree), much of the unreported off-balance-sheet activity likely consists of cross-border transactions that concentrate worldwide activity in individual types of derivatives in particular trading centers.

Some reporting of off-balance-sheet instruments may be important for international statistics. Off-balance-sheet instruments can generate large capital flows and have significant other effects on the reported balance sheet. They can also themselves have significant positive or negative market values. The accounting rules for many of these instruments are complex and ambiguous. “For many of the new and innovative financial instruments, there is precious little accounting guidance available. The accounting guidance that is available ... is often not relevant in today’s turbulent financial markets.”3

Accountants and tax authorities have acknowledged the need for more disclosure and for recognition of how changes in the value of these instruments affect financial conditions. A full-scale review of the accounting of all financial instruments, which is currently under way in the United States, will shed light on the activity in financial derivatives. New U.S. accounting rules now require extensive disclosure of off-balance-sheet instruments and will also likely call for increased market-value accounting. Draft rules for dealing with these innovative instruments have been prepared for the Manual and the United Nations System of National Accounts (SNA).

The reporting of international transactions in financial innovations is also affected by whether the instruments are traded on an established exchange, over the counter, or privately, and whether they are traded separately or attached to another instrument. Exchange-traded instruments (futures and many options) are readily identifiable, subject to market-price variation (that is, they have a balance-sheet value), and are often monitored in ways that permit identification and measurement of international transactions and positions. International purchases or sales of exchange-traded instruments should unambiguously be included in international capital flow statistics, because they constitute public trading of market-price instruments and because capital flows are generated by the transactions. However, few countries are known to incorporate transactions in these instruments into their balance of payments statistics.

The off-exchange instruments tend to be more diverse and specialized than their on-exchange cousins, which are standardized to ensure liquidity. Information regarding the off-exchange instruments ranges from reasonably good coverage of gross turnover, such as for swaps and cap options, to no information at all. In no case, however, is the reporting of international transactions in these instruments adequate for estimating international accounts. The nominal values of gross transactions in some off-exchange instruments are tremendous ($600 billion in OTC equity options and $3 trillion in swaps), but there is little information on the portion that constitutes international transactions. Consequently, large international capital flows may be occurring that are not captured in the statistics. On a final note, some off-exchange derivatives are attached to original instruments, and some are separately traded. Attached derivatives may be captured as part of the price of the traded original instrument.

Standard accounting treatment of instruments may vary depending on the economic purpose of the instrument—whether it is used to hedge risk, generate income, or speculate. An instrument used for hedging is purchased to prevent a price loss or to guarantee income on some other instrument or transaction. An income instrument is held to earn interest or dividends. A speculative instrument is actively traded in order to profit from price fluctuations.

The new instruments have evolved in an environment where the applicable accounting, regulatory, and tax rules often depend on the purpose for holding the instrument. For example, in the United States, if an instrument such as an option qualifies as a hedge, then the gain or loss on the option may be reflected in the underlying real or financial transaction. If the same option is not recognized as a hedge, changes in its value would be treated as a capital gain or loss and marked to the current market price each accounting period. The applicable rules in the United States are complex and vary by instrument, intent of the asset holder, and regulatory agency. Practice in other countries undoubtedly differs from the U.S. approach, which further complicates the development of internationally comparable standards for reporting transactions. Thus, statistics on such instruments will reflect differing national practices, and these differences will contribute to discrepancies in the reporting of world capital transactions.

If a company uses an instrument as a hedge, there are potentially important balance of payments consequences. In practice, hedged instruments are effectively rebundled in the company’s records with an underlying real or financial transaction. The hedge may or may not be picked up in statistical reporting of the underlying transaction, depending on specific data collection techniques; thus, the hedge may distort current account estimates as well as those of capital flows and positions in financial instruments. In countries that obtain balance of payments information directly from enterprises, the question would be what information is available, or should be requested, to take account of influences on capital flows or income resulting from the use of these instruments. If such information is buried in overall operating costs, it is unlikely to be available. In countries that compile data from exchange records or similar indirect processes, the question would be whether intermediaries can obtain and report such information.

Measurement Problems

The principles of balance of payments accounting for these instruments are to some extent specified in the draft revision of the Fund’s Manual. There remains, however, the empirical problem of capturing, in existing statistical systems, the capital flows and income streams related to the instruments.

The new financial instruments have contributed to an unprecedented degree to the integration of international capital markets and to structural changes in the organization of financial institutions, A specific transaction may involve activity in several countries and in multiple instruments and currencies. For example, casual observation by market participants suggests that few of the deals that originate in Tokyo are fully contained in Japan. One individual noted that “virtually every transaction has a major leg that involves another financial center. “4 It has also been observed that “there are three or four parties linked behind each product, and they bridge different tax and regulatory systems across countries.”5 Typically, end-users purchase off-balance-sheet instruments, but the intermediary that arranges the transaction will lay off its risks in public exchanges, resulting in a mix of reportable and non- reportable transactions. It is likely that some of the legs of diverse transactions are not reported, especially if transacted outside major financial centers. Even if they are reported, discrepancies in international capital flow statistics might occur because of varying treatments across jurisdictions.

The character of more traditional financial instruments and income flows is also modified because of bundling with the new instruments. Derivatives complement the issuance of standard instruments by cutting costs and adjusting exposures, which further promotes bundling and may increase the competitive advantage of national securities markets that deal in liquid derivatives. However, information on which instruments are involved and how they are affected is usually missing from the statistical sources.

Bundling can bias the reporting of capital movements when standard reporting systems are based on the market behavior of traditional instruments. For example, in the 1980s heavy swapping of U.S. corporations’ fixed-rate Eurobonds for floating-rate liabilities may have created a distortion of this sort. Because prevailing floating interest rates were significantly lower than the fixed rates, estimates of the U.S. interest payments on those bonds, which were based on the original Eurobonds, may have been exaggerated. Similarly, an enterprise may either receive or make payments on an interest rate swap, but balance of payments statisticians lack data on swap positions and other details, and thus they have little basis for estimating variations in interest flows. Similar problems exist for many options and margin calls on futures.

Derivatives create additional statistical problems. Fees are often embedded in the interest flows and amortized over the life of the instrument; therefore, they cannot be accounted for separately. Also, the standard accounting treatments remain ambiguous, and the cost of hedges, as well as the capital gains or losses on them, may be commingled with capital account or current account transactions. Options present a particular problem because the payment of a nonrefundable premium is lost at expiry, possibly affecting the measurement of net capital flows and outstanding positions. Finally, specific coverage gaps may occur, such as the conversion of warrants into actual debt or equity and the lack of reporting for the many new financial centers.

Overcoming Statistical Discrepancies

The widespread lack of information on the effect of derivatives on balance of payments statistics suggests that further study should be carried out to obtain a better notion of the volume of transactions and the possible costs of data collection and reporting burden. Below, some steps are discussed that might be taken by national compilers, and by the United States in particular.

Compilers must first decide whether derivatives should be treated in the national accounts solely as financial instruments, as recommended in the SNA draft, or as mixed current and capital account instruments, depending on the enterprise’s practice. That decision will determine whether data collection focuses on measuring transactions not already incorporated in existing reporting or on identifying and removing transactions from accounts where they are unwanted. Either task is challenging.

For national compilers, the process of increasing their understanding of the instruments and their economic impacts as well as the diverse accounting, tax, and regulatory environments in which the instruments are traded is well under way and should continue. In light of the cross-border nature of many transactions, consultation among national offices should be encouraged, and consistency among national treatments strongly promoted. Given the present concentration of activity in a limited number of financial centers, the standards applied in those centers should have precedence. Statistical authorities in those centers could also take the lead in providing data on international transactions, suitably aggregated, to statistical offices in countries with systems that are not yet adapted to the collection of data on derivatives.

Two data collection strategies appear necessary. For exchange-traded instruments, regular data reporting systems need to be developed for public markets in futures, options, and other instruments, perhaps along the lines of the Large Trader Reporting System used by the U.S. Commodity Future Trading Commission. Establishing such reporting should be given a high priority because of the number of new markets that have been established, especially in continental Europe. Consistent reporting among countries should be encouraged, and confidentiality of individual transactions must be preserved.

For over-the-counter and privately traded instruments, some basic research is still required. Means must be found to identify how specific instruments are used, to prepare statistical estimates, and to monitor market trends for research and policy purposes. Much of this activity will concentrate on New York, London, Tokyo, and a few other specialized financial centers.

Clearly any modification of statistical systems must be compatible with current national record keeping and prevailing institutional practices. With the United States as an example, the principal existing channels for balance of payments reporting are noted below:

  • —Reporting by enterprises presently occurs through two channels. Direct investors report all transactions with affiliated foreign enterprises directly to compilers at the U.S. Department of Commerce, with exemptions for small transactions. Where the enterprise has substantial claims or liabilities Vis-à-vis nonaffiliated foreign parties, the amounts of such claims and liabilities are reported to the U.S. Treasury.

  • —Transactions in long-term securities with nonresidents are also reported to the Treasury. Such reports are filed primarily by banks and securities dealers, plus some large institutions that regularly deal directly in foreign markets.

  • —Banks regularly report to the Treasury their own and their custody claims and liabilities Vis-à-vis nonresidents.

Within this framework, the possible avenues for insuring that dealings in derivatives are encompassed within the system are fairly clear.

  • —For direct investment transactions, reporting enterprises could note the treatment of any expenses connected with the use of a derivative Vis-à-vis foreign affiliates—that is, whether the gains and losses are treated as current account items in the recording of direct investment transactions or charged to intercompany capital accounts. It is doubtful that separate recording is necessary. With respect to reports to the Treasury about transactions with unaffiliated parties, one possibility is to instruct enterprises to include these instruments in their reports if the value of the deals (together with other claims or liabilities Vis-à-vis nonresidents) exceeds an exemption level. However, since the extent to which derivative instruments are used is not known, it might be useful to conduct an initial survey of relevant enterprises to determine the approximate size of the amounts on their books.

  • —For transactions in long-term securities, reported to the Treasury, the instructions should clarify the reporting requirements for derivatives. If already incorporated in the value of a transaction with nonresidents, presumably no change would be necessary. When derivatives are traded separately, provision should be made for reporting them. This leaves open the question of whether a separate classification of derivatives is desirable or whether they should be combined into the standard debt and equity categories. It will be necessary to decide in advance (even if such decisions seem arbitrary) what the treatment should be for each major type of derivative, in line with the findings of the Fund’s Manual.

  • —For banks dealing on their own account, or holding items in custody, the instructions on the Treasury reporting form may require expansion. For instance, the expiration of an option may have the appearance of a transaction but probably should not be reported as such for balance of payments purposes. The proper treatment of such cases needs to be clarified for the reporting institutions. Again, it may be useful to specify institutional thresholds before a reporting obligation is imposed. Here, too, an initial survey of banks’ positions in derivatives could be a useful first step.

The indicated approaches to improving the coverage of derivatives in the U.S. balance of payments accounts suggest that it may be possible to resolve some major sources of error and omission by building on the existing reporting structure. Given the high cost of compiling acceptable data on traditional instruments, efforts should certainly focus first on establishing where the most sizable errors from derivative instruments are arising in the accounts. Then, if necessary, collection methods should change. The general area of financial derivatives is a rapidly evolving field, however, and progress in balance of payments measurement is likely to depend on better standardization of general corporate accounting and in other statistical contexts. Thus, it is likely that progress will require concerted and persistent efforts by national compilers and reporting parties alike.

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