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Gay Evans is the Chairwoman of the International Swaps and Derivatives Association. Gay is also a Managing Director of Bankers Trust International. It appears that 15 percent of the $40 trillion in outstanding derivative contracts are denominated in currencies that will comprise the "Euro". Inevitably, some of those contracts were written to extend beyond the scheduled initial start-up date of trading in the projected currency.

Obviously, this raises certain significant questions:

1. What will be the legality of a contract to purchase a currency if that currency no longer exists? 2. How will new derivative currency contracts be written as trading becomes inevitable. (A single currency for government bond issues is scheduled for January of 1999) 3. Will each derivative contract contain either/or language, in one case, if the Euro comes to pass, and the other case, if it doesn't? 4. Will the derivative require a double hedge? 5. What court will handle the dispute if the parties can't agree?

Each new action by the public sector at a global level requires a leveling action by the private sector. The contracts between parties to derivatives that tend to extend out a substantial number of years cannot possibly predict the composition of that future marketplace. Worse than that, we have no conception of the nature of the regulator of that period, or even if there will be one. The Bank for International Settlements has no particular mandate in any area with the exception of certain war reparations, and to think that it would have global legal standing relative to non-bank derivative trading is beyond nave'.

The "Euro" is an accident waiting to happen. Unwinding hedged positions will be murder, back office problems will probably create momentous transactional deficits while opportunists such as Meriwether will roll out statistics that say, "it always worked that way before, thus it will work in the future". We believe that trading loses and profits in the "Euro" will become monumental, but someone is going to leverage his action to the hilt and guess wrong, throwing the entire monetary system of Europe off kilter for years to come and bring down its markets as well. Long-Term Capital Management was not the only gambler to guess wrong, but it was the biggest; so far.


Instantaneous electronic information flow has caused a change in the way we think, the way we live and the way we foresee the future. Regulators, cognizant of the immense changes occurring globally, are attempting to modernize their rules to fit the dynamically fluid circumstances. However, as change accelerates, regulators' grip on the machinery of change loosens or at best becomes confused. "Time sensitive" data becomes scarcer and scarcer. Regulatory bureaucracies do not operate in real time; they are, therefore, left in the dust.

If American regulations do not change, each participant will be playing under a completely different set of internal accounting rules, all of which are highly complex and substantially opaque to other participants. Far from transparency and harmonization, in the United States we are heading back into an financial anarchy. In addition, as illustrated below, the increasing interdependence of financial institutions and accelerated capital movement guarantee that when disaster strikes, it does so quickly and massively.

Banks around the world have recently taken a terrific pounding in Asian loans, Eastern European repudiation and trading loses. It has not been the best of all times for banks anywhere. In spite of the fact that most large banks are either traded in global securities markets or are appendages of a government, the majority of recent loses have been publicly opaque for numerous reasons not the least of which is the fact that accounting does not require derivative holding to be part of the bank's disclosable balance sheet. These are called off-balance sheet items. In Asia, concerned governments have allowed their banks make up new definitions for words like "non-performing" and even if they have such nomenclature, to send into oblivion the time necessary for a lender to go into regulatory default.

So the financial institutions of the world continue to spew out meaningless reports on how they are doing while inside the caldron a fire is ever smoldering. The fact that our systems are able to cope with these numbers and not suffer from chronic disarray is one of the miracles of our age. However, our brethren at the Bank of International Settlements are extremely concerned that we are taking a run of good luck with a far too cavalier attitude. While there seems to be a degree of harmonization within global settlements, there is no synchronization, thus casting a pall over the entire field of foreign exchange and there is no question that it is only a matter of time before the "other shoe will fall". Foreign exchange volume is only gearing up as many of the world's largest countries only now enter the arena. Russia, China and India, all of whom had been primarily on the sidelines, are now becoming active participants in the market. Their addition, plus several others, geometrically increases the size of the market and its effect will be visible in the short years ahead. Small slips by fast cars make big accidents and often leave traffic tied up for miles.

Suddenly, all of the world's country's seem to have become globalized simultaneously, geometrically increasing the number of players in the foreign exchange markets. Our ever more sensitive computers continue to keep pace with the skyrocketing volume of international settlements, but the quality of the data continues to erode as less sophisticated players enter an established highway without a road map. Ultimately, we will be faced with a problem of too many cooks, putting too much "garbage" in to the mix and as a result, as they say in computer jargon, garbage will come out.

The new players have their own style and venue and have not been coached in the "Marquis of Queensbury Rules" by which the money game has historically been played. Many of these transactions are done by countries so new to the game of international trade that their own laws do not appropriately cover all of the machinations that are conceivable. Thus, when private sector transactions are done in foreign exchange, can the other side always be sure that there are not impediments to settlement beyond mechanically priming the pump.

Just determining where equilibrium lies in transactions, which consist of foreign exchange settlement exposure, when the "risk that one party to a foreign exchange transaction will pay the currency it sold but not receive the currency it bought" is the stuff that nightmares are made of. The international systems are not synergistic and work on various levels of efficiency. The bottom line though, is that these are clearly not "deliveries against" payment, the only thing holding the transaction together is the agreement of the parties to consummate the transaction. One may take the high road and another the low road, but even if one gets to Scotland afore the other, it has not been consequential because of the historic creditworthiness of the parties involved. Creditworthiness was simple to define in more classical times when everyone in the business (banks), in a manner of speaking, belonged to the same club. In this globalized society where the players may not don white gloves, do we really want our money traveling down different roads in order to get to the same place at the same time.

So in August of 1982, Mexico's Finance Minister, in a meeting with the U. S. Treasury, informed officials that Mexico could not repay its external debt of over $88 billion. "It is hard to say who was in worse trouble, Mexico or its creditors. However much its people would suffer as a result of its default, there still would be a Mexico. The same could not be said with certainty of the banks that had lent it money. Mexico owed its largest American creditor, Citibank, $3.3 billion - more than two-thirds of Citibank's net corporate assets. The Bank of Tokyo was even worse off; 80 percent of its net assets were at risk in Mexico. In theory on that day, the loans became under-performing and the banks literally insolvent."

In an unforgiving, electronically regulated global banking system, Citibank's connection to the international source of funds would have been terminated. All of its positions would have been considered in default and the cyber-police would have started fighting a losing battle to unwind billions and billions of dollars of derivative transactions carried on the banks' books. It would be difficult enough if the cyber-police could even decipher the nature of derivatives. However, unless the cadre' of highly educated tinkerers that created the derivatives were kept together, this process would be impossible. Many of the derivatives could have been issued as straight gambles on the part of the bank with no compensating collateral. Some of the transactions may have been so complex that only the maker could unwind them; had he left the bank, the task would have been impossible, particularly because these are time denominated instruments.

"Obviously, we could not allow Citibank to go under, and the American Banking System in general, to suffer irreparable damage to their ability to lend. The solution was simple; we paid Mexico in advance for oil that was to be delivered at some time in the future, to our strategic petroleum reserve. We then arranged for the Federal Reserve Bank to forward Mexico enough to bring their debt current as well as to take care of certain social amenities; and lastly, we imposed upon the International Monetary Fund to arrange an entire restructuring of Mexican Debt". Masters of Illusion, Catherine Caufield

Interestingly enough, we caused the Mexican default indirectly forcing money down their throats. This came about when the Federal Reserve (Fed), in order, to bring the market out of the doldrums, which was as a result of the 1970 stock market crash, dropped interest rates and expanded the money supply. Having no solid source of investment, instead of putting the money to work in the United States, investors bought so many Euro-dollars that interest rates in Europe fell, while in turn, its money supply rose. The only outlet available was in Latin America, and never folks to turn down a bargain, the South Americans joined as invited guests to a royal monetary disgorgement. Mexico was the star performer on the bread line.


Strangely enough, with all of this talk of transparency and harmonization, derivatives are not required by GAAP to be shown on corporations' financial statements. Derivatives are off balance sheet items. In the world of "Alice in Wonderland", it would theoretically be possible for a financial institution to have billions of dollars of these obligations floating around in all parts of the globe; yet have miniscule assets and little cash.

The reason for the opacity of derivatives is that there is generally no historic cost attributable to their creation or sale. Each instrument is unique, making valuation difficult. The Financial Accounting Standards Board (FASB) has been attempting to force reporting standards on the industry, in spite of a General Accounting Office (GAO) study advocating disclosure. Representative John Dingel of Michigan even went so far as to bring the matter up with Secretary of the Treasury, Robert Rubin, inquiring as to a "need for improved derivatives accounting and disclosure." Makes you kinda wonder what's going on.

This type of opacity on a worldwide scale, with billions of dollars at risk, could cause a meltdown so rapid as to be uncontainable. This is particularly true because of the risks that attend transnational trading:

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