4
FINANCIAL DERIVATIVES: DATA GAPS AND NEEDS

Among the most important changes in world financial markets over the past two decades has been the emergence of a myriad of new and rediscovered financial instruments in the form of derivative products. Financial derivatives include swaps, options, forwards, and futures for interest rates, currencies, stocks, bonds, indexes, and commodities. Many derivative transactions are international, involving residents of different countries, and they are often conducted in multiple currencies. Their rapid growth can be attributed to the need of investors and borrowers to manage risks in an environment of fluctuating exchange rates, interest rates, and commodity prices. Adverse changes in exchange rates, for example, can eliminate a firm's overseas profits; commodity price fluctuations can increase input prices of production; and changes in interest rates can put pressure on a firm's financial costs.

The wave of financial deregulation, technological innovation, and competition among market participants has further facilitated the development of derivatives. In addition, the cost-saving features of these products and the flexibility they afford investors and borrowers have fueled their expansion. They have been used not only for hedging, but also for trading activities.

Particularly since the early 1980s, derivatives have come to account for a significant share of international financial transactions. Since derivative products appear in numerous forms and



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Following the Money: U.S. Finance in the World Economy 4 FINANCIAL DERIVATIVES: DATA GAPS AND NEEDS Among the most important changes in world financial markets over the past two decades has been the emergence of a myriad of new and rediscovered financial instruments in the form of derivative products. Financial derivatives include swaps, options, forwards, and futures for interest rates, currencies, stocks, bonds, indexes, and commodities. Many derivative transactions are international, involving residents of different countries, and they are often conducted in multiple currencies. Their rapid growth can be attributed to the need of investors and borrowers to manage risks in an environment of fluctuating exchange rates, interest rates, and commodity prices. Adverse changes in exchange rates, for example, can eliminate a firm's overseas profits; commodity price fluctuations can increase input prices of production; and changes in interest rates can put pressure on a firm's financial costs. The wave of financial deregulation, technological innovation, and competition among market participants has further facilitated the development of derivatives. In addition, the cost-saving features of these products and the flexibility they afford investors and borrowers have fueled their expansion. They have been used not only for hedging, but also for trading activities. Particularly since the early 1980s, derivatives have come to account for a significant share of international financial transactions. Since derivative products appear in numerous forms and

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Following the Money: U.S. Finance in the World Economy are used for various purposes in financing and portfolio management strategies, they have complicated many aspects of the accounting, regulating, and statistical reporting of financial transactions. This chapter explores the revolutionary changes that financial derivatives have brought to world financial markets and their implications for the collection of accurate, timely, and relevant data for public and private decision making. It is important to understand the basic features and uses of these instruments and how they have affected the coverage of the existing balance-of-payments data and their interpretation. USES AND GROWTH OF FINANCIAL DERIVATIVES Financial derivatives are secondary instruments, the values of which are dependent on changes in the value of the underlying financial instrument or commodity. They are generally linked to a primary financial instrument or an indicator (such as foreign currencies, government bonds, corporate equities, certificates of deposit, stock price indices, and interest rates) or to a commodity (such as gold, petroleum, copper, wheat, coffee, and cattle). They usually do not result in a transfer of the underlying primary instrument or commodity at the inception of a contract. Instead, they usually entail an exchange between the counterparties to the contract at some future date. Derivatives can generally be classified as either ''option-like" or "forward-like." Options give the holder the right—but not the obligation—to purchase (or sell) an underlying financial instrument or commodity at a specified price at a future date. Forwards are a commitment to purchase (or sell) an underlying financial instrument or commodity at a specified price at a future date. Derivative products can take the form of one or a combination of several basic financial contracts: A financial option contract gives the purchaser of the option the right to buy, sell, or exchange specific financial instruments at a fixed or determinable price (called the exercise or strike price) at the exercise of the option. Examples include currency, interest rate, stock, index, and commodity options. A warrant can be considered as a type of option: it is a contract that entitles the holder to subscribe to a specified number of shares or bonds at a fixed price during a set period. Like options,

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Following the Money: U.S. Finance in the World Economy warrants can be purchased and sold independently of the underlying shares or bonds. A financial forward contract is one in which two parties agree to exchange specific financial instruments at a future date on predetermined terms. Examples are foreign exchange forwards and interest rate forwards. A swap contract is the binding of two parties to exchange two different payment streams over time, the payments being tied, at least in part, to subsequent and uncertain market developments. Examples include swap contracts on interest rates and foreign currencies, equities, and commodities (notably gold and petroleum products). A swap can be considered as a series of financial forwards, except that the underlying credit risks of the two types of instruments can be different. A futures contract requires the delivery of a specified amount of an underlying asset at some future date at a price agreed on the day the contract is made. Examples are currency futures, interest rate futures, index futures, and commodity futures. Futures contracts can also be considered as a form of forward contract traded on public exchanges, except that the underlying credit risks of the two types of contracts can be different. BASIC FEATURES AND USES A primary purpose of these secondary instruments is to hedge against exposure to risk. Most, therefore, are designed to transfer one or more of the financial risks inherent in an underlying primary financial instrument or commodity to a third party willing to accept the risks. The counterparty (buyer or seller) to the transaction assumes the risk either for speculative purposes or to hedge an offsetting exposure of its own. Some derivative instruments are not new but have been rediscovered and promoted since the early 1980s. Others are new products designed to enable borrowers and investors to deal with volatility in exchange rates, interest rates, and stock and commodity prices. In principle, portfolio managers can realign financing risks through cash markets without using financial derivatives. For example, borrowers and investors can diversify their foreign exchange risks by holding assets and liabilities in different currencies. A company that wants to lock in an attractive interest rate to meet future financing needs can issue the debt in the cash market before the funding is needed. In practice, however, the transaction costs of cash market strategies can be daunting, and their liquid-

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Following the Money: U.S. Finance in the World Economy ity and credit risk implications can be unacceptable. Also, there may be regulatory barriers and tax disincentives. When used prudently, derivatives can offer cheaper alternatives than cash market products to achieve the same hedging or trading objectives. Derivatives are also designed to provide borrowers and investors with flexibility to unbundle and hedge different risks separately. In the case of foreign exchange futures contracts, a U.S. exporter can transfer its foreign exchange risk to a firm with the opposite exposure or to a firm in the business of managing foreign exchange risks, leaving the exporter free to focus on its core business. This strategy will avoid the risk of loss if exchange rates move against the firm before payments for the goods are received. Furthermore, financial derivatives can be combined with a debt issuance to unbundle the financial price risk from other risks inherent in the process of raising capital. By coupling its bond issues with swaps, for example, a firm can separate interest rate risk from traditional credit risk (Rawls and Smithson, 1989). Yet another use of derivatives relates to home mortgages. Innovative financial derivatives have been one means to support residential refinancings in the United States. During 1993, as U.S. interest rates declined to their lowest levels in a number of years, refinancings of residential mortgages reached record high numbers. Prepayments reduced the income stream of mortgage holders. To hedge against bursts of prepayment exposure, some mortgage bankers and other financial institutions were able to transfer prepayment risk by turning to reversed indexed principal notes (see Feigenberg et al., 1993). Such instruments are designed to extend cash flows to financial institutions as interest rates decline and to shorten cash flows as interest rates rise. The more prevalent approach to handling prepayment risk, however, has been through the securitization of mortgage assets through collateralized mortgage obligations. Derivatives such as futures and options tend to involve lower transaction costs, and at times they offer higher liquidity than cash markets (for example, through index trading). This higher liquidity is useful for investors who can also use derivatives to change their risk exposures—by hedging against downside risk, swapping bond coupons for equity dividends, diversifying into foreign markets—without having to buy or sell the underlying securities. An investor holding a long-term bond can protect asset value through a period of expected interest rate turbulence by a swap with floating rate income during that period, rather than selling the holding outright.

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Following the Money: U.S. Finance in the World Economy Active participation in derivatives markets requires capital strength, in-depth market information, and technical expertise. Consequently, derivative instruments, and the rights and obligations underlying them, are for the most part created by financial enterprises—either acting as agents or brokers in setting up contracts between two other parties or as principals in contracting with a customer. That is, activities in financial derivatives are largely conducted at the "wholesale" rather than at the "retail" level. An indication of the institutional nature of swap transactions comes from the International Swap Dealers Association (ISDA), an international group of commercial, investment, and merchant banks and other swap dealers: the average size of the swap transactions in the portfolios of the respondents surveyed in 1992 was about $27 million. Major users of financial derivatives include large business enterprises, banks, savings associations, insurance companies, institutional investors, government agencies, and international organizations. Derivatives can be traded on organized exchanges or they can be over-the-counter (OTC) contracts.1 Exchange-traded instruments are in standardized forms, amounts, terms, maturities, and delivery dates. OTC instruments are generally customized to clients' needs; they often specify commodities or instruments and terms not offered on exchanges. OTC market transactions are generally negotiated over the telephone before being confirmed in writing. As in the case of cash instruments, it is not uncommon for financial derivatives to be cross-listed in international capital markets. Through arbitrage, these secondary instruments link different derivative markets, as well as the cash markets. There are major risks in the use of derivatives—risks both for individual firms that are users or dealers in derivatives and potential risks for the financial system as a whole. At the level of the individual firm or other user, there have been several recent cases of major financial losses through the use of derivatives in often complex and highly leveraged transactions. Among the more widely publicized cases are those of Codelco, Metalgesellschaft, Procter and Gamble, Gibson Greeting Cards, and Orange County, Califor- 1   In the United States, exchanges in which derivatives contracts are traded include the American Stock Exchange, the Philadelphia Stock Exchange, the Chicago Mercantile Exchange, the Chicago Board Options Exchange, and the Chicago Board of Trade. Unlike exchange markets, in which orders are brought to a central facility (a "floor") to be executed, OTC orders are handled by dealers working over the telephone or through a computerized order execution system.

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Following the Money: U.S. Finance in the World Economy nia. The need for a more disciplined approach by users of derivatives and for greater senior management attention and responsibility has been recognized, and a set of "best practices" for the handling of these instruments proposed by industry sources through a report of the Group of Thirty (1993). The issue of systemic risk, that is, the potential impact of derivatives on the financial system as a whole, is also a subject of debate. Questions have been raised about possible scenarios in which derivatives might be a source of a widespread disturbance in the financial system. One area of concern has focused on the high degree of concentration of derivatives' trading in a small number of institutions: the question is whether the failure of a major derivatives dealer could impose credit losses on a large number of counterparties, threaten their financial health or solvency, and endanger the financial system more broadly. A second area of concern has centered on the issue of whether certain risk management techniques, such as dynamic hedging of options positions—techniques that lead market participants to buy assets when prices are rising and sell when prices are falling—can disturb markets by exacerbating volatility. RECENT GROWTH From a limited beginning in financial forward and futures contracts in the late 1970s have come a plethora of currency, interest rate, and commodity options, futures, and swaps instruments and many combinations of them. Among derivatives, swaps have grown the fastest in recent years. Most swap activity to date has been concentrated on interest rates. According to market participants, swaps are attractive as a way to either hedge against existing risks or transform exposures from one source of risk to another. In addition, financial swaps are simple in principle and unusually versatile in practice. They are therefore revolutionary, especially for portfolio management. A swap coupled with an existing asset or liability can radically modify effective risk and return. Swaps have been a powerful force in integrating global capital markets. Increasingly, they link currency and money markets and erode price discrepancies that result from differences of liquidity and credit standing across markets. Globally, the key uses of swaps lie in the arbitrage of yield and credit differentials across borders, the management of interest and exchange rate risk, and the global diversification of funding and investing. Swaps can

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Following the Money: U.S. Finance in the World Economy be tailored to meet a variety of needs, often as major components of elaborate structured financings. Comprehensive statistics are not available on the levels of activity in derivative instruments, but several sources do collect data on these instruments:2 The Bank for International Settlements (BIS) publishes estimates of market size for selected derivative financial instruments. Estimates are in notional (principal) amounts. BIS estimates are based on its own calculations and data from various other sources, including the International Swap Dealers Association, futures and options exchanges worldwide, industry associations, and U.S. organizations, such as the Commodity Futures Trading Commission (CFTC) and the Options Clearing Corporation.3 The CFTC, which oversees the U.S. commodity futures market, collects data from reports on large trades submitted by exchanges' clearing houses. There is a very high cutoff point for these reports. The Chicago Board Options Exchange collects proprietary data on foreign holdings of U.S. options. These unpublished data include the number of covered long and short call and put contracts and the number of uncovered calls and puts traded on the Chicago Board Options Exchange. The National Futures Association collects data for the CFTC on foreign options and futures traded by U.S. residents. These unpublished data cover the total number of contracts by brokerage firms and by general geographic distribution, but they are not distinguished by type. The Intermarket Surveillance Group collects daily data on U.S. options traded by foreign residents on all U.S. exchanges and provides data to member exchanges and other board members. The Federal Reserve, the FDIC, and the Office of the Comptroller of the Currency, using the Call Report, collect data on interest rate contracts, foreign exchange rate contracts, and contracts on other commodities and equities, as well as on other off-balance-sheet items. The data are limited to derivatives transac- 2   Ann M. Lawson of the Bureau of Economic Analysis assisted with the compilation of these sources. 3   The ISDA conducts surveys every six months on turnover and every year on outstanding positions. Their coverage of derivative products and markets is limited, however.

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Following the Money: U.S. Finance in the World Economy tions of banks, and they do not show the direction of trade or residency of trader. The data are available to the public. The explosive growth of financial derivatives has been charted by the BIS, with data covering outstanding (open) instruments throughout the world; see Table 4-1. The notional amount of exchange-traded interest rate and currency futures and options outstanding was estimated to be $7.4 trillion at the end of 1993, a more than tenfold increase from $684 billion in 1987. Interest rate futures and options accounted for about 98 percent of the total. The notional value of OTC swaps and swap-related derivatives was about $8.5 trillion at the end of 1993. About 75 percent of these derivatives were interest rate swaps. In addition to the currently available data, 26 central banks planned to conduct a global survey of derivative markets in April 1995. The survey was to be performed in conjunction with the triennial central bank survey of foreign exchange markets. In addition to data on the cash foreign-currency markets, the 1995 survey was to collect data on derivative markets in foreign exchange, interest rates, equities, and commodities. The survey will provide data on the size and structure of derivative markets. Market size will be measured in terms of both notional amounts and market values, and the data will be broken down by counterparty type as well as whether it is a domestic or international transaction. The national data will be published by each of the 26 central banks, and global statistics will be compiled and published by the BIS. REPORTING DERIVATIVES TRANSACTIONS Unlike traditional financial instruments, such as loans and deposits, which can easily be defined as assets and liabilities and recognized in accounting systems when they are acquired, derivatives can create either future or contingent financial assets and liabilities. Actual financial assets and liabilities are balance-sheet transactions; contingent ones are off-balance-sheet items. BASIC CONCEPTS AND PRACTICES Derivative transactions can be measured in terms of either notional amount or market (cash) value. Notional values represent the face value of the principal of the underlying contract on which the derivative instruments are based. They are the underlying

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Following the Money: U.S. Finance in the World Economy TABLE 4-1 Derivative Contracts Traded Over the Counter, Notional Principal Amounts (in billions of U.S. dollars) Instrument 1987 1988 1989 1990 1991 1992 1993 New contracts — — 1,347.2 1,769.3 2,332.9 3,717.0 5,516.9 Interest rate swaps 387.8 568.1 833.6 1,264.3 1,621.8 2,822.6 4,104.7 Currency swapsa 86.5 124.3 178.2 212.8 328.4 301.9 295.2 Other swap-related derivativesb — — 335.5 292.3 382.7 592.4 1,117.0 Amounts outstanding at end-of-year — — — 3,450.3 4,449.4 5,345.7 8,474.6 Interest rate swaps 682.9 1,010.2 1,502.6 2,311.5 3,065.1 3,850.8 6,177.3 Currency swapsa 183.7 319.6 449.1 577.5 807.2 860.4 899.6 Other swap-related derivativesb — — — 561.3 577.2 634.5 1,397.6 Memorandum items: exchange-traded financial instruments 683.9 1,234.2 1,654.2 2,126.0 3,308.7 4,392.2 7,433.8 Interest rate futures and options 610.3 1,174.6 1,588.5 2,053.6 3,229.7 4,287.6 7,322.8 Currency futures and options 73.6 59.6 65.7 72.4 79.0 104.6 110.9 NOTE: Data collected by the International Swaps and Derivatives Association (ISDA) only; the two sides of contracts between ISDA members are reported once only; excluding instruments such as forward rate agreements, currency options, forward foreign exchange contracts and equity and commodity-related derivatives. a Adjusted for reporting of both currencies, including cross-currency interest rate swaps. b Caps, collars, floors, and swaptions SOURCE: Bank for International Settlement (1994a).

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Following the Money: U.S. Finance in the World Economy amounts used to calculate contract cash flows. With the important exception of currency swaps, principal is usually not exchanged in a swap transaction. For example, the notional amount of an interest rate swap is the reference or benchmark amount used to calculate the periodic interest payments of either leg of the swap. A fixed and a floating interest rate are multiplied by the respective notional values to determine the amounts to be exchanged by the parties to the swap. In this example, the market or cash value of the derivative contract is determined by calculating the present value of all expected future cash flows (interest payments) under the contract. Since the expected cash flows normally are just a fraction of the notional amount, the cash value (or replacement cost) is only a fraction of the notional value (Federal Reserve Board of Governors et al., 1993). Therefore, notional value is a misleading indicator of the economic significance of derivative transactions; it is, however, a useful measure for comparing relative importance of differing types of derivatives and their growth. The cash, or market, value of a derivative is the appropriate measure for estimating, at a particular moment in time, the economic value of the derivative transaction. The notional value of the derivative is an inappropriate measure because it is a reference amount on which payments are determined and is not itself exchanged. For example, the cash payment initiating a stock option contract would consist of the fee or premium paid for the purchase of the option and the cash margin required by the exchange during the life of the contract. The notional value, in this example, is the value of the stock on which the option has been written. Only if the option is exercised (i.e., the stock is actually purchased by the holder of the option) does a transaction equal to the value of the stock occur. In balance-of-payments accounting, which relies heavily on national accounting practices for compilation of data from balance-sheet assets or liabilities, any change in ownership of an asset or liability gives rise to a balance-of-payments transaction if a counterparty is a nonresident. Derivatives that give rise to off-balance-sheet (future or contingent) assets and liabilities become reportable in the balance of payments only when the contractual obligation is actually carried out and a payment is made in the form of a capital or income flow or service charge. In theory, the cash value of cross-border derivatives transactions, including the capital gains and losses, should be covered in the U.S. balance-of-payments data. In practice, however, only limited information on the cash value of derivatives transactions

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Following the Money: U.S. Finance in the World Economy is captured by the current data collected on U.S. international capital transactions. The lack of standard accounting practices and designated reporting, the complexity of the instruments, the multiple purposes they serve, and the growing volume of derivative transactions, especially in OTC markets, have posed difficulties for their coverage in the balance of payments. These difficulties include, among others, identifying derivatives transactions, determining their cash (and "marked-to-market" or fair position) values, and allocating them to the current or the capital account under the balance-of-payments framework. Specifically, under the Treasury International Capital (TIC) system, reporters are instructed to include warrants and options pertaining to long-term securities in their reporting of international sales and purchases of long-term securities only when the underlying security is a stock or long-term bond. Data on purchases and sales of warrants and options are not separately reported but are commingled with purchases and sales of long-term securities.4 All other options and warrants are omitted from the current TIC system. For futures and options contracts, BEA measures trading by foreigners in U.S. futures exchanges in this country in an effort to improve the data in the U.S. balance of payments. BEA's estimates include two major components: commissions received by U.S. brokerage firms from foreign traders, which are estimated by applying average commissions (derived from the schedules of major brokerage firms) to the number of contracts closed with foreign residents; and profits and losses and the margin requirements and subsequent changes of foreign traders between two consecutive quarters, which are estimated from the "large trade" data of the CFTC. According to BEA, it does not estimate U.S. receipts and payments related to U.S. residents' transactions in foreign futures because of the lack of data. No other derivatives transactions are covered. The limited information on derivatives transactions presently available is inadequate for BEA's purposes of estimating corresponding balance-of-payments transactions. The panel's canvassing of TIC data filers also confirms that filers believe that they are not required to report on their deriva 4   Transactions in claims on specific coupons or principal payments stripped from an underlying security (for example, TIGR, Treasury Investment Growth Receipts, or CATS, Certificates of Accrual on Treasury Securities), are commingled with reported purchases and sales of U.S. Treasury bonds and notes. Collateralized mortgage obligations are commingled with reported transactions in long-term debt securities.

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Following the Money: U.S. Finance in the World Economy tives transactions, whether tradable or not, and that the TIC forms (except the S forms, as discussed above) do not specifically request such information. The guidelines currently being developed by the U.S. accounting profession and international organizations (see below) will help the TIC data collection system to capture such transactions. DERIVATIVES IN BALANCE-OF-PAYMENTS ANALYSIS As discussed above, most derivative transactions are not included in the balance of payments. The absence of these data can mislead analysts in evaluating the economic or market significance of recorded capital flows. Some examples can illustrate how derivatives can substitute in practice for types of assets or liabilities that are a part of the U.S. balance of payments. A German export company that is selling goods for dollars but wishes to be protected against a decline in the deutsche mark (DM) value of the dollar during the interval before it receives the dollars, could do so in several ways. Only one of them, however, would probably appear fully in U.S. balance-of-payments data. The German company could borrow dollars from a U.S. bank, expecting to repay the loan with proceeds from the export; this transaction would increase claims on foreigners reported by U.S. banks for inclusion in U.S. balance-of-payments statistics. There would be an offset to the claims in increasing liabilities to foreigners, as the German company would hold the dollar proceeds of the loan until receiving payment for the goods. Derivatives transactions that accomplish the same purpose would largely be excluded from balance-of-payments data. The German exporter might buy a DM forward from a U.S. bank, anticipating paying for this purchase with dollars received from the export. The exporter might buy DM futures from a U.S. exchange, expecting to pay for the purchase with dollars received from the export. Only a small portion of either transaction, representing margin requirements and perhaps a commission paid by the exporter for the purchase, would be reflected in U.S. balance-of-payments data. The exporter might also purchase a call option from a U.S. bank to buy DM for dollars or purchase a put option to sell dollars for DM. These option transactions could also protect the exporter if the dollar weakened against the DM, and they, too, would not appear in U.S. balance-of-payments data. Similar examples can be constructed for other capital account transactions. For example, a Japanese investor in U.S. securities

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Following the Money: U.S. Finance in the World Economy could hedge a purchase either by borrowing dollars from a U.S. bank or by the use of derivatives—such as a sale of forward dollars, a sale of dollar futures, or transactions in call or put options. The dollars borrowed from a U.S. bank would enter the U.S. balance of payments, but the value of the derivatives would not. An analyst examining balance-of-payments data and noting the rise in U.S. bank claims on foreigners in one case and not the other might be misled about the nature of exchange market pressures during the period. If the analyst assumed that the absence of bank borrowing meant the transaction was unhedged, she or he might conclude that the securities purchase was a source of more upward pressure on exchange markets than it actually was. Borrowing from a bank by a foreigner to help finance and hedge a long-term security purchase reduces the upward pressure on the dollar from the purchase, since the buyer is to that extent initiating less net new demand on the cash foreign exchange market. Had the securities purchase been hedged by a derivative transaction, the analyst, lacking information on the derivative transaction, might overestimate the net new demand in the exchange market. If the related derivatives data were available, the analyst would be in a better position to assess the likely net effect on exchange markets, as well as the structure of interest rates and of capital flows. Somewhat similar examples can be constructed for currency swaps. A U.S. borrower who has a choice of borrowing abroad in yen or dollars might choose to borrow in yen and to enter into an interest rate swap so that the payments would be in dollars. Since U.S. balance-of-payments data do not distinguish between borrowing in yen or dollars, knowledge about currency swaps might not be especially helpful. If currency distinctions were made in the U.S. balance of payments, however, capital account data would be more revealing, and supplementary information about currency swaps could be informative. Knowledge of derivatives is also important both for U.S. agencies like the Treasury Department and the Federal Reserve and for private participants in the exchange markets or firms that have exposure to foreign-currency developments. The flows in the capital account of the balance of payments need to be supplemented by knowledge of activities in the derivatives market in interpreting the international sources of exchange market and interest rate pressures. That is not an argument for changing the capital account or for eliminating it, nor is it an argument for giving up a balance of payments based on national

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Following the Money: U.S. Finance in the World Economy borders; rather, it is an argument for recognizing that there are now international financial transactions that are not registered in the capital account in their full dimension and that they can affect interpretation of international financial flows. Yet another point relates to the U.S. net investment position. To assess potential exchange market pressures in today's globalized economy, it is useful to know whether U.S. obligations to foreigners are denominated in dollars or foreign currencies. If a foreigner borrows in the United States and invests the funds in the United States, there is no net additional dollar exposure (the U.S. international investment position would not show a net increase in debt). However, if a foreigner invests in the United States and is fully hedged in the derivatives market (through a currency swap, for example), the U.S. international investment position shows a net increase in debt but does not show whether the foreign claimant has taken a dollar risk. (There is clearly a credit risk taken by a U.S. obligor.) From the foreigner's perspective, the debt is fully hedged, so that from that transaction alone there is no future dollar exposure when interest and principal come due. (There may be an exposure, depending on how or whether the banks in the middle have covered their risks.) These kinds of transactions raise issues about the implications of derivatives on foreign—and even domestic—attitudes toward the dollar. Overall, data on derivatives are useful in gauging potential exchange market and interest rate pressures. Evidence of a strong build-up in short positions against the dollar might be useful in judging the timing and extent of exchange market intervention. Data on derivatives may also help in judging whether foreigners—or even residents—are willing investors in the United States. If they are willing investors, monetary policy might not need to be so tight as otherwise to ensure enough of a capital inflow to avoid currency instability and undue weakness in bond and stock markets in the face of a persistent current account deficit. Experts responsible for the revisions of the International Monetary Fund (IMF) Balance-of-Payments Manual and the System of National Accounts (SNA) have developed guidelines for the compilation of data on derivatives. In addition, the U.S. Financial Accounting Standards Board is formulating standards for the treatment of derivatives, and federal regulatory agencies are collecting some data on these financial transactions. However, the proposed treatments of derivatives, as developed by the various expert groups, are not identical (see below). Improved data on these transactions will facilitate assessments

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Following the Money: U.S. Finance in the World Economy of the risks associated with these products, enhance the coverage of the capital and current account data, and assist in the interpretation of the balance-of-payments data. Derivatives transactions have considerable bearing on international financial services in the form of fees and commissions, which also are components of the current account of the balance of payments. PROPOSED IMF BALANCE-OF-PAYMENTS AND SNA TREATMENT OF DERIVATIVES The importance of financial innovations has been explicitly recognized in the recent revisions of the IMF's Balance-of-Payments Manual (International Monetary Fund, 1993a) and the international System of National Accounts (see United Nations et al., 1993). The revisions to these systems present closely coordinated criteria for determining whether derivative instruments are classified as financial assets that should be recorded in the SNA financial account, the balance-of-payments capital account, and the national and sectoral balance sheets. The fifth edition of the IMF Manual emphasizes the linkages of the balance of payments, international investment positions, and the external sector accounts of the SNA as a set of integrated national accounts. The treatment of derivatives in the IMF Manual parallels that proposed in the SNA. In the IMF Manual, ''financial derivatives" are classified within the portfolio investment category. In addition, the coverage of portfolio investment has been widened to include, in addition to equities and long-term debt securities (bonds and notes), short-term (money market) debt instruments and financial derivatives. Financial derivatives—options, traded financial futures, and others—are to be classified as financial assets and thus included in the portfolio investment category. Essentially, the Manual distinguishes between assets, which represent actual claims, and the authorization, commitment, or extension of an unutilized line of credit or the incurring of a contingent obligation, which does not establish such a claim. According to the Manual, options, futures, and warrants give rise to transactions in current periods that create current assets and liabilities. Other derivative instruments yield contingent liabilities and assets. The Manual notes, however, that it cannot provide standards to cover all circumstances because of the complexity and diversity of the instruments. Its proposed treatments are to be applied to the most common instruments in their basic uses.

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Following the Money: U.S. Finance in the World Economy The SNA revision, jointly produced by statistical agencies of the United Nations, the IMF, the Organization of Economic Cooperation and Development (OECD), the European Community, and the World Bank, proposes that contingent or future liabilities and assets not be included in the balance sheets for the current period, since financial transactions would arise in a future period only if the contingency arose, or when the future asset or liability became a current one. Secondary instruments that are marketable, however, would be included. These marketable instruments have characteristics that give rise to actual financial assets or liabilities in the current period, such as a required margin payment or a current resale value. ACCOUNTING AND REGULATORY ISSUES Currently, the treatment of secondary financial instruments in the accounts of corporate enterprises varies according to the purpose for which the instrument is being held—that is, whether it is used for hedging, investment, or trading. This treatment affects the valuation and time of recording of transactions in the accounts and makes data collection on a consistent basis more difficult than otherwise would be the case. Contingent liabilities and assets are usually mentioned in the notes to corporate accounts rather than in the balance sheets. The premium paid for an option is entered in the balance sheet as an asset—usually as an investment within current assets. In contrast, the premium received by the writer of an option is not entered as a liability, as the premium is not repayable to the purchaser. Premiums received are credited to profit-and-loss accounts, but they are usually offset by a provision of the same amount in order to defer recognition of the receipt of income until the outcome of the option is known. The treatment of traded options by the writer (seller) of an option, however, is different: these are entered in the accounts of corporate enterprises as a liability (or negative asset), reflecting the fact that sales of these contracts produce short positions in these instruments, in contrast to the long positions reflected in the accounts of a purchaser. Concerns about the accounting and reporting of financial derivatives have by no means been confined to matters of collecting balance-of-payments data. In the United States, both the accounting standards authorities and federal regulatory agencies have taken great interest in these instruments. On the issue of market participants' public disclosures relating to derivatives, some observ-

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Following the Money: U.S. Finance in the World Economy ers have come to the conclusion that traditional accounting approaches have limited ability to encompass financial derivatives. New approaches to reporting and disclosure that focus on exposures to underlying risk factors (for example, exchange rate risk, interest rate risk) may be more informative than the traditional accounting focus on balance sheet categories and instrument definitions. In this alternative approach, derivatives would not be viewed in isolation, but instead would be considered in the context of a portfolio of cash market and derivatives positions exposed to the same underlying risk factors. 5 Financial Accounting Standards Board The Financial Accounting Standards Board (FASB) added to its agenda in May 1986 a project on financial instruments and off-balance-sheet financing. This project was to develop broad standards for resolving the accounting issues raised by off-balance-sheet instruments and transactions, as well as those raised by the inconsistent accounting guidance and practice that have developed for financial instruments over the years. Furthermore, the project was to provide a consistent conceptual basis for resolving financial instrument accounting issues—those issues that have already been identified as well as the many issues that have arisen as financial innovation continues. In October 1994 the FASB issued Standard 119 pertaining to disclosure and fair valuation of derivatives (Federal Accounting Standards Board, 1994). Early in its project, FASB proposed interim steps to improve disclosure about financial instruments while it considered more difficult and time-consuming issues of recognition and measurement. Work on such disclosure resulted in two FASB statements (Financial Accounting Standards Board, 1990a, 1991a). Statement No. 105 (1990a) extends present disclosure practices of some entities for some financial instruments by requiring all entities to disclose certain information about financial instruments with off-balance-sheet risk of financial loss. Statement No. 107 (1991a) requires disclosure of fair value of financial instruments for which it is practical to estimate fair value, including those not recognized in the statement of financial position. 5   Several recent reports by U.S. and international groups address issues of proper accounting and public disclosure: Bank for International Settlements (1994b, 1994c, 1995), Federal Reserve Bank of New York (1994), Group of Thirty (1993), and Institute of International Finance (1994).

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Following the Money: U.S. Finance in the World Economy Following these interim steps, FASB proceeded to the recognition and measurement part of its project. It issued a discussion memorandum on that subject (Financial Accounting Standards Board, 1991b) that delved into such basic issues as what financial assets or liabilities should be recognized in financial statements, how they should be reported, and how they should be measured. Questions directly relating to derivative and off-balance-sheet financial instruments were raised: "What should be the accounting for financial instruments that are intended to transfer market or credit risks—for example, futures contracts, interest rate swaps, options, forward commitments, nonrecourse arrangements, and financial guarantees—and for the underlying assets or liabilities to which the risk-transferring instruments are related?" The new Standard 119 applies to futures, forwards, swaps, options, and other financial instruments with option-or forward-like characteristics. It requires disclosure of the contract amount or notional equivalent of derivatives. In addition, it requires a discussion of the credit and market risks, cash requirements and accounting policies associated with these instruments. It also amends Statements 105 and 107 to require greater disaggregation of information, including information about fair value and risk. Federal Bank Regulators Federal bank regulatory authorities have been interested in derivatives and off-balance-sheet financial instruments for prudential reasons, reflecting their concern about the safety and soundness of U.S. banking institutions. In accordance with the Basle Capital Accord, the three federal bank regulatory agencies—the Office of the Comptroller of Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve System—in 1989 adopted risk-based capital requirements for the banks under their supervision. To monitor banks' risk-based positions, the three regulatory agencies, acting through the Federal Financial Institutions Examination Council (FFIEC), now require banks to submit certain information about derivatives. Currently, the quarterly Call Report covers financial contracts on interest rates, foreign exchange, and stock indexes as well as those on commodities and individual stocks (see Table 3-3 in Chapter 3).6 Bank holding companies 6   Financial guarantees (such as guarantees of loans, performance bonds, and letters of credit) are also covered by the Call Reports.

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Following the Money: U.S. Finance in the World Economy provide similar data in their quarterly (Y-9C) reports, filed with the Federal Reserve (see Table 3-3). Both reports cover the notional values of interest rate swaps, futures and forward contracts, option contracts, and similar contracts involving commodities and equities. They exclude market value data for certain exchange-traded contracts, as well as foreign exchange contracts with original maturities of less than 14 days. Annual report disclosures of the "amount of accounting loss," as required by FASB's Statement No. 105, generally include these contracts. Such disclosures in annual reports of corporations may also differ from the market value data included in Call Reports and Y-9C reports, depending, for example, on how the organization discloses contracts that are used for hedging purposes. Other than these differences, market value disclosures in both reports are generally similar to disclosures of the amount of accounting loss in corporate annual reports. The information reported on the Call Reports and the Y-9C differs from that required for balance-of-payments purposes in various ways. Specifically, the Call Report information is submitted on a consolidated basis, by institution, with each U.S. bank including in its report the aggregate of its worldwide activities, including those activities of its overseas branches. Contracts are not disaggregated in terms of residents and nonresidents, and a single amount would be reported for the total value of a reporting bank's holdings of, for example, interest rate swaps, with no separate reporting of the amount of those swaps contracted between resident and nonresident parties. More recently, federal bank regulators, again operating through the FFIEC, introduced a limited but focused reporting form (FFIEC 035), the Monthly Consolidated Foreign Currency Report of Banks in the United States. It is required only of banking institutions that engage in significant amounts of foreign exchange activities: generally, U.S.-chartered banks and U.S. branches and agencies of foreign banks that have more than $1 billion in commitments to purchase foreign currencies and U.S. dollar exchange. Again, the data are reported on a consolidated basis, with each U.S. chartered bank that files reporting its worldwide activity. However, the FFIEC 035 focuses not on all the off-balance-sheet activity of a bank, but rather on the institution's foreign-currency exposure. Thus, it calls for reporting items that affect the institution's foreign-currency position: both off-balance-sheet activities (contracts to buy or sell foreign currencies, spot or forward, through OTC or organized exchanges; foreign-currency options, written or purchased;

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Following the Money: U.S. Finance in the World Economy interest rate swaps if there is a cross-currency exchange included) and on-balance-sheet activity (in the form of "noncapital" assets and liabilities denominated in foreign currencies).7 The FFIEC 035 asks filers to submit the data disaggregated by individual foreign currency: each filing institution reports for both major types of off-balance-sheet contracts (options, futures, etc.) and on-balance-sheet items the assets and liabilities in each of the major foreign currencies (German deutsche marks, Swiss francs, British pounds, etc.). This monthly report thus provides data on the filing institutions' consolidated long positions and short positions in specific foreign currencies. Data collected in the five FFIEC reports (031, 032, 033, 034, and 035) are primarily intended for bank supervisory and regulatory purposes. Aggregated data are published in the Federal Reserve Bulletin and in the Federal Reserve's Annual Statistical Digest. The Call Report data are also included in the Uniform Bank Performance Report and the annual report of the FFIEC.8 RECOMMENDATIONS An interagency group led by the Federal Reserve and including the Federal Reserve Bank of New York, the Treasury Department, the Bureau of Economic Analysis, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and other financial regulatory bodies, should be established to undertake several tasks. Specifically, the interagency group should identify the major participants in financial derivatives markets, the intermediaries involved, and the various forms of transactions. It should also examine the coverage, quality, and consistency of the limited data on financial derivatives currently collected by the Federal Financial Institutions Examination Council, the Commodity Futures Trading Commission, the Securities and Exchange Commission, and private institutions and determine ways to expand coverage, eliminate duplication, standardize definitions, and, whenever appropriate, integrate the data. The group should 7   In addition, Section 305 of the FDIC Improvement Act requires increased disclosure of derivative exposures, and Section 308 requires banks to establish standards to evaluate their exposure to weak institutions, including those arising from derivative products (see Federal Reserve Board et al., 1993). 8   Call Report data are available to the Reserve Bank staff through the Federal Reserve Board's computer facility, and to the public on magnetic tape through the National Technical Information Service subscription files.

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Following the Money: U.S. Finance in the World Economy work closely with market participants, industry groups, and the accounting profession to ensure harmonization of accounting, regulatory, and statistical reporting practices, especially for classifying derivatives transactions and recognizing their market values, income flows, and gains and losses. It is important that the group secure the cooperation of filers and that filers have an appreciation of the purpose and significance of the transactions they are required to report. Because many of the fastest growing derivatives transactions are international in nature, consideration should be given to collecting data on such activities from large financial institutions and multinational corporations, and to classifying the data by major financial instruments and in key currencies. Over the long-term, harmonization of international reporting standards for derivatives is desirable. (4-1) Data on financial derivatives are needed for interpretation of market developments for macroeconomic policy purposes, as well as for regulatory purposes. These data also are needed for the more specific purpose of improving the measurement of the capital account of the balance of payments. Better coverage of U.S. international currency exposure also is needed as an addendum to the data on the U.S. international investment position. The Federal Reserve, other financial regulators, the Treasury Department, and the Bureau of Economic Analysis should work together, in consultation with data providers, to define the most important data needs and to develop procedures for data collection. (4-2) As a near-term step, using the guidelines contained in the IMF Manual, the Treasury's TIC data collection program should be expanded to cover derivatives transactions that represent on-balance-sheet activities. The panel believes that the concepts and procedures proposed in the Manual and in the revised international System of National Accounts are useful to facilitate the development of data reporting frameworks on financial derivatives for balance-of-payments purposes. Nonetheless, given the complexity of these instruments and differences in national accounting systems, it is important that the U.S. data compilers work with the U.S. accounting profession and market participants to refine the guidelines for firms reporting in the United States. (4-3)