The Last Look…
Posted by Colin Lambert. Last updated: November 7, 2022
Yet again we are reading about a corporation suffering losses thanks to FX derivatives, and yet again the product in question is a Target Forward, so do we need better guidance on disclosures to clients around the use of these products because clearly the lesson of (recent) history is not being heeded?
So many of the derivatives that were sold to clients were a product of their time – specifically they are/were products that are predicated upon low vol and that potentially blow up when things get busy. This happened in Asia in 2008 when the onset of the GFC saw a large number of firms suddenly facing large losses as a result of what were seen as out-sized moves in rates, but, as I observed at the top, just over a decade later, no-one seems to have been bothered to learn the lessons, for here we are again – this time with European corporates suffering.
This is not to criticise the use of these products, in certain circumstances they are a valuable tool, but rather one has to question why (largely unsophisticated) corporates are concerned about shaving a few dollars off their cost of hedging in return for taking on the one thing they seek to avoid – market risk.
I have no doubt that some institutions sold (and again I am reminded of the difference between how we “sell” a derivative and “trade” an FX forward) derivatives to firms without adequate disclosure, but equally I am convinced that just as many corporate treasuries confidently assured their counterparty that they fully understood how the products worked and were happy to proceed. Both approaches were, are, a recipe for disaster.
The FX Global Code touches on this problem in as much as it recommends high ethical standards (don’t mis-sell) as well as making sure that the product is appropriate for the client, but how do we deal with the participants that say they understand when they don’t? It strikes me we could probably do with firmer language around disclosures regarding these products, because while the Term Sheets do indeed explain them, perhaps, given recent history, we need an “Armageddon explanation”?
Very simply, the seller of the derivative should explicitly state that the buyer is taking on market risk and provide examples of when these products have blown up and what the worst-case scenario is. It is not as though we don’t have enough real-life examples to use, but even if they don’t exist, provide a graph showing what happens is, for example, USD/JPY moves 15% over a six-month period.
If the corporate treasuries and sales desks of the world are going to persist in ignoring history, then we need an adjustment to the Code in the next re-write to make them heed it
This could be provided in the Code via an Example in the Annex and then at least we would have a specific guideline that people could not (or should not) ignore.
Of course, this would also require greater awareness of the Code amongst corporates who are not, especially at the medium/lower levels it has to be accepted, the main target of the document. This may prove too difficult, but at least the selling institution – the one that always ends up in trouble and facing a lawsuit – can point to its adherence to the Code. If the counterparty declines to pay attention to the Code that is its own issue and I would hope that in any court of law it would be significant to the outcome that one party adheres to an industry-recognised code of conduct, and did so in this case – doubly so if the buyer has the harsh facts in black and white that they are taking on some market risk and this is how bad it could get.
We have to understand that, as a result of the recent outsized moves in exchange rates, we are likely to see even more lawsuits over alleged mis-selling of derivatives – there is a blame game going on here that is as inevitable as night following day. This cannot be avoided for the time being, but if the corporate treasuries and sales desks of the world are going to persist in ignoring history, then we need an adjustment to the Code in the next re-write. If we get it, then the Code is continuing to do what it has done from the start – help the industry avoid a raft of bad headlines and lawsuits. Because I find it hard to believe that in another decade’s time when, inevitably, there is a largely-unforeseen market event, these issues won’t come up again.