The mysterious case of missing $500 billion!

Here is the first part of a 3-part series on exotic financial derivatives, how they wreaked havoc globally, and why the global financial game of currency derivatives seems to resemble rigged casions.

It is a $500-billion fraud story, perhaps not yet fully realised by the financial world.

Despite its size, mainstream media, both in India and abroad, seem to have ignored it. Perhaps most of them are unaware of the story in all its dimensions.

The victors of this game -- the global financial players -- are silently jubilant while the victims -- are facing the situation with inexplicable stoicism. In short, the global silence on this issue is funereal.

A startling revelation by an IMF Working Paper, authored by Randall Dodd, points out to the extent of damage caused by currency derivatives.

It estimates that over 50,000 firms in several Asian countries -- including India, Sri Lanka, Malaysia, Indonesia, Japan, Korea, Hong Kong SAR, Taiwan and China, besides a few other countries -- had lost in excess of $530 billion -- yes, $530 billion! -- due to exotic currency derivatives.

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According to this paper, "an international pattern of exotic derivatives trading appears to have helped transmit the financial crisis from the United States and the European Union to many different emerging market economies."

It further adds rather ominously: "The losses turned out to be large enough to have financial market and macroeconomic consequences. As these large financial sector problems appeared in country after country, the pattern began to take shape."

And that is the crux of the issue.

In India, for instance, the paper points out that Axis Bank (a small player in the Indian context) is being sued by its customers that lost over $3 billion on foreign currency derivatives.

Similar stories are reported from Brazil, Poland, and Mexico, with the Brazilian authorities estimating that its loss to be in exceed $28 billion!

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A well-planned operation

That is not all. The IMF paper increasingly points to a well thought out and planned operation carried out with military precision by certain global banks. These contracts, for instance, were entered around the same time in 2007-08.

Further, the banks in these countries sold these 'products' to these exporters with a missionary zeal. At times banks have lured exporters with freebies and, in some instances, even with bribes. It surely was taken from Art of War: Draw them in with the prospect of gain, take them by confusion.

Subsequently, the exporters found to their horror that the deal had turned bad and they were saddled with significant losses.

The profile of the victims too is similar across continents -- mostly the victims were small and medium enterprises, usually exporters (SMEs).

These 'products' were in effect complex currency derivatives. And when currencies gyrated violently, as they did in 2007 and 2008, exporters uniformly across continents found out that they were holding the wrong end of the stick.

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What is intriguing is that the potential gains for these exporters -- read potential loss for the banks -- were strictly capped to favour banks under these contracts.

However, potential loss for exporters -- read potential gains for banks -- remained uncapped. And when the potential turned into actual, all hell broke.

Naturally, the adverse currency movements (from the exporters' perspective) turned into a virtual bottomless pit for them.

Obviously, the banks had done their home work pretty well in structuring the contracts as well as anticipating the currency movements of 2007-08.

Or did they fashion these contracts fully confident of shaping currency movements across continents? This requires some global investigation.

. . . 

Nevertheless, exporters -- some of whom are bankrupt -- now allege that the banks had lured them into these contracts with repeated assurances of absolute safety and decent profits.

Bankers allege that the exporters by their excessive greed have turned a simple hedging mechanism into a complex profit making tool. Exporters in turn have invoked the concept of mis-selling and alleged breach of trust by banks.

Further exporters now claim to have no financial expertise to comprehend these complex products and the magnitude of risks embedded in them.

Derivatives: Complexity compounded by confusion

Derivatives, it may be noted, are the confluence of high-end mathematics and economics. And most people can neither comprehend mathematics nor economics.

Naturally explaining all these to the uninitiated is akin to a dumb teaching Chinese to a blind. Surely, in this diffused scenario of charges and counter charges, things cannot get any worse. Risk management is definitely a risky business.

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But what is worrying is the size and complexity of the derivatives traded globally, especially those entered Over The Counter (OTC). It may be noted that as at December 31, 2009, the value of outstanding OTC derivatives across the globe aggregated to in excess of $615 trillion.

That implies that every person on this planet (with a population of 6 billion) has a derivative exposure in excess of $100,000! Naturally, the gargantuan size of the OTC derivatives, and their obscurity and complexity poses a significant systemic risk to countries.

As already pointed out several of these cases are in Courts. What is confounding the judicial system across countries, besides its inability to fully comprehend these 'products', is how to balance the contractual obligations (between financial players and SMEs) on the one hand and to decipher the global pattern on the other, and figure out the linkages between the two.

In the process they seem to be falling between the two stools.

With the benefit of hindsight it can be safely stated that there is a very clear pattern in the manner in which these products were marketed, structured and sold by financial players.

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While exporters and SMEs were felled by their own greed, one is indeed stumped by the laser like precision of global banks that marketed and seem to have profited by all these.

Unfortunately, in a world of globalised finance, regulation to this day is strictly national. That provides the necessary leeway to global banks to wreak havoc at a national level and get away citing contractual obligations without getting probed at the global level.

Greed or machinations of the banks -- it is your call. But the moot point remains -- how could global banks be so sure of the currency movements even before they entered into the contracts?

Are central bankers a mute witness to a game played in a rigged casino?

Part-II: Why currency derivatives are like rigged casinos! 
Part-III: Who will bell the big banking cats?