Deriving a hard bargain

‘Any finance director who doesn’t know what his treasury team is up to isn’t doing his job.’ This stern reproach from John Precious, former finance director of Wellcome, serves as a reminder that treasury operations, particularly derivatives, are not the exclusive preserve of whizz-kids locked in padded dealing rooms.

As if such a reminder were necessary after the spate of derivatives-inspired horror stories over the last ten years. The most frightening is probably the Procter & Gamble episode. It is the one which, above all, shows that finance directors simply cannot leave treasury matters to the treasury department.

True, the $100m loss suffered by the US consumer products giant was tiny compared to many. And true, Barings was the ultimate nightmare – no treasury boss or finance director has slept quietly since February 1995 when Nick Leeson’s ‘profitable’ derivatives arbitrage operation was exposed as an u850m black hole of hidden loss-making deals.

The Hammersmith & Fulham disaster of the 1980s was a double whammy: not only were the council finance people so confused that they didn’t know if they were dealing in futures or options, but the courts ruled that local authorities had no power to dabble in such financial exotica anyway.

It left the counter-party banks holding the bag, unable to make the London borough cough up for the losses it suffered at their expense.

What was different about Procter & Gamble was the fact that its own treasury people claimed that they simply did not understand the interest rate swaps deal that Bankers Trust sold to them.

P&G suffered not from a fraud, nor from a cover-up of a series of dealing errors, nor from a critical mistake in market forecasting. Instead, the treasury team of one of the US’s largest corporations was bedazzled by the rocket scientists on Wall Street. They didn’t realise that a deal based on an assumption that interest rates would stay low would hit them very hard if, as happened, they suddenly soared.

Lessons learned from disasters

Two things have happened in the treasury world since then. First, some market intelligence suggests that corporate users are shying away from the more complicated derivatives deals. ‘The lesson is, don’t deal in things you don’t understand,’ says one banker at Standard Chartered who watched the P&G saga unfold.

Something more mundane, but just as important, is also happening. ‘In common with all the other banks, Bankers Trust is now being extremely careful to document the capacity in which it is dealing with a company,’ says Derek Ross, partner in charge of treasury services at Deloitte & Touche Consulting Group. ‘A bank can either deal with the client on the basis that it is the company’s adviser in risk management or it can deal on the basis that it is simply selling them transactions.

‘If acting as an adviser, then the adviser has a duty of care only to recommend something which is appropriate. If the company is being sold to, it has to recognise that the person at the other end of the telephone is actually selling something.’ Caveat emptor, writ large.

Ross explains that the engagement letters between the banks and their corporate clients now spell out whether the bank is acting as adviser or counter-party. These engagement letters form part of the master agreements which govern all treasury transactions between a bank and its client.

Pleading ignorance seems unlikely to work in an English court. In a High Court case last year, the judge ruled in favour of Bankers Trust and against the client: ‘The assumption on which business is conducted is that both parties understand, or avail themselves of advice about, the area in which they are operating,’ the judge said. ‘Business could not otherwise be carried on.’

He added: ‘A (person) holding himself out as able to understand and evaluate complicated proposals would be expected to be able to do so, whatever his actual abilities.’

The way finance and treasury functions deal with each other and with the rest of the business is also changing. A survey last autumn by the English ICA’s Board for Chartered Accountants in Business found 35% of accountants in commerce and industry regarded knowledge of treasury matters as an important skill for them to have or to acquire. By way of contrast, just 31% thought the same about accounting standards and only 10% thought it was important to have knowledge of international accounting practices.

Departments working together

Derek Ross at Deloittes says treasury departments are now rarely run as ‘black boxes’. Rather, ‘the treasurer is having to undertake his role in conjunction with the commercial parts of the business in a more integrated fashion than in the 1970s or 1980s when they just picked up the cashflows and decided where to take things from there’. Now, he says, treasury departments are working with, for example, buying departments or sales-teams on foreign currency exposure and cashflow management.

David Swann, a project manager at Price Waterhouse, says: ‘Business managers often don’t realise that they are creating a treasury event. They might say, “We got a good deal on the price – provided we pay in sterling”.’

Ross adds that one sign of the changing relationship is being seen in IT systems: ‘Systems in treasury are typically stand-alone, client-server, PC-type systems. But, increasingly, the major accounting software houses are producing treasury modules for their systems.’

Paul Norton, head of system accounting at Abbey National Treasury Services, has recently been responsible for introducing a new accounting system.

His Dodge software system has a ten-gigabyte database. After all, it has to be able to handle 50,000 accounting entries per day. Sound like a lot?

‘People like Nomura would run 200,000 a day,’ he says. Each trade may involve postings to some two dozen separate accounts in the general ledger, such as interest accruals or premium/discount amortisation accounts. Each instrument traded may have its own account.

The aim is to be able to analyse vast amounts of data as quickly as possible.

The system is designed for regulatory and financial reporting purposes, so the accounting treatment has to be scrutinised carefully. It doesn’t help that some of the reporting rules are a grey area. ‘A lot of systems can’t handle it,’ he says.

To hedge or not to hedge

But why bother with derivatives at all? David Swann points out that the common US attitude is that hedging is risky, while the common perception in the UK is that not hedging is risky.

A booklet by the Association of Corporate Treasurers, A Treasury Policy Blueprint, gives many examples of different corporate policies and dilemmas.

Jaguar, for example, has to deal with the fact that it has a sterling cost base, a large proportion of its customers in the US, its main competitors in Germany and a growing competitive element from Japanese luxury car-makers.

Coats Viyella said in its 1994 annual report that it did not hedge its profit & loss foreign exchange risks ‘as it is not felt that this necessarily adds to shareholder value in the longer term’. But the company effectively hedges its US dollar-related assets by financing them with US dollar loans – a hedge that does not involve using derivatives. But it does manage its interest rate exposure through a balance of longer-term fixed and shorter-term floating rate instruments, forward deals and swap arrangements.

US industrial giant General Electric uses many different interest rate and currency instruments ‘to achieve the lowest cost of funds’. The company makes clear that it deals in such instruments purely as an ‘end-user’ and not as a trader. British Petroleum, on the other hand, says that it uses derivatives for hedging purposes – ‘which do not expose the group to market risk because the change in their market value is offset by an equal and opposite change in the market value of the asset, liability or transaction being hedged’ – and trading purposes – ‘changes in market value give rise to gains and losses’.

The Accounting Standards Board is still wrestling with the problems of accounting for derivatives. Chairman Sir David Tweedie is famous for his example of the UK company which wants to import a u50,000 machine from Germany. If it hedges perfectly against the Deutschmark, it will cost u50,000, even if the DM depreciates by half. If it doesn’t hedge, then the asset will only cost u25,000. Tweedie’s view is: ‘If you hedged, you’ve taken a punt on the Deutschmark and you’ve got it wrong.’ Hence, the hedge cost should go straight into the p&l, though the asset itself goes into the balance sheet and is amortised over several years.

So who is trading derivatives? Certainly most FTSE-100 companies are.

And many in the FTSE-mid-250. Go much further than halfway down that list, though, and the number of companies that get involved in derivatives dealing is very low (other than foreign exchange forwards which, Ross says, ‘couldn’t be any more “plain vanilla”‘ and are not generally regarded as real derivatives).

A survey by the National Association of Pension Funds last February revealed that 47% of pension fund managers use futures or options – a thought that must give fund trustees nightmares of the ‘Robert Maxwell meets Nick Leeson’ variety.

The size of the market is frightening. The International Swaps and Derivatives Association estimates that interest rate swaps worth $8.7 trillion were executed in 1995 alone, and that the total amount of interest rate and currency swaps outstanding at the end of that year was $14 trillion.

Exchange-traded derivatives – futures and options – are an even bigger market, since they are standardised, easily traded contracts, rather than bespoke deals arranged between banks or between a bank and its client.

The London International Financial Futures & Options Exchange recently revealed that average trading volumes in short-term interest rate and long-term bond options and futures amounted to u118bn per day. And LIFFE is probably the third largest market after the Chicago Board of Trade and the Chicago Mercantile Exchange.

Perhaps 95% of these figures relate to bank-to-bank business, with just a small fraction involving end-user corporate investors. But Ross points out that this vast pool of inter-bank trading creates the liquidity that makes it possible to execute big deals for companies.

But isn’t all of this a zero-sum game? ‘Yes,’ says Ross, ‘because there is no transaction which doesn’t have a counter-party. But the reason why it’s not easily noticeable as a zero-sum game is that you don’t get to a point where everyone adds it all up.’

Or as John Maynard Keynes very nearly said, in the long run we are all dead – but not all at the same time.

Derek Ross, partner in charge of treasury services at Deloitte & Touche Consulting Group, gives some advice on how to deal in futures, options and swaps – and live to tell the tale

How to survive derivatives

Board approval of strategic policy is page one stuff. You shouldn’t do a series of derivatives transactions until you have already determined what your policy framework should be. The company should decide as a matter of policy in what set of currencies it wants its liabilities, and in what proportion, and what proportion of these liabilities should be at fixed rates and which should be at variable. From that point on, anything which the treasury does will be done in order to achieve that policy.

Has the board of directors approved the use of derivative transactions including their strategic use, the explicit policies and the related procedures?

Is this approval specific as to purpose (for example, hedging or trading), product type and market and credit risk limits?

Have the terms been adequately defined?

Does the senior management have an adequate understanding of derivatives?

Has the board of directors or senior management approved the company’s risk management approach?

If you have dealing mandates in place with a bank, you can’t stop a dealer doing an unauthorised transaction if it is within the terms of the mandate, because the mandate provides that that person is authorised to deal in specified instruments. But what you can do is ensure that if an unauthorised transaction is done, that it is picked up the following morning at the latest. You insist on an exchange of confirmations with the bank and that confirmation should go to somebody independent of the dealer. This is the one control which you should never compromise on.

Do procedures ensure that only authorised persons can commit the company to derivative transactions?

Are these arrangements documented in mandates with all counter-parties?

Are stop-loss limits established by the company?

Are counter-party position limits in place?

Have individual authority limits been established to cover all financial exposures?

Is internal audit staffed with personnel with sufficient skill and experience?

A swap is effectively an arbitrage which enables a company to borrow, say, US dollars at floating rates, then swap so that it effectively becomes a loan in sterling at fixed rates. This may be cheaper than borrowing in the sterling market. But you have to consider the additional risk that you are taking on by entering into the derivatives transactions. And that’s where the treasury skill comes in.

Does the company evaluate and review the credit quality of its counter-parties?

Does the trading manager have a real-time method of monitoring exposure against limits?

Has the company established appropriate and independent performance measures for its derivatives activities?

Are market values obtained or fair values calculated for derivatives?

Are trades or hedges valued independently from the area responsible for transaction execution?

Checklist questions derived and abridged from, Risk Management and Control of Derivatives, by Derek Ross, Deloitte & Touche Consulting Group.