Hammersmith and Fulham:

Interest Rate Swaps Debacle

Group 4

Devi Prasad Biswal 09P192

Gaurav Agrawal 09P194

Nikhil Pai 09P215

Saurabh Jain 09P229

Table of Contents
Introduction.................................................................................................................................................2
Background of the debacle..........................................................................................................................3
About Hammersmith and Fulham...........................................................................................................3
The Background.......................................................................................................................................3
The Start..................................................................................................................................................3
Perverse Incentives..................................................................................................................................4
The Questioning......................................................................................................................................4
The Lawsuit..............................................................................................................................................5
The Judgement........................................................................................................................................5
Underlying Risks of the Debacle..................................................................................................................6
What is Legal Risk?..................................................................................................................................6
The consequences of Legal Risk...............................................................................................................6
Types of Legal Risk...................................................................................................................................7
Legal Risk and Hammersmith and Fulham...............................................................................................7
Magnitude of the loss due to the debacle...................................................................................................8
Influence of the judgement on other cases.............................................................................................8
Reasons for the debacle and the role of the derivatives...........................................................................10
Inadequacy of the system and role of proper risk management...............................................................12
Macro / systemic impact of the debacle...................................................................................................14
Post-debacle scenario of the company or organization or economy.........................................................14
The Learning from the Debacle.................................................................................................................16
Define Risk Limits...................................................................................................................................16
Do not assume you can outguess the market........................................................................................16
Make Sure You Fully Understand the trades you are doing...................................................................16
Make sure a Hedger does not become a speculator.............................................................................17
Conclusion.................................................................................................................................................18
Introduction
The late 1980s and 1990s saw some spectacular losses in derivatives market. Some of these were made
by financial institutions while the others by nonfinancial organizations and were ranging from few
million dollars to even billions of dollars. These events were viewed as the indictment of the whole
derivatives industry. But the truth is that the derivatives market is a vast multitrillion-dollar market that
by most measures has been outstandingly successful and has served the needs of it users well. These
events were but a tiny proportion of the total trades in the derivatives market. Thus it makes it
imperative to study the details of these debacles, what made them occur in the first place and the
lessons derived from them so as to study and analyze the reasons for these aberrations in the derivative
market.

The Hammersmith and Fulham debacle of 1989 was a similar event in the series of such debacles. In
1989 a nervous district auditor pulled the plug on the Hammersmith and Fulham Local Authority’s
massive swaps book. This was just the start of the notorious Hammersmith and Fulham debacle. The
subsequent default and legal battle, which ultimately involved more than 130 UK local authorities and
75 banks, cost the banks concerned an estimated L750 million, and focused derivatives providers’ minds
on legal risk.
Background of the debacle
About Hammersmith and Fulham
The London Borough of Hammersmith and Fulham is a London borough in West London, and forms part
of Inner London. The London Boroughs are the principal local authorities in London and are responsible
for running most local services in their areas, such as schools, social services, waste collection and roads.
These boroughs are administered by London Borough Councils which are elected every four years. The
London boroughs are local government districts and have similar functions to metropolitan boroughs.
Each London borough is a Local Education Authority. Until 1990 the Inner London boroughs were served
by a shared LEA, the Inner London Education Authority.

The London Borough of Hammersmith and Fulham was formed in 1965 by merging the Metropolitan
Borough of Hammersmith and the Metropolitan Borough of Fulham. It was known as the 'London
Borough of Hammersmith' until its name was changed on 1 January 1979 by the borough council. The
two had been joined together previously as the Fulham District from 1855 to 1886.

The Background
Before embarking on the details of the debacle, it is important to understand the background of the
situation and the context in which the events occurred. There were three factors which conspired at the
one time. First, the local authorities in the UK had a statutory cap placed on the amount of money which
they were able to raise through local taxation and also on the amounts which they were entitled to
borrow. Therefore, the local authorities were seeking alternative means of raising finance or of
manipulating existing financial arrangements. Given that interest rate swaps were, at the material times,
off-balance sheet instruments, finance directors were able to use them without any requirement to
declare them in annual accounts. This created a potential hidden source of extra funding.

Second, at a time of very high interest rates, the floating rate debt profiles of local authorities were
unattractive. Given that local authorities were on fixed budgets, there was no advantage to paying rising
amounts from that capped financial resource in interest payments. Therefore, the interest rate swap
offered a tool with which local authorities could relieve the pressure on their restricted budgets by
seeking fixed rate funding. This is the prudent, hedging motivation for the financial strategies of the local
authorities.

Third, at a time of volatile market movements, interest rate swaps could enable the local authorities to
speculate on the markets. Any profit which could be made on financial markets could add to local
authority budgets without requiring borrowing in breach of statute.

The Start
Thus at this time of rigorous rate-capping, the local authorities in the UK were seeking alternative means
of raising finance or of manipulating existing financial arrangements. Given that interest rate swaps
were, at the material times, off-balance sheet instruments, finance directors were able to use them
without any requirement to declare them in annual accounts. This created a potential hidden source of
extra funding.

Under an interest rate swap, one party (the fixed rate payer) agrees to pay the other over a certain
period interest at a fixed rate on a notional capital sum; and the other party (the floating rate payer)
agrees to pay to the former over the same period interest on the same notional sum at a market rate
determined in accordance with a certain formula. Interest rate swaps can fulfil many purposes, ranging
from pure speculation to more useful purposes such as the hedging of liabilities.

One form of interest rate swap involves what is called an upfront payment, i.e. a capital sum paid by one
party to the other, which will be balanced by an adjustment of the parties' respective liabilities. The
fixed rate payer may make an upfront payment to the floating rate payer, and in consequence the rate
of interest payable by the fixed rate payer is reduced to a rate lower than the rate which would
otherwise have been payable by him. It was this feature which, in particular, attracted local authorities
to enter into transactions of this kind, since they enabled local authorities subject to rate-capping to
obtain upfront payments uninhibited by the relevant statutory controls.

Local authorities began to enter into transactions of this kind soon after they came into use in the early
1980s. At that time, there was thought to be no risk involved in entering into such transactions with
local authorities. Financially, they were regarded as secure; and it was assumed that such transactions
were within their powers.

Perverse Incentives
During the fiscal years 1987-1988 and 1988-1989 Hammersmith and Fulham had entered into
substantial transactions through a capital market fund in the name of the council with a view to making
a profit. The capital market fund was established without a specific resolution of the council and the
council members received no report on the transactions. For the year 1987-88 the council resolved, on
the recommendation of its financial and administration committee, to borrow to meet its capital and
revenue payments during the year, and authorized the director of finance to arrange and administer the
council's borrowing on its behalf.

By January 1988, the finance and administration committee had received a report that the director of
finance had continued to arrange transactions in the London Money and Capital Market in order to
maximise gains on favourable interest rate movements. No details in writing of the transactions were
given. On 24 February 1988 the council resolved to authorize the director of finance to arrange
transactions in the London Money and Capital Market in order to take advantage of favorable interest
rate movements. By 31 July 1988, the council had entered into a number of transactions of which the
majority were ones in which the council would benefit if interest rates fell and lose if interest rates rose.

The Questioning
The auditor questioned the legality of the transactions with the result that the council's director of
finance closed all the transactions save those where the council would incur a loss if he did so. From
August 1988 to 23 February 1989, the council continued to carry out transactions but as part of an
"interim strategy" designed to reduce the extent of the council's exposure to loss which arose from a
rise in interest rates.

The council obtained its own legal opinion in which it was advised that if the transactions were
undertaken as part of the proper management of the council's funds, they would be intra vires under
section 111 of the Local Government Act 1972, but if the council was carrying on a business in
transactions it would be ultra vires. The council was not advised however as to what action it should
take at that stage and at a meeting on 22 February 1989 the auditor advised the director of finance that
the council had to desist from further activity unless supported by legal opinion. Later that day, the
council was advised by counsel that the scale of the transactions was outside acceptable parameters and
was therefore unlawful. After 23 February, the council was involved in only seven such transactions.
The Lawsuit
The auditor applied, under section 19 of the Local Government Finance Act 1982, for a declaration that
the items of account appearing in the capital market fund for the financial years 1987-1988 and 1988-
1989 were contrary to law, and an order for rectification of the accounts.

The Divisional Court granted the auditor a declaration that the items of account appearing within the
capital markets fund account of the first respondent for the financial years beginning on 1 April 1987
and 1 April 1988 were contrary to law and ordered that the accounts of the first respondent for those
financial years be rectified with liberty to the parties to apply if what was required to rectify those
accounts was not agreed.

On appeal by the banks, the Court of Appeal ordered that the declaration made by the Divisional Court
should stand save in so far as it related to transactions entered into in, on or after 25 July 1988 and that
there should be no order for rectification. It was further ordered that questions relating to the
enforceability of the transactions reflected in the accounts should not be decided in those proceedings.
There was also an appeal by the council in respect of the variation made by the Court of Appeal to the
declarations made by the Divisional Court. The two appeals were conjoined.

The Judgement
The House of Lords held that such transactions were ultra vires for the local authorities who had
entered into them. The key legal argument discussed during the case was that whilst there was no
express statutory power entitling the council to enter into financial transactions, it had an implied power
under section 111 of the Local Government Act 1972 to do anything which was ancillary to the discharge
of any of its functions, which included borrowing. However, having regard to the provisions and
limitations of the Act of 1972, in particular Part I of Schedule 13, it could not be said that the
transactions were calculated to facilitate, or were conducive or incidental to the discharge of, the
council's function of borrowing within the meaning of section 111, and, therefore, the transactions were
ultra vires and unlawful.

In his judgement Lord Ackner concluded that:

“The purpose and function of swap transactions is not to facilitate, to help, or to make more easy the
discharge by the local authority of its function of borrowing. The original underlying debt or debts
continue in existence and are all unaffected by the swap transactions. In many cases the swap
transactions are entered into long after the underlying borrowing and were not even in contemplation
when such borrowing took place. The function and purpose of swap transactions is to alleviate the
consequences of borrowing by the local authority purchasing what has been conveniently called ‘a
stream of income’ or a ‘cash flow’ which will enable it to reduce the net cost of its borrowing.”

This judgement caused grave concern among financial institutions, and especially foreign banks, which
had entered into such transactions with local authorities in good faith, not necessarily contemplating
that the ultra vires doctrine might undermine what they saw as a perfectly legitimate commercial
transaction.
Underlying Risks of the Debacle
The main fallout of the case was the failure of the courts to enforce the credit enhancement and risk
allocation provisions of the contracts and standard form agreements between the commercial parties to
the swaps contracts thereby giving rise to credit risks in such contracts. But another significant form of
risk that arose out of the case and gained substantial traction in the further years among the
academicians and regulators is the Legal Risk.

What is Legal Risk?

Legal risk can have different meanings for different people. Some have suggested that legal risk
comprises the risk that a contract may not be legally enforceable. Others have suggested that the legal
uncertainties with rules and regulation are also valid elements of legal risk. Although there may not be
any universal accepted definition of what is meant by legal risk, a general definition of the Legal Risk can
be: a failure in the legal framework, documentation or counterparty that results in the increased
probability of risk and loss.

The above definition has the advantage of recognising that legal risk consists of macro and micro
elements. Macro legal risk refers to the risk that the legal framework or regulatory environment may fail
to protect market counterparties from enforcing their derivatives contract. Macro legal risks are generic
in nature. They can have systemic ramifications because they represent risks that are not entity-specific
and have the potential for wide application. Some notable examples of macro legal risk found to exist
with financial derivatives include:

• the risk of loss because a derivatives contract cannot be legally enforced in a court of law
because one of the counterparties lacks the legal capacity to contract;
• the risk that certain netting arrangements may be unenforceable in a bankruptcy or insolvency
proceeding;
• the risk that a derivative may be characterised either as an illegal gaming, insurance contract or
bucket shop arrangement, or as an unauthorised and illegal securities or futures transaction;
and
• the risk that compound interest may not be awarded by a court in the absence of a legally
binding agreement.

In contrast to macro risks, micro legal risks are not generic but instead entity-specific. They principally
arise at the entity level because there is a failure by the entity itself, which has adversely affected their
rights under the contract. Micro legal risk can be thought of as a subset of operational risk because it
represents a failure at the operational level of the entity or individual in question. A good example of
micro legal risk is the risk posed by customer litigation. Customers and end-users litigate when they
believe that they have been misled or lied to by a dealer or broker. Dealers who have misled their clients
or committed fraud have received little sympathy from the courts or market regulators, who have been
keen to uphold market integrity and protect consumers from market abuse.

The consequences of Legal Risk

Legal risk, defined in this manner, poses a significant threat to overall efficiency in derivatives markets
because it adversely affects the enforceability of contractual rights and obligations, generates
uncertainty, and exposes market participants to costly and inappropriate disclosure. Legal risk may not
only impeach the enforceability of a derivatives contract but has the potential to affect the
recoverability of any monies or other property paid under a contract that is later found to be legally
unenforceable.

Types of Legal Risk

The three ways in which a contract for financial derivatives can be affected by a null and void ruling are
as follows:

• First, over-the-counter (OTC) derivatives that are speculative in nature may be characterised by
a court as an unauthorised gaming and wagering arrangement. This exposes market issuers and
counterparties to the risk that the derivative itself, or the contract, may be declared null and
void because it represents an illegal gaming venture.
• Second, legal enforceability of a derivatives contract may also be affected by a counterparty that
lacks, prima facie, the requisite capacity to enter into the agreement. The consequence of this
action is that the contract will also be declared null and void by virtue of the legal doctrine of
ultra vires.
• Third, a derivatives transaction may be declared null and void by a court if the broker/dealer has
engaged in conduct that amounts to a misrepresentation, fraud or negligence, or the transaction
is unsuitable to the client.

Legal Risk and Hammersmith and Fulham

The legal risk as described above manifests itself aptly and demonstrably in the present case of
Hammersmith and Fulham. Contract enforceability concerns arise when a derivatives contract is held to
be legally unenforceable in a court of law because the contract has been declared null and void from the
very beginning of the transaction. The consequences of nullity may be quite severe because it exposes
counterparties to other risks under the laws of restitution.

In this case, the House of Lords held that interest rate swap contracts that had been entered into by
Hammersmith and Fulham London Borough Council (LBC) were null and void, and legally unenforceable.
The decision had widespread ramifications for other government and statutory authorities whose legal
capacity to enter into financial transactions was questioned, and the validity of whose contracts was cast
into doubt.
Magnitude of the loss due to the debacle
The arrangement made by many local authorities under the swap contract collapsed when some
authorities’ speculation on interest rate movements meant that they ended up owing ever more money
under their debt portfolios than they had owed originally. But the most appalling impact was on the
finances of the London borough of Hammersmith and Fulham which led to the litigation and
subsequently caused the House of Lords to rule that these products were ultra vires UK local authorities.
Hammersmith & Fulham became the lead case, which was unfortunate given that Hammersmith &
Fulham had entered into more interest rate swap transactions than all of the other 77 local authorities
in the UK put together.

There were a number of interest rate swaps outstanding between local authorities and the financial
institutions before the litigation commenced in 1990 around Hammersmith and Fulham’s entry into the
marketplace. Lord Templeman found that there had been about 400 swaps entered into by 77 out of the
450 local authorities at that time. However, in relation to Hammersmith & Fulham, by 31 March 1989
the council had entered into 592 swap transactions and 297 of these were still outstanding. The total
notional principal sum involved in all the transactions entered into by the council amounted in the
aggregate to £6,052m … These figures distort the position because some swap transactions were a
hedge against others. But there is no doubt that the volume of swap business entered into by the
council was immense. The council’s actual borrowing on that date amounted to £390m, its estimated
expenditure for the year ending 31 March 1989 was £85.7m and its quoted budget for that year was
£44.6m. Additionally, the council lost about $600 million on these swaps.

In the context of such a massive exposure compared to such a small level of borrowing and of
expenditure, it would have been extremely surprising if the House of Lords had not decided the way it
did. Otherwise, it would have fallen to the ratepayers of the borough to make good those amounts
owed to the banks. It is also significant to note that this particular authority had entered into far more of
these transactions than all of the other authorities put together.

Influence of the judgement on other cases

The judgement delivered in the Hammersmith and Fulham case influenced various other cases of local
authorities which had been following similar policies. There then followed litigation in which banks and
other financial institutions concerned sought to recover from the local authorities with which they had
dealt the balance of the money paid by them, together with interest. Out of the many actions so
commenced, two were selected as test cases. These were Westdeutsche Landesbank Girozentrale v.
Islington Borough Council [1994], and Kleinwort Benson Ltd. v. Sandwell Borough Council [1994]. In a
powerful judgment it was determined that the banks were only entitled to recover from the councils the
net balance outstanding on the transaction between the parties, i.e. the difference between the upfront
payment paid by the bank to the council and the total of interest payments paid by the council to the
bank. It was decided that the bank's right to restitution at common law arose from the fact that the
payment made by the bank to the council was made under a purported contract which, unknown to
both parties, was ultra vires for the council and so void.

In the leading case of Westdeutsche Landesbank v. Islington, the bank had made payments to the local
authority under a ten year interest rate swap before the parties learned that the contract was void ab
initio. The question was then whether the bank was entitled to recover moneys already transferred to
the local authority under the contract under an action for money had and received: dubbed a “personal
claim in restitution” by Lord Goff. In considering the appropriate principles affecting restitution at
common law, the starting point for Lord Goff was with the speech of Lord Mansfield in Moses v.
Macferlan, where he said that the “gist of the action for money had and received” is that “the
defendant, upon the circumstances of the case, is obliged by the ties of natural justice and equity to
refund the money”.

It was held that there was therefore no reason of principle why a personal claim in restitution in favour
of the bank should have been refused. In accordance with the prescriptions of the House of Lords in
Sinclair, permitting such a claim would not have indirectly enforced the ultra vires contract “for such an
action would be unaffected by any of the contractual terms governing the borrowing, and moreover
would be subject (where appropriate) to any restitutionary defences …” Further it achieved Lord Goff’s
underlying concern that the lender should not be without a remedy.

Similarly in the case Guinness v. Kensington it was held that a contract which was ultra vires one of the
parties was always devoid of any legal effect. Further, payments made under such a purported
contracted were necessarily made for a consideration which had totally failed. Therefore, the money
was recoverable under a personal claim in restitution (or, money had and received). A party to such a
void swap was entitled to recover an amount equal to the difference between his payments and his
receipts over the life of the purported swap. It would make no difference to the analysis that the swap
had been completely performed. There could be no different right to property based on complete
performance than had otherwise been the case.
Reasons for the debacle and the role of the derivatives

As discussed above, the primary reason for the debacle is not giving due importance to the inherent
legal risks present in such contracts. The ‘lack of authority’ claims have plagued derivative transactions
in the United States also. The enforceability of transactions, and uncertainty in rules and regulation, has
been longstanding litigious issues with financial derivatives. The laws in such jurisdictions demonstrate
the fundamental problems and challenges posed by innovative financial markets. The regulatory
frameworks used show the difficulties of regulating financial derivatives in a consistent and efficient
manner. Some derivative products and the problems they face for law making can be discussed as
below:

 OTC derivatives may be characterised as illegal gaming and wagering contracts under state
gaming and wagering laws.
• OTC derivatives, such as credit derivatives, may be characterised as unlicensed and
unauthorised insurance agreements. This may lead to potential criminal prosecution for the
unlicensed dealer or provider of the OTC instrument.
• Exchange-traded financial derivatives, such as security derivatives, may be characterized as
securities. This risk is particularly relevant for security derivatives.
• OTC derivatives, such as swap agreements, may be characterised as ‘futures contracts’ or
‘securities’. The concerns here are that OTC market participants may be criminally liable for
conducting unauthorised futures or securities markets and, further, that the OTC agreements
are illegal and unenforceable.
• Certain equity derivatives may be characterised and regulated as ‘securities’ under the new
regulatory framework, and subjected to fundraising or prospectus disclosure in each of the
three jurisdictions.

Likewise, in the present case, the authorities were not sure as to whether the use of interest rate swaps
came in their ambit or not. This was aptly captured in the observations of Hobhouse J. who stated that:

‘… the purpose of those [interest rate swap] contracts was not any aspect of debt management or the
hedging of any loan contracts; it was simply another device which was designed to increase the revenue
available during the current year albeit at the cost of reducing the net revenue available in later years.’

What is not clear is what would have happened if the local authority involved had demonstrated that it
was using interest rate swaps solely for the purposes of managing the cost of funding its debt. What is
frequently forgotten is the breadth of the legislation that was at issue. Under s.111(1) of the [Local
government Act] 1972:

‘… a local authority shall have power to do anything (whether or not involving expenditure, borrowing or
lending of money or the acquisition or disposal of any property or rights) which is calculated to facilitate,
or is conducive or incidental to, the discharge of any of their functions.’

On this basis, the authorities themselves, the financial institutions and the Audit Commission came to
the view that local authorities would be able to enter into interest rate swaps for debt management
purposes. Indeed, it would seem to be logical that derivatives should be used to control exposure to
movements in interest rates in the same way that umbrellas are carried to guard against rain.
It is submitted that the only possible reading of this litigation and the speech of Lord Templeman in the
House of Lords in Hazell is that the courts were concerned to guard against a particular risk rather than
to deal with a specific failure on the part of one particular local authority to act prudently in the
management of its finances.
Inadequacy of the system and role of proper risk management
The large losses experienced by local authorities dealing in derivatives and further the unresolved issues
associated with the stock market crash in 1987 focused regulatory attention on the role that derivatives
played in each catastrophe. Regulators all over the world, including in Australia, were concerned about
the potential for systemic failure when major corporations disclosed large losses. Certain regulators
believed that they had been ‘left behind’ by the innovation in new derivative instruments. Some
regulatory authorities believed that up-to-date regulation was required to ensure orderly and secure
markets, and appropriate use of derivative products.

Financial markets create, manage and exploit risk: frequently at the same time. The role of the lawyer in
that context is to be a risk manager. Legal risk management can be achieved in one of two ways. The
first is by not entering into the market at all and thus avoiding any risk. The second is by creating
contracts which seek to control those risks. Where these contracts are held to be void, the ability of the
parties to control their risk portfolio is effectively removed. In unregulated financial markets, the role of
commercial and property law is to support prudential and lawful attempts to manage risk.

It was within this context that many regulators worldwide undertook a review of their existing
regulatory frameworks. The major objectives of the reviews were to identify problems that existed in
regulation and to take corrective action to remedy any problems. The reviews involved open forums
where market participants were encouraged to put forward written submissions on any aspect of the
current regulatory framework, including the creation of new proposals.

Regulators in the United Kingdom and United States undertook such reviews, and found similar
problems in their respective regulatory and legal frameworks. In the United Kingdom a number of
committees were convened and reports commissioned, including the Bank of England Report (1993),13
the Bank of England Report on the Collapse of Barings and the Legal Risk Review Committee Report on
Legal Risk in UK derivatives markets.

In the United States a number of committees and reports were also commissioned to investigate the
regulation of derivatives markets, including legal risk concerns confronting markets in the United States.
There was also extensive testimony before the US House of Representatives Committee on Banking and
Financial Services, as well as other committees, by Federal Reserve Board Governor Alan Greenspan,
Republican James Leach, the Chairperson of the CFTC, Brooksley Born, and other prominent individuals
and entities.

An important private initiate in the United States was the creation of the Derivatives Policy Group (DPG).
The DPG was formed by six major Wall Street firms in August 1994. The DPG is a voluntary framework
providing self-regulation for its members. The DPG’s role is to examine and respond to a number of
public policy issues raised by the OTC derivatives activities of unregulated affiliates of SEC-registered
broker-dealers and CFTC-registered futures commission merchants. It achieves these objectives by
adopting an active and analytical framework designed to investigate and evaluate management controls,
enhance reporting, evaluate risk in relation to capital, and provide guidelines for counterparty
relationships.

In Australia, the Companies and Securities Advisory Committee (CASAC) was one such committee
established by Parliament with the authority to review the existing regulatory framework and put
forward recommendations for reform. In developing proposals for regulatory reform CASAC worked in
conjunction with the Australian Securities and Investments Commission (ASIC). The problems identified
in Australian regulation by the ASIC in its report on the Australian OTC derivatives market23 included
legal uncertainty arising from the definition of terms, which included the generic terms ‘futures
contract’ and ‘futures market’; the problem of regulatory arbitrage arising from the inconsistent
regulatory treatment of certain derivative products; uncertainty over the impact of gaming and
wagering legislation on OTC markets; uncertainty over licensing provisions of the Corporations Act;
ineffective regulatory oversight and gaps within the existing framework; and overlap between different
regulatory jurisdictions.

A thorough review of the Australian regulatory framework for financial markets and services was also
undertaken. The review was commissioned by the Commonwealth Parliament to investigate and make
recommendations for reform to the current regulatory framework regulating Australian financial
markets. A number of recommendations made by the review called for reform to the derivatives
industry. These reports were tabled in Parliament in 1997 and included the Financial System Inquiry
Final Report (March 1997), the Corporate Law Economic Reform Program (CLERP) Proposals for Reform:
Paper No.6 (1997)25 and the Financial Products, Services Providers and Markets – An Integrated
Framework Consultation Paper.

Like their American, British and Australian counterparts, international regulators have also expressed
concern and have conducted urgent reviews of existing international regulatory frameworks. A number
of influential reports have been published and include the Bank of International Settlements (BIS)
Recent Developments in International Interbank Relations (October 1992), the Group of Thirty (G30)
Global Derivatives Study Group, Derivatives: Practices and Principles, (July 1993), the BIS Public
Disclosure of Market and Credit Risk by Financial Intermediaries (September 1994), the Basle Committee
Report on Risk Management Guidelines for Derivatives (July 1994), the BIS Survey of Foreign Exchange
and Derivative Markets Activity (May 1996) and the BIS Framework for Supervisory Information about
Derivatives and Trading Activities (September 1998).

The Group of Thirty (G30) concluded that financial derivatives do not increase systemic risk. In fact there
was strong evidence to suggest that derivative markets – when operating efficiently – may reduce the
probability of systemic or contagion risk because derivatives markets facilitate the efficient transfer of
risk away from the risk-averse to the risk-taker. This, in turn, leads to an optimal and efficient allocation
of financial risk within the economy. However, the G30 further concluded that a major impediment to
the efficient operation of derivatives markets is the emergence of legal risk. According to the G30, legal
risk poses a serious threat to market sentiment and market confidence because it adversely affects
operational efficiency.
Macro / systemic impact of the debacle
The comprehensive reviews conducted in the United Kingdom, the United States and Australia
culminated in a raft of new legislation and proposed laws, designed to implement both incremental
reform and entire new regulatory frameworks for financial markets.

In the United Kingdom, Parliament has recently enacted the Financial Services and Markets Act 2000
(UK). The Act makes wholesale changes to the way financial markets are regulated in the United
Kingdom. In particular the Act creates a single regulatory authority, the Financial Services Authority
(FSA) that is responsible for the regulation of all financial markets. The Act harmonises regulatory
control and supervision in the FSA, and replaces former regulatory bodies responsible for regulation.

In the United States, recent legislation has been passed by Congress and enacted as law in the form of
the Commodity Futures Modernization Act 2000 and the Gramm–Leach–Bliley Act 1999. Both Acts make
fundamental changes to the way financial markets, in particular derivative markets, are regulated in the
United States. The emphasis now is on functional regulation of financial markets, where regulation is
tailored to the markets and products functions rather than on the basis of the instruments’ place of
trade. In addition to new derivatives regulation, a number of other Acts dealing with netting in financial
contracts have been before Congress and include the Financial Contracts Bankruptcy Act 2001 and the
Financial Contract Netting Improvement Act 2001.

In Australia the Financial Services Reform Act 2001 (Cth) (FSRA) was introduced and passed as law. The
Act implements a new regime for the regulation of financial markets, one that is premised upon
functional policy and functional terminology. The Act adopts a broad and generic meaning of ‘financial
product’, which extends uniform regulation to all financial products including securities, derivatives,
superannuation, insurance, foreign currency and non-cash payments.

The FSRA makes important inroads into the problems of legal risk and the regulation of financial
derivatives. The Act introduces a new generic definition of ‘derivative’ that emphasizes the inherent
functional characteristics of all financial derivatives. This removes the potential for gaps in regulatory
coverage and reduces the incentive for regulatory arbitrage, because all markets are regulated.
Removing internal divisions between the different types of derivatives also alleviates some of the
current characterisation concerns, since all derivatives are now caught and regulated by the new generic
definition. Furthermore, the Act introduces useful reforms by removing the legal risk posed by gaming
and wagering laws.
Post-debacle scenario of the company or organization or economy
Despite the recent improvements made in all three jurisdictions, it will be shown here that considerable
uncertainty and legal risk remain. In particular, there are certain key areas that continue to pose
considerable challenges and important ramifications for market practitioners dealing in financial
derivatives. Some areas included are listed below:

• Risks posed by gaming and wagering legislation to market practitioners and market issuers of
financial derivatives.
• The potential overlap between insurance legislation and certain financial derivatives
instruments such as credit derivatives.
• Considerable legal risk remains with market practitioners who deal with trusts, pension funds,
local and statutory authorities, and non-bank financial institutions and intermediaries. The main
concern here lies with the potential for contracts to be declared null and void, and thus
rendered legally unenforceable, because one of the parties may lack the legal capacity or
authority to enter into such transactions.
• Doubts remain over the ability of market counterparties to claim compound interest and
achieve full restitution for the losses that they have suffered. This is because the House of Lords,
in its landmark ruling in Westdeutsche v. Islington LBC, denied the German merchant bank the
ability to claim compound interest from the local authority, which had wrongfully withheld
monies under an interest rate swap agreement.
• Customers and end-users of financial derivatives have challenged market practitioners in
extensive litigation. Claims are made that the transaction has been marred by fraud or
misrepresentations on the part of the dealer. Sometimes the litigation is due to opportunistic
attempts by a losing counterparty to circumvent payment obligations. However, there are also
times when such claims do have merit. How does one avoid such legal traps?
• Uncertainty in the enforceability of netting arrangements continues to pose problems in the
event of a cross-border insolvency. The main problem here lies with the difficulty of enforcing
netting arrangements where the transaction and payments involve more than one jurisdiction.
Moreover, the problem cannot be easily solved through the use of contractual provisions
because foreign laws may intervene to dictate the outcome. This is especially the case where
assets are located in the foreign jurisdiction.
• Regulation continues to generate considerable uncertainty in all three jurisdictions. Uncertainty
in the way security derivatives are characterized and regulated persists. This is especially the
case in the United States, where regulation is divided between securities and derivatives
markets. The characterisation issue is also a problem in the United Kingdom and Australia
because of different disclosure obligations to market issuers of securities and financial
derivatives instruments.
The Learning from the Debacle
There can be various lessons learnt from this debacle which might help in preventing the future
occurrence of similar events. Some of them can be:

Define Risk Limits

It is essential that all organizations define in a clear and unambiguous way limits to the financial risks
that they are authorized to take. They should then set up the procedures for ensuring that the limits are
obeyed. Ideally, overall risk limits should be set at board level. These should then be converted to limits
applicable to the individuals responsible for managing particular risks. Daily reports should indicate the
gain or loss that will be experienced for particular movements in market variables.

It is particularly important to monitor the risks carefully when derivatives are used. This is because
derivatives can be used for hedging, speculation and arbitrage. Without close monitoring, it is
impossible to know whether a derivatives trader has switched from being a hedger of the company’s
risks to a speculator. The case of Barings Bank is a classic example of what can go wrong. Similar thing
happened in the present case.

The argument here is not that no risks shall be taken. A treasurer working for a corporation or a trader
in a financial institution or a fund manager should be allowed to take positions on the future direction of
relevant market variables. What is being argued is that the sizes of the positions that can be taken
should be limited and the systems in place should accurately report the risks being taken.

Do not assume you can outguess the market

Some traders are quite possibly better than others.But no trader gets it right all the time.A trader who
correctly predicts the direction in which the market variables will move 60% of the time is doing well.If a
trader has an outstanding trach record(as Robert citron did in his early 1990’s) it is likely to be a result of
luck rather than superior trading skill.

Suppose that a financial institution employs 16 traders and one of those traders makes profits in every
quarter of a year.Should the trader reveive a good bonus.Should the trader’s risk limits be increased?
The answer to the first question is that inevitably the trader will receive a good bonus. The answer to
the second question should be no. the chance of making a profit in 4 consecutive quarters from random
trading is 0.5^4 or 1 in 16. This means that just by chance one of the 16 traders “will get it right” every
single quarter of the year.We should not assume that the trader’s luck will continue and we should not
increase the trader’s risk limits.

Make Sure You Fully Understand the trades you are doing
Corporations should never undertake a trade or a trading strategy that they do not fully understand.
This is somewhat obvious point,but is supervising how often a trader working for a non financial
corporation will,after a big loss admit to not knowing what was going on and claim to have been misled
by investment bankers.Robert citron the treasurer of Orange County did this.So did the traders working
for Hammersmith and Fulham,who in spite of their huge positions were surprisingly uninformed about
how the swaps and other interest rate derivatives they traded really worked.

If a senior manager in a corporation does not understand a trade proposed by a subordinate the trade
should not be approved.A simple rule of thumb is that if a trade and the rationale for entering into it are
so complicated thatthey cannot be understood by the manager,it is almost certainly inappropriate for
the corporation. The trades understaken by Procter and Gamble and Gibson Greeting would have been
vetoed using this criterion.

One way of ensuring that you fully understand a financial instrument is to value it.If a corporation does
not have in house capability to value and instrument,it should not trade it.In practice,corporations often
rely on their investment bankers for valuation advice. This is dangerous,as procter and gamble and
Gibson Greetings would have been vetoed using this criterion.

One way of ensuring that you fully understand a financial instrument is to value it.If a corporation does
not have the in house capability to value an instrument if should not trade it.In practice corporations
often rely on their investment bankers for valuation advice. This is dangerous as Procter and Gamble
and Gibson Greetings found out.When they wanted to unwind their deals, they found they were facing
prices produced by bankers trust’s proprietary models which they had no way of checking.

Make sure a Hedger does not become a speculator

One of the unfortunate facts of life is that hedging is relatively dull,whereas speculation is exciting.When
a company hires a trader to manage a foreign exchange risk or interest rate risk there is a danger that
following thing happens.At first the trader does the job diligently and earns the confidence of the top
management.He asseses the company’s exposure and hedges it.As time goes by the trader becomes
convinced that he or she can outguess the market Slowly the trader becomes a speculator.at first things
go well,but then a loss is made. To recover the loss the trader doubles up the bets.Further losses are
made and so on. The result is likely to be disaster.

As mentioned earlier,clear limits the risks that can be taken should be set by senior
management.Controls should be set in place to ensure that the limits are obeyed. The trading strategy
for a corporation should start with an analysis of the risks facing the corporation in foreign
exchange,interest rate,commodity market, and so on.A decision should then be taken on how the risks
are to be reduced to acceptable levels.It is a clear sign that something is wrong within a corporation if
the trading strategy is not derived in a very direct way from the company’s exposures
Conclusion
The huge losses experienced from the use of derivatives have made many treasures very wary.Since the
spate of mishaps in 1994 and 1995,some non financial corporations have announced plans to reduce or
even eliminate their use of derivatives. This is unfortunate because derivatives provide treasurers with
very efficient ways to manage risks.

The stories behind the losses emphasize the point, that derivatives can be used for either hedging or
speculation; that is they can be used either to reduce risks or to take risks.Most losses occurred because
derivatives were used inappropriately.Employees who had an implicit or explicit mandate to hedge their
company’s risks decided instead to speculate.

The key lesson to be learned from the losses is the importance of internal controls.Senior management
within company should issue a clear unambiguous policy statement about how derivatives are to be
used and the extent to which it is permissible for employees to take positions on movements in market
variables.Management should then institute controls to ensure that the policy is carried out.It is a
receipe for disaster to give individuals authority to trade derivatives without a close monitoring of the
risks being taken.
References

1. http://www.euromoneyplc.com/images/covers/Derivatives%20Regulation%20and%20Legal%20Risk
%20Managing%20Uncertainty%20in%20Derivatives%20Transactions/Derivatives%20Ch-01.qxd.pdf
2. http://www.alastairhudson.com/financelaw/equityrestitutionproperty.pdf
3. http://en.wikipedia.org/wiki/London_Borough_of_Hammersmith_and_Fulham
4. http://en.wikipedia.org/wiki/London_borough
5. http://www.alastairhudson.com/financelaw/derivativeslawcourse.pdf
6. http://www.iranderivatives.com/eBook/Fundamentals%20%20English/Chapter%2021.pdf
7. Hazell v. Hammersmith & Fulham [1991] 1 All E.R. 545