International Finance: New Players and Global Markets [1 ed.] 3030692310, 9783030692315

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Felix I. Lessambo

International Finance New Players and Global Markets

International Finance

Felix I. Lessambo

International Finance New Players and Global Markets

Felix I. Lessambo Fordham University New Britain, CT, USA

ISBN 978-3-030-69231-5 ISBN 978-3-030-69232-2 (eBook) https://doi.org/10.1007/978-3-030-69232-2 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Acknowledgments

Writing a book is always a challenge. But writing a book on International Finance, a more daring intellectual exercise. I would like to thank my astoundingly supportive friends who motivated me all along the project, knowing my dedication to the subject and thought I am more than able to complete this project: Dr. Marsha Gordon, Dr. Lavern A. Wright, Dr. Lester Reid, Pastor Roland Dalo, Rahim Samuel Mama, and Jerry Izouele. And last but not least, thank you to all the original readers of this book when it was in its infancy. Without your enthusiasm and encouragement, this book may have never been ready.

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Contents

1

International Finance 1.1 General 1.2 Features of International Managerial Finance 1.2.1 Foreign Exchange Risk 1.2.2 Political Risk 1.2.3 Market Imperfection 1.2.4 Enhance Opportunities 1.3 International Financial transactions

1 1 2 2 2 3 5 5

2

International Institutions of International Finance 2.1 General 2.2 The Bretton Woods Architecture 2.2.1 The Broader Compromise: From 1945 to 1971 2.2.2 The Floating-Rate Dollar Standard: 1973–1984 2.2.3 The Plaza-Louvre Accords: From 1985 to 1999 2.3 The Post-Bretton Woods Era: New Mandates 2.4 Reforming the Bretton Woods Institutions 2.5 The Relevancy of the Bretton Woods Institutions 2.6 The Two Additional Financial Institutions 2.6.1 The New Development Bank

7 7 8 9 10 11 12 13 14 15 15

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CONTENTS

2.6.2

2.7

The Asian Infrastructure Investment Bank (AIIB) The Dual Framework of International Finance

19 26

3

The Balance of Payments 3.1 General 3.2 BoP Key Concepts 3.2.1 Double-Entry Recording 3.2.2 Net and Gross Recording 3.2.3 Time of Recording 3.2.4 Valuation 3.3 Balance of Payment Accounts 3.3.1 The Current Account 3.3.2 The Capital Account 3.3.3 Financial Account 3.4 Statistical Discrepancy 3.5 Official Reserves 3.6 Significance of the Balance of Payments

29 29 30 30 31 31 32 33 33 37 40 42 42 43

4

International Corporate Governance 4.1 General 4.2 The Aim of Corporate Governance 4.3 The Agency Approach 4.3.1 The Board Fiduciary Duties 4.3.2 The Safeguards: The Business Judgment Rules 4.3.3 Limited Shareholders’ Rights 4.4 The Flaws and Inadequacies of the Agency Approach 4.4.1 The Sarbanes–Oxley Act 4.4.2 Re-Examination of the Compensation Structure

45 45 46 48 48

56

Foreign Exchange and Money Markets Transactions 5.1 General 5.2 Foreign Exchange Market Participants 5.2.1 Commercial and Investment Banks 5.2.2 Multinationals or Big Corporations 5.2.3 Brokers

61 61 62 62 63 63

5

50 51 52 53

CONTENTS

5.3

5.4 5.5

5.6 5.7

5.8

5.9

5.2.4 Noncommercial Banks 5.2.5 Central Banks Management of Foreign Exchange Risk 5.3.1 Hedging 5.3.2 Foreign Exchange Gap Analysis 5.3.3 Foreign Exchange Rate Duration Analysis 5.3.4 Foreign Exchange Rate Simulation Analysis 5.3.5 Foreign Exchange Rate Volatility Analysis Taxation of FOREX The International Money Markets: Role, Functions, and Features 5.5.1 Roles and Functions 5.5.2 The IMM Features Money Market Interest Rates Market Participants 5.7.1 Commercial Banks 5.7.2 Governments 5.7.3 Corporations 5.7.4 Government-Sponsored Enterprises 5.7.5 Money Market Mutual Funds and Other Short-Term Investment Pools 5.7.6 Dealers and Brokers 5.7.7 Central Banks Types of Instruments Traded in the Money Market 5.8.1 Treasury Bills 5.8.2 Certificate of Deposit 5.8.3 Commercial Paper 5.8.4 Banker’s Acceptance 5.8.5 Repurchase Agreements 5.8.6 Discount Window 5.8.7 Bankers Acceptances 5.8.8 Backup Line of Credit 5.8.9 Municipal Notes Interest Rates in FX and IMM 5.9.1 Interest Rates Determination 5.9.2 Low-Interest Rates and Risk Concerns

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63 63 64 64 64 65 65 65 66 70 70 70 71 71 72 72 72 73 73 73 74 74 75 75 75 75 76 76 76 77 77 77 77 77

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6

International Equity Markets 6.1 General 6.2 Equity and Diversification 6.3 Top 10 Stock Markets Around the Globe 6.3.1 Equity Markets in the United States 6.3.2 The New York Security Exchange 6.3.3 The Nasdaq 6.3.4 The Better Alternative Trading System 6.3.5 The Chicago Board Options Exchange 6.4 Equity Markets in the EU 6.5 Equity Markets in Asia 6.6 Equity Markets in Emergingi Economies

79 79 79 80 80 81 82 82 83 83 88 90

7

International Bond Markets 7.1 General 7.2 Types of Bond Markets 7.2.1 Domestic Bonds 7.2.2 Foreign Bonds 7.2.3 Eurobonds 7.3 International Bond Market Participants 7.4 International Bond Market Volatility 7.5 Bond Interest Rates

91 91 92 92 93 93 94 95 95

8

International Derivative Markets 8.1 General 8.2 Forward Contracts 8.3 Futures Contracts 8.4 Options 8.5 Swaps 8.5.1 Interest Rate Swaps 8.5.2 Currency Swaps 8.5.3 Credit Swaps 8.5.4 Commodity Swaps 8.5.5 Equity Swaps 8.6 Credit Derivatives 8.6.1 Credit Index 8.6.2 Credit Index Tranche

97 97 100 101 102 107 108 109 109 111 111 114 114 115

CONTENTS

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Exchange Traded Funds (ETF) 9.1 General 9.2 Differences Between ETFs and Mutual Funds 9.3 Purchase and Redemption of ETFs 9.4 Regulatory Requirements 9.5 ETFs in the Global Markets 9.6 Types of ETFs 9.6.1 Index-Based ETFs 9.6.2 Actively Managed ETFs 9.6.3 Leveraged and Inverse ETFs

117 117 118 118 118 118 119 119 119 123

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International Securitization Markets 10.1 General 10.2 Benefits or Securitization 10.3 Securitization Process 10.3.1 The Borrower 10.3.2 The Originator/Servicer 10.3.3 The SPV 10.3.4 The Investors 10.4 Securitization Tranches 10.5 Securitized Assets 10.6 Types of Securitization 10.7 Conclusion

125 125 126 128 129 129 130 130 132 133 136 138

11

Sovereign Wealth Funds 11.1 General 11.2 Types of SWFs 11.2.1 Stabilizations Funds 11.2.2 Saving Funds 11.2.3 Reserve Investment Corporation 11.2.4 Strategic Development Funds 11.2.5 Contingent Pension Reserve Funds 11.3 The Dominant Petrodollar-Oil SWFs 11.3.1 Oil Funds of the Persian Golf 11.3.2 Kuwait 11.3.3 The United Arab Emirates 11.3.4 Iran 11.3.5 Qatar

139 139 140 141 142 142 143 143 143 143 144 145 146 147

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11.3.6 11.3.7 11.3.8

11.4

Saudi Arabia Norway Oil Fund The Stabilization Fund of the Russian Federation Conclusions and Policy Implications

148 149 150 152

Glossary of Terms

157

Bibliography

165

Index

167

Acronyms

ABS BIS BJR BoP BRICS BWIs CBO CBOE CD CDS CEO CFD CFIUS CFO CFTC CHF CLO CLN CMO CPA DAX DEM EM ETF FDIC FTSE

Asset-Backed Securities Bank for International Settlements Business Judgment Rule Balance of Payments Brazil, Russia, India, China, and South-Africa Brettons-Woods’ Institutions Collateralized Bond Obligation Chicago Board Options Exchange Certificate of Deposit Collateralized Debt Obligation Chief Executive Officer Contracts for Differences Committee on Foreign Investment in the United States Chief Financial Officer Commodity Futures Trading Commission Confoederatio Helvetica Franc (Swiss Franc) Collateralized Loan Oligation Credit-Linked Note Collateralized Mortgage Obligation Certified Public Accountant Deutscher Akrienindex Deutsche Mark Emerging Market Exchange Traded Funds Federal Deposit Insurance Corporation Financial Times Stock Exchange xiii

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ACRONYMS

FX GAO GCC GDP IBRD IMF IRC LIBOR LSE MNC MTF Nasdaq NDB NYSE OECD OSF OTC QIA SAMA SEC SOX SPV SSE SWF TRS TSE UK US VaR WBG XTF

Foreign Exchange Government Accountability Office Gulf Cooperation Council Growth Domestic Product International Bank for Reconstruction and Development International Monetary Fun Internal Revenue Code London Interbank Offered Rate London Stock Exchange Multinational Company Mutual Trading Facility National Association of Securities Dealers Automated Quotations Exchange New Development Bank New York Security Exchange Organization for Economic Cooperation and Development Oil Stabilization Fund Over-the-Counter Qatar Investment Authority Saudi Arabia Monetary Authority Securities and Exchange Commission Sarbanes-Oxley Act Special Purpose Vehicle Shanghai Securities Exchange Sovereign Wealth Fund Total Return Swap Tokyo Securities Exchange United Kingdom United States of America Value at Risk World Bank Group Exchange Traded Fund

List of Figures

Fig. 2.1 Fig. 3.1 Fig. 4.1 Fig. 4.2 Fig. 6.1

Fig. 6.2 Fig. 7.1 Fig. 8.1 Fig. 10.1 Fig. 11.1 Fig. 11.2

AIIB: Contributions and Voting shares (%) (Source Korean Ministry of Strategy and Finance [CSIS]) United States BoP: 2016–2019 (Source US Dept of Trade) CEO-to-Worker Compensation ratio, 1968–2018 (Source Economic Policy Institute [2019]) Ratio between CEO and average worker pay in 2018 (Source OECD) US household equity equity owners (Note Household sector includes nonprofit organizations. Includes both directly held equities and equities held through mutual funds. Source federal reserve flow of funds accounts) US equity markets ADV (Source Cboe exchange, Inc) Global bond market outstanding (2009–2018) (Source Bank of International Settlement [BIS]) Outstanding notional amounts of OTC derivatives trend upwards Securitization structure Top 10 largest sovereign wealth funds SWFs by funding and region (Source Sovereign wealth fund institute)

21 42 58 59

81 84 92 98 129 140 141

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List of Tables

Table 2.1 Table 2.2 Table Table Table Table Table Table Table Table Table

2.3 2.4 3.1 3.2 4.1 6.1 6.2 9.1 10.1

Pre-reform and post-reform voting rights Countries by shareholding at the New Development Bank Geographic distributions of loans Loans by sector Current account balance Overview of financial account Five CEOs with most pay in 2018 The top 10 stock markets around the globe Largest stock exchange in Europe Best broad international stock ETFs Global structure Finance Volumes

14 17 25 26 38 41 57 80 86 121 136

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List of Cited Cases

Brehm v. Eisner, 906 A 2d 27, 64 (Del. 2006). Francis v. New Jersey Bank, 432 A 2d. 814 (NJ 1981). In Re Walt Disney Co. Derivative Litigation, Del. Ch. 2003In Re Walt Disney Co. v. Derivative Litigation (Disney IV), 906 A 2d 27, 63-68. Moleney v. Brincat, 722 A 2d 5, 10 (Del. 1998). Paramount Communications, Inc. v. QVC Network, Inc. 637, A 2d (Del. 1994). Revlon Inc. v. MacAndrews & Forbes Holding Inc., 506 A 2d 173 (Del. 1985). Smith v. Gorkhom, 488 A 2d 858 (Del. 1985). Unocal V. Mesa Petroleum Co., 493 A 2d 946 (Del. 1985).

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CHAPTER 1

International Finance

1.1

General

International finance is a branch of financial economics that deals with the monetary interactions that occur between two or more countries. International Finance is concerned with topics that include foreign direct investment and currency exchange rates. International finance is different from domestic finance in many aspects and the first and the most significant of them is foreign currency exposure. International financial management involves a lot of currency derivatives whereas such derivatives are very less used in domestic financial management. So, the understanding of international financial transactions is vital to any MNC. In the twenty-first century, business has become much more globalized. Large corporations have customers and production facilities all over the world now. That accentuates the need for mastery of international finance. There are numerous risks in transactions involving foreign currencies. Risk management requires that these risks be identified, quantified, and monitored. Some risks (such as exchange rate risk) affect all cross-border currency movements, while others are limited to investment decisions or financing decisions.

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1.2

Features of International Managerial Finance

International finance provides four types of challenges unknown to domestic finance: (i) foreign exchange risk, (ii) political risk, (iii) market imperfection, and (iv) enhanced opportunities. 1.2.1

Foreign Exchange Risk

The financial benefits and costs of an international transaction can be affected by exchange rate movements that occur after the firm is legally obligated to complete the transaction. Foreign exchange exposure refers to the risk a company undertakes when making financial transactions in foreign currencies. All currencies can experience periods of high volatility which can adversely affect profit margins if suitable strategies are not in place to protect cash flow from sudden currency fluctuations. The VaR measure of exchange rate risk is used by firms to estimate the riskiness of a foreign exchange position resulting from a firm’s activities, including the foreign exchange position of its treasury, over a certain time period under normal conditions. Savvy managers take actions to protect against FX risk, such as hedging (forward contract). Otherwise, the firm’s performance will be negatively affected by exchange rate movements. 1.2.2

Political Risk

Political risk is the risk an investment’s returns could suffer as a result of political changes or instability in a country. Political risk is among the most important factors facing international investors. In many emerging and frontier markets, the political situation is affected by more than influences within the country being considered. Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policymakers, or military control. Political risk is also known as “geopolitical risk,” and becomes more of a factor as the time horizon of investment gets longer. There are a variety of decisions governments make that can affect individual businesses, industries, and the overall economy. These include taxes, spending, regulation, currency valuation, trade tariffs, labor laws such as the minimum wage, and environmental regulations. The laws, even if just proposed, can have an impact. Regulations can be set at all levels of government, including federal, state,

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and local, as well as in other countries. Political risk is a dynamic phenomenon. Hence, political risk assessment requires constant monitoring of all five categories of risks and fashioning of mitigation strategies. Multinational and global companies have come to manage their cash flows in a basket of currencies (dollars, euros, and yen) to mitigate the risk of the sudden devaluation and revaluation of a single currency, often a reflection of a country’s fragile state of economy and unstable politics. In the contemporary globalized economy, sound assessment of political risk can save millions to a business from regulatory or structural risks or can generate windfall profits. Major political risks include: Nationalization, confiscation, and others. 1.2.3

Market Imperfection

An imperfect market is one in which individual buyers and sellers can influence prices and production, where there is no full disclosure of information about products and prices, and where there are high barriers to entry or exit in the market. It’s the opposite of a perfect market, which is characterized by perfect competition, market equilibrium, and an unlimited number of buyers and sellers. Sellers and businesses use the imperfect of the markets as a means to make/maximize profits. Under perfect competition, the equilibrium price, margin profits, and margin cost are known to both sellers and buyers. Portfolio investments target arbitrage between different markets, for instance, different rates of interests or the reduction of risks by diversification to markets that are not perfectly positively correlated. Market imperfections also generate profit opportunities for businesses that can reduce or eliminate them. MNC can lower costs tracing to imperfections and earn a competitive advantage not available to a firm operating domestically.1 All financial markets are by nature imperfect markets. That is, individual buyers and sellers can influence prices and production, there is no full disclosure of information about products and prices, and there are high barriers to entry or exit in the market. Many financial transactions are made in a situation of imperfect information, where either the buyer, the seller, or both, are less than 100% certain about the qualities of what is being transacted. For example, traders in the financial market do

1 Ramon P. DeGennaro (2005): Market Imperfections, The Federal Reserve of Atlanta.

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not possess perfect or even identical knowledge about financial products. The traders and assets in a financial market are not perfectly homogeneous. New information is not instantaneously transmitted, and there is a limited velocity of reactions. The term imperfect market is somewhat misleading, and the range of market imperfections is as wide as the range of all real-world markets—some are much or less efficient than others. Every industry has some form of imperfection. Imperfect competition can be found in the following structures: • Monopoly This is a structure in which there is only one (dominant) seller. Products offered by this entity have no substitutes. These markets have high barriers to entry and a single seller who sets the prices on goods and services. Prices can change without notice to consumers. • Oligopoly This structure has many buyers but few sellers. These few players in the market may prevent others from entering. They may set prices together or, in the case of a cartel, only one takes the lead to determine the price for goods and services while the others follow. • Monopolistic Competition In monopolistic competition, there are many sellers who offer similar products that can’t be substituted. Businesses compete with one another and are price makers, but their individual decisions do not affect the other. • Monopsony and Oligopsony These structures have many sellers, but few buyers. In both cases, the buyer is the one who manipulates market prices by playing firms against one another.

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Enhance Opportunities

International finance is an important tool to find the exchange rates, compare inflation rates, get an idea about investing in international debt securities, ascertain the economic status of other countries, and judge the foreign markets. The international financial system is vast and complex. It consists of various financial institutions and markets (i.e., stocks, bonds, commodities, and derivatives). The growth of the global financial system creates new opportunities for businesses and governments to drive economic growth, and increases access for new participants, in addition to expanding opportunities for innovation.2 Put differently, international finance enables individuals and firms to protect against adversity in one financial jurisdiction (state), and seize the best opportunity in another financial jurisdiction and achieve global growth. For instance, the structure and regulation of the US banking system differ from the rest of the world.3 US banks are subject to more stringent regulations than banks elsewhere, therefore, US banks may seek incentives by migrating their activities within jurisdictions with less stringent regulations.

1.3

International Financial transactions

International transaction implies financial transactions that cross the borders because of various situations: (i) the lender and the borrower reside in two different countries, (ii) borrowing in foreign currencies, (iii) sending money from a US-based head office to a factory in Mexico City. In the last example, even though the money never changes hands— it still belongs to the company—it did cross borders. So, it’s a form of international finance.

2 Anjan Thakor (2015): International Financial Markets: A Diverse System Is the Key to Commerce, Center for Capital Markets, p. 22. 3 Felix Lessambo (2020): The US Banking System: Laws, Regulations, and Risk Management, Palgrave Macmillan, p. 2.

CHAPTER 2

International Institutions of International Finance

2.1

General

The International Financial Institutions need to be adjusted to the needs and challenges of the twenty-first century. Today economy differs significantly from the world status of economy of the 1940s which lead to the creation of the Bretton Woods and most of the existing international financial institutions. The globalization of financial markets, the debt crisis, cross-border flows of capital, and the raise of new economic power have weakened the current system. As Solimano stated: “the dividing lines between the balance of payments financing (the realm of the IMF) and development lending (the scope of multilateral development banks) have become less clear.1 ” In the same vein, the Report of the High-Level Commission on Modernization of World Bank Group Governance pointed out: Regional institutions have become increasingly important in the economic and political life of the Bretton Woods institutions, serving as catalysts for regional integration, cooperation, and development assistance.2 1 Andres Silimano (1999): Can Reforming Global Institutions Help Developing Countries Share in the Benefits from Globalization? The World Bank Paper, Washington, DC. 2 Report of the High-Level Commission on Modernization of World Bank Group Governance, p. 8.

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Thus, time has come to rethink an adequate balance of power between the Bretton Woods Institutions, the regional development banks, and even the International Investment Banks. As many countries seem to prefer their close regional development banks over the distant global Bretton Woods institutions. As Jose Antonio Ocampo has said: The current system will only be workable if it is based on stronger regionalism. A stronger regionalism is the only way to balance the huge asymmetries in power that we have in the system—that is centerperiphery. It is good to have competition between regional and sub-regional development banks and among the bilateral donor community. Similarly, it is good to have various regional monetary funds. Indeed, the governance within these development banks are more inclusive relative to the corporate structure still in existence within the Bretton Woods institutions dominated by the West. There is a greater degree of representation for developing countries in the most important decision-making bodies.

2.2

The Bretton Woods Architecture

The Bretton Woods Conference, officially known as the United Nations Monetary and Financial Conference, was a gathering of delegates from 44 nations that met from July 1 to 22, 1944 in Bretton Woods, New Hampshire, to devise a new financial architecture for the post-War World. The two major accomplishments of the conference were the creation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD).3 Participants in the conference, to some extent, believed that free trade not only promoted international prosperity but also international peace. The conference discussion was dominated by two rival plans developed, respectively, by Harry Dexter White of the US Treasury and John Maynard Keynes of Great Britain. The Keynes plan proposed during the Bretton Woods negotiations in 1944 involved the creation of an International Clearing Union, which would act as an international central bank and issue its own currency 3 Jose Antonio Ocampo (2005): “The Democratic Deficit in International Arrangements,” in Protecting the Poor: Global Financial Institutions and the Vulnerability of Low Income Countries, pp. 117–118.

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(the bancor), the value of which would be determined at a fixed price to gold. Each member country would establish a fixed but adjustable exchange rate in relation to the bancor. International payments balances would be settled by using the bancor as a unit of account. The bancor would have very limited convertibility; countries could purchase bancors but could not convert them into gold. In other words, bancor reserves would remain within the system to avoid the possibility of a drain on reserves. Each country would also be allocated a quota of bancor based upon their levels of imports and exports. Dexter White, the “Assistant Secretary” pushed for the exchange rates of member-country currencies fixed to the dollar, and foreign governments and central banks could exchange dollars for gold at $35 per ounce. Dexter convinced other participants that the newly designed architecture would help reduce trade barriers and allow capital to flow freely between member countries. 2.2.1

The Broader Compromise: From 1945 to 1971

The compromise that ultimately emerged was much closer to Dexter White’s plan than to that of Keynes, reflecting the overwhelming power of the United States as World War II was drawing to a close.4 Under the new architecture, trade would be progressively liberalized, but restrictions on capital movements remained.5 Harry Dexter White, Special Assistant to the US Secretary of the Treasury, and John Maynard Keynes, an advisor to the British Treasury, independently drafted plans for organizations that would provide financial assistance to countries experiencing short-term deficits in their balance of payments. This assistance would help ensure that such countries would not adopt protectionist or predatory trade and monetary policies to improve their balance of payments position. Both plans envisioned a world of fixed exchange rates: the US dollar was to be pegged to gold at $35 per ounce, while other countries of the world were to peg to the US dollar or directly to gold. Thus the US dollar stood as 4 The World Bank and the IMF are two distinct institutions: the bank is primarily a development institution, while the IMF is a cooperative institution that seeks to maintain an orderly system of payments and receipts among nations. 5 Benjamin J. Cohen (2008): “Bretton Woods System,” in Routledge Encyclopedia of international Political Economy.

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the currency of the international financial institutions. A role it plays still today. The fixed exchange rate regime established at Bretton Woods endured for the better part of three decades. However, in the late 1940s, with the US growing balance of payment deficits coupled with the pressure facing the US$ in global currency exchanges, the United States could not withstand the situation and after some failed monetary policies in the 1960s, the US Treasury took some palliative measures to fix the system. In January 1961, for instance, the Kennedy Administration pledged to maintain $35 per ounce convertibility. The United States and its European allies set up a gold pool in which their central banks would buy and sell gold to support the $35 price in the London market. The effort was not successful, until 1968 when the rush out of dollars began—capital flight. Investors and multinational companies began to flow out of dollar assets and into German mark assets.6 Advocates of the Gold-exchange system argue that the system economizes on gold because countries can use not only gold but also foreign exchange as an international means of payment. However, the gold-exchange system as devised contained its germ of failure. Professor Robert Triffin,7 on the other hand, predicted that the system was programmed to collapse in the long-run. He pointed out two elements: (i) to satisfy the growing need for reserves, the United States needed to run continuous balance-of-payment deficits; and (ii) continuous balance-of-payment deficits would impair the public confidence in the US$. Robert Triffin’s prediction, known as the “Triffin Paradox” came to pass in the early 1970s. 2.2.2

The Floating-Rate Dollar Standard: 1973–1984

After the dollar exchange crisis of August 1971 (when President Richard Nixon suspended the dollar’s convertibility into gold) and February/March 1973 floating exchange rates became the norm for the currencies of the major industrialized nations. To understand the situation, it is worthy to recall that in 1970, the United States entered into recession. The markets believed that in order to counter the recession, 6 Niall Fergusson (2008): The Ascent of Money: A Financial History of the World. New York Penguin, p. 305. 7 Kenneth A. Reinert (2012): An Introduction to International Economics: New Perspectives on the World Economy. Cambridge University Press, New York, Chapter 17.

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the United States should devaluate its dollar currency. In 1971, President Nixon announced that the United States would no longer automatically sell gold to foreign banks for the US$. The Nixon administration imposed a 10% tax on all imports to the United States. Put differently, in August 1971, the United States announced that it is abandoning the convertibility of the dollar because of the decrease of the confidence in the US dollar and was seeking to convert the dollars into gold from States. This was achieved through the Smithsonian Agreement entered by the ten countries in 1971. Among other things, the Smithsonian Agreement allowed each one of the ten countries gathered to (i) re-evaluate its currency against the US$ by up to 10%; and (ii) the band within which the exchange rate was allowed was raised from 1 to 2.25% in either direction. The US dollar was devaluated against foreign currencies by about eight percent. The markets reacted again in February 1973, attacking the US dollar and forced FOREX to close. In February 12, 1973, the US administration announced another 10% depreciation of the US dollar. The US Treasury announced a second devaluation of the dollar against gold to $42. 2.2.3

The Plaza-Louvre Accords: From 1985 to 1999

The Plaza Accord was a growth transfer policy for Europe and Japan that was wholly detrimental to the United States. It was a pro-growth agreement signed by the former “G-5 nations8 ” constraining the United States to devalue its currency due to a current account deficit approaching an estimated 3% of GDP. The Plaza Accord allowed the dollar to slide 20% against the Japanese yen, 15% against the French franc and 15% against the German Deutsch mark. Some considered the Plaza Accord as being broadly detrimental to the United States. However, the US manufacturers would again become profitable due to favorable exchange rates abroad, an export regimen that became quite profitable. A high US dollar means American producers can’t compete at home with cheap imports coming from Japan and European nations because those imports are much cheaper than what American manufacturers can sell according to their profitability arrangements. The United States pushed for a multilateral intervention, designed to allow for a controlled decline of the dollar 8 Cheol S. Eun and Bruce G. Resnick (2007): International Financial Management, 4th edition. McGraw-Hill, p. 30.

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and the appreciation of the main anti-dollar currencies. Each country agreed to make changes in its economic policies and to intervene in currency markets as necessary to bring down the value of the dollar. The United States agreed to cut the federal deficit and to lower interest rates. Japan promised a looser monetary policy and financial-sector reforms, and Germany agreed to institute tax cuts. France, the UK, Germany, and Japan agreed to raise interest rates. The impact of the intervention was immediate and within two years the dollar had fallen 46% to the Deutsche Mark (DEM) and 50% to the Yen (JPY). By the end of 1987, the dollar had fallen by 54% against both the Deutsche Mark and the yen from its peak in February 1985. The US Economy became geared more toward exports, while Germany and Japan increased their imports. This helped resolve the current account deficits and helped to minimize protectionist policies. Despite these efforts, the US$ continued to decline vis-à-vis the Deutsche and other concurrent currencies. The United States was sustaining huge twin deficits in its domestic and current account budgets. In 1986, the trade deficit rose to approximately $166 billion with exports at about $370 billion and imports at about $520 billion. The trade deficit alone approached approximately 3.5% of the GDP, while the Japanese had a surplus of 4.5% and the Germans 4% of the GDP. To halt the decline, the G-6 entered into a new arrangement “The Louvre Accord,” aimed to stabilize the US$, to cooperative to achieve exchange rate stability, and to closely monitor macroeconomic policies. The United States pledged to tighten fiscal policy, Japan agreed to loosen monetary policy. The participants agreed to intervene if major currencies moved outside a set of ranges. The dollar rose shortly after the accord was signed.

2.3

The Post-Bretton Woods Era: New Mandates

The post-Bretton Woods era which started in 1973 has altered the mandates of the two key institutions from the Bretton Woods: the IMF and the World Bank. The IMF was assigned new roles in the international monetary system, and the World Bank champions the fight against poverty in order to lift its member countries on the path of sustainable economic growth. Further new global challenges, mainly (i) the prevention and emergence of the spread of infectious diseases, (ii) climate change, (iii) international financial stability, (iv) international

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trading imbalances, (v) threat of terrorism, (vi) wars, and other insecurities compel several experts in these fields to rethink our world. As far as the international financial institutions are concerned, the enhancement of international financial stability becomes an emergency: the quality and the management of the international financial institutions need to be rethought, and their governance revisited in order to face the new challenges. They need to set up or upgrade monitoring and evaluation systems to properly assess their performances.

2.4

Reforming the Bretton Woods Institutions

The Bretton Woods institutions, in their current structures, require major reform in their governance approach. The reform package, which came into effect on January 26, 2016 after a five-year delay, failed to meet the demands and expectations proposed by developing countries at the G-20 summit in London. Indeed, the BRICS pushed for a redistribution of IMF voting shares in order to better reflect the twenty-first century economic realities. Voting shares are crucial not only in determining the maximum amount of financial resources a member country commits to provide to the IMF, but also, the member country’s access to the IMF resources. At the IMF, for instance, the distribution of voting power remains severely imbalanced in favor of the United State, European countries, and Japan. More, the United States still has veto power over an array of major decisions. Though the US share of world gross domestic product (GDP) has declined from about 50% of the world economy at the end of World War II to about 20% today, It is uncertain whether the United States will support a substantial increase in IMF quotas and sure up financial resources. The choice lies with other major countries, mainly the European Union, on whether they are willing to update these institutions governance and perhaps their survival. From corporate governance viewpoint, the under-representation of low- and middle-income countries on the Bretton Woods institutions (BWIs). More, the Executive Boards is exacerbated by the historic gentleman agreement between the United States and European countries, which has seen the Fund and Bank led by a European and US national, respectively, since their inception (Table 2.1).

14

F. I. LESSAMBO

Table 2.1 Pre-reform and post-reform voting rights

Pre-reform

Post-reform

United States Japan Germany France United Kingdom China

17.661 6.553 6.107 4.502 4.502

United States Japan China Germany France

17.398 6.461 6.390 5.583 4.225

3.994

4.225

Italy Saudi Arabia Canada Russia India Netherlands Belgium Brazil Spain

3.305 2.929 2.670 2.493 2.441 2.164 1.931 1.782 1.687

United Kingdom Italy India Russia Brazil Canada Saudi Arabia Spain Mexico Netherlands

3.159 2.749 2.705 2.315 2.311 2.095 1.999 1.868 1.831

Source IMF

2.5 The Relevancy of the Bretton Woods Institutions With China becoming the largest official external creditor to developing country governments worldwide, and its loan conditions more lenient, the relevancy of the BWIs is at stake. By some estimates, China is larger than World Bank and IMF individually and all of the Paris Club creditors combined.9 More recent study estimates that more than two dozen countries now owe more than 10% of their GDP of the Chinese government.10 The under-representation of the developing countries within the decisional instances of both the IMF and the World Bank Group is well-documented. According to Daniel D. Bradlow, only 16 directors represent the remaining 176 member states of both institutions. This means that each of these directors represents on average slightly less than 11 states. This unrepresentativeness has largely blown the Bretton

9 Horn, Reinhart, and Trebesch, 2019. 10 Horn et al., 2019.

2

INTERNATIONAL INSTITUTIONS OF INTERNATIONAL FINANCE

15

Woods Institutions’ credibility. Often it has led to a profound hard feeling toward the IMF. The unfairness of their institutional process has led the IMF and World Bank to lose a part of their moral influence, reduce the value of their recommendations, and thus conduct states to be reluctant to implement their advice. It is clear that the unfairness of the decision-making process inside the Bretton Wood Institutions, and the under-representation of the developing world inside their executive board, has largely blown their credibility and legitimacy.

2.6

The Two Additional Financial Institutions 2.6.1

The New Development Bank

The New Development Bank (NDB), formerly referred to as the BRICS Development Bank, is a multilateral development bank established by the BRICS states.11 Frustrated by the corporate governance of the Bretton Woods Institutions, BRICS leaders agreed to set up a Development bank at the 5th BRICS summit held in Durban, South Africa on March 27, 2013. On 27 February 2016, the NDB signed the Headquarters Agreement with the Government of the P.R.C. and the Memorandum of Understanding with Shanghai Municipal People’s Government concerning the arrangements in relation to the Headquarters of the bank in Shanghai. • The NDB Objectives The bank aims to contribute to development plans established nationally through projects that are socially, environmentally, and economically sustainable. Taking this into account, the main objectives of the NDB can be summarized as follows: 1. Promote infrastructure and sustainable development projects with a significant development impact in member countries. 2. Establish an extensive network of global partnerships with other multilateral development institutions and national development banks.

11 BRICS is the acronym for: Brazil, Russia, India, China, and South Africa.

16

F. I. LESSAMBO

3. Build a balanced project portfolio giving proper respect to their geographic location, financing requirements, and other factors. The New Development Bank is planning to give priority to projects aimed at developing renewable energy sources. As it was stated by the Bank, it wants to cooperate with other institutions in accelerating “green” financing expansion and promoting environmental protection. As of March 6, 2019, the NDB Board of Directors approved 30 projects with loans aggregating over approx. USD 8 billion. • The NDB Funding The New Development Bank has an initial subscribed capital of US$50 billion and an initial authorized capital of US$100 billion. The initial subscribed capital is equally distributed among the founding members. The payment of the amount initially subscribed by each founding member to the paid-in capital stock of the Bank will be made in dollars in 7 installments. Each member cannot increase its share of capital without all other four members agreeing. The bank will allow new members to join but the BRICS capital share cannot fall below 55%. The initial authorized capital of the bank is divided into 1 million shares, having a par value of $100,000. Each founding member of the bank has initially subscribed 100,000 shares, in a total of $10 billion, of which 20,000 shares correspond to paid-in capital, in a total of $2 billion and 80,000 shares correspond to callable capital, in a total of $8 billion. The current distribution of shares between NDB member countries is presented in Table 2.2. • The New Development Bank Governance Structure The governance structure of the NDB differs from the structures of other development banks. The NDB’s structure and decision-making rules reflect a strong commitment to equality among its members. Under Article 6.b of the NDB’s Agreement, ordinary matters are to be decided by a Simple Majority of the votes cast. However, a Special Majority

2

INTERNATIONAL INSTITUTIONS OF INTERNATIONAL FINANCE

17

Table 2.2 Countries by shareholding at the New Development Bank Country

Brazil Russia India China South Africa Unallocated Shares Grand Total

Number of shares

Shareholding (% of total)

Voting rights (% of total)

Authorized capital in $ bn

100,000 100,000 100,000 100,000 100,000 500,000

20 20 20 20 20 –

20 20 20 20 20 –

10 10 10 10 10 50

1,000,000

100

100

100

Source NDB

is required on specific matters.12 Under such a framework, no single country has veto power. More, the NDB is set up on an equal share basis among the member states. While the nominal GDP of China is larger than that of the other BRICS members combined, the five-member states have an equal share. More, the NDB’s charter sets up a rotary presidency system, with each of the other member countries supplying a Vice President. The inaugural President is from India, and the four Vice Presidents are, therefore, from Brazil, Russia, China, and South Africa. According to the Articles of Agreement, the main organs of the bank are: • Board of Governors All the powers of the NDB are vested in the Board of Governors, which consists of one governor and one alternate appointed by each member. Governors may be replaced by the members’ states appointing them. No alternate is allowed to vote except in the absence of his principal. The Board meets on an annual basis to select one of the governors as chairperson. On May 27, 2020, the Board of Governors of the New Development Bank (NDB) unanimously elected Mr. Marcos Prado Troyjo as the President of the NDB from July 7, 2020. Except those 12 A special majority is understood as an affirmative vote by four of the founding members concurrent with two thirds of the total voting power.

18

F. I. LESSAMBO

powers listed under Article 2(b)(i)-(ix), the Board of Governors can delegate its powers to the Directors. Governors and alternates serve as such without compensation from the Bank. • Board of Directors The Board of Directors is responsible for the conduct of the general operations of the Bank. Directors serve a two-year term and may be re-elected. A Director continues in office until his successor is chosen and qualified. In the absence of a respective Director, an Alternate has full power to act for him. The Board of Directors also appoints a nonexecutive chairperson from among the Directors for a mandate of four years. If the Director does not serve a full mandate or if he is not re-elected for a second term, the Director that replaces him will serve as chairperson for the remainder of the term. The Board of Directors functions as a nonresident body, and meets quarterly, unless the Board of Governors decides otherwise by a qualified majority. The Board of Directors appoints a Credit and Investment Committee and such other committees as it deems advisable. • President and Vice Presidents The President is a member of the Board of Directors, but he has no voting power except a deciding vote in case of an equal division. The President is elected among the founding members on a rotational basis. He shall not be a Governor or a Director or an alternate for either. The President serves for a five-year term, nonrenewable. The President is the chief of the operating staff of the Bank and conducts, under the direction of the Directors, the ordinary business of the Bank. In that capacity, he presides over the credit and investment committee, which includes the Vice Presidents who are also responsible for decisions on loans, guarantees, equity investments and technical assistance of no more than a limit amount to be established by the Board of Directors, provided that no objection is raised by any member of Board of Directors within 30 days since such project is submitted to the Board.

2

INTERNATIONAL INSTITUTIONS OF INTERNATIONAL FINANCE

19

• Vice Presidents There is at least one Vice President from each founding member except the country represented by the President. Vice Presidents are appointed by the Board of Governors on the recommendation of the President. Each Vice President serves for a five-year term, non-renewable, except for the first term of the first Vice Presidents, whose mandate is for six years. Vice Presidents exercise such authority and perform such functions in the administration of the Bank, as may be determined by the Board of Directors. 2.6.2

The Asian Infrastructure Investment Bank (AIIB)

The Asian Infrastructure Investment Bank is a multilateral development bank that aims to support the building of infrastructure in the AsiaPacific region. Headquartered in Beijing, the AIIB began operations in January 2016 and have now grown to 102 approved members worldwide. The AIIB is a multilateral development bank first proposed by Chinese President Xi Jinping in 2013, with 21 countries signing an initial memorandum of understanding in October 2014. In October 2013, President Xi made his first trip to Southeast Asia since assuming office in March. In his speeches before the Indonesia Parliament and at the AsiaPacific Economic Cooperation (APEC) CEO Summit in Bali, President Xi proposed to establish an Asian infrastructure investment bank to promote interconnectivity and economic integration in the region. By the time of the AIIB official launch and the release of its Articles of Agreements in June 2015, 57 countries had signed on, notably the United Kingdom, Germany, France, and Australia (despite U.S. opposition and much to China’s surprise). As of today, 87 countries have joined the AIIB. The AIIB has quickly become a global institution, both in its membership, the Non-Regional Members category spans Africa, the Americas, and Europe and in the scope of its lending operations. As of late 2018, membership in the bank is 87 states and counting, 20 more countries than the ADB and almost half the membership of the World Bank.13

13 Jason A. Kirk: China and the AIIB, 2019.

20

F. I. LESSAMBO

• The AIIB Purposes First, the AIIB only finances Asian infrastructure construction. The AIIB is distinguished from existing MDBs by its sole focus on infrastructure development, not poverty reduction and by the extension of loans at commercial, not concessionary rates. As many Asian countries are either at the initial or acceleration stage of industrialization and urbanization, the demands for the infrastructure of transportation, energy, and communication are considerable. Statistics show that infrastructure investment needs in Asia for the period of 2010– 2020 are estimated to be 8 trillion US dollars.14 There is a large chunk of it that has yet to be met, on top of 10–20 billion dollars the World Bank and the AsDB are able to commit each year. The AIIB should dedicate to this cause by mobilizing much needed additional resources from inside and outside Asia. The Bank will finance infrastructure in a broad sense. Its investment will not stick to traditional infrastructure sectors; it will reach out to any needed infrastructure project, as long as it is conducive to a better life for Asian people. Second, the AIIB has the potential to increase China authority in the international sphere. The AIIB provides leverage from the threat of exit offering an alternative to the existing Bretton Woods system of multilateral development lending, and in turn, to the US-dominated institutions that provide it hegemony and expand liberal internationalism. • The AIIB Capital Structure The authorized capital of the Bank consists of US$100,000,000,000 divided into paid-in shares having an aggregate par value of US$20,000,000,000 and callable shares having an aggregate par value of US$80,000,000,000. As of March 31, 2019, the members had subscribed an aggregate of US$96,403,800,000 of the Bank’s share capital, of which US$19,280,800,000 was paid-in and US$77,123,000,000 was callable. Payment of subscribed, paid-in capital is due in five installments, except for members designated as less developed countries, which may pay in up to ten installments. As of March 31, 2019, US$15,031,590,905

14 AsDB and AsDB Institute, Infrastructure for a Seamless Asia, 2009, at 167. https:// www.adb.org/publications/infrastructure-seamless-asia (visited 31 January 2017).

2

INTERNATIONAL INSTITUTIONS OF INTERNATIONAL FINANCE

21

had been received from members, all in convertible currency, and US$4,171,190,369 was not yet due (Fig. 2.1). • The AIIB Governance Structure The AIIB governance departs from the governance style of the IMF and the World Bank. At the IMF and the World Bank, the voting right of any member state is linked with its payment of contributions. That is, the more capital a member puts up, the more votes it enjoys. The World Bank and the IMF generally take the capital count approach. For example, when new country members join an international organization, or to increase representation in the Board of Directors of smaller less developed member countries, the organization may need to decide to increase the number of directors as appropriate. It requires a four-fifths majority of the total voting power of the World Bank Board of Governors to make such a decision. Similarly, it requires an 85% majority of the total voting power

Brazil

2.91 3.05 3.02 3.18

Indonesia

3.17 3.36

France

3.19 3.38

United Kingdom

Total capital: US$ 100 bn Vong Rights Contribuons

3.46 3.69 3.5 3.74

Australia South Korea

4.15 4.48 5.93 6.54

Germany Russia

7.51 8.37

India

26.06

China 0

5

10

15

20

25

29.78 30

Fig. 2.1 AIIB: Contributions and Voting shares (%) (Source Korean Ministry of Strategy and Finance [CSIS])

22

F. I. LESSAMBO

for the IMF Board of Governors to make the decision. The voting power corresponds to capital shares. The AIIB, like the AsDB, takes a mixture of headcount and capital count. For example, to decide to increase the number of directors as appropriate requires a Super Majority, i.e., a twothirds majority of the total number of the AIIB Board of Governors, representing not less than three-fourths of the total voting power of the members.15 That is, it is a majority of the votes cast, representing capital count, that applies to most decisions of the two banks.16 (FN: AIIB AOA Article 28.2 (i), Agreement Establishing the AsDB Article 33.2, 33.3.) The AIIB has designed a three-class voting system, i.e., a Simple Majority for most matters, a Super Majority for important matters, and a Special Majority for special matters like the establishment of a Bank subsidiary. However, China is open to further dilute its share votes as more members are expected to join in the future. (i) The Board of Governors All the powers of the Bank are vested in the Board of Governors. The Board of Governors may delegate to the Board of Directors any or all its powers, except the power listed under Article 23 (2) (i) to (xi) of the Agreement. Each member is represented on the Board of Governors and appoints one Governor and one Alternate Governor. Each Governor and Alternate Governor serves at the pleasure of the appointing member. No Alternate Governor may vote except in the absence of his principal. At each of its annual meetings, the Board elects one of the Governors as Chairman; who holds office until the election of the next Chairman. Governors and Alternate Governors serve as such without remuneration from the Bank, but the Bank may pay them reasonable expenses incurred in attending meetings. (ii) The Board of Directors The non-resident Board of Directors is responsible for the direction of the Bank’s general operations, exercising all powers delegated to it by the Board of Governors. This includes approving the Bank’s strategy, 15 AIIB AOA, Article 25.2. 16 AIIB AOA Article 28.2 (i), Agreement Establishing the AsDB Article 33.2, 33.3.

2

INTERNATIONAL INSTITUTIONS OF INTERNATIONAL FINANCE

23

annual plan, and budget; establishing policies; taking decisions concerning Bank operations; and supervising management and operation of the Bank, and establishing an oversight mechanism. The Board of Directors consists of 12 members who are not members of the Board of Governors. Nine are elected by the Governors representing regional members, and three are elected by the Governors representing non-regional members. Each Director is elected by the Governors of a particular constituency, which is a small group of members with minimum aggregate voting power. Matters before the Board of Directors are decided by a majority vote, except as otherwise provided in the Articles of Agreement. The BoD is divided into committees: (i) Audit and Risk Committee, (ii) Budget and Human Resources Committee, and (iii) Policy and Strategy Committee. (iii) The President The President is the legal representative of the Bank and the chief of the staff of the Bank. The President conducts, under the direction of the Board of Directors, the current business of the Bank. The President is elected for a five-year term, renewable once. The President may be suspended or removed from office when the Board of Governors so decides by a Super Majority vote as provided in Article 28. The Board of Governors, through an open, transparent, and merit-based process, elects a President of the Bank by a Super Majority vote as provided in Article 28. The President shall be a national of a regional member country. While holding office, the President shall not be a Governor or a Director or an Alternate for either. The President has the authority to establish management committees. Such committees perform a variety of functions, and currently include the following: (i) the Executive Committee, (ii) the Investment Committee, (iii) the Special Fund Committee, (iv) the Human Resources Review Committee, (v) the Risk Committee, (vi) the Operational Procurement Committee and (vii) the Asset and Liability Management Committee. (iv) The Vice-President(s) One or more Vice Presidents are appointed by the Board of Directors on the recommendation of the President, on the basis of an open, transparent, and merit-based process. A Vice President shall hold office

24

F. I. LESSAMBO

for such term, exercise such authority, and perform such functions in the administration of the Bank, as may be determined by the Board of Directors. In the absence or incapacity of the President, a Vice President exercises the authority and performs the functions of the President. • AIIB Operations AIIB’s mission is to (i) foster sustainable economic development, create wealth and improve infrastructure connectivity in Asia by investing in infrastructure and other productive sectors and (ii) promote regional cooperation and partnership in addressing development challenges by working in close collaboration with other multilateral and bilateral development institutions. The Bank commenced operations on January 16, 2016, to help its members meet a substantial financing gap between the demand for infrastructure in Asia and available financial resources. The Bank aims to work with public and private sector partners to channel its own public resources, together with private and institutional funds, into sustainable infrastructure investment (Tables 2.3 and 2.4). • The AIIB Projects Performed With $100 billion in pledged capital, through mid-2018 the Asian Infrastructure Investment Bank had lent more than $5 billion on 28 projects in 13 countries, ranging from a motorway in Pakistan to a gas storage facility in Turkey. By the second half of 2017, seven of the 13 proposed projects were in India, which has emerged as the bank’s largest borrower echoing its cumulative position in the World Bank even as security ties between China and India have grown tenser during Xi demonstrative presidency and under the assertive Modi government. India joined the AIIB in January 2016 and is the second-largest shareholder after China with US$8.4 billion in total subscriptions. In the AIIB first two years, India alone accounted for US$1 billion of its US$4.3 billion in Asian lending; as of late 2018, total AIIB commitments in India approach US$2 billion. Also, the European Union has seen significant engagement with the AIIB. Half of the European Union (EU) member countries have joined the bank, along with Iceland, Norway, and Switzerland.

2

25

INTERNATIONAL INSTITUTIONS OF INTERNATIONAL FINANCE

Table 2.3 Geographic distributions of loans As of December 31, 2018

As of December 31, 2017

As of December 31, 2016

Amount (in millions of US$)a

Amount (in millions of US$)a

Amount (in millions of US$)a

Committed amounts Central Asia 71.2 Eastern Asia 200.0 South-Eastern 820.7 Asia Southern Asia 992.4 Western Asia 1201.5 Total regional 3285.8 Total 42.3 non-regional Total 3328.1 committed Disbursed amounts Central Asia 16.5 Eastern Asia 47.0 South-Eastern 98.6 Asia Southern Asia 413.6 Western Asia 701.4 Total regional 1277 .2 Total 104.2 non-regional Total 1381.4 disbursed

As a percentage of total loan portfolio (%)

As a percentage of total loan portfolio (%)

As a percentage of total loan portfolio (%)

2 6 25

27.4 – 422.5

1 0 22

27.4 – 216.5

8 0 65

30 36 99 1

1013.7 336.9 1800.5 147 .0

52 17 92 8

90.4 – 334.3 –

27 0 100 1

100

1947.5

100

334.3

100

1 3 7

0.1 – 38.5

0 0 5

0.1 – –

1 0 0

30 51 92 8

98.6 641.4 778.5 0.0

13 82 100 0

9.7 – 9.8 –

99 0 100 0

100

778.5

100

9.8

100

Notes The above table sets forth AIIB’s loan portfolio classified by geographic distribution a The amounts set forth in this table include both sovereign and non-sovereign-backed loans Source SEC (2019)

26

F. I. LESSAMBO

Table 2.4 Loans by sector As of December 31, 2018

As of December 31, 2017

As of December 31, 2016

Amount (in millions of US$)a

As a percentage of total loan portfolio (%)

Amount (in millions of US$)a

As a percentage of total loan portfolio (%)

Amount (in millions of US$)a

As a percentage of total loan portfolio (%)

47 6 4 18 8 17 100

778.3 – – 751.5 296.3 121.4 1947.5

40 0 0 39 15 6 100

– – – 117.8 216.5 – 334.3

0 0 0 35 65 0 100

68 0 0 26 5 1 100

672.5 – – 83.0 19.7 3.4 778.5

86 0 0 11 3 0 100

– – – 9.8 – – 9.8

0 0 0 100 0 0 100

Committed amounts Energy 1562.1 Finance 199.5 ICTb /others 125.2 Transport 620.6 Urban 249.7 Water 571.0 Total 3328.1 committed Disbursed amounts Energy 945.0 Finance 0.1 ICTb /others 1.1 Transport 358.3 Urban 67.6 Water 11.5 Total 1381.4 disbursed

Notes The above table sets forth AIIB’s loan portfolio by sector a The amounts set forth in this table include both sovereign and non-sovereign-backed loans b ICT means the information, communication and technology sector Source SEC (2019)

2.7 The Dual Framework of International Finance China Development Bank has total assets (domestic and international) that exceed the combined total assets of the World Bank, the European Investment Bank, and all four major regional development banks combined (Morris, 2018). A more recent study estimates that more than two dozen countries now owe more than 10% of their GDP to the

2

INTERNATIONAL INSTITUTIONS OF INTERNATIONAL FINANCE

27

Chinese government (Horn et al., 2019). The same study notes that lowincome governments, as a group, owe substantially more to China ($380 billion) than they do to all 22 members of the Paris Club combined ($246 billion). The geographical reach of China overseas financing is broad and generally comparable to that of the World Bank. During our period of study, China lent to 130 countries, while the World Bank lent to 127 countries. 42% of official Chinese lending comes directly from China Eximbank, the government export credit agency (ECA). ECAs are not primarily development institutions, and China Eximbank mandate—consistent with other ECAs—is to promote domestic firms through export credits.

CHAPTER 3

The Balance of Payments

3.1

General

The BoP is a statistical statement that summarizes transactions between residents and nonresidents during a period. Put differently, the Balance of Payment is an organized account of all economic transactions between a country (i.e., United States) and the rest of the world, carried out in a particular time period. It is a country archives all the inflows and outflows of funds in a statement. The balance of payments for a country compares to what a balance sheet is for a company. For example, the balance of payments for the United States accounts for all international transactions between individuals, businesses, and government agencies. The BoP is divided into three main categories: the current account, the capital account, and the financial account. Within these three categories are subdivisions, each of which accounts for a different type of international monetary transaction. The current account records exports and imports of goods, services, income, and current transfers. The capital account records capital transfers, such as debt forgiveness. The financial account records transactions for official assets, for US government assets other than official reserve assets, for direct investment, for portfolio investment, and for other investment. An IMF-member country is experiencing severe balance of payments difficulties and reserve depletion may request assistance from the IMF. Under this approach, the IMF may provide a loan to the country in exchange for macroeconomic © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 F. I. Lessambo, International Finance, https://doi.org/10.1007/978-3-030-69232-2_3

29

30

F. I. LESSAMBO

policy conditionality. IMF financing, usually with structural adjustmentrelated financing support from the multilateral development banks or other donors, involves a commitment to appropriate economic stabilization policy objectives, provides for economic and balance of payments adjustment and seeks to avoid a crisis, allowing the capacity for loan repayment to develop within a reasonable period of time. A country’s balance of payments tells whether it saves enough to pay for its imports. … A balance of payments deficit means the country imports more goods, services and capital than it exports. It must borrow from other countries to pay for its imports.

3.2

BoP Key Concepts

3.2.1

Double-Entry Recording

In the balance of payments, in accordance with the general principle of double-entry business accounting, every increase in an asset must be offset by a decrease in another asset or by an increase in a liability, and a decrease in an asset must be offset by an increase in another asset or by a decrease in a liability. The converse is true, of course, for changes in liabilities. The same rules of debit and credit that are applied in business accounting are applied in recording international transactions; namely, increases in assets and decreases in liabilities are entered as debits, and decreases in assets and increases in liabilities are entered as credits. By convention, a debit entry is represented by a negative (−) sign and a credit entry by a positive (+) sign.1 • An export of merchandise is recorded as a credit because it reduces the exporting country’s assets. • The same is true for the rendering of services to nonresidents. • Unilateral transfers, such as gifts, are also recorded using the doubleentry principle, although there is no exchange of assets. As a practical matter, the credit and debit entries required for each specific transaction in double-entry accounting are seldom separately identifiable either in the basic data reported to BEA or in the published balance of payments statement. 1 Robert A. Mosbacher, Michael R. Darby, Allan H. Young, and Carol S. Carson, 1990.

3

3.2.2

THE BALANCE OF PAYMENTS

31

Net and Gross Recording

International transactions may be shown either on a net or gross basis. The net basis is used for most financial items and for unilateral transfers. For financial transactions, increases and decreases in assets during a period are usually consolidated into single entries and are recorded either as a net increase (debit) or a net decrease (credit); similarly, increases and decreases in liabilities are consolidated, and the net amount is recorded with the appropriate sign. This practice reflects the fact that banks and other reporters generally report their financial transactions in terms of net outstanding amounts as of the end of a period. For unilateral transfers, transfers to and from nonresidents are consolidated into single entries. For goods and most services, transactions are recorded on a gross basis, with exports and imports shown separately.2 3.2.3

Time of Recording

To provide for the uniform recording of international transactions in the balance of payments, the timing principle employed in the accounts specifies that transactions are to be recorded when the change of ownership occurs in real or financial assets. This principle is the same as that employed throughout the US national economic accounts. The change of ownership is generally understood to refer to the time when the parties to the transaction record the relinquishment and the acquisition of assets on their books. Consistency among the balance of payments accounts requires that, for example, an export of merchandise or service and its corresponding financing entry be recorded at the same time.3 As a practical matter, the application of the change of ownership rule varies per the nature of the transaction. • First, merchandise trade is recorded in the balance of payments based on the physical movement of goods across the US customs frontier, as evidenced by the export and import documents filed with the US Customs Service. However, it is not clear that a legal change of ownership always occurs at that time; in lieu of other evidence,

2 Robert A. Mosbacher, Michael R. Darby, Allan H. Young, and Carol S. Carson, 1990. 3 Robert A. Mosbacher, Michael R. Darby, Allan H. Young, and Carol S. Carson, 1990.

32

F. I. LESSAMBO

• •

•

•

the physical movement is taken as the best available indication of ownership change. Second, services—such as travel, transportation, and insurance (which are produced, transferred, and consumed at the same time)— are recorded when performed. Third, investment income is generally recorded on an accrual basis, regardless of when the income is paid or received. If funds are not actually transferred at that time, an offsetting entry is made in the appropriate capital account. Fourth, reinvested earnings of direct investment enterprises are recorded as income when earned, with offsets of opposite sign in the direct investment capital account. (Direct investment is defined as ownership of at least 10% of the voting stock of, or an equivalent interest in, an affiliate located in another country.) Fifth, unilateral transfers are recorded when the assets—real or financial—change ownership. The change in ownership of financial items is presumed to occur when the parties to the transaction enter the claim or liability on their books.

In the special case of shipments between a parent company and its unincorporated foreign affiliate, no legal change of ownership can occur in the strict sense because the parent and foreign affiliate are one legal entity. 3.2.4

Valuation

Transactions in real and financial assets must be valued uniformly if the balance of payments accounts are to be consistent. In conformity with the valuation concept employed throughout the US national economic accounts, international transactions are usually valued at market prices. In theory, this is the price that a willing buyer pays to a willing seller in a purely commercial transaction when the parties are not related and when there are no noncommercial considerations. In practice, these conditions do not always exist, because many international transactions occur between parties affiliated in a business relationship, and noncommercial considerations often enter the determination of the price. Nevertheless, adjustments in the reported values are made only in unusual cases.4

4 Robert A. Mosbacher, Michael R. Darby, Allan H. Young, and Carol S. Carson, 1990.

3

THE BALANCE OF PAYMENTS

33

• For merchandise trade, the reported transactions are generally assumed to represent market prices, even for shipments between affiliated enterprises. • For services, transactions are generally estimated from sample surveys in which reporters are asked to report transactions at market values. • For income on direct investment, including reinvested earnings, transactions are actual amounts reported by direct investment enterprises; income on portfolio investment, even when related financial institutions are involved, is estimated using market prices. • For unilateral transfers, transactions are usually valued based on the actual cost incurred in providing real and financial assets. Transactions in financial assets and liabilities are recorded at acquisition or sales values. Market prices for traded securities are usually established in organized markets; claims and liabilities reported by banks and nonbanks are recorded at face value. • Real or financial assets are acquired at one price and sold at another; both transactions are recorded at their market values. Thus, realized capital gains and losses, including those due to exchange rate changes, are reflected in the balance of payments statement. Except for direct investment income and its related capital flows, unrealized gains and losses are not reflected in the balance of payments. • Transactions denominated in foreign currencies are reported at their dollar equivalents, generally converted at exchange rates prevailing at the time of the transaction.

3.3

Balance of Payment Accounts 3.3.1

The Current Account

The current account on the balance of payments measures the inflow and outflow of goods, services, investment incomes, and transfer payments. The main components of the current account are: trade in goods (visible balance), and trade in services (invisible balance). The current account represents a country’s imports and exports of goods and services, payments made to foreign investors, and transfers such as foreign aid. In keeping with double-entry bookkeeping, any credit in the current account (such as an export) will have a corresponding debit recorded in the capital account. The exchange rate exerts a significant influence on the trade balance, and by extension, on the current account. An overvalued

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currency makes imports cheaper and exports less competitive, thereby widening the current account deficit or narrowing the surplus. An undervalued currency, on the other hand, boosts exports and makes imports more expensive, thus increasing the current account surplus or narrowing the deficit. The current account is subdivided into: • merchandise (“goods”) trading These are movable and physical in nature, and for a transaction to be recorded under “goods,” a change of ownership from or to a resident to or from a nonresident has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in), and an import is noted as a debit (money going out). The goods are valued at transaction prices—exports at the customs boundaries of the United States and imports at the foreign port of export. Transfers are recorded at the time of change of ownership. In practice, BEA estimates the merchandise trade accounts from data compiled by the Census Bureau, U.S. Department of Commerce. The data record the physical movement of goods across US customs boundaries, but not always the change of ownership. In using the data for the balance of payments, the assumption is made that goods moving across US customs boundaries change ownership, so that physical possession indicates actual ownership. Goods shipped between affiliated firms in the United States and abroad are assumed to change ownership as well, even though the change of ownership rule may not strictly apply in a legal sense for some transactions—as in the case of shipments to an unincorporated foreign affiliate, which may not be a separate legal entity from its parent company. A similar assumption of ownership change is made for shipments of goods under leasing agreements if the leases are for periods exceeding one year, irrespective of whether the leases are financial or operational. Shipments under leases for periods of less than one year are excluded from Census Bureau data, as are other temporary shipments, that is, shipments to be returned in less than one year. The basic data that BEA uses are the seasonally unadjusted monthly data on exports (including re-exports and military grant-aid) and imports (general imports at customs values).

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• service purchases Services include tourism, transportation, engineering, and business services, such as law, management consulting, and accounting. Fees from patents and copyrights on new technology, software, books, and movies also are recorded in the service category. These transactions result from an intangible action, such as transportation, business services, tourism, royalties, or licensing. If money is being paid for a service, it is recorded as an import (a debit). If money is received, it is recorded as an export (credit). • income receipts The country’s residents receive income from two sources: (i) income earned on foreign assets owned by a nation’s residents and businesses. That includes interest and dividends earned on investments held overseas, and (ii) income earned by a country’s residents who work overseas. The first category is interest and dividend payments to foreigners who own assets in the country. The second is wages paid to foreigners who work in the country. • unilateral transfers The unilateral transfers account is one part of the current account of the balance of payments. It tracks the “one-way” transfer of funds from one country to another that are made without any counter flow or exchange or goods and services. The unilateral transfers accounts cover international transactions in which goods, services, or financial assets are transferred between US residents and residents of other countries without something of economic value being received in return. In general, transfers are recorded as of the time of delivery of goods, the performance of services, or disbursement of cash; the valuation of noncash transfers generally corresponds to the value of the goods or services to which they are offsets. Unilateral transfers often involve gifts to governments, foreign aid or any transaction where one party is promising to deliver and then delivering payments or items to another country, population or government without receiving anything in return. Unilateral transfers are recorded in the following accounts:

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(1) Transfers under US military grant programs: This account measures net transfers of goods delivered and services rendered by US military services to foreign countries under programs enacted by the US Congress to authorize the provision of military assistance for which no repayment is expected or for which repayment terms are indeterminate. (2) US Government grants, excluding military grants of goods and services: This account measures the utilization of US Government financing to transfer real resources or financial assets to foreigners under programs enacted by the US Congress for the provision of nonmilitary foreign assistance (grants) for which no repayment is expected. (3) US Government pensions and other transfers: This account measures (1) payments of social security, railroad retirement, and other social insurance benefits to eligible persons residing abroad, (2) payments under retirement and compensation programs for former US Government civilian employees, military personnel, and veterans residing abroad, including the cost of providing medical services abroad under Veterans’ Administration programs, (3) payments under US educational, cultural exchange, and research programs, (4) membership contributions to international nonfinancial organizations, (5) damage claims paid by the US armed services in countries where they have installations, and (6) other transfers. (4) Private remittances and other transfers: This account measures net private unilateral transfers of goods, services, and cash and other financial assets between US private residents and foreign residents. The below table illustrates the current account of the United States for 2015 (N.A., U.S. International Transactions—Fourth Quarter of 2015 and 2015, 2016). The Current Account in a Nutshell • Trade in goods and services represents the largest component of the current account. A trade deficit alone is enough to create a current account deficit. A deficit in goods in services is large enough to offset any surplus in net income, direct transfers, and asset income.

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• The current account balance is the difference between current receipts from abroad and current payments to abroad. When the current account balance is positive, the country can use the surplus to repay foreign debts, to acquire foreign assets or to lend to the rest of the world. When the current account balance is negative, the deficit will be financed by borrowing from abroad or by liquidating foreign assets acquired in earlier periods.5 • Growing current account deficits are usually a precursor to balance of payments difficulties. Funding of current account deficits requires capital inflows, other net currency inflows or a drawdown in foreign currency reserves. The United States has a significant deficit in its current account.

• The formula for the current account balance is: C AB = (X − M) + (N Y + N C T ) where X M NY NCT

Exports of goods and services Impots of goods and services Net income abroad Net current transfers

3.3.2

The Capital Account

The capital account tracks capital transfers and nonfinancial assets between businesses and individuals in different countries. The capital account shows credit and debit entries for non-produced nonfinancial assets and capital transfers between residents and nonresidents. It records acquisitions and disposals of non-produced nonfinancial assets, such as land sold to embassies and sales of leases and licenses, as well as capital transfers, that is, the provision of resources for capital transfers, that is, the provision of resources for capital purposes by one party without anything of

5 OECD (2015-2016): Globalization—FDI and Balance of Payments.

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economic value being supplied as a direct return to that party. Capital account tracks all capital transfers and nonfinancial transfers. • Capital transfers Capital transfers include items such as debt forgiveness, transfer of title for fixed assets, inheritance taxes, and uninsured damage to fixed assets. There are three components of the capital transfer sub-account. (i) the insured catastrophic losses, (ii) any debt forgiveness, and (iii) the transfer of a government’s assets. • Nonfinancial transfers Nonfinancial assets are defined as non-produced assets, such as natural resources, patents, copyrights, franchises, and leases (Table 3.1). The capital account of the BoP is subdivided into (i) foreign direct investment, (ii) portfolio investment, and (iii) other investment. • Foreign Direct Investment Foreign direct investment consists of long-term financial investment abroad, characterized by large ownership stakes (over 10%) in foreign Table 3.1 Current account balance Credits Current account balance Acquisitions (DR)/disposals (CR) of non-produced, nonfinancial assets Natural resources Contracts, leases, and licenses Marketing assets Capital transfers Debt forgiveness Other Capital account balance Net lending (+)/net borrowing (−) (from current and capital account) Source IMF (2013)

Debits

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firms. The 10% rule is a bit arbitrary, but economists think of foreign investment as highly illiquid. While one can easily sell a foreign bond, large stakes in foreign enterprises are thought to represent ownership interests that cannot be liquidated at the tip of a hat. For example, Samsung Corporation of South Korea might see a potentially profitable financial investment opportunity in a Japanese startup, and thus acquires more than 10% of the startup’s stock. This transaction is recorded as a debit on South Korea’s BoP, since it is a purchase of foreign assets (by analogy the purchase of foreign goods, an import, is also a debit). The purchase of financial assets is accompanied by some payment—with double-entry accounting—and this payment corresponds to a flow of financial capital from Korea to Japan. It is thus clear that a purchase of assets abroad will trigger a capital outflow—domestic financial capital is put to work abroad. Since goods exports are recorded as a credit on the BoP, one might mistakenly think that South Korea’s capital “exports” should also be recorded in the same manner. However, from the point of view of South Korea, Samsung is purchasing Japanese assets, and all purchases are recorded as a debit (just like imports, the purchase of foreign goods). By the same reasoning a 12.8 sale of assets to foreigners—recorded as a credit in the financial account triggers a capital inflow—foreign capital is put to work in the domestic economy. • Portfolio and Other Investments Portfolio investment is composed of more liquid financial investments, generally undertaken in the form of stocks, bonds, and bank balances. In the BoP, portfolio investment is given by the categories that refer to “securities,” a term that refers generally to liquid assets. The accounting for this category works in the same way as for FDI: if the country is buying foreign assets (investing abroad), finances are flowing out of a country (capital outflow), the purchase of the foreign assets is recorded as a negative in the financial account for that country, and if the foreigners are buying assets in the domestic economy (investing in the domestic economy) financial capital is flowing into the country (capital inflows), the sale of domestic assets to foreigners is recorded as a positive in the financial account. For example, if Russian businessmen want to invest in the US stock market, their investment in the US economy is counted negatively on the portfolio investment subsection of Russia’s financial

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account balance. Conversely, the Russian investment in the US economy is entered positively on the United States’ financial account balance. It is a capital outflow for Russia and a capital inflow for the US. Categorizing changes in bank balances as credits or debits is more difficult to conceptualize. There are several ways to explain it. If an American, draws on his Barclay bank balance in London to make a payment for a British good, he is lowering his claims on Britain as he is relinquishing (selling) some of his assets (the British pounds): all this points to a credit (a sale). A more simplistic approach would be to assert that since he purchased a British good (a negative entry), with double-entry accounting, the other side of the transaction, the payment for the good, must be a positive entry. These changes in bank balances allow us to suggest another way to categorize the financial accounts: the autonomous accounts and the settlement accounts. The autonomous accounts correspond to the initial deal (e.g. buying bonds) while the settlement accounts correspond to the resulting payment for the deal, a change in bank balance, or currency holding. Private citizens undertake foreign direct investments and portfolio investments mainly. However, the government can also undertake them. For instance, the government might build a university or an airbase in a foreign country or it might invest in foreign companies. So, the financial accounts make a strict distinction between financial transactions carried out by the government and financial transactions carried out by the central bank. The latter is akin to a form of monetary policy as changes in the account involved (the official reserve transactions) directly affect the level of an asset in the central bank balance sheet. 3.3.3

Financial Account

The financial account records transactions that involve financial assets and liabilities and that take place between residents and nonresidents. The financial account indicates the functional categories, sectors, instruments, and maturities used for net international financing transactions. The financial account is classified according to the instrument and functional categories. Entries in the financial account can be corresponding entries to goods, services, income, capital account, or other financial account entries. For example, the corresponding entry for export of goods is usually an increase in financial assets, such as currency and deposits or trade credit. Alternatively, a transaction may involve two financial account entries. The overall balance on the financial account is called

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Table 3.2 Overview of financial account Net acquisition of financial asset

Net incurrence of liabilities

• Direct Investment • Portfolio investment • Financial derivatives (other than reserves) and employee stock options • Other investments • Reserve assets Total Of which Equity investment fund shares Debt instrument Other financial assets and liabilities Source IMF-Overview of Financial Account

net lending/net borrowing. Net lending means that, in net terms, the economy supplies funds to the rest of the world, taking into account acquisition and disposal of financial assets and incurrence and repayment of liabilities.6 Transactions involving financial assets are recorded when economic ownership changes. Some financial liabilities, such as trade credit and advances, are the result of a transaction in nonfinancial items. In these cases, the financial claim is deemed to arise at the time the corresponding nonfinancial flow occurs.7 A financial account includes: direct investment, portfolio investment, financial derivatives (other than Reserves) and Employee Stock Options, and other investment (Table 3.2 and Fig. 3.1).

6 IMF (2013): BoP and International Investment Position Manual (BPM6), Chapter 8Financial account, p. 133. 7 IMF (2013): BoP and International Investment Position Manual (BPM6), Chapter 8Financial account, p. 134.

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Fig. 3.1 United States BoP: 2016–2019 (Source US Dept of Trade)

3.4

Statistical Discrepancy

If all items in the three accounts of the BoP are recorded correctly, the sum of all of these items equals zero. In practice, they are not and do not, so that a line called “statistical discrepancy” is added to make the accounts add to zero. The statistical discrepancy represents the net of many items that are either ill-measured, unaccounted, or missed due to errors or omissions. Very often, the statistical discrepancy exists because recordkeeping for the BoP is incomplete, especially on the financial side of international transactions. However, the amount of the statistical discrepancy is often very small.

3.5

Official Reserves

The official reserve account, a subdivision of the capital account, is the foreign currency and securities held by the government, usually by its central bank, and is used to balance the payments from year to year. Official reserve assets are those financial assets that can be used as international means of payments. Currently, official reserve assets comprise (i) gold, (ii) foreign exchanges, (iii) special drawing rights (SDRs), and

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(iv) reserve positions with the IMF. Foreign exchanges are by far the most important official reserves. Put differently the official reserve account represents the foreign currencies held by a nation’s central bank, resulting from accumulations in the current account and the financial account in the nation’s balance of payments. To balance the two accounts in the balance of payments, a country’s official foreign exchange reserves measures the net effect of all the money flows from the other accounts. Sometimes, central banks use their official reserves to intervene in the foreign exchange market. For instance, if the dollar is too strong, the Fed might sell dollars to bring down its value. Conversely, if a currency is too weak, the central bank will purchase its currency. This increases the demand for that currency, which subsequently raises its value compared to others. However, exchange rate interventions are only temporary fixes. Market forces are continually influencing exchange rates. Therefore, the market equilibrium will soon resume after the central bank’s intervention.

3.6

Significance of the Balance of Payments

The BoP essentially serves as the financial ledger and source of truth around a country’s financial transactions on all fronts. It reveals the economic health of a nation and helps economists postulate its future economic landscape. It is used to inform a wide variety of people, including investors, investment managers, business owners, and policymakers. The BoP is very often a key point of reference at the heart of many major decisions a country makes, both financial and nonfinancial. For instance, businesses may examine a country’s BoP if they are searching to potentially expand into foreign markets or an investor may look to a country’s BoP to help them decide if they want to invest in foreign currency. Economists and analysts utilize the balance of trade in understanding the strength of a country’s economy in comparison to other countries. For example, a country with a large trade deficit is typically borrowing money for purchasing goods and services, whereas a country with a large trade surplus is typically doing the opposite. The balance of trade may correlate with the country’s political stability because it is indicative of the level of foreign investment taking place there.

CHAPTER 4

International Corporate Governance

4.1

General

The United States struggles with its corporate governance framework. The US corporate governance is made of multiple facets: legal, securities, and accounting rules designed to protect the interests of shareholders in a transparent means. The overall system lacks rigorous implementation or at least is perceived as such. Despite the existence of a diverse and inarticulate legislation thereon, the overall perception is that the country has a broken corporate governance record, with most white-crime get unpunished. The reasons are multiple. The most currently cited are: • The excessive concentration of power in the hands of top management; • The lack of personnel, both qualitatively and quantitatively, on the part of the agencies such as the Securities and Exchange Commission (“SEC”), the Internal Revenue Service, the Federal Reserve, and others; • The complacency of professional organizations in charge of selfregulating their professions, such as the Public Company Accounting Oversight Board (PCAOB); • The lack of expertise, training, and willingness on the part of prosecutors to prosecute efficiency the crimes brought to their attention; © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 F. I. Lessambo, International Finance, https://doi.org/10.1007/978-3-030-69232-2_4

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• The revolving door culture between the representatives of the white-crime delinquents, whether lawyers or accountants, and the regulators before which they appear; • The existing loopholes engineered by Congress under the mandate of Washington DC lobbyists. Contrary to the European Union countries and Asia-Pacific, the top 1000 US firms are owned by institutional investors.1 With more and more companies registered with the SEC and raising money from the public, the United States has come to fictionally elaborate a corporate governance structure based on a theoretical and legal principal–agent concept, despite the flaws and inadequacies of such approach. The overall corporate governance lacks a conceptual analytical approach in terms of checks and balances. A comparative look with its neighboring Canada reveals that the United States is lagging far behind.

4.2

The Aim of Corporate Governance

For so long, the concept of “shareholder primacy,” or a corporation’s duty to maximize shareholder value was considered as the governance norm, but things begin to change. In August 2019, the Business Round Table2 released a statement which reads: Investing in employees, delivering value to customers, dealing ethically with suppliers and supporting outside communities are now at the forefront of American business goals.

The new statement puts an official stamp on a more stakeholder-driven approach to governance that some CEOs have individually advocated for in recent years.

1 As of 2010, almost 61% of the overall 100 firms’ outstanding equity is controlled by institutional shareholders: pension funds, mutual funds, banks, life insurance companies, and endowments. 2 The Business Roundtable, which represents the chief executives of 192 large companies in the United States.

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Statement on the Purpose of a Corporation Americans deserve an economy that allows each person to succeed through hard work and creativity and to lead a life of meaning and dignity. We believe the free-market system is the best means of generating good jobs, a strong and sustainable economy, innovation, a healthy environment and economic opportunity for all. Businesses play a vital role in the economy by creating jobs, fostering innovation and providing essential goods and services. Businesses make and sell consumer products; manufacture equipment and vehicles; support the national defense; grow and produce food; provide health, care; generate and deliver energy; and offer financial, communications and other services that underpin economic growth. While each of our Individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders. We commit to: • Delivering vaLlue to our customers. We will further the tradition of American companies leading the way in mee ting or exceeding customer expectations. • Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect. • Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions. • Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses. • Generating long-term value for shareholders,who provide the capital tliat allows companies to invest,grow and innovate. We are committed to transparency and effective engagement with shareholders. Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communites and our country.

Source Business Round Table (2019)

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4.3

The Agency Approach

The US corporate governance is based on the conventional agency relationship, which relies upon the separation of ownership and control. The underlying idea is that the Board shares mutual interest with shareholders in protecting the corporation. In theory, the board acts as the agent of the shareholders (“the Principal”). Thus, the board must comply with all rights and duties under the principal–agent relationship. The board of directors owes fiduciary duties to the shareholders: duty of care, duty of loyalty, duty of candor. Breaches of these duties can result from shareholders’ specific suits and damages stemming from the actions of the Board. 4.3.1

The Board Fiduciary Duties

Courts in the United States, and particularly the Delaware Chancery and Supreme Courts have developed specific standards to ascertain the board actions. The directors of Delaware corporations have a triad of primary fiduciary duties: (i) due care; (ii) loyalty; and (iii) good faith. However, the Delaware courts adhere to the view that management owes fiduciary duty of care and loyalty to the corporation and its stakeholders, simultaneously.3 Such an approach has been characterized by Professor Christopher Bruner as a “decided reluctance to focus solely on the shareholders, to the exclusion of the other constituencies contributing to the corporate enterprise.4 ” • Duty of Care Directors must discharge their duty in good faith, with such a degree of diligence, care, and skill than an ordinary prudent person would exercise under similar circumstances. Directors would be held responsible for either nonfeasance or misfeasance, any time their inaction or action causes harm to the corporation. 3 Moleney v. Brincat, 722 A 2d 5, 10 (Del. 1998). 4 Christopher M. Bruner (2010): Power and Purpose in the Anglo-American corpora-

tion, Virginia Journal of International Law, Vo. 50(3), p. 599.

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The duty of care requires directors to take certain responsibilities or actions. In Francis v. United Jersey Bank,5 the New Jersey Supreme Court held that: Directors should have some understanding of the business, keep informed on activities, perform general monitoring including attendance at meetings, and have some familiarity with the financial status of the business as reflected on the financial statements. However, the company certificate of incorporation may shield the directors from the liability pursuant to their duty of care if the breach and the harm suffered by the corporation did not occur in bad faith6 or with an intentional misconduct of disregard. To establish that a director has failed to act in good faith, a shareholder must show whether that the director conduct was motivated by an actual intent to do harm, or that the director acted with a conscientious disregard as to his (her) fiduciary duties. • Duty of Loyalty Directors should perform their duty with loyalty. That is, directors must act (i) in good faith, (ii) with the conscientiousness, fairness, morality, and honesty that the law requires of fiduciaries. The duty of loyalty prevents them for engaging in self-dealing, usurping the corporation opportunity, or making secret profits at the detriment of the corporation. The duty of loyalty is often breached when directors engage in interested transactions. Such transactions are suspicious and set aside, unless the directors establish that the transactions were fair and reasonable at the time they are entered into; or have disclosed the material facts and won the approval of the Board. Likewise, directors should not usurp the corporation’s business opportunity. This refers to any business or transaction the corporation has a tangible interest or expectancy in, or logically related to the corporation core and auxiliary businesses.

5 Francis v. New Jersey Bank, 432 A 2d. 814 (NJ 1981) 6 In Re Walt Disney Co. Derivative Litigation, Del. Ch. 2003.

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• Good Faith Conduct The Delaware courts are still struggling to provide clear opinions concerning Delaware directors’ duty to act in good faith. The duty to act in good faith has been described simultaneously as a third component of the triad of primary fiduciary duties, or confusingly as an aspect of the duty of care or the duty of loyalty. In the Walt Disney cases,7 the duty to act in good faith was described as an independent duty from the two other duties (care and loyalty). The Delaware Supreme Court has stated that bad faith conduct may be found where a director “intentionally acts with a purpose other than that of advancing the best interests of the corporation, . . . acts with the intent to violate applicable positive law, or . . . intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.” However, in subsequent cases, the Delaware court holds that directors would be liable for bad faith if the facts establish an intentional dereliction of duty, a conscious disregard as to their responsibilities.8 4.3.2

The Safeguards: The Business Judgment Rules

The “Business Judgment Rule” principle can be traced back in the United States to the “Harvard College and Massachusetts General Hospital v. Francis Amory” case in 1830, where judge Samuel Putnam asserted: “trustee cannot be held accountable for bad outcomes except for gross neglect and willful mismanagement. In the same vein, the Supreme court of Michigan went on to add in ‘Dodge v. Ford’” that the best judgment rule must include long-term consideration. The business judgment rule (BJR) protects the board of directors against suits that derive from a violation of the duty of care, or malfeasance. It protects directors who are not negligent while making decisions for the corporation. As a general rule, courts will not second guess the board decision even when it is damageable to the business. The rule introduces a rebuttable presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action

7 In Re Walt Disney Co. v. Derivative Litigation (Disney IV), 906 A 2d 27, 63–68. 8 Brehm v. Eisner, 906 A 2d 27, 64 (Del. 2006).

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taken was in the best interests of the company. The directors must show that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed. Further, they must show that the defensive mechanism was “reasonable in relation to the threat posed.” Moreover, that proof is materially enhanced, as in UNOCAL,9 where a majority of the board favoring the proposal consisted of outside independent directors who have acted in accordance with the foregoing standards. The safeguard of the best judgment rule shields directors even if “hindsight later reveals other choices that arguably were better or wiser.” The shareholders can overcome the presumption by establishing malfeasance or breach of duty of care. When the directors were grossly negligent as in the Van Gorkom case,10 the Chancery Court has no difficulty finding in a breach of duty of care. In applying the best judgment rule, the Delaware courts have elaborated specific requirements that the boards must meet. These requirements or standards are often referred to as either the Revlon standard,11 or the Unocal standard,12 or the Paramount standard.13 The board must demonstrate that: (i) it had reasonable grounds for believing that a danger to corporate policy and effectiveness existed,14 and (ii) its defensive actions were reasonable in relation to the threat posed.15 4.3.3

Limited Shareholders’ Rights

In contrast to the United Kingdom, Canada, Japan, and even China, US shareholders have limited role in the governance of their companies. They do not have the right to amend the corporate charter, they do not have a final say in the event of their corporation wind-up. As professor Lorsch admitted:

9 Unocal V. Mesa Petroleum Co., 493 A 2d 946 (Del. 1985). 10 Smith v. Gorkhom, 488 A 2d 858 (Del. 1985). 11 Revlon Inc. v. MacAndrews & Forbes Holding Inc., 506 A 2d 173 (Del. 1985). 12 Idem, reference # 42. See note 8. 13 Paramount Communications, Inc. v. QVC Network, Inc. 637, A 2d (Del. 1994). 14 To satisfy this standard, the directors must prove that they were informed and acting

in good faith. 15 The second condition requires the board prove two things: (i) that the response was not “coercive” or “preclusive,” and (ii) the response was within a range of reasonableness.

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US shareholders participate in governance as they always have: by following the Wall Street rule. They sell stock when they are unhappy with the company’s performance and prospects, and they buy when a company’s future seems promising.

However, Lorsch goes on to explain the US shareholders limited participation in corporate governance as follows: The reason is simple: over 60% of US shareholders are institutions (hedge, mutual, and pension funds). An examination of the shareholding among developed countries such as the United Kingdom or Canada just contradict the facts; Indeed, in both Canada and the United Kingdom, institutional shareholders hold more than 60%, still shareholders enjoy substantial corporate governance rights. The reason seems to lie in the role institutional shareholders play in the US contrary to the United Kingdom or Canada where institutional shareholders have positively contributed to the enhancement of corporate governance rules, US institutional investors have refrained to play such a role for both lack of resource and lack of expertise.

4.4

The Flaws and Inadequacies of the Agency Approach

The agency theory, developed in the early Twentieth Century, bears with it an inherent conflict of interest between the Board which acts as both the agent of the shareholders and the driving force of the corporation, and the shareholders to whom the agent owes fiduciary duties. Shareholders are considered to be risk-neutral since in addition to their investment in the firm they can hold their wealth in well-diversified portfolios and thereby diversify away firm-specific-risk; while the Board undiversified human capital investment is bound up with the future of the firm. The conflict goes even deeper if we consider that despite the existence of the so-called “gatekeepers” such as independent auditors, rating agencies, and the like, the US Corporate governance has poorly delivered on its promises and will do so likely in the near future, unless a radical change is conducted. External auditors, credit rating agencies and analysts together failed to detect and denounce creative accounting and the financial statement thereof. Despite some progress made through the Sarbanes–Oxley (SOX)

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Act of July 2002, shareholders are still largely at the mercy of corporate management. 4.4.1

The Sarbanes–Oxley Act

Enacted in July of 2002, in response to Enron, Worldcom, scandalous discoveries in mutual and hedge fund industries, and other public governance failures, the Sarbanes–Oxley Act (“SOX Act”), has introduced some changes in the US corporate governance for publicly traded companies. Some provisions of the SOX Act have been revisited recently in 2010, by the NYSE-Euronext Corporate Governance Principles. Prior to the Sarbanes–Oxley Act, the US securities laws did not directly address board structure. Three distinct provisions from the Sarbanes–Oxley Act are relevant to enhance the corporate governance in the United States: Section 302, Section 404(a) and (b), Section 906, and Sections 301, 1102. In addition, the SOX Act created a Public Company Accounting Oversight Board (PCAOB) to oversee the audit of public companies that are subject to the securities laws. • Section 302: Corporate Responsibility for Financial Reports Pursuant to Section 302 of the SOX Act, the CEO and the CFO of a publicly traded corporation should certify that (i) they have reviewed the financial statements being filed, (ii) to the best of their knowledge, the financial statements do not contain any untrue statement of material fact or omit to state a material fact relevant to the truthfulness of the financial records, (iii) the financial statements and notes or addenda thereon, fairly represent in all material respects the statement of condition, the statement of income, and the cash flows, as of the period being reported, (iv) there are responsible for setting up and maintaining proper disclosure controls and procedures. • Section 404: Management Assessment of Internal Audit Section 404(a) requires both the CEO and the CFO to annually assess and certify the effectiveness of the corporation internal auditing process. In addition, the SOX Act requires the CEO and the CFO to disclose any

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material weaknesses uncovered in the company’s internal auditing process. Furthermore, Section 404(b) requires that the company’s external or independent auditor examines the management assessment of internal audit process, and reports as to the effectiveness of such assessment. • Section 906: Certification of Compliance with the SEC Section 906 requires both the CEO and the CFO to sign and certify that the company’s financial statements comply with the Security and Exchange Commission requirements, and fairly represent the statement of condition, income, and cash flow for the reported period. While this provision is well-received by financial analysts it fails short to require a comprehensive disclosure and does not include the disclosure of foreseeable risk factors. The contrast with the United Kingdom’s Combined Code is striking. The UK code requires listed companies to review annually “all material controls, including financial operation and compliance controls, and risk management systems.” • Section 101: The Public Company Accounting Oversight Board Under Section 101(c), the PCAOB duties include, inter alia, of: (i) the registration of public accounting firms that prepare audit reports for issuers, (ii) the adoption of rules for auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports for issuers; (iii) the conduct investigations and disciplinary proceedings concerning the public auditing companies. In practice, the effects of the PCOAB are very limited. To be more effective, the five PCAOB board’s member must come from the academic experts in the field of accounting, finance, and business, with special skill and expertise in the preparation and issuance of audit reports with respect to the required disclosures. That is the approach taken by prominent European countries such as France, Germany, and the United Kingdom. Unless, such a reform is conducted the PCAOB will remain ineffective, and auditing scandals flourish, and the victims of fraud belittled through inconsiderate settlements within inconsistent federal system courts. The cross-selling of consulting services by auditing firms, the credit rating agencies, the analysts, coupled with the roll-over practice between the federal agency employees in SEC, the Federal Reserve, and other agencies justify and support a call for enhanced

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standard of liability pursuant to gatekeepers. Moreover, the auditing, and rating agency industries have been characterized as super-concentrated by the Government Accountability Office (GAO). Facing new series of regulations, the gatekeepers remain even in size despite the request for more laborious fact-checking. The tendency will last as the Public Company Accounting Oversight Board, has recognized, in 2008, that its quality controls are inadequate. To protect shareholders and the financial markets’ trust, the US government can do three things (i) to enhance the standard of liability, (ii) to use its constitutional power as a market participant to shift public contracts to mid-size firms, or (iii) back up the EU Commission effort to dismantle the big-4, which become too big to control. The European Union Commission is considering a “Regulation” that could eradicate the conflicts of interest under which the big-4 operates. The draft of the regulation, in part, says: “audit firms of significant dimension should not be allowed to undertake other services unconnected to their statutory audit function such as consultancy and advisory services.” Whether it is the European Union or tomorrow China, and the G-20, the restructuring proposal would allow other small and mid-size audit firms to penetrate the auditing market and provide quality-oriented audit, rather than the complacent unqualified opinions we become so accustomed to PCOAB are very limited. The SOX Act requires that the five members of the PCAOB “be appointed from among prominent individuals of integrity and reputation who have a demonstrated commitment to the interests of investors and the public, and an understanding of the responsibilities for and nature of the financial disclosures required of issuers under the securities laws and the obligations of accountants with respect to the preparation and issuance of audit reports with respect to such disclosures.” To be more effective, and due to the mission assigned to the board, it would be better if the SOX Act used a precise qualification such as: the five PCAOB board’s member should be prominent PhD professors in accounting or related science, for at least 10 years, with CPA in effect, and a deep commitment to the auditing industry. Such an enhanced qualification for the PCAOB members would provide them with heightened status close to the Federal Reserve executives in charge of the monetary and tax policies. That is the approach taken by prominent European countries such as France, Germany, and the United Kingdom. Unless, such a reform is conducted the PCAOB

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will remain ineffective, auditing scandals will flourish, and the victims of fraud belittled through inconsiderate settlements within inconsistent federal system courts. • Section 301: Independent Financial Expert in the Board Section 301 of the SOX Act requires that at least one member of the board of directors with financial expertise sit on the corporation audit committee. Failure to meet this requirement will trigger criminal liabilities in case of failure. • Section 1101: Corporate Tax Returns Section 1101 of the SOX Act requires that the Federal income tax return of a corporation be signed by the Chief Executive Officer of such corporation. 4.4.2

Re-Examination of the Compensation Structure

The gap between normal workers and CEOs is particularly high in the United States. The richest CEO in 2018 was Elon Musk, with an annual compensation of about 2.84 billion US dollars. US CEOs average over quadruple the global major corporate CEO average, with $14.25 million in annual pay and a 401 index value. US workers labor under the world’s highest-paid bosses. Average workers in Switzerland made $70,835 in 2017. Average workers in the United States made $52,988. The U.S. Securities and Exchange Commission has released the compensation of McDonald’s CEO Stephen Easterbrook. He was paid $15.9 million in 2018. That is 2,124 times the median employee salary of $7473. Principle VI. D. 4 of the OECD-Corporate Governance recommends that the board remuneration be aligned with the longer term interests of the company and its shareholders. In addition, Principle 6 of the Basel Committee, which includes senior executives goes on to add that the Board of directors should ensure that compensation policies and practices are consistent with the bank’s corporate culture, long-term objectives, and strategy. Section 954 of the Dodd–Frank Act requires that publicly traded companies develop and implement (i) a policy for the disclosure

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of incentive-based compensation “that is based on financial information required to be reported under the securities laws,” and (ii) a policy for the recovery of incentive-based compensation from current and former executive officers in the event of an accounting restatement due to material noncompliance of the issuer with any financial reporting requirement under the securities laws. Despite this telling guidance, Corporate America has looked the other way around. It is recommendable that a large portion of CEO wages and bonuses be set aside until their terms are over and their success is made clear. As professor Bebchuck has argued, “flawed compensation arrangements have not been limited to a small number of bas apples: they have been widespread, persistent, and systemic.” Executive compensation, in the United States has no link with management’s performance. That is due in most part, to the fact that the market for corporate takeovers is manager-friendly, with inadequate holding from the Delaware Chancery court or the Delaware Supreme Court. Whether they fail the shareholders or not, CEOs are welcome with “golden hello” and when they have to cut ties with the companies, they walked away with their “golden goodbye” package, always in millions of US dollars. Furthermore, another arrangement, known as “stealth compensation” would be negotiated apart, allowing them post-retirement consulting contracts for the firms they defrauded. Compensation arrangements have often deviated from arm’s length contracting because directors have been influenced by management, sympathetic to executives, insufficiently motivated to insist on shareholder-serving compensation, or simply ineffectual (Table 4.1). In 1968, the average corporate CEO made twenty times the salary of his average worker. Internal incentives from management ownership of stock and options were modest. Today it is more than 350 times, the Table 4.1 Five CEOs with most pay in 2018 Rank

CEO

Company

Pay (2018)

Shareholder return (%)

#1 #2 #3 #4 #5

David Zaslav Stephen Angel Bob Iger Richard Handler Stephen MacMillan

Discovery, Inc. Linde Disney Jefferies Hologic

$129.4 million $66.1 million $65.6 million $44.7 million $42.0 million

10.5 3.1 20.4 −14.9 11.7

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average annual salary of an ordinary worker. The situation contrasts significantly with the reality all around the world, considering that in term of productivity, the United States stands after Germany, Japan, and South Korea (Figs. 4.1 and 4.2). In both Germany, Japan and South Korea, where employees are part of the corporate governance equation, the corporate profits have soared, the executive remuneration is contained. That is due to the fact that they participate in the definition of their corporation goals and challenges and are willing, after some negotiations, to give up some of their “acquis sociaux.” In Germany, for instance, the corporate law requires firms to have representatives of employees and unions in their supervisory board. The German corporate law considers employees as well as stockholders, as important stakeholders in the firms. Some have argued, in the United States, that the use of stock options for executives and boards is nowadays an agreed upon solution because it is generalized. But, the mere fact that a system is followed in many countries does not make it fair or acceptable.

Fig. 4.1 CEO-to-Worker Compensation ratio, 1968–2018 (Source Economic Policy Institute [2019])

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Fig. 4.2 Ratio between CEO and average worker pay in 2018 (Source OECD)

CHAPTER 5

Foreign Exchange and Money Markets Transactions

5.1

General

Foreign currency transactions are transactions denominated in a currency other than the entity’s functional currency. As a result, identifying a foreign currency transaction first requires the entity’s functional currency to be determined. Foreign currency transactions arise when a reporting entity: • Buys or sells goods or services on credit for prices denominated in a foreign currency. • Borrows or lends money denominated in a foreign currency. • Is a party to an unperformed forward exchange contract. • Acquires or disposes assets denominated in a foreign currency. • Incurs or settles liabilities denominated in a foreign currency. The first Forex market was established in Amsterdam, roughly 500 years ago. This possibility to freely trade currencies helped stabilize currency exchange rates. From Amsterdam, Forex trades throughout the whole world were initiated. By 1913, the number of Forex trading firms rose from 3 to 71 within only 10 years in London. Fifty percent of all Forex transactions were made in Pound Sterling. In 2013, the Pound Sterling was the fourth most traded currency after the US Dollar, the

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 F. I. Lessambo, International Finance, https://doi.org/10.1007/978-3-030-69232-2_5

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EURO, and the Japanese Yen. Trading in FX markets reached $6.6 trillion per day in April 2019, up from $5.1 trillion three years earlier. This means that on an average day in 2019, the sum of all transactions in the forex market amounted to almost 6.6 trillion US dollars. The global FX market is more opaque than many other financial markets because it is organized as an over-the-counter (OTC) market built upon credit relationships.1 The US dollar retained its dominant currency status, being on one side of 88% of all trades. The share of trades with the euro on one side expanded somewhat, to 32%. FX trading continues to be concentrated in the largest financial centers. In April 2019, sales desks in five locations— the United Kingdom, the United States, Singapore, Hong Kong SAR, and Japan—intermediated 79% of all foreign exchange trading. Governments and central banks, such as the European Central Bank, the Bank of England, and the Federal Reserve, are regularly involved in the forex market.

5.2

Foreign Exchange Market Participants

There are various participants with the Foreign Exchange markets: (i) commercials and investment banks; (ii) multinationals or big corporations; (iii) brokers; (iv) noncommercial banks (e.g., hedge funds, private equity firms); central banks. 5.2.1

Commercial and Investment Banks

Global commercial and investment banks are foremost big players in FX markets. Most of them get involved in serving their clients conducting businesses worldwide. In so doing, commercial and investment banks perform or act in a broker capacity at the request of their clients (i.e., multinational firms, exporters, and importers). Besides serving their clients, commercial and investments banks trade in interbanks FX for their own sake, as a distinct sector of activities. They speculate or make arbitrages in FX seeking for spread, as dealers. The market maker function of any global bank involves two primary foreign exchange activities: (i) commercial and investment banks quote a two-way price, (ii) they buy currency as inventory at bide price, with the expectation to sell the

1 Andreas Schrimpf (2019): Sizing Up Global Foreign Exchange Markets, p. 21.

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currency later at ask price, and realize a spread. As all foreign currencies are assigned an International Standard Organization (ISO) abbreviation, the market maker expresses the relationship using the two currencies’ ISO designations (e.g., USD/JPY). Hundreds of international commercial and investment banks are actively involved in the FX markets through their FX desks. Deals are conducted by telephone with brokers or via electronic dealing terminal connection to their counterparty. The standard dollar parcels vary between 5 and 10 million. Sometimes, higher dollar parcels from 100 to 500 million are also quoted. 5.2.2

Multinationals or Big Corporations

Multinationals and big corporations operating worldwide have to make or receive payment in foreign currencies. Besides performing through their commercial or investment banks, most international managers play directly in the FX markets in order to hedge their risks or offset FX receivables or payables that might jeopardize the firm financial strength. 5.2.3

Brokers

Brokers perform mainly as intermediaries in the FX markets, matching dealers order to buy and sell currencies. They earn fees for the involvement. The brokers industry in FX is dominated by two biggest players: Reuters and the European Broking Services (EBS). 5.2.4

Noncommercial Banks

Noncommercial banks include hedge funds, private equity firms, large institutional investors, and other participants in the FX markets. They are mainly speculators on the watch for opportunities in the FX markets. Hedge funds particularly are increasing their market share, stirring up fears to destabilize the markets. 5.2.5

Central Banks

Central banks hold official reserves or international reserves to assist their governments in international trade. Whenever their balances of payments are under deficits/surpluses, central banks intervene in the FX to buy/sell

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foreign currencies. Central bank’s intervention is often closely watched because it can provide some indications as to the financial wealth of a nation.

5.3

Management of Foreign Exchange Risk

The most used techniques in measuring FX risk are: (i) hedging, (ii) FX gap analysis, (iii) FX rate duration analysis, (iv) FX rate simulation analysis, and (v) FX rate volatility analysis. 5.3.1

Hedging

The purpose of foreign exchange hedging consists of minimizing the bank’s exposure to changes in foreign exchange rates. There are several hedging techniques, each bearing its own particular features. Some banks use foreign exchange options to hedge currency risk, while others use “delta hedging” to hedge options-type risk or to synthetically create foreign exchange options. If the appropriate measure of risk is related to deviations between actual and predicted exchange rates, a bank may use the forward rate as a prediction of the future spot rate. However, even so, the use of the forward rate does not eliminate completely the volatility risk for a couple of reasons: (a) the forward rate is not a good indicator of the future exchange rates; (b) quotations are available only for major currencies. 5.3.2

Foreign Exchange Gap Analysis

Gap trading allows the bank to take advantage in the gap price of a specific currency from one day to the next day. Knowledge of the gap and other relevant information can boost the bank’s FX profits, in the short term. Bank’s FX department would have to determine their own gaps for each currency traded between the close and the next day. International banks with offices around the world have advantages relatives to domestic banks, as they can trade over the clock.

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Foreign Exchange Rate Duration Analysis

Banks and other investors use two methods when purchasing and selling foreign exchange markets: (i) the fundamental analysis, and (ii) the technical duration analysis. Foreign exchange rate duration analysis is a variant of the technical duration analysis. In the context of foreign exchange, duration means three things: • the change in the value of a foreign currency bond with respect to foreign currency interest rates; • the change in the value of a foreign currency bond with respect to domestic currency interest rates; • the change in the value of a foreign currency bond with respect to the spot rate interest. The exchange rate duration analysis focuses on the interest rate sensitivity of a given currency. 5.3.4

Foreign Exchange Rate Simulation Analysis

An international bank with open positions in many currencies can manage its foreign exchange risk through simulation models (i.e., Monte Carlo) to simulate various risk scenarios. However, the model should be properly conceived to take into account any deviation. 5.3.5

Foreign Exchange Rate Volatility Analysis

Since the collapse of the Bretton Woods system in March 1973, there has been a high degree of volatility of most exchange rates. Volatility is related, in the most part, to macroeconomic fundamentals (i.e., inflation, real GDP growth, current account deficit). It may also depend on external developments. However, despite the voluminous literature on the topic, there is no generally accepted model of bank behavior subject to risk arising from fluctuations in exchange rates.

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5.4

Taxation of FOREX

The taxation of forex is not uniform. The taxing regimes are different from (i) spot forex; (ii) the forward forex; and (iii) the futures forex. (i) Taxation of Spot Forex The taxation of spot forex is one of the opaque area in the taxation of financial products. From the IRC, only Section 988 explicitly provides the taxing regime of spot forex. Under IRC Section 988, gains or losses resulting from spot forex trades are treated as ordinary gains or losses. That is, a forex trader with excess ordinary losses would not be allowed to carry back or carry forward its losses, unless it has the status of professional trader. The spot trading appeared in the 2000s, just after the collapse of the online securities trading in the 1990s. Small securities traders turned onto the spot forex, taking advantage of the interbanks openness with the retail forex platforms. Thus, the spot forex market as we know it today develops after the Internal Revenue Service 1982 and 1984 amendments to the overall foreign exchange taxation. The 1982 and 1984 amendments, to some extent, adapted to the situation in the 1980s where banks created an unofficial market referred to as “the inter-banks’ market,” in which banks participants started holding out to the general public as willing to purchase, sell, or enter into foreign currency contract with retailers. Banks participants in the forex generally trade the forward forex, whereas individual traders enter usually into the spot forex. Pressed by the banking lobbyists, Congress, in 1982, added Section 1256(b)(2) in the IRC, allowing banks to opt for IRC Section 1256 contract, if they satisfy three requirements: (1) the contract must require delivery of a foreign currency; (2) the foreign currency should be the one traded through the RFCs; (3) the contract must provide a settlement date. If these three requirements aforementioned are met, banks trading in forwards forex were fiscally aligned under the preferential regime under section 1256, then recognized only to futures forex contracts. But nothing in the 1982 and 1984 openness mentions explicitly the spot forex trading. Therefore, forex traders have repeatedly argued that, based upon the rationale behind the 1982 and 1984 amendments, the spot forex traders should also be allowed to opt for the preferential regime under IRC Section 1256(g). In the absence of clear guidance from neither the IRS nor the Courts,

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they have come to believe, through a substantial authority position that the spot forex traders can also opt for IRC Section 1256 (g). They rely upon some relevant analogies between the spot and the forwards (1) both the spot and the forward are bilateral contracts; (2) both the spot and the forward require delivery of the foreign currency or settlement at the expiration date. Therefore, they argue that an option is also available to the spot under the same requirements set up in 1982 and 1984. But proponents of the option under IRC Section 1256 went on to question the second requirement, which would demand that the spot forex qualify only if the foreign currency is traded in a Regulated Futures Contract. They argue that such a requirement is outdated, because only a handful of currencies are traded through RFCs. That says, the spot forex trader as well as the forward forex trader should be allowed to opt out IRC Section 988 and make an election to be treated under IRC Section 1256(g). Besides the straight analogies with the forward forex, proponents of the IRC Section 988 opt out have found in IRS Notice 2007-1, and the recent Tax Court holding in the Summit case the second analogy in support of their arguments. Indeed, neither the IRS Notice nor the Summit case mentions directly the spot forex trading. They dealt with OTC options forex. (ii) Taxation of Forward Forex In general, Forward Forex contracts are subject to IRC section 988. However, the taxpayer can make an election to opt out of Section 988 and elect for Section 1256. Moreover, the Section 1256 election is available only if the forward forex is in major currencies, for which RFCs are traded. Forward forex, like futures forex are “foreign currency contract,” under IRC Section 1256. The term “foreign currency contract” means a contract which: • Requires delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts (“RFCs”); • Is traded in the interbank market; and • Is entered into at arm’s length at a price determined by reference to the price in the interbank market.

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(iii) Taxation of Futures Forex Futures forex are different from the forward in that they are traded in an organized market with a clearing mechanism, are standardized, and offer mark-to-market election. Futures forex contract are recognized foreign currency contract subject to the preferential 60/40 rules under IRC Section 1256. Futures forex meet all the three requirements (i) they are bilateral and not unilateral contracts; (ii) they are traded in organized markets; (iii) they always come with settlement date. (iv) Taxation of Options Forex In contrast to the spot or the forward forex, an option forex is a unilateral contract, at the discretion of the option holder, which does not require delivery or settlement, unless and until the option holder chooses to exercise the option. Options forex do not qualify as foreign currency contract and thus are outside the scope of IRC Section 1256(g). Thus, option forex tax treatment is different from the taxing regime of the spot, forward, and futures forex. That is, the parties to an option have no income, gain, or loss at the time they entered into an option. The taxing regime of an option forex becomes a relevant question whenever the option is exercised or lapsed. The exercise of an option forex is treated as a sale of the underlying currency in exchange for the strike price. If the option forex lapses, the paid premium becomes an income for the writer and an expense for the holder. In the recent Summit case, the Tax Court was called to hold whether a major foreign currency call option, a non-exchange-traded contract, comes within the meaning of “foreign currency contract” so as to qualify for IRC Section 1256 treatment. The facts under the case may be summarized as follow: • Summit entered into agreements with Beckenham (“Beckenham”) Trading Co., Inc. to engage in cross-currency transactions. • Beckenham was designated the calculation agent for the transactions to determine all amounts due to or from each party in accordance with terms specified in the agreements with Summit.

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• On September 21, 2002, Summit authorized multinational to purchase two 180-day major currency options, and to sell on behalf of Summit two 180-day written minor foreign currency options. • On September 23, 2002, Summit purchased from Beckenham two major currency options, each pegged to the US dollar and the European Union euro. • As the purchaser and holder of the major currency call option, Summit, by exercising its option could require Beckenham to deliver the Euro (e) at a price of $0.9788 USD/Euro. • As the purchaser and holder of the put option, Summit by exercising its option could require Beckenham to take delivery of the Euro at a future date or dates at a price of $0.9788 USD/Euro. • On the same day that Summit purchased the major currency options, Summit wrote and sold to Beckenham two minor currency options, each pegged to the USD and the Danish Krone (DKK). The written minor options moved inversely in value to one another over the 180day period, thus ensuring that Summit would hold a gain position in one of the two minor currency options. • On September 25, 2002, Summit assigned the major foreign currency call option and the minor foreign currency call option to a charity pursuant to an assignment agreement in which the charity was substituted for Summit with respect to all obligations under the minor foreign currency call option. • Summit recognized loss upon its assignment to charity of a major foreign currency call option, but did not include any income upon its assignment to charity of a minor foreign currency call option. Summit relied upon Section 1256 of the IRC. • In March 2007, The CIR issued a notice of deficiency to petitioners for 2002 which disallowed a $1767 flow-through loss from Summit’s foreign currency option transactions. • The Tax Court ruled that IRC Section 1256 applies only to futures and options contracts that are traded on a qualified exchange, as well as forex contracts entered into by commercial banks within their “informal market,” but not to non-exchange-traded contract. • The Tax Court went on to explain that Section 1256 requires delivery of the foreign currency, not to a contract in which delivery was left to the discretion of the holder. Or a foreign currency option is a unilateral contract that does not require delivery or settlement

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unless and until the option is exercised by the option holder. An obligation to settle may never arise if the holder does not exercise its rights under the option.

5.5 The International Money Markets: Role, Functions, and Features 5.5.1

Roles and Functions

The function of the international money market is to efficiently generate the flow of international funds from firms or governments with excess funds to those in need of funds. The money market provides financing to local and international traders who are in urgent need of shortterm funds. It provides a facility to discount bills of exchange, and this provides immediate financing to pay for goods and services. In short, money markets serve five functions—to finance trade, finance industry, invest profitably, enhance commercial banks’ self-sufficiency, and lubricate central bank policies. Money markets provide an important mechanism in an economy for transferring short-term funds from lenders to borrowers. For corporations, governments, and financial institutions with temporary excess funds, these markets provide an efficient means to lend to other corporations, governments, and individuals who have a temporary need for funds. Money markets, therefore, represent the short-term spectrum of the financial markets, where securities that mature in a year or less are traded. 5.5.2

The IMM Features

IMM is generally characterized by a high degree of safety of principal. Most markets are informal “telephone” markets with low transaction costs. Assets are typically issued in large denominations, often $1 million or more. Most money market instruments are liquid, which means that they can be quickly converted into cash assets without a sizeable loss. Maturities range from one day to one year; the most common are three months or less. Active secondary markets for most of the instruments allow them to be sold prior to maturity. Unlike organized securities or commodities exchanges, the money market has no specific location. It is centered in New York, but since it is primarily a telephone market it

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is easily accessible from all parts of the nation as well as from foreign financial centers.2

5.6

Money Market Interest Rates

Forces influencing interest rates in the money markets are varied and may reflect supply and demand conditions in different money market instruments. There are also broader forces that affect interest rates in all money and capital markets. Rose notes that Treasury bills, with no default risk and an active secondary market, usually yield the lowest rate in the money market and that other instruments appear to move with Treasury bill rates. Goodfriend and Whelpley, however, point out that the current and expected interest rates on federal funds are “… the basic rates to which all other money market rates are anchored.” That relationship reflects the use of the federal funds rate by the Federal Reserve in implementing monetary policy. A number of factors may influence foreign exchange rates, including the following cited by Rose (1994): • Balance-of-payments position. A country experiencing a trade deficit usually faces downward pressure on its foreign exchange rate. • Speculation over future currency values. Speculators buy or sell currencies when they see profitable opportunities. • Domestic economic and political conditions. Deteriorating economic conditions and inflation typically have an adverse effect on foreign exchange rates. • Central bank intervention. Central banks may buy or sell currencies to influence the value of their currency.

5.7

Market Participants

The major participants in the money market are commercial banks, governments, corporations, government-sponsored enterprises, money market mutual funds, futures market exchanges, brokers and dealers, and the Federal Reserve.

2 Timothy Q. Cook and Robert K. LaRoche (1998): Money Markets, Federal Reserve Bank of Richmond Richmond, Virginia.

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5.7.1

Commercial Banks

• Banks play three important roles in the money market. First, they borrow in the money market to fund their loan portfolios and to acquire funds to satisfy noninterest-bearing reserve requirements at Federal Reserve Banks. In the United States, for instance, banks and other depository institutions can also borrow on a short-term basis at the Federal Reserve discount window and pay a rate of interest set by the Federal Reserve called the discount rate. A bank’s decision to borrow at the discount window depends on the relation of the discount rate to the federal funds rate, as well as on the administrative arrangements surrounding the use of the window. The most active banks in the IMM are: Deutsche Bank, HSBC, Barclays Capital, UBS AG, Royal Bank of Scotland, Bank of America, Goldman Sachs, Merrill Lynch, and JP Morgan Chase. 5.7.2

Governments

Governments play a vital role in international money markets. For instance, the US Treasury and state and local governments raise large sums in the money market. The Treasury raises funds in the money market by selling short-term obligations of the US government called Treasury bills. Bills have the largest volume outstanding and the most active secondary market of any money market instrument. Because bills are generally considered to be free of default risk, while other money market instruments have some default risk, bills typically have the lowest interest rate at a given maturity. State and local governments raise funds in the money market through the sale of both fixed- and variable-rate securities. A key feature of state and local securities is that their interest income is generally exempt from federal income taxes, which makes them particularly attractive to investors in high-income tax brackets. 5.7.3

Corporations

Nonfinancial and nonbank financial businesses raise funds in the money market primarily by issuing commercial paper, which is a short-term unsecured promissory note. In recent years an increasing number of firms have gained access to this market, and commercial paper has grown at a rapid pace. Business enterprises, generally those involved in international trade,

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also raise funds in the money market through bankers’ acceptances. A banker’s acceptance is a time draft drawn on and accepted by a bank (after which the draft becomes an unconditional liability of the bank). In a typical bankers’ acceptance a bank accepts a time draft from an importer and then discounts it (gives the importer slightly less than the face value of the draft). The importer then uses the proceeds to pay the exporter. The bank may hold the acceptance itself or rediscount (sell) it in the secondary market. 5.7.4

Government-Sponsored Enterprises

Government-sponsored enterprises are a group of privately owned financial intermediaries with certain unique ties to the federal government. These agencies borrow funds in the financial markets and channel these funds primarily to the farming and housing sectors of the economy. They raise a substantial part of their funds in the money market. 5.7.5

Money Market Mutual Funds and Other Short-Term Investment Pools

Short-term investment pools are a highly specialized group of money market intermediaries that includes money market mutual funds, local government investment pools, and short-term investment funds of bank trust departments. These intermediaries purchase large pools of money market instruments and sell shares in these instruments to investors. In doing so they enable individuals and other small investors to earn the yields available on money market instruments. These pools, which were virtually nonexistent before the mid-1970s, have grown to be one of the largest financial intermediaries in the United States. 5.7.6

Dealers and Brokers

The smooth functioning of the money market depends critically on brokers and dealers, who play a key role in marketing new issues of money market instruments and in providing secondary markets where outstanding issues can be sold prior to maturity. Dealers use RPs to finance their inventories of securities. Dealers also act as intermediaries between other participants in the RP market by making loans to those wishing to borrow in the market and borrowing from those wishing

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to lend in the market. Brokers match buyers and sellers of money market instruments on a commission basis. Brokers play a major role in linking borrowers and lenders in the federal funds market and are also active in a number of other markets as intermediaries in trades between dealers.3 5.7.7

Central Banks

Central banks play a significant role in the International Money Markets as they control the supply of reserves available to banks and other depository institutions primarily through the purchase and sale of Treasury bills, either outright in the bill market or on a temporary basis in the market for repurchase agreements. Bin the United States, for instance, the Federal Reserve is able to influence the federal funds rate. Movements in this rate, in turn, can have pervasive effects on other money market rates. The Federal Reserve’s purchases and sales of Treasury bills— called “open market operations”—are carried out by the Open Market Trading Desk at the Federal Reserve Bank of New York. The Trading Desk frequently engages in billions of dollars of open market operations in a single day. The Federal Reserve can also influence reserves and money market rates through its administration of the discount window and the discount rate. Under certain Federal Reserve operating procedures, changes in the discount rate have a strong direct effect on the funds rate and other money market rates. Because of their roles in the implementation of monetary policy, the discount window and the discount rate are of widespread interest in the financial markets.

5.8 Types of Instruments Traded in the Money Market Several financial instruments are created for short-term lending and borrowing in the money market, they include:

3 Timothy Q. Cook and Robert K. LaRoche (1998): Money Markets, Federal Reserve Bank of Richmond Richmond, Virginia, p. 5.

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Treasury Bills

Treasury bills are considered the safest instruments since they are issued with a full guarantee by the US government. They are issued by the US Treasury regularly to refinance Treasury bills reaching maturity and to finance the federal government’s deficits. They have a maturity of one, three, six, or twelve months. Treasury bills are sold at a discount to their face value, and the difference between the discounted purchase price and face value represents the interest rate. They are purchased by banks, broker-dealers, individual investors, pension funds, insurance companies, and other large institutions. 5.8.2

Certificate of Deposit

A certificate of deposit (CD) is issued directly by a commercial bank, but it can be purchased through brokerage firms. It has a maturity date ranging from three months to five years and can be issued in any denomination. Most CDs have a fixed maturity date and interest rate, and they attract a penalty for withdrawing prior to the time of maturity. Just like a bank’s checking account, a certificate of deposit is insured by the Federal Deposit Insurance Corporation (FDIC). 5.8.3

Commercial Paper

Commercial paper is an unsecured loan issued by large institutions or corporations to finance short-term cash flow needs such as inventory and accounts payables. It is issued at a discount, with the difference between the price and face value of the commercial paper being the profit to the investor. Only institutions with a high credit rating can issue commercial paper, and it is therefore considered a safe investment. Commercial paper is issued in denominations of $100,000 and above. Individual investors can invest in the commercial paper market indirectly through money market funds. Commercial paper has a maturity date between one month and nine months. 5.8.4

Banker’s Acceptance

A banker’s acceptance is a form of short-term debt that is issued by a firm but guaranteed by a bank. It is created by a drawer, providing the bearer the rights to the money indicated on its face at a specified date.

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It is often used in international trade because of the benefits to both the drawer and the bearer. The holder of the acceptance may decide to sell it on a secondary market, and investors can profit from the short-term investment. The maturity date usually lies between one month and six months from the issuing date. 5.8.5

Repurchase Agreements

A repurchase agreement (repo) is a short-term form of borrowing that involves selling a security with an agreement to repurchase it at a higher price at a later date. It is commonly used by dealers in government securities who sell Treasury bills to a lender and agree to repurchase them at an agreed price at a later date. The Federal Reserve buys repurchase agreements as a way of regulating the money supply and bank reserves. Their date of maturity ranges from overnight to 30 days or more. Banks raise short-term funds by selling securities but promising at the same time to repurchase them in a short period of time. This often means the next day with a little added interest. Even though it’s a sale, it’s booked as a short-term collateralized loan. The buyer of the security, who is actually the lender, executes a reverse repo. 5.8.6

Discount Window

If a bank can’t borrow fed funds from another bank, it can go to the Fed’s discount window. The Fed intentionally charges a discount rate that’s slightly higher than the fed funds rate. It prefers banks to borrow from each other. Most banks avoid the discount window, but it’s there in case of an emergency. 5.8.7

Bankers Acceptances

This works like a bank loan for international trade. The bank guarantees that one of its customers will pay for goods received, typically 30–60 days later. For example, an importer wants to order goods, but the exporter won’t give him credit. He goes to his bank which guarantees the payment. The bank is accepting the responsibility for the payment.

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5.8.8

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Backup Line of Credit

The backup line of credit is a short-term note that protects the investors in a company. Here, a bank will guarantee to pay 50–100% of the money market instrument if the issuer defaults. 5.8.9

Municipal Notes

Cities and states issue short-term bills to raise cash. The interest payments on these are exempt from federal taxes.

5.9

Interest Rates in FX and IMM 5.9.1

Interest Rates Determination

There is a linkage between the two markets. The domestic interest rate is the endogenous variable in the money market and an exogenous variable in the Forex market. Monetary conditions in one country are generally considered to be exogenous to developments in another country. That is, when considering the Forex, the interest rate is determined outside of the Forex market. It is determined in the US money market as the interest rate that satisfies real supply and demand for money. In other words, the US money market determines the dollar interest rate, which in turn affects the exchange rate that maintains interest parity. 5.9.2

Low-Interest Rates and Risk Concerns

Interest rates have been at low levels for most of the past 12 years. That is due to a chronically weak demand in the United States, Europe, and Japan. The recovery from the 2008 financial crisis was the most anemic since World War II, and the US economy grew at an average rate of just 2.5% from 2017 through the end of last year. Aging populations and the global pandemic of Covid-19 scare led the Federal Reserve, earlier this year, to return its benchmark borrowing rate to near zero and to resume large-scale buying of corporate and government securities.4 When central banks decreased interest rates and embarked on quantitative easing (QE), there are concerns that it would lead to excessive risk-taking. That 4 Fed Chair Jerome H. Powell Has Said Rates Would Remain Near Zero At Least Through 2023.

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is, investors would want to maintain the same rates of return by taking more risk. Borrowers would be attracted by low rates and accumulate excessive levels of debt. Keeping rates at zero can adversely impact savers, encourage excessive risk-taking and create distortions in financial markets. The low-interest rate era is imperiling retirement security for millions of Americans, making it more expensive for investors such as public pensions to meet their promise of guaranteed income decades in the future.5 The portfolio allocation theory predicts that a fall in interest rate on safe assets induces investors to shift away from safe assets toward riskier ones, thereby raising the riskiness of their portfolio.6 Further, changes in interest rates may not only cause lenders to switch between borrowers with different risks and hence different spreads, they may also cause changes in the spreads themselves, for given levels of credit risk.7 Thus, the overall effect of interest rates on risk-taking depends on the nature of interest rate changes—short term versus long term—and the type of financial institutions in consideration—banks versus nonbanks.

5 David, Lynch Oct. 3, 2020: Lengthy Era of Rock-Bottom Interest Rates Leaving Its Mark on U.S. Economy. 6 Seung Jung Lee, Lucy Qian Liu, and Viktors Stebunovs: Risk Taking and Interest Rates: Evidence from Decades in the Global Syndicated Loan Market, IMF Working Paper 1716 (2016), p. 4. 7 Idem, pp. 18–19.

CHAPTER 6

International Equity Markets

6.1

General

The equity market is one of the most important ways through which companies can raise capital. An equity market is a market where shares are either issued or traded. It is one of the important sources for the company to raise the money. This allows businesses to become publicly traded and raise additional financial resources for expansion of their operations by selling shares of ownership of the company in a public market, i.e., the equity market. The liquidity that a stock exchange affords the investors enables the holders of stocks to quickly and easily sell them. Global stock markets have increased significantly in 2019, adding more than $17 trillion in total value, according to Deutsche Bank calculations. The value of global equities began the year just under $70 trillion but has now surpassed $85 trillion. The US domination of the global marketplace explains why the U.S. Federal Reserve remains the focus of investors around the globe.

6.2

Equity and Diversification

A portfolio invested solely within an investor’s home market would deprive him from a large portion of the global opportunity set. There are some good reasons for investors to hold international equities: (i) simply focusing on domestic companies means an investor has no stake in leading © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 F. I. Lessambo, International Finance, https://doi.org/10.1007/978-3-030-69232-2_6

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Table 6.1 The top 10 stock markets around the globe

1) 2) 3) 4) 5) 6) 7) 8) 9) 10)

Countries

Size

United States China Japan Hong Kong France India Canada Germany Switzerland South Korea

$30.44 trillion $6.32 trillion $5.3 trillion $3.82 trillion $2.37 trillion $2.08 trillion $1.94 trillion $1.76 trillion $1.44 trillion $1.41 trillion

global companies that are domiciled outside their home market, (ii) many firms seek to hedge away currency fluctuations of their foreign operations, and (iii) the opportunity to participate in whichever regional market is outperforming. While market-capitalization weight is a valuable starting point, a number of other critical factors should be examined when considering an appropriate allocation to international equities. Investors should carefully weigh the trade-offs, such as volatility reduction, implementation cost, tax considerations, and their own preferences1 (Table 6.1).

6.3

Top 10 Stock Markets Around the Globe 6.3.1

Equity Markets in the United States

Securities market in which common stock (ordinary shares) is traded. The US equities market, for example, comprises of American Stock Exchange (AMEX), NASDAQ National Market, and New York Stock Exchange (NYSE). Equity is anything that is invested in the company by its owner or the sum of the total assets minus the sum of the total liabilities of the company and the example of which includes Common stock, additional paid-in capital, preferred stock, retained earnings, and the accumulated other comprehensive income. The US stock market is five times the size of the closest competitor. In fact, the United States is so large it accounts for just under half

1 Brian J. Scott (2019): Global Equity Investing: The Benefits of Diversification and Sizing your Allocation, Vanguard Research p. 6.

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Fig. 6.1 US household equity equity owners (Note Household sector includes nonprofit organizations. Includes both directly held equities and equities held through mutual funds. Source federal reserve flow of funds accounts)

of global equity value. The leading stock exchanges in the United States include the New York Stock Exchange (NYSE), Nasdaq, the Better Alternative Trading System (BATS), and the Chicago Board Options Exchange (CBOE). These leading national exchanges, along with several other exchanges operating in the country, form the stock market of the United States (Fig. 6.1). 6.3.2

The New York Security Exchange

The New York Security Exchnge (NYSE) is the world’s most trusted equities exchange, with a market model designed to deliver optimal market quality to large corporates and investors. The NYSE is the only exchange with a unique model which combines state-of-the-art technology with a human being at the point of sale—which together delivers the lowest levels of volatility and deepest pool of liquidity. During global events, turmoil and volatility, investors turn to the NYSE.2 The New York Stock Exchange has been the premier exchange of choice for innovators, visionaries, and leaders for over 225 years. As the leading global listing exchange at the heart of the capital markets, the NYSE’s unique market model, unmatched network, brand visibility, and core services

2 www.NYSE.com.

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help companies access capital and navigate global markets.3 The four-step process for submitting an application to list at NYSE includes: (i) selection of the market,4 (ii) reservation of the ticket symbol,5 (iii) application submission, and (iv) selection of the Designated Market Maker.6 6.3.3

The Nasdaq

The National Association of Securities Dealers Automated Quotations exchange is the first electronic exchange that allowed investors to buy and sell stock on a computerized, speedy, and transparent system, without the need for a physical trading floor. The NASDAQ is an electronic exchange where stocks are traded through an automated network of computers instead of a trading floor. It trades listed stocks as well as over-the-counter (OTC) stocks. For stock or security to be listed on the NASDAQ electronic exchange, a company must meet certain requirements based on their finances, liquidity, and corporate governance, be registered with the Securities Exchange Commission (SEC) and have at least three market makers.7 Major stocks that trade on the NASDAQ include Apple, Amazon, Microsoft, Facebook, Gilead Sciences, Starbucks, Tesla, Intel, and Oracle. 6.3.4

The Better Alternative Trading System

Bats Global Markets was previously known as Better Alternative Trading System (BATS) and was initially branded as an alternative trading platform, marketing itself to investors as a company that was more innovative than established exchanges. When it entered the European market in 2008, the company was rebranded as Bats Global Markets. CBOE 3 www.NYSE.com. 4 The NYSE offers several different markets designed to meet the needs of companies of all sizes with all different issue types (stocks, bonds, ETPs, etc.). NYSE—the world’s listing venue for mid- and large-cap companies across all verticals NYSE American—the leading global marketplace for small-cap companies NYSE Arca—a highly liquid, fully electronic marketplace for ETPs. 5 An issuer’s symbol is unique and can reinforce branding initiatives. 6 A DMM facilitates price discovery for your stock during market opens, closes, and

during periods of substantial trading imbalances or instability. 7 Joshua Kennon (2019): What is the Nasdaq, The Balance.com.

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acquired Bats in 2017 and migrated three of its exchanges to the Bats Global Markets platform. As an exchange, Bats grew into the main competitor to the New York Stock Exchange (NYSE) and Nasdaq. In 2016, Bats had become the second-largest US equity exchange by market share and was the largest exchange-traded fund (ETF) exchange. 6.3.5

The Chicago Board Options Exchange

Founded in 1973 as the Chicago Board Options Exchange, it is the world’s largest options market with contracts focusing on individual equities, indexes, and interest rates. In 2010, the company converted to a publicly traded corporation and rebranded as Cboe Global Markets, Inc. (Cboe). Traders refer to the exchange as the CBOE. Cboe is now the holding company and the exchange is a primary asset. It is the largest options exchange in the United States and the largest stock exchange in Europe, by value traded. It is the second-largest stock exchange operator in the United States and a top global market for ETP trading. Chicagobased Cboe is the third-largest US stock exchange operator after the NYSE and Nasdaq Inc., as measured by market share (Fig. 6.2).

6.4

Equity Markets in the EU

While nearly every country in Europe has a stock exchange, only five are considered major, and have a market capital of over one trillion US dollars. European stock exchanges make up two of the top ten global major stock markets. Euronext is one of the key stock exchanges in Europe. It is located in several major European cities, including London, Paris, Brussels, Amsterdam, and Lisbon. With over 1200 issuers and a market capitalisation of $4,3 trillion, Euronext is the largest European stock exchange. Major EU indexes include: • The Financial Times Stock Exchange 100 Index, commonly referred to as the FTSE 100, is a benchmark index that is commonly seen as a gauge of the UK economy’s performance. It represents 81% of the UK’s market value on the London Stock Exchange. The FTSE 100 includes shares of the 100 companies listed on the London Stock Exchange with the highest market capitalisation.

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Fig. 6.2 US equity markets ADV (Source Cboe exchange, Inc)

• The Stoxx Europe 50 is the popular market index of the largest blue-chip companies from 18 countries in the eurozone. Introduced in February 1998, the EU 50 represents the leading European businesses, covering almost 50% of European stock

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market capitalisation. Geographically, the index comprises stocks from the United Kingdom, Switzerland, Sweden, Norway, Finland, Spain, Portugal, Luxembourg, Netherlands, Italy, Germany, France, Denmark, Austria, Belgium, Czech Republic, Ireland, and Greece. • CAC 40: The Cotation Assistée en Continu, better known as the CAC 40, is a benchmark index of the French stock market performance. The index represents the 40 businesses with the highest market capitalization on the Euronext Paris stock exchange. The CAC 40 is one of the largest European stock markets and one of the most important national indices of the Euronext Pan-European stock exchange group. • DAX 30: The Deutscher Akrienindex, or simply the DAX 30, is seen as a gauge of the health of the German economy. The index tracks the performance of the 30 biggest companies traded on the Frankfurt Stock Exchange (FSE). The DAX 30 constituent businesses represent almost 75% of the total market capitalization of the FSE. For a long time, the German economy has held a leading position in the European Union, estimated as the fifth-largest economy globally. That is why so many traders choose the DAX 30 to invest in the European stock market. • Swiss SMI 20: The Switzerland 20, often referred to as the Swiss Market Index (SMI), is the most highly valued blue-chip market index in Switzerland. The SMI tracks the performance of the 20 biggest and most traded large and midcap stocks listed on the SIX Swiss Exchange. Considered as a benchmark of the Swiss stock market, the Swiss Market Index accounts for 90% of the market capitalization and trading volume of Liechtenstein’s and Switzerland’s equities on the SIX stock exchange. The largest stock exchanges in Europe include (Table 6.2): • Euronext Founded in 2000, as a result of the merger of the Brussels and Amsterdam Stock Exchanges and Paris Bourse, Euronext further merged

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Table 6.2 Largest stock exchange in Europe

The top five largest stock exchange in Europe 1) 2) 3) 4) 5)

Euronext London Stock Exchange Deutche Borse SIX Swiss Echange Nasdaq Nordic

US US US US US

4388 4297 2181 1649 1561

bn bn bn bn bn

with the NYSE Group to form the NYSE Euronext. Euronext is one of the key stock exchanges in Europe. It is located in several major European cities, including London, Paris, Brussels, Amsterdam, and Lisbon. With over 1200 issuers and a market capitalization of $4,3 trillion, Euronext is the largest European stock exchange. • London Stock Exchange Founded in 1801, the London Stock Exchange is one of the oldest exchanges in the European stock market history, with its routes going back to 300 years. On June 23, 2007, the London Stock Exchange announced that it had agreed on the terms of a recommended offer to the shareholders of the Borsa Italiana S.p.A. The London Stock Exchange group was established in 2007 as a result of the merger of the LSE with the Milan Stock Exchange. The merger of the two companies created a leading diversified exchange group in Europe, but still remained two separate legal and regulatory entities. As of April 2018, London Stock Exchange had a market capitalization of US$4.59 trillion. London Stock Exchange allows companies to raise money, increase their profile and obtain a market valuation through a variety of routes, thus following the firms throughout the whole IPO process. The LSE operates several markets for listing, meaning that companies of different sizes may list there. International companies are also allowed to list their shares in London. There are two main markets on which companies trade on the LSE: (i) the main market, and (ii) the alternative investment market. The main market is home to over 1,300 large companies from 60 different countries. Over the past 10 years over £366 billion has been raised through new and further issues by main market companies. The FTSE 100 Index is the main share index of the 100 most highly capitalized UK companies listed on the Main Market. The Alternative Investment

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Market is LSE’s international market for smaller companies. A wide range of businesses including early stage, venture capital-backed as well as moreestablished companies join AIM seeking access to growth capital. The AIM is classified as a Multilateral Trading Facility (MTF) under the 2004 MiFID directive, and as such it is a flexible market with a simpler admission process for companies wanting to be publicly listed. • Deutsche Boerse Founded in 1993, the Deutsche Borse has locations in Germany, Switzerland, Spain, Luxembourg, and Czech Republic. The Deutsche Borse Group is the primary marketplace in Germany that operates the Frankfurt Stock Exchange. It provides companies with the access to global capital markets and delivers transactional services. It has listed more than 765 companies and enjoys a market capitalization of $2.1 trillion. Deutsche Boerse AG provides a variety of stock exchange introduction, trading, and operational services to institutions and private investors. It offers electronic trading systems for buying and selling of securities on stock exchanges in Europe. Deutsche Boerse offers indices such as DAX, MDAX, SDAX, and XTF, as well as trading in options and futures. The stock exchange supply and demand of securities are brought together and offset by price determination and executed at these prices, mediated by specialists in floor trading (market maker). • Six Swiss Exchange Six Swiss Exchange AG was founded in 1995. The company’s line of business includes the furnishing of space and other facilities to members for the purpose of buying, selling, and trading in stocks, options, bonds, and commodities. Based in Zurich, SIX Swiss Exchange is Switzerland’s principal stock exchange. The company is owned by its users (127 banks). With a workforce of some 2600 employees and a presence in 20 countries, it generated operating income in excess of CHF 1.9 billion and Group net profit of CHF 221.3 million in 2018. The SIX was the world’s first to implement an automated trading system. SIX Swiss Exchange is part of the SIX Group, which provides a number of other financial infrastructure services in Switzerland. These include clearing, acting as central counterparty, custody services, market data services, share registry, payment

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services, and running the real-time gross settlement (RTGS) system on behalf of the central bank of Switzerland, the Swiss National Bank. The SIX Swiss Exchange is owned jointly by an extended network of 55 banks, having equal voting rights in decision making and management of the exchange. The SIX Swiss Exchange is the fourth largest stock exchange in Europe, with a market capitalization of $1.6 trillion, in 2018. SIX Exchange Regulation AG performs the functions assigned under Swiss federal law and enforces and monitors compliance with the rules laid down by the Regulatory Board. SIX Exchange Regulation AG imposes sanctions in so far as it is authorized to do so by the regulations, or submits sanction requests to SIX Swiss Exchange’s Sanction Commission. • NASDAQ Nordic A subsidiary of the American NASDAQ, NASDAQ Nordic is a marketplace for trading securities in Nordic and Baltic countries. It has two divisions: OMX Exchange, which operates stock exchanges in Nordic and Baltic countries; and OMX Technology, which develops technological systems, used by the OMX Exchange. Headquartered in Stockholm, Sweden, NASDAQ Nordic employs more than 2,000 specialists. Completing the list of the top 5 largest European stock exchanges, it has a market capitalization of $1.5 trillion. More than 600 companies are traded across our Main Markets in Stockholm, Copenhagen, Helsinki, and Iceland, including some of the most innovative companies in Europe. By listing on the Main Market, companies benefit from increased visibility and investor exposure, and Nasdaq’s efficient and independent surveillance of issuers, members and trading. More than 170 trading member firms engage in the daily trading, with most trades made by international banks and brokerage houses.

6.5

Equity Markets in Asia

Asia is rapidly growing into the world’s largest stock market. In 2018, 51% of all equity capital raised through initial public offerings (IPOs) went to Asian companies. Today more than half of the world’s listed companies are from Asia.8

8 OECD (2019): OECD Equity Market Review of Asia.

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– The Tokyo Stock Exchange (TSE) Founded in 1878, is the third-largest stock exchange in the world by market capitalization, despite having only about half of the value of the NASDAQ. While the TSE’s origin dates all the way back to the nineteenth century, the exchange was closed for four years after World War II before continuing trading activity in 1949. The TSE is famously known by its benchmark index, the Nikkei 225, which is up over 10% YTD and contains many blue-chip stocks such as Toyota, Honda, Sony, and Suzuki. – Shanghai (China) Founded in 1866, the Shanghai Stock Exchange (SSE) makes its mark by being the largest stock exchange in China by market capitalization. The Shanghai Stock Exchange was suspended in 1949 due to the Chinese Revolution. The Shanghai exchange is unique in that the stocks it chooses to list have either “A” shares, which are traded using the local Yuan currency, as well as “B” shares that are targeted toward foreign investors and valued in USD. The SSE’s status as a non-profit organization has not held it back this year, as it has risen over 19% YTD. The Shanghai Stock Exchange is the world’s 4th largest stock market by market capitalization at US$5.5 trillion as of April 2018. – Hong Kong (Hong Kong) Shifting over to the other crucial geographical area of the Chinese economy, the Hong Kong Stock Exchange comes in as the fifth-largest stock exchange by market cap, touting over 2,300 listed companies. The Hong Kong Stock Exchange is distinctive in that about half of its listed companies are based on mainland China. This fact comes despite the overall region currently vying for continued separation from mainland China’s policies and regulation. In 2017, the stock exchange made major headlines when it decided to permanently close its physical trading floor and shift all of its efforts toward ramping up its electronic trading software. The Hong Kong Stock Exchange lists a few of China’s major corporations including AIA, Tencent Holdings, China Mobile, HSBC Holdings, and PetroChina. Founded in 1891, the stock exchange is still producing substantial returns, including being up over 12% YTD.

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– Bombay Stock Exchange Founded in 1875, the Bombay Stock Exchange was the first stock exchange in Asia. As of November 2018, it had a market capitalization of $2.05 trillion. It is the stock exchange with the highest number of listed companies on this list. According to Visual Capitalist, the BSE has 5749 listed companies.

6.6

Equity Markets in Emergingi Economies

Emerging markets (EMs) are countries with economies transitioning from “developing” to “developed” status. A country’s status is measured using many socio-economic factors, including the liquidity of local debt and equity markets, and the level of market efficiency. The Morgan Stanley Capital International Emerging Market Index (MSCI Index) lists 23 countries.9 This index tracks the market capitalization of every company listed on the countries’ stock markets. Global emerging market equities includes: single country and pan-regional portfolios, using core income, unconstrained, enhanced diversification, and midcap strategies. Emerging markets are very likely a good place to be invested over the next 10–20 year. A study conducted by Mikhail Simutin of the Rotman School of Management at the University of Toronto, along with Rotman colleague Redouane Elkamhi and Joon Woo Bae of Case Western Reserve University, found that the best way to invest in EM is through developed-market stocks that do a lot of business there.

9 They are Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Qatar, Peru, Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand, Turkey, and United Arab Emirates.

CHAPTER 7

International Bond Markets

7.1

General

An international bond is a debt investment that is issued in a country by a non-domestic entity. International bonds are issued in countries outside of the United States, in their native country’s currency. They pay interest at specific intervals and pay the principal amount back to the bond’s buyer at maturity. The international bond market allows investors to diversify their portfolio, preserve their wealth, and realize attractive returns on their investment. Bond markets posted strong performance in 2019: Investment-grade corporate bonds brought in 14%, Treasuries returned 7.6%, and high-yield bonds gained 12%, according to ICE BofAML Indices. Tax-exempt municipal bonds returned 7.4%. International bond markets are not unified into a single market (like FX and Eurocurrency market), therefore, they can be done OTC. The foreign bond market includes the bonds that are sold in a country using that country’s currency but issued by a non-domestic borrower. For example, the Yankee bond market is the US dollar version of the market. The global bond markets increased from $87 trillion in 2009 to over $115 trillion in mid-2019. Japan and Greece are the most indebted countries in the world, with debt-to-GDP ratios of 237.6% and 181.8%, respectively. Meanwhile, the United States sits in the number eight spot with a 105.2% ratio, and recent Treasury estimates putting the national debt at $22 trillion (Fig. 7.1). © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 F. I. Lessambo, International Finance, https://doi.org/10.1007/978-3-030-69232-2_7

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Fig. 7.1 Global bond market outstanding (2009–2018) (Source Bank of International Settlement [BIS])

7.2

Types of Bond Markets

The international bond market is composed of three separate types of bond markets: Domestic Bonds, Foreign Bonds, and Eurobonds. 7.2.1

Domestic Bonds

A domestic bond is an obligation of a domestic issuer, denominated in domestic currency, and sold and traded in the domestic market. For example, in the United States, a bond issued by Federal Reserve will be a part of the domestic bond market. A domestic bond is an obligation of a domestic issuer, denominated in domestic currency, and sold and traded in the domestic market. Domestic bonds are issued, underwritten, and then traded with the currency and regulations of the borrower’s country. Unlike international bonds, domestic bonds are not subject to currency risk. Example • The management of Lucrous LLC needs money to expand the factory. • The manager issues bonds and promises to make a single payment.

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• The manager then offers these bonds for sale, announcing that they will be sold to the buyers who offer the highest prices. • Suppose the highest price offered is $950, and all the bonds are sold at that price. • Each bond is, in effect, an obligation to repay buyers $1000. • The buyers of the bonds are being paid $50 for the service of lending $950 for a year. • The $1000 printed on each bond is the face value of the bond, or the amount the issuer will have to pay on the maturity date of the bond—the date when the loan matures, or comes due. • The $950 at which they were sold is their price. • The difference between the face value and the price is the amount paid for the use of the money obtained from selling the bond.

7.2.2

Foreign Bonds

A foreign bond is a bond issued in a domestic market by a foreign entity in the domestic market’s currency as a means of raising capital. For foreign firms doing a large amount of business in the domestic market, issuing foreign bonds, such as bulldog bonds, Matilda bonds, and samurai bonds, is a common practice. For example, Japanese Government issuing a US dollar denominated bond in the US foreign bond market. Another example is Ford Motor Corporation issuing a yen denominated bond in Japan. Foreign bonds in the United States are called Yankee bonds, and foreign bonds in UK are called Bulldog bonds. They are called Samurai bonds in Japanese market, and Panda bonds in China. Note that foreign bonds are similar to domestic bonds except that the issuer is a foreign entity. Investors can buy foreign bonds roughly the way they buy US bonds. Their broker provides them with a list of bonds that are available and they can buy the bonds at the market’s price. Because investing in foreign bonds involves multiple risks, foreign bonds typically have higher yields than domestic bonds. 7.2.3

Eurobonds

The Eurobond is a special type of bond issued in a currency that is different from that of the country or market in which the bond is issued. Due to this external currency characteristic, these types of bonds are also

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known as external bonds. Put differently, A Eurobond is a debt instrument that’s denominated in a currency other than the home currency of the country or market in which it is issued. Eurobonds are important because they help organizations raise capital while having the flexibility to issue them in another currency. A distinguishing characteristic for Eurobonds is that a Eurobond is offered for sale simultaneously in a number of countries. Eurobonds are bonds issued by a non-resident and denominated in other than the currency of the country in which it is being placed. The bond’s currency of denomination is referred to as an offshore currency. An example is a US-based company issuing a US dollar denominated bond in Europe.

7.3

International Bond Market Participants

International bond market participants are those involved in the issuance and trading of debt securities. It primarily includes government-issued and corporate debt securities, and can essentially be broken down into three main groups: issuers, underwriters, and purchasers. • Bond Issuers The issuers sell bonds or other debt instruments in the bond market to fund the operations of their organizations. The three main bond issuers are (i) governments, (ii) banks, and (iii) corporations. The biggest of these issuers is the government, which uses the bond market to fund a country’s operations, such as social programs and other necessary expenses. Banks ranked second as key issuers in the bond market and they can range from local banks up to supranational banks such as the European Investment Bank, which issues debt in the bond market. The final major issuer in the bond market is the corporate bond market, which issues debt to finance corporate operations. • Bond Underwriters The underwriting segment of the bond market is traditionally made up of investment banks and other financial institutions that help the issuer to

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sell the bonds in the market. In general, selling debt is not as easy as just taking it to the market. In most cases, millions (if not billions) of dollars are being transacted in one offering. Thus, the need for underwriters is greatest for the corporate debt market because there are more risks associated with this type of debt. • Bond Purchasers The final players in the market are those who buy the debt that is being issued in the market. Bond purchasers basically include every group mentioned as well as any other type of investors (i.e., individuals). Governments play one of the largest roles in the market because they borrow and lend money to other governments and banks. More, governments often purchase debt from other countries if they have excess reserves of that country’s money as a result of trade between countries. For example, China and Japan are major holders of US government debt.

7.4

International Bond Market Volatility

For the market participants owing bonds, collecting coupons and holding it till maturity, market volatility is not a matter to ponder over. The principal and interest rates are predetermined for them. However, participants who trade bonds before maturity face many risks, including the most important one—changes in interest rates. When interest rates increase, the bond value falls. Therefore, changes in bond prices are inversely proportional to the changes in interest rates. Economic indicators and paring with actual data usually contribute to market volatility.

7.5

Bond Interest Rates

An interest rate is the payment made for the use of money, expressed as a percentage of the amount borrowed. In general, the interest rate is determined by the interaction of a number of types of behavior: the policy of the central bank, investment in productive assets, the choice between current and future consumption, and the responses of wealth holders to risk. Key among these factors is the central bank policy. Central banks

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devote considerable effort to determining equilibrium real rates, around which they set their policy rates.1 The interest rate of the bond equals to the difference between the face value and the bond price, divided by the bond price, and then multiplied by 100 to form a percentage. Potential buyers bid for the bonds, which are sold to the highest bidders. The lower the price of the bond relative to its face value, the higher the interest rate.

1 Robert E. Hall (2018): Low Interest Rates: Causes and Consequences. Hoover Institution and Department of Economics, Stanford University, National Bureau of Economic Research.

CHAPTER 8

International Derivative Markets

8.1

General

The derivatives market is, in a word, gigantic—often estimated at more than $1.2 quadrillion on the high end. Notional amounts of OTC derivatives rose to $640 trillion at end-June 2019. This is up from $544 trillion at end-2018 and the highest level since 2014. It marks a continuation of the trend increase evident since end-2016 (Fig. 8.1). A derivative is a bilateral executory contract (a contract under which either or both parties must perform in the future, by delivering property or money) with a limited term (lifespan), the value of which is determined by reference to the price of one or more fungible securities, commodities, rates (such as interest rates), or currencies (an “underlier”). The derivative securities markets have blossomed the last two decades, with the United States and Canada trading more than half of the $96.67 trillion contracts outstanding in 2007. A financial “derivative” is a broad term covering a variety of different financial instruments, all of which share the common property that their value is dependent upon an underlying asset. Derivatives can take numerous forms, including options, swaps, futures, forwards, structured debt obligations, and others. Derivatives can also be traded in two different ways: some are traded through standardized instruments over exchanges, while others are traded privately through individualized contracts, also called “over-the-counter,” “bilateral,” or “bespoke” derivatives. Derivatives have been used by taxpayers in the past © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 F. I. Lessambo, International Finance, https://doi.org/10.1007/978-3-030-69232-2_8

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Fig. 8.1 Outstanding notional amounts of OTC derivatives trend upwards

to take advantage of “economic imperfections in the tax law” and lower their taxes. They can be used to create more highly leveraged trading positions than otherwise permitted under current law, including by putting up significantly less collateral for a derivative trade than permitted for a direct purchase of a security. Derivatives improve the efficiency of financial markets and, by permitting more financial risks to be hedged, may permit some borrowers more access to sources of funds. Derivatives are a double-edged sword in that (i) they can be used to manage risk and (ii) they can become financial weapons of mass destruction if used solely for speculative purposes. Managing derivatives positions has shown to be tricky since only a small amount (“margin”) is needed to establish a position. That may hide the full extent of a firm or bank financial obligations. Among the players are commercial banks, investments banks, and hedge funds. Derivative securities (forwards, futures, options, and swaps) are securities whose value depends on the value of an underlying asset but whose payoff is not guaranteed with cash flows from these assets. The underlying asset may be a single security, commodity, or currency, interest rate or other asset. Banks and other market participants have seen in the derivative market the opportunity of overall distribution of risks among various participants. Moreover, banks see the derivative market as a mean to increase liquidity and access to capital. That is because, credit derivative swaps, for instance, allow banks and other financial institutions to pass on risks from making loans. The term “credit derivative” encompasses an array of transactions whose value is determined by an underlying entity’s creditworthiness. The most common of which is the credit default

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swap (CDS). The total notional amount of CDS in the market was about $34.4 trillion by the end of 2006. To quote an example among many Wall Street derivative players, Goldman Sachs trading in derivatives generated between $11.3 billion and $15.9 billion of its $45.17 billion in net revenue, from 2006 to 2009. Credit derivative swaps, equity swaps, and interest rates swaps were among the most traded. Prior to the Wall Street Reform and Consumer Protection Act of 2010, the Swap market was not standardized. Market fundamentalists, among them the former head of the Federal Reserve, Alan Greenspan, preached that the swap market was able to self-regulate. With the failure, and bailout of main Wall Street Swaps’ players (e.g., AIG), Congress has, through the aforementioned Act, framed and shaped the Swap market. The Wall Street Reform and Consumer Protection Act of 2010 amends significantly the Over-The-Counter (“OTC”) derivatives. However, the full extend or scope of the new law will be revealed later on, after completion of the mandated rulemaking by the government-agencies involved. The swap market jurisdiction, for instance, is still split between the Securities and Exchange Commission and the Commodity Futures Trading Commission (“CFTC”). The SEC has jurisdiction over a portion of the equity swap and a portion of a credit default swap, whereas the CFTC jurisdiction covers the commodity swaps, foreign exchange swaps, interest rate swaps, CDS index swaps, and equity index swaps. Most of the regulatory and prudential efforts, under the new law, target two classes of entities: (i) Swap dealers and Security-based swap dealers and (ii) Major Swap participants and Major Security-based swap Participants, which are both required to clear most of their standardized swaps with a Central counterparty. However, the new law provides an exemption from the mandatory clearance for derivatives end users. Another big change that affects the derivatives’ market is the mandatory reporting: Swap Dealers and Major Swap Participants are required to disclose to the SEC or the CFTC information concerning (i) the terms and conditions of their swaps; (ii) their Swap trading operations, and (iii) their financial integrity protections. Furthermore, all non-cleared swaps’ agreement must be reported to a Swap Data Repository. Besides their disclosure and reporting obligations, Swap Dealers and Major Swap Participants have to keep and maintain their daily trading record as to each transaction for audit purposes. When entering into swap agreement with a layperson or a counterparty which is not a swap dealers, Swap

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Dealers and Major Swap Participants must disclose in a clear and understandable language: (i) the material risks and characteristic of each Swap agreement; (ii) the source and amount of any compensation; (iii) any incentives or conflicts of interests; (iv) the clearinghouse for cleared swaps; (v) the daily mark of the Swap Dealer or Major Swap Participant, for noncleared swaps. Swap Dealers and Major Swap Participants will be subject to prudential capital and margin requirements to be determined by either the SEC or the CFTC under their specific jurisdictions.

8.2

Forward Contracts

A forward contract is an agreement between financial or banking institutions and their corporate clients to buy and sell an asset at a certain future time, for a certain price. The parties entered into a forward because the future (spot) price or interest on the underlying asset is uncertain. Fearing that the future spot price will fluctuate against them in the future, they pay a financial institution to arrange a forward contract for them. The underlying assets are often non-standardized. That is, each forward contract seems to be different from another one. However, with the development of a secondary market of forward contracts, an effort has been made to “standardized” basic or most common used forward contracts entered into by traders. The existence of such a secondary market has enticed many bank managers to invest and trade in forward contracts. Very often Bank manager would trade on securities that provide a predictible cash income, such as stock indexes. Example: Net cash-settled, forward contract for stock On December 1, 2008, when XYZ stock is trading at $100/share, Party A, the forward seller, enters into a net cash-settled forward contract with Party B, the forward buyer, for the forward sale of one share of XYZ stock at a forward price of $106 on December 31, 2009. If the price of XYZ stock on the settlement date is above the forward price, the contract requires Party A to pay Party B the excess of the market price over $106. If the price is below $106 on December 31, 2009, Party B is required to pay Party A the amount by which $106 exceeds the market price.

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• Tax Regime The execution of a forward contract in respect to an underlying stock has no tax consequences. If a forward contract is settled by delivery of the underlying asset, the taxpayer delivering the asset must recognize a gain or loss based upon the difference between the price received and the taxpayer’s basis in the asset. The gain or loss bears the same character as the underlying asset. Usually, a forward contract is settled by cash payment. However, if a forward contract is sold, prior to the pre-agreed date, gain or loss therefrom is deemed a capital asset in the hands of the selling taxpayer. If the character of the income recognized by a party to a forward contract is a capital gain or loss, the income is normally sourced based upon the residence of the taxpayer. However, the character of gain or loss recognized by a forward seller may be affected by the tax straddle and short sale rules of sections 1092 and 1233, respectively.

8.3

Futures Contracts

A futures contract is an agreement between two parties to buy and sell (at time O) a standardized asset for cash in the future, for a certain price. A futures contract is different from the forward contract in that (i) the delivery date is usually not specified as the contract’s price is adjusted daily based upon the price of the underlying asset; (ii) futures contracts are traded on an organized market (e.g., NYFE, CBT); (iii) a futures contracts is a default risk free in that if a counterparty defaults on a futures, the Exchange steps in and assumes the defaulting party’s position and payment obligation; (iv) the terms of a futures contract is set forth by the market organization. Some authors define a futures contract merely as a forward contract that is standardized and traded on an organized futures exchange. That is because, under the futures contracts, buyer, and sellers do not complete the trade by their own. The process is supervised by a clearinghouse department of the Exchange, which ensures that each party has met his obligations under the contract. Bank managers trade on these markets as either speculators and hedgers based upon their strategies and studies of the underlying assets.

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• Tax Regime A futures contract traded on domestic and same foreign futures exchanges are generally treated as “section 1265 Contract” in the hand of the investors. Under IRC Section 1256(b), the term ‘section 1256 contract’ means: • • • • •

Any regulated futures contract; Any foreign currency contract; Any non-equity option; An dealer equity option; and Any dealer securities futures contracts.

The term ‘section 1256 contract’ shall not include any securities or option on such a contract unless such contract or option is a dealer securities futures contract. Section 1256 contract held by the taxpayer at the end of the taxable year shall be treated as sold for its fair market value on the last business day of such taxable year (and any gain or loss shall be taken into account for the taxable year). Put differently, Code section 1265 requires taxpayers to treat each section 1265 contract as if it were sold (and re-purchased) for its fair market value on the last day of the year. Furthermore, it imposes a mark-to-market timing regime on instruments within its scope. Any gain or loss with respect to section 1256 contract is treated as short-term capital gain or loss—to the extent of 40% of the gain or loss, and the remaining 60% is treated as long-term gain or loss. This special “60/40” rule does not apply to certain transactions: (i) hedging transactions, (ii) section 1256 contract that is part of a mixed straddle if the taxpayer makes the election, (iii) section 1256 contract held by a dealer in commodities or by a trader in commodities that makes the mark-to-market election under IRC section 475(d)(1).

8.4

Options

An option contract is a contract that gives the holder of the option the right, but not the obligation, to buy or sell an underlying asset, at a preagreed price, within a pre-agreed period of time. There are two basic types of options: a call option and a Put option.

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The forms and terms of options can vary greatly. A “European style” option, for example, can be exercised by the buyer only on a specified date, while an “American style” option can be exercised by the buyer any time prior to the final date on which the option expires. The option buyer pays the option seller a “premium” for the option, which can vary with the terms of the option. This premium is usually paid at the start of the option and is the potential profit for the option seller. Options also have a “strike price,” which is the price specified in the option contract at which the buyer may purchase the underlying property when exercising the option. The final day on which an option may be exercised is generally called the “exercise date” or “maturity date.” Options are often priced using the Black-Scholes model, which takes into account several factors including the volatility of the price of the underlying assets, the duration of the option, and the strike price as compared to the market price of the underlying assets. • A call option is an option that gives the holder (purchaser) the right to buy the underlying security or asset from the option writer or the seller, by a certain date referred to as the expiration date or the exercise date or the maturity, for a certain price called the exercise or strike price. A warrant is a call option that is written by a corporation on its own stock.

Example: European-style, net cash-settled call option Party A purchases a European-style, net cash-settled call option on a single share of XYZ stock from Party B (the issuer) on December 1, 2008, when XYZ is trading at $100 per share. The option requires Party B to pay Party A the amount (if any) by which the market price of XYZ on the settlement date exceeds $110. Suppose the value of XYZ stock on the settlement date is $150. Party B would pay Party A $40. Conversely, if the value of XYZ is $105 on the settlement date, the option would expire unexercised. In either case, Party A would have paid a non-refundable premium for the option.

• A Put option gives the holder of the option the right to sell the underlying security or asset to the option writer (or seller) by a certain date, for a pre-specified price.

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Two scenarios are also possible with put options. In the first, the exchange rate when the option expires is above the strike price, and the holder has no interest in selling at the strike price because he can do better on the market. The premium he paid initially is therefore lost. In the second, the exchange rate on expiration of the option is below the strike price, and it is therefore in the holder’s interest to exercise this option, because he can sell the currency at the strike price, which is advantageous. Example: Physically settled, European-style put option Party A purchases a physically settled, European-style put option on a single share of XYZ stock from Party B (the issuer) on December 1, 2008, when XYZ is trading at $100 per share. The option gives Party A the right (but not the obligation) to sell one share of XYZ stock to investor B on December 31, 2009, for $100. (This is an “at-the-money” put option; that is, one where the strike price equals the market price for XYZ stock at inception.) Party A is betting that the price will fall. If the price of a share of XYZ is below $100 on the settlement date, Party A will exercise his right to require Party B to buy one share for a price that exceeds its market value. Conversely, Party B is betting that the price will increase, and Party A will not exercise the option. In that case, Party B will profit to the extent of the premium Party B collected when Party B issued the option to Party A. Suppose the price of one share of XYZ on the settlement date is $90. Party A will exercise his option and require Party B to purchase a share for $100. Since A can acquire the share for $90 and immediately sell it to B for $100, A profits by $10 (less the amount of option premium that A paid to B).

• Other varieties of options include: collar, barriers, caps, and floors. • Collar A collar is a combination of two contracts to obtain a very specific profit diagram. There are two ways to create a collar. The first involves buying a call option and selling a put option, while the second involves buying a put option and selling a call option. In both cases, the company guarantees that its purchase or selling price of US currency will not go

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beyond a range between the two strike prices of the options in the collar. The price of this structure is generally equivalent to the amount paid to buy one of the options less the price received for selling the second option. • Barriers Is an option contract that may only be exercised when the underlying asset reaches some barrier price. There are four basic types of barrier options that have slightly different payoff structures. Barrier options are sometimes come with a rebate paid at the time of the event or at the expiration date. These options have the same characteristics as standard options but include barriers. The barrier can be above or below the actual currency price and may be knock-in or knock-out. • Caps and Floors Caps and Floors: over-the-counter contracts often referred to as interest rate options. An interest rate cap will compensate the purchaser of the cap if interest rates rise above a predetermined rate (strike rate) while an interest rate floor will compensate the purchaser if rates fall below a predetermined rate. Option contracts are different from both the forward contract and the futures contract in that (i) the option holder has the right to exercise the option or not to exercise it at all. He is not compelled to buy or sell as under the forward and the futures contracts. (ii) the option holder must pay to the option writer or the seller an up-front fee referred to as the call premium, whereas parties into a forward or futures contracts entered into these contracts free of any premium. Option contracts are traded as future contracts on an organized exchange. There are three types of options trade: stock options, stock index options, and options on futures contract. The Securities and Exchange Commission (SEC) is the main regulator of the option contracts. The Commodity Futures Trading Commission (CFTC) regulates only options on futures contracts. In the 1990s, banks and other financial institutions developed a new form of option contracts known as “exotic options.” Those options were written for the purpose of hedging very specific risks, and were traded over-the-counter (OTC).

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• Exotic options Exotic options are OTC derivatives trade by major banks or financial institutions. Exotic options include a variety of financial instruments such as: barrier options, convertible reset option, digital option, quantity adjusting option (or quanto), differential option (or Diff option), rainbow option, etc. These options allow the writer to manage only the specific risks they intend to hedge against. • Digital option A digital option is an option whose payout is characterized as having only two potential values: (i) a fixed payout when the underlying price is above the strike price) or (ii) zero payout otherwise. • Quantity adjusting options (Quanto) Is an option which has an underlier denominated in one foreign currency, but settles in another domestic currency, at a fixed exchange rate. Quanto options have both the strike price and the underlier denominated in a foreign currency, but the value of the option is determined as the option’s intrinsic value in a foreign currency. That intrinsic value is then converted to the domestic currency at the fixed exchange rate. • Differential options Are a variant of quanto options with a fixed-floating or floating-floating interest rates. One of the floating rates is a foreign interest rate, but it is applied to a notional amount in the domestic currency. • Rainbow options Are options whose value are dependent on two or more underlying securities or events. The option holder is allowed to exercise the option based on the change in the two or more securities used as underlying assets.

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The price of the rainbow option is dependent on the correlation of the underlying events or assets. One form of rainbow options is the outperforming option, which value is determined by the differential in performance of two securities or assets. • Tax Regime In general, gain or loss from options (i.e., on stock) is recognized on a wait and see (open transaction) basis. The purchaser capitalizes the cost of his option premium, and the option writer does not immediately include it in income. The amount of gain or loss is determined at the time of a subsequent recognition event; that is, the parties wait and see what happens when the option is exercised or sold (or when it expires unexercised). Gain or loss recognized by the purchaser of an option is considered to have the same character as the underlying asset that the option relates to. In the case of a purchaser of an option on publicly traded stock as an investment, gain or loss will be capital. However, if the purchaser were a dealer in securities, or a taxpayer using the option as a hedging contract, gain or loss will be treated as ordinary income under Code section 1221(a)(7). Thus, US persons typically recognize US-source gain or loss, and non-US persons recognize foreign-source gain or loss. In the case of termination of an option other than through delivery of the underlying asset, the writer’s gain or loss is deemed short-term capital gain or loss, regardless of the terms of the contract. The character of the income recognized by the holder of an option on publicly traded asset is capital gain or loss, the income is normally sourced based on the residence of the taxpayer. Thus, US persons typically recognize US-source gain or loss, and non-US persons recognize foreign-source gain or loss.

8.5

Swaps

Swaps are private agreement between parties to exchange cash flows, at specified intervals. The first know swap contracts were negotiated in the 1980s. Swap markets were developed in order to meet the needs of corporations, financial institutions, and portfolio managers to modify their exposures to a substantial increase in currency and interest rate volatility that followed the demise of the Brettons-Woods fixed exchange rate system. Since then the swap market has sprung exponentially to reach

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out the amount of $347.09 trillion in 2007. The US commercial banks, investment banks, insurance companies are the biggest players in the swap market with an overall total of $95.39 trillion in 2007. Swap market participants include swap facilitators and their clients and customers. By and large, there are five generic types of swaps: • • • • •

The The The The The

interest rate swaps; currency swaps; credit risk swaps; commodity swaps; equity swaps.

Of the five generics, interest rate swaps being the most commonly used. Usually, bank managers entered into swaps agreements in order to eliminate, mitigate, interest rate inherent to their global positions. 8.5.1

Interest Rate Swaps

Interest Rate Swaps are contracts whereby one party agrees to pay the other party interest at a fixed rate on a notional Principal for a number of years, in exchange for a floating interest rate on the same notional Principal for the same periods of time. The most used is a fixed/floating in which the payment made by a counterparty is based on a variable or floating rate of interest, and the return payment is based on a variable at floating rate, which is reset periodically, according to a benchmark. Counterparties can also enter into a cross-currency swap whereby payments are made in two different currencies, based on fixed or floating interest rates. In a fixed/floating interest rate swap, the notional is never exchanged, rather, it is used to calculate the payment flows. Once a floating payment is made, the rate is reset to establish the next floating payment based upon the benchmark reference rate agreed on (e.g., LIBOR). This makes a fixed/floating interest rate swap different from a cross-currency swap where the principal amounts are generally exchanged at the spot foreign exchange rate from the outset and then re-exchanged at the maturity, at the same rate. The floating interest rate is usually pegged to some short-term interest rate, such as LIBOR; and is referred

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to as the “reference rate.” The fixed interest rate is made of two components: (i) a risk-free yield for the maturity of the swap and (ii) a swap spread over the risk-free yield which is the basis for pricing the swap. Interest rate swaps are often entered into by counterparties seeking to improve the cost of funding, or to hedge the interest rate risks. Banks invest in fixed/floating interest rate swap in anticipation of future interest rate increases, in order to grab some spreads. 8.5.2

Currency Swaps

Currency swaps are essentially forward contracts between two parties, tailored to meet their specific needs. Currency swaps consist of exchanging Principal and fixed-rate interest payments on a loan in one currency for Principal and fixed-rate interest payments on an approximately equivalent loan in another currency. A currency swap agreement requires the Principal be specified in each of the two currencies. The Principal amounts are usually exchanged at the beginning and the end of the life of the swaps. On each settlement date through maturity, the US party pays interest to the foreign counterparty. That interest is based upon a fixed interest rate and is denominated in the foreign currency that was delivered on the origination date to the US party. At the maturity, the US party repays the foreign currency principal to the counterparty, along with the last interest payments; and the foreign counterparty repays the US dollar principal including the last interest payment: this is known as a synthetic fixed/fixed currency swap. Currency swap can also be created with both counterparties receiving a fixed interest rate. Currency swap can be used to either align assets or liabilities with the market expectations or to exploit mispricings among markets, through arbitrage. 8.5.3

Credit Swaps

There are four types of credit swaps: the credit default swap (CDS), the first-to-default CDS, the Total return swap, and the Asset-Backed CreditLinked notes.

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• The Credit Default Swap A credit default swap is an agreement between two counterparties (the buyer of the protection and the seller of the protection) against default on a loan or a bond. The borrower (or issuer) also called the referenced credit, pays a premium to the seller of the protection in exchange for contingent payment depending on agreed credit events, which may occur during the lifetime of the agreement. Put differently, a credit default swap consists of transferring risks that a party is not willing to bear to another party with a desired risk profile. Credit Default Swaps (CDS) have been often criticized. Some have argued that CDS operate as stock absorber during corporate crises, cushioning against the worst possible losses. The notional amount of CDS outstanding by the end of 2007 was estimated to exceed $60 trillion. It declined sharply to just over $30 trillion at the first half of 2010. Market participants include: commercial banks, broker-dealers, insurance companies, hedge funds, and special purpose vehicles (SPV). Bank managers enter into CDS in order to reduce the level of credit risks on their various portfolios. Hedge funds enter the CDS market both as credit protection buyers and credit protection sellers in order to manage their risks, speculate, or acquire synthetic exposure. Prior to the Wall Street reform and Consumer Protection Act of 2010, CDS were traded in over-the-counter markets. The 2010 Act has moved to include the CDS deals in an organized market to be defined by regulations. • First-to-Default CDS The First-to-default CDS allows the insurer to reduce its risk exposure of the loan portfolio to the first loan default. It is an agreement by which a protection seller would have to compensate the counterparty (the buyer of the protection) by paying it a par and receive the defaulted loan. • Total Return Swaps (TRS) Is a swap agreement whereby the buyer of the risk receives from the seller of the risk a specified economic value for the reference credit rather of a lump sum notional payment in the event of default. Total return

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swap is often used as a means to transfer the market risk of an asset offbalance sheet to lower regulatory charges. Total return swap is different from CDS in that (i) the market and credit risks are transferred from the seller to the buyer; (ii) no exchange of the principal, no legal change of ownership, and no voting rights passed from the seller to the buyer. The buyer of a TRS receives the cash flows of benefits (or pays the losses) if the value of the underlying asset rises (or falls). To hedge against the credit/or market risks, the seller of the TRS often buys the underlying asset. • Asset-Backed Credit-Linked Notes (CLN) A CLN is an actual security with a credit derivative (a credit default swap) embedded in its structure. A CLN is a debt obligation with a coupon and redemption tied to the performance of the loan. An investment bank manager would enter into a CLN if he wants to take a liability out the balance sheet. CLN is different from the TRS in that the principal exchanged hands, though there is no legal change of ownership of the underlying asset. • Tax regime Despite their financial importance and recognition credit swaps and particularly CDS, their tax treatment has remained a mystery. The US tax laws provide no clues as to how CDS should be taxed. 8.5.4

Commodity Swaps

The character of gains or losses realized by a US person selling or exchanging a commodity is largely a function of the taxpayer’s status as (i) an investor, (ii) a trader or dealer. 8.5.5

Equity Swaps

An equity swap is a contractual agreement between two counterparties to exchange cash flows from specific assets over a defined period. Put differently, an equity swap is an agreement between counterparties to exchange payments, one of which depends on the value of a selected

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share or an index. A variant of equity swap is a total return swap, whereby the exchange payments reflect the dividends on the share or index. The notional principal of the swap is not exchanged, instead, it is used to calculate the periodic payments. Equity swaps give investors like investment banks the benefits of stock ownership, without actually owning the stocks. The exact size of the equity swap market is unknown, but according to the bank of international settlement, the notional value of all equity swaps and forwards approximates $1.7 trillion in 2009. Banks enter into equity swap any time they need to trade on a basket of foreign shares but face certain restrictions on ownership, or when there is no such restriction, in order to avoid paying withholding tax on dividends to receive from their equity investments. Well-advised investment bank managers often enter into an equity swap with a specific dealer who is not subject to any withholding tax (or capital gains) prior to making their equity investments. The dealer will borrow money to acquire the shares, and enter into a swap agreement whereby he agrees to pay the total return on the shares to the bank manager. The Internal revenue Service is currently investigating whether banks, hedge funds, and other financial institutions are using the Equity swap as a device to collect dividends without owning the instruments, and at the same time escape the withholding tax payments. Example: Equity Swap. In a “plain vanilla” equity swap Party A agrees to make 10 payments to Party B on December 31 of each of the next 10 years, in an amount equal to the sum of: (1) the appreciation, if any, in value of 100 shares of XYZ stock during the year and (2) dividends paid on 100 shares of XYZ stock during the year. Likewise, Party B agrees to make 10 identically timed payments to Party A, in an amount equal to the sum of: (1) the depreciation, if any, in value of 100 shares of XYZ during the year and (2) a fixed (or floating) rate of interest multiplied by the value of 100 shares of XYZ stock at the beginning of the year. Since the payments are all due on the same day, the parties agree that all payments are netted, and only one party makes a net payment to the other.

The different types of Equity swaps include: (i) Contracts for Difference; (ii) Debt-for equity swaps.

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• Contracts for Differences (CFD) Contracts for Differences, also referred to as synthetic swap allow investors to participate in stock price, stock indexes, or exchange without buying or selling the shares themselves. Investment bank managers derive their spread from the difference between the opening and the closing value for the contract. • Debt-for-Equity Swap Debt-to-equity swap consists of exchanging debt for a predetermined amount of equity (stock).The value of the swap is determined usually at current market value rates. However, a management may still offer a higher exchange value to entice share and debt holders to participate in a swap. Debt-to-equity swap was a fairly common means of acquiring a distressed business in the 1980s and the 1990s. It is performed when the debtor needs positive net equity or needs to improve its financial conditions by reducing interest-bearing debts. Debt-for-Equity Swap is or has been considered as a route by which a company can avoid imminent insolvent liquidation due to a persistent negative cash flows or balance sheet insolvency. • Tax Regime A swap with respect to publicly traded equity is taxed as a “notional principal contract“ under IRC section 446, which requires that the parties to a notional contract classify all payments thereto as either (i) a “periodic payment,” (ii) a “non-periodic payment,” or (iii) a “termination payment.” The characterization of payments as “periodic,” “non-periodic,” or “termination” is important in that the tax treatments are not the same. For periodic and non-periodic payment, taxpayer must recognize the ratable daily portions for the taxable year. Whereas for termination payment, taxpayer recognizes income in the year the notional principal contract is either extinguished, assigned, or terminated. Income from a swap contract is generally sourced by reference of the residence of the taxpayer, except for income earned through a US branch. Equity

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swap also deviates from the main source-rule in that the dividend equivalent payment is treated as non-US-source income, not subject to US withholding tax.

8.6

Credit Derivatives

Credit derivatives derive their value from the creditworthiness of a specified financial instrument such as a corporate bond or stock, or from the creditworthiness of a referenced entity such as a corporation or sovereign nation. In essence, credit derivatives place bets on whether, during a specified period of time, the referenced financial instruments or entities will experience a negative “credit event,” such as a bankruptcy, default, or failure to pay. Parties taking the “long” side of the bet wager that no credit event will occur; parties taking the “short” side of the bet wager that the negative credit event will occur. These credit instruments are often described as “synthetic,” because they do not contain any tangible assets such as a loan or bond; they simply reference the financial instrument or entity whose credit quality is at issue. Credit derivatives are (i) CDS, (ii) credit index, and (iii) credit index tranche. CDS being already covered, I mainly discuss the two others. 8.6.1

Credit Index

A more complicated form of credit derivative involves a credit index. Credit indices were first invented by JPMorgan Chase and Morgan Stanley in 2001. Each credit index references a basket of selected credit instruments, typically credit default swaps or other types of credit instruments. The value of the index is typically determined by calculating the value of each constituent credit instrument and using a mathematical formula to combine them into a single dollar value for the entire basket. Parties then enter into swaps that reference the index value. The long party bets the index value will increase;140 the short party bets it will fall. The short buyer of a credit index, as with a credit default swap, typically makes an up-front payment reflecting the value of the index and then makes fixed periodic payments to the long party over a specified timeframe. Those periodic payments are, again, typically referred to as premiums, coupon payments, or credit spreads. When the instrument matures or expires, or a trade otherwise closes, the short party may be required to make a final payment reflecting the change in the value of

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the instrument. On the other hand, if a credit event takes place during the covered time period, it triggers a typically substantial payout by the long party to the short party. After the credit event, the defaulting credit instrument is effectively eliminated from the index. Credit index transactions are typically entered into “over the counter” (meaning outside of a regulated exchange) between a licensed swap dealer and an investor, using standardized documents. Once the initial index swap is executed, as the value changes, either party can trade or unwind its side of the bet. The index’s changing value typically reflects the initial index price or premium amount, which is also called the credit spread. The parties holding a swap when the referenced index expires are typically required to make a final payment reflecting the value of the index at the time of expiration. 8.6.2

Credit Index Tranche

A third, still more complicated type of credit derivative involves credit tranches. The credit tranches that were traded by the CIO typically related to Markit credit indices. Each of the Markit credit indices tracked the value of a specified basket of credit instruments. Instead of requiring bets on the creditworthiness of the entire basket, for some credit indices, Markit offered instruments that enabled parties to place bets on just a portion of the basket, offering four tranches with different degrees of vulnerability to default. The riskiest tranche, called the “equity tranche,” was immediately affected by any default at any company in the basket. The next tranche, called the “mezzanine,” was affected only by losses that exceeded 15% of the loss distribution. Those losses usually required one or more defaults to take place. The next tranche, called the “senior” tranche, was affected only by losses that exceeded 25% of the loss distribution. The last and most secure tranche, the “super senior tranche,” was affected only by losses that exceeded 35% of the loss distribution. Those losses typically required multiple defaults to take place. Credit tranche instruments, like other credit derivatives, typically required the short party to make an up-front payment and periodic payments during the covered time period, although the riskiest tranches often did not require any premiums. These instruments also typically required the parties to make a final payment when the swap expired or the trade otherwise closed. CIO documents show that the CIO traded credit tranches as well as credit indices and credit default swaps.

CHAPTER 9

Exchange Traded Funds (ETF)

9.1

General

Exchange traded funds, or ETFs, were first developed in the 1990s as a way to provide access to passive, indexed funds to individual investors. Since their inception, the ETF market has grown exponentially. The ETF creation process begins when a prospective ETF manager (known as a sponsor) files a plan with the US Securities and Exchange Commission to create an ETF. The sponsor then forms an agreement with an Authorized Participant, generally a market maker, specialist, or large institutional investor. Exchange-traded funds make it possible to build a diversified portfolio with relatively low investment amounts. In addition, ETFs trade throughout the day, providing ample liquidity, and many have relatively low-cost structures. ETFs have several advantages over traditional openend funds. The four most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs, and tax benefits. However, ETFs are subject to market fluctuation and the risks of their underlying investments. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their net asset value (NAV),1 and are not individually redeemed from the fund.

1 The net asset value (NAV) of an ETF represents the value of each share’s portion of the fund’s underlying assets and cash at the end of the trading day.

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Differences Between ETFs and Mutual Funds

Unlike with mutual fund shares, retail investors can only purchase and sell ETF shares in market transactions. That is, unlike mutual funds, ETFs do not sell individual shares directly to, or redeem their individual shares directly from, retail investors. Instead, ETF sponsors enter into contractual relationships with one or more financial institutions known as “Authorized Participants.” Only Authorized Participants are permitted to purchase and redeem shares directly from the ETF, and they can do so only in large aggregations or blocks commonly called “Creation Units.”

9.3

Purchase and Redemption of ETFs

To purchase shares from an ETF, an Authorized Participant assembles and deposits a designated basket of securities and cash with the fund in exchange for which it receives ETF shares. Once the Authorized Participant receives the ETF shares, the Authorized Participant is free to sell the ETF shares in the secondary market to individual investors, institutions, or market makers in the ETF. The redemption process is the reverse of the creation process. An Authorized Participant buys a large block of ETF shares on the open market and delivers those shares to the fund. In return, the Authorized Participant receives a pre-de ned basket of individual securities, or the cash equivalent.

9.4

Regulatory Requirements

ETFs are investment companies. As such they are subject to the regulatory requirements of the federal securities laws as well as certain exemptions that are necessary for ETFs to operate under those laws. Together, the federal securities laws and the relevant exemptions apply requirements that are designed to protect investors from various risks and conflicts associated with investing in ETFs. In addition, ETFs are subject to oversight by boards of directors.

9.5

ETFs in the Global Markets

While many of the top performing ETFs are focused on US markets and economic sectors, there are a number of international ETFs that offer solid returns and can provide diversification to a portfolio. In 2019, assets

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held in US-based ETFs reached a record $4 trillion. More money is now invested in ETFs than hedge funds. ETFs are known as a passive investment as they are not actively managed by a fund manager. Shares of ETFs are traded on exchanges just like a stock and rise or fall along with the market or sector they are tracking. ETFs are also cheaper to own than mutual funds that are actively managed and charge high management expense fees. The combination of low fees and market matching performance have made ETFs very popular with investors.

9.6

Types of ETFs

There are many types of ETFs. The most common are: 9.6.1

Index-Based ETFs

Most ETFs trading in the marketplace are index-based ETFs. These ETFs seek to track a securities index like the S&P 500 stock index and generally invest primarily in the component securities of the index. For example, the SPDR, or “spider” ETF, which seeks to track the S&P 500 stock index, invests in most or all of the equity securities contained in the S&P 500 stock index. Some, but not all, ETFs may post their holdings on their websites on a daily basis. Most ETFs are based on indexes that are designed to track specific market sectors. Thus, an ETF may be based on an index specifically designed to meet the ETF sponsor’s customers’ interests. Leveraged, inverse, and inverse leveraged ETFs may be considered by some to be index-based ETFs because they seek to deliver daily returns that are multiples (or inverse multiples) of the performance of the index or benchmark they track. In addition, like index-based mutual funds, ETFs with seemingly similar benchmarks can actually be quite different and can deliver very different returns. However, some ETFs will track an S&P 500-styled index that is equal-weighted, meaning all the companies have equal representation on the index, irrespective of the size of the company. Although these two benchmarks may seem similar, they provide very different returns. 9.6.2

Actively Managed ETFs

Actively managed ETFs are not based on an index. Instead, they seek to achieve a stated investment objective by investing in a portfolio of stocks, bonds, and other assets. Unlike with an index-based ETF, an adviser of

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an actively managed ETF may actively buy or sell components in the portfolio on a daily basis without regard to conformity with an index. More, actively managed ETFs are required to publish their holdings daily. Because there is no index that can serve as a point of reference for an actively managed fund’s holdings, publishing the specific holdings allows the arbitrage mechanism to function. • Stock ETFs The most popular ETFs on the market today track stocks. Stock ETFs track a particular set of equities, similar to an index. It is traded much like a normal share of stock, but with the addition of intraday price fluctuation. [FN: Ashworth, Will (2011): 6 Popular ETF Types For Your Portfolio]. Some stock ETFs, such as Vanguard Russell 3000, track US national market indexes, while others, such as the Vanguard Total World Stock, track international or All-World indexes. Aside from these broad market ETFs, some stock ETF also track major market indices, such as the S&P 500 or Russell 2000. There are also style ETFs, which track a certain investment style or market capitalization. Stock ETFs invest style include value stocks, growth stocks, or a blend of the two. Stock ETFs capitalization chose investments based on the size, or capitalization, of a company. Additionally, there also exist sector ETFs, which focus on indices from a specific market sector. When investors choose an ETF that invests solely in a specific sector of the market, like health care, technology, or telecommunications, these ETFs have a very narrow focus and expose investors to more risk. Sector ETFs should only be used to supplement an already diversified portfolio. A stock ETF could contain hundreds-sometimes thousands-of stocks, which spreads out risk more than owning individual stocks. According to the survey, Vanguard Total Stock Market ETF holds more than 3500 domestic stocks. Vanguard Total International Stock ETF holds more than 5500 non-US stocks. In general, investing in both United States and international stock ETFs can add another level of diversification to an already well-balanced portfolio (Table 9.1). • Bond ETFs As the name suggests, bond ETFs invest in bonds. Bond ETFs, which focus on income. Like bonds, bond ETF provides a fixed income and

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Table 9.1 Best broad international stock ETFs ETF Name Vanguard Total International Stock (VXUS) iShares Core MSCI Total Intl Stock (IXUS) Schwab Intl Equity (SCHF)

Expense % 0.11 0.11 0.06

Top Countries Japan, UK, Canada Japan, Canada, China Japan, UK, France

reduces a portfolio’s volatility. Because of this relative financial stability, bond ETFs thrive during economic recessions as investor pull their money from the stock market into bonds (Moskowitz, 2015). However, while bonds are not active on secondary markets since they are normally held onto maturity, bond ETFs are liquid and can be actively exchanged. The key to this seeming paradox is that bond ETFs usually consist of only the largest and most liquid bonds in the underlying bond index, which then gives the ETF the ability to emulate the index while maintaining its liquidity (Ashworth, 2011). Bond ETFs give investors portfolio the opportunity to earn income. When included in a well-balanced portfolio, bond ETFs can help limit the risks associated with stock ETFs. According to the research, Vanguard Total Bond Market ETF holds more than 7500 domestic investment-grade bonds. Vanguard Total International Bond ETF holds more than 3500 non-US bonds. Bond ETFs come with short-, intermediate-, or long-term maturities. The longer the maturity, the more sensitive the fund is to changes in interest rates. Bonds that are backed by the US government or one of its agencies have the best “creditworthiness” and a lower chance of default than most corporate bonds. Corporate bonds with high credit quality are considered investment-grade bonds, and those below investment grade are considered high-yield bonds. There are many types of bond ETFs that invest in corporate, national, or international markets. Examples of some popular bond ETFs on the market today include the Vanguard Total Bond Market ETF, iShares Barclays Agency Bond ETF, iShares Barclays Short Treasury ETF, among many more. • Commodity ETFs Commodity ETFs, also known as exchange-traded commodities (ETC), target a certain area of the market. These ETFs let investors gain exposure to physical goods such as agricultural products, precious metals,

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industrial materials, and energy resources. Unlike most other ETFs that track market indices, commodity ETFs are made up of future, or assetbacked, contracts. For example, the purchase of a gold ETF does not give you the asset of gold itself, but rather assets backed up by gold. Because these ETFs don’t track securities, they are not regulated by the Investment Company Act of 1940 but are rather subject to regulations under the Commodity Futures Trading Commission (Sackheim et al., 2006). Among the four aforementioned categories of commodity ETFs, precious metal ETFs are the most popular and are different from the other three in that they hold physical stocks of the metal rather than future values. Examples of popular commodity ETFs on the market today include ETFS Physical Swiss Gold Shares and the ELEMENTS Rogers Agriculture ETN. Commodities exchange-traded funds (ETFs) make commodities accessible to just about every class of investor. Since commodities have been on a hot streak since midst 2016. In fact, commodities are outpacing equities for the first time in about five years. Industrial metals, sugar, oil, and tin have all shown solid gains and look strong for the near future (Sheila Olson, 2017). • Currency ETFs Similar to how an index ETF tracks a certain index, currency ETFs track either a specific currency or a basket of currencies. It is put together with the goal of emulating the performance of the currency, but without outperforming it (Ashworth, 2011). Investing in foreign currency ETFs is one way for investors to protect their portfolio from the depreciation of the US dollar. For example, if the Japanese Yen is appreciating while the US dollar is depreciating, then it may be worth to invest in the CurrencyShares Japanese Yen ETF. On the flip side, if the US dollar is appreciating or if there are events in foreign countries that significantly impact the value of their currency, then it may be time to short that ETF. In comparison to other types of ETF, currency ETFs takes a significant advantage in its relative lack of taxes. Currencies have their own pressures that drive their direction-interest rates, global economic conditions, political instability, and even natural disasters-which are mostly independent from Wall Street (Sheila Olson, 2017). Most professional traders approach currency investing in one of two ways, choosing either a momentum or value strategy driven by technical analysis—a lot of work for anyone but the most dedicated investor.

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Leveraged and Inverse ETFs

Leveraged and inverse exchange-traded funds are designed for a one-day holding period, a horizon over which price movements are unpredictable. The primary purpose a trader will want to use leveraged ETFs is to amplify his or her returns. Leveraged ETFs will typically carry two or three times the returns of the index, depending on the product. Example • If an index tied to a 2x leveraged ETF moves 1 percentage point, a leveraged ETF trader will earn 2%. • If it moves 2 percentage points, the trader will earn 4% and so on.

The amplified return is due to a leveraged ETF using futures contracts as its underlying assets. The futures contract is an agreement to purchase or sell assets at a fixed price, but the assets are delivered at a later date. As stated, leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track, whereas, inverse ETFs (also called “short” funds) seek to deliver the opposite of the performance of the index or benchmark they track. Like traditional ETFs, some leveraged and inverse ETFs track broad indices, some are sector-specific, and others are linked to commodities, currencies, or some other benchmark. Inverse ETFs often are marketed as a way for investors to profit from, or at least hedge their exposure to, downward moving markets. Leveraged inverse ETFs (also known as “ultra short” funds) seek to achieve a return that is a multiple of the inverse performance of the underlying index. An inverse ETF that tracks a particular index, for example, seeks to deliver the inverse of the performance of that index, while a 2x (two times) leveraged inverse ETF seeks to deliver double the opposite of that index’s performance. To accomplish their objectives, leveraged and inverse ETFs pursue a range of investment strategies through the use of swaps, futures contracts, and other derivative instruments. Most leveraged and inverse ETFs “reset” daily, meaning that they are designed to achieve their stated objectives on a daily basis. Their performance over longer periods of time—over weeks or months or years—can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. This effect can be magnified in volatile markets.

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Example • An hypothetical index is going to have an awful week. • An undecided investor is wavering between shorting an index fund or buying an inverse ETF. • On the first day of the week, the index starts at $1000 and drops to $900, and on the second day, the index falls to $800, lower value. • In this case, simply shorting an index fund would produce a 20% gain. • However, because each day’s performance is a separate event with an inverse ETF, the undecided investor would have gained 10% the first day, and another 11% the second day (the decline from $900 and $800), for a compounded gain of 21%. When prices are dropping, the inverse ETF produces good results.

In October 2020, the Securities and Exchange Commission (SEC) passed a new rule (Rule 18f-4) which, among other things, would make it significantly easier to launch leveraged and inverse exchange-traded funds, but at smaller multipliers than previously approved. Rule 18f-4 allows ETFs and other funds that were not allowed by the Investment Company Act of 1940 to use derivatives, without first having to obtain exemptive relief to launch leveraged and inverse ETFs. Rule 18f-4 will impact leveraged and inverse ETFs as these funds use derivatives to build geared exposure to underlying indexes. ETFs and other funds are allowed to use derivatives, as long as they comply with certain investor protections. That includes the adoption of a derivatives risk management program, administered by a dedicated risk manager and overseen by the board of directors. They will also have to carry out certain fund reporting and recordkeeping requirements surrounding their derivatives use. Rule 18f-4 also requires brokers and registered investment advisors to first evaluate and approve retail clients’ accounts before letting them trade leveraged/inverse ETFs.

CHAPTER 10

International Securitization Markets

10.1

General

Securitization is not a new financial practice. The first mercantilist corporations served as vehicles of sovereign debt securitization for the British Empire during the late seventeenth and early eighteenth centuries. Britain restructured its debt by offloading it to corporations with political backing, which in turn sold shares backed by those assets. The process was so pervasive that, by 1720, the South Sea Company and East India Company held nearly 80% of the country’s national debt. These corporations essentially became special purpose vehicles (SPVs) for the British treasury. Eventually, the worry about the frailty of those corporate shares led the British to stop securitizing and focus on a more conventional bond market. The debt security market was essentially nonexistent between 1750 and 1970. During 1970, the secondary mortgage market began to see the first mortgage-backed securities (MBS) in the United States. The modern history of securitization began in 1970s when Government Sponsored Enterprises (“GSE’s) including the Government National Mortgage Association (“Ginnie Mae”), the Federal National Mortgage Association (“Fannie Mae”), and the Federal Home Loan Corporation (“Freddie Mac”) issued the first residential mortgage-backed securities.

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Lew Ranieri is known as the “father of securitization” because he helped invent the securitized mortgage in 1977 while working for Salomon Brothers. He’s even been credited with inventing the word “securitization.” Securitization creates a financial instrument by bundling financial assets, such as individual loans, and then selling different tiers of the repackaged instruments to investors. The process transforms a pool of otherwise illiquid assets into tradable securities, enabling investors to purchase a small share of a large asset pool. One example is mortgagebacked securities.1 The main reason for securitization is to reduce a company’s funding costs. Through securitization, a company that is rated BB but maintains assets that are very high in quality (AAA or AA) can borrow at significantly lower rates, using the high-quality assets as collateral, as opposed to issuing unsecured debt. Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS). Securitization got its start in the 1970s, when home mortgages were pooled by US government-backed agencies. Starting in the 1980s, other income-producing assets began to be securitized, and in recent years the market has grown dramatically. In some markets, such as those for securities backed by risky subprime mortgages in the United States, the unexpected deterioration in the quality of some of the underlying assets undermined investor confidence.2 According to the Securities Industry and Financial Markets Association (SIFMA), the ABS market is currently a $1.6 trillion market that has seen substantial growth since its emergence in the mid-1980s.

10.2

Benefits or Securitization

Securitization offers various benefits for the parties involved in the process3 :

1 IMF (2015): Reform Securitization to Improve Growth, Financial Stability. 2 Andreas Jobst (2008): What is Securitization, IMF Monetary and Capital Markets

Department. 3 Allen Taylor (2018): Demystifying Securitization, Lending Times.

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i. Securitization is Cost Efficient Securitization allows a company to issue low-cost senior debt independent of the company’s rating and fund itself less expensively than it could on an unsecured basis. Through securitization, a company can grow its business and earnings without additional equity capital and/or enhance return on equity. These benefits derive primarily from the capital efficiency of securitization. Depending on the structure, securitized assets can be supported with less equity capital than on balance sheet assets primarily due to the transfer of asset-related risks to investors. ii. Securitization Transfers Asset-Related Risks Firms that specialize in originating new loans and have difficulty funding existing loans may use securitization to access more liquid capital markets for funding loan production. In doing so, the originator or finance company also transfers risk. These risks generally include interest rate risk, basis risk, liquidity risk, prepayment risk, and credit risk. While in some transactions the issuer may retain most of the economic credit risk associated with securitized assets, the credit risk of certain asset types may be small compared with these other risks. Further, securitization creates opportunities for more efficient management of the asset ability duration mismatch generally associated with the funding of long-term loans. iii. Diversification for Investors Investors seek diversification of investments for the benefit of their overall portfolio. Securitizations offer unique investment opportunities and attractive risk-return profiles compared to other asset classes such as government and corporate bonds. More, securitization allows the structuring of securities with differing maturity and credit risk profiles from a single pool of assets that appeal to a broad range of investors. iv. Risk Sharing and Liquidity Securitized products allow institutional investors opportunities to participate in consumer and corporate assets that cannot be found elsewhere. With securitization, investors may invest in various consumer

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and business loans without having to develop in-house origination and servicing capabilities required to procure loans, collect payments and managed defaults and liquidations. That is, investors benefit from the sourcing and servicing expertise of originators freeing money for more efficient capital deployment. Finally, the conversion of basically illiquid banking assets into tradeable capital market instruments often gives investors the opportunity to sell securities in the secondary market and obtain liquidity. v. Securitization provides markets driven pricing discipline Securitization can provide a market-driven pricing discipline by highlighting the market price for risks transferred to investors and, thereby, providing pricing benchmarks to judge the profitability of a business.

10.3

Securitization Process

The securitization process involves two steps: • In step one, a company with loans or other income-producing assets (the originator) identifies the assets it wants to remove from its balance sheet and pools them into what is called the reference portfolio. It then sells this asset pool to an issuer, such as a special purpose vehicle (SPV)—an entity set up, usually by a financial institution, specifically to purchase the assets and realize their off-balance-sheet treatment for legal and accounting purposes. • In step two, the issuer finances the acquisition of the pooled assets by issuing tradable, interest-bearing securities that are sold to capital market investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio. In most cases, the originator services the loans in the portfolio, collects payments from the original borrowers, and passes them on—less a servicing fee—directly to the SPV or the trustee4 (Fig. 10.1).

4 Andreas Jobst (2008): What is Securitization, IMF Monetary and Capital Markets Department.

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Fig. 10.1 Securitization structure

10.3.1

The Borrower

The borrower is the person or entity who originally took out a loan and promised to repay. 10.3.2

The Originator/Servicer

The loan originator is the person or entity who receives the initial claim to the borrower’s repayments. The Originator is the entity that assigns assets or risks in a securitization transaction. Usually, it is the party (lender) who originally underwrote and securitized the claims (loans). The originator is typically a financial institution that extends credit, such as a bank or mortgage lender. Other originators include large commercial enterprises, utilities, or specialist entities set up for securitization purposes. The originator transfers the assets to be securitized to the issuer in a so-called “true

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sale.5 ” The loan originator is able to realize, immediately, most or all of the value of the loan contract by selling it to a third party, usually a trust 10.3.3

The SPV

An SPV acts as a subsidiary company to enable an asset and liability structure as well as hold up a legal status and secure obligations, on the off chance that a company goes bankrupt. Hence, it can also be referred to as a bankruptcy remote entity. An SPV can be structured in different ways, depending on what the parent company plans to utilize it for. Initially, the parent company creates an SPV so as to sell the assets on the balance sheet to it, and hence obtain financing through it. The percentage of equity investment is based on the fair market value of the assets that have been transferred. If the SPV controls the assets transferred and retains risk, then the company that sold the assets to the SPV loses control over the activities altogether, making the consolidation of the off-balance-sheet treatment desirable. An SPV can be regarded as a bankruptcy remote entity because of the manner in which it is created. This is done so as to isolate the assets sold to the SPV from inheriting risk, on the off chance that either the SPV, or the parent company whose assets are being securitized, goes bankrupt. 10.3.4

The Investors

Investors are the ultimate purchasers of the Securities. Usually banks, insurance companies, retirement funds, and other “qualified investors.” In some cases, the Securities are purchased directly from the Issuer, but more commonly the Securities are issued to the Originator or Intermediate SPE as payment for the Receivables and then sold to the Investors, or in the case of an underwriting, to the Underwriters. A securitized debt product eventually sends loan repayments to investors in the form of investment returns. Besides the four parties aforementioned, the securitization process involves the participation of the underwriter, the rating agency, and the credit enhancer. 5 A true sale provides the issuer’s creditors with assurances that in the event the company defaults or becomes bankrupt or insolvent its creditors will not have access to the assets sold to the issuer.

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• The underwriter The primary assignment of the underwriter is to analyze investor demand and design the structure of the security tranches accordingly. In general, underwriters are brokers, investment banks or banks that sell or place the Securities in a public offering or private placement. The Underwriters/Placement Agents usually play the principal role in structuring the transaction, frequently seeking out originators for Securitizations, and their counsel (or counsel for the lead Underwriter/Placement Agent) is usually, but not always, the primary document preparer, generating the offering documents (private placement memorandum or offering circular in a private placement; registration statement and prospectus in a public offering), purchase agreements, trust agreement, custodial agreement, etc. Such counsel also frequently opines on securities and tax matters. • The rating agency Moody’s, S&P, Fitch IBCA, and Duff & Phelps. In Securitizations, the Rating Agencies frequently are active players that enter the game early and assist in structuring the transaction. In many instances they require structural changes, dictate some of the required opinions, and mandate changes in servicing procedures. • The credit enhancer Credit enhancements are required in every Securitization. The nature and amount depends on the risks of the Securitization as determined by the Rating Agencies, Underwriters/Placement Agents and Investors. They are intended to reduce the risks to the Investors and thereby increase the rating of the Securities and lower the costs to the Originator. • The Servicer The servicer is the entity that collects principal and interest payments from obligors and administers the portfolio after transaction closing. Regularly the originator acts as servicer, although this is not always the case. For example, in most Non-Performing Loans (NPL) transactions, specialized servicers tend to carry out this role. Servicing includes

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customer service and payment processing for the obligors in the securitized pool and collection actions in accordance with the pooling and servicing agreement. Servicing can also include default management, collateral liquidation, and the preparation of monthly reports. The servicer is typically compensated with a fixed servicing fee.

10.4

Securitization Tranches

The term “tranche” comes from the French word for slice. The discrete tranches of a larger asset pool are usually defined in transaction documentation and assigned different classes of notes, each with a different bond credit rating. Tranches are complex and may pose a problem to uninformed investors. They are complex in that they require detailed deal-specific documentation and estimation of an asset pool’s loss distribution to ensure that the desired characteristics are delivered under all possible circumstances. Tranches allow investors to create a single or several classes of securities with a higher rating than the underlying asset pool. Tranches are pieces of a pooled collection of securities, usually debt instruments, that are split up by risk or other characteristics in order to be marketable to different investors. Tranches carry different maturities, yields, and degrees of risk and privileges in repayment in case of default. Tranches allow investors to customize their investment strategies to their needs. For example, investors who would like to have a long-term steady cash flow should invest in tranches with long maturity dates. Investors who prefer to have short-term cash flow should invest in tranches with short maturity dates. All tranches, regardless of interest and maturity, allow investors to customize investment strategies to their specific needs. Conversely, tranches help banks and other financial institutions attract investors across many different profile types. Investors who desire to have long-term steady cash flow will invest in tranches with a longer time to maturity. Investors who need a more immediate but a more lucrative income stream will invest in tranches with less time to maturity. • Senior tranches A senior tranche is the highest tranche of a security. The senior tranches with a higher rating are insulated from the risk of default of the underlying asset pool since the losses are absorbed by the junior tranches. Any

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losses on the value of the security are only experienced in the senior tranche once all other tranches have lost all their value. For this safety, the senior tranche pays the lowest rate of interest. • Junior tranches If there are more than two tranches, the lowest priority tranche will absorb the losses from bad debts. For a portfolio, investors can choose from securitization investments such as prime and subprime mortgages, home equity loans, credit card receivables, or auto loans.

10.5

Securitized Assets

There are many different types of assets that can be securitized. But the most commonly used are: • Home Equity Loans Home equity loans represent the largest portion of asset-backed securities. They are a natural extension of mortgage-backed securities. This increased lending requires additional capital. The securities are backed by the underlying collateral and the creditworthiness of the borrowers. The income is provided by the regular payments of principal and interest. • Credit cards As consumers continue to take on increasing debt loads—benefitting from marginal real wage growth, GDP growth, and a low unemployment rate—revolving consumer debt hit an all-time high in 2018 of close to $1.04 trillion. • Auto Loans The rise of the auto loan industry following 2008 has been punctuated with a rise in the securitization of auto loans. In the past, auto lenders would make the loans and either seek additional capital in the credit markets themselves or they would sell their loans to other financial institutions. Higher vehicle prices and used vehicle demand have increased

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the issuance of ABS. Asset-backed securitization in the auto loan industry has changed the process and provided lenders with increased access to capital. Auto lenders are bundling loans with similar credit profiles and issue them as an asset-backed security. Auto lenders are able to sell the loans to investors who receive returns from the loan payments and auto lenders can use the funds to increase their own lending. • Student Loans The student loan industry is booming in the United States. Students can take out both government and private loans. Most students use their student loans as an investment in themselves. They utilize the loans to pay for education and pay for the loans when they enter the workforce. Loan amounts are more than offset by future earning capacity. When private lenders securitize their student loans, they gain the capital to issue new student loans. For the first time in quite a while, annual student loan ABS issuance increased to approximately $18 billion in 2018. Investors gain a steady return on their investment from the aggregate principal and interest paid on these loans as well as other loan collection efforts. • Equipment Leases When companies lease equipment, the leasing company needs to buy the equipment that it leases. The leasing company ties up a lot of capital to fulfill the leases. The leasing company receives the interest/rent portion of the lease. While the returns are good, it ties up a lot of capital and limits the number of leases that can be written. Securitizing these equipment leases allows leasing companies to turn their lease agreements into usable capital for their business. They don’t need to seek out a bank to provide them with loans. Investors are able to invest in a lease-backed security that provides them with a steady income from a variety of leases that minimize risk and maximize returns. • Account Receivables Businesses have long used factoring companies to handle their account receivables. Instead of trying to collect on these debts, they will sell them to a factoring company at a discount. Factoring companies receive the

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payments while businesses get quicker access to funds without needing to wait 30–60 days for payment. Factoring companies charge from 2 to 10% for the funds. Factoring companies need capital to do these deals and traditional sources of capital can be too expensive. By securitizing these account receivables, factoring companies can complete more deals. Investors in these securitized receivables get returns that are higher than they would in a bank or other traditional investment. • Intellectual Property Royalties Intellectual property payments run the gamut from musician royalties to patent royalties to copyright royalties and everything in between. Intellectual property payments are a close to $1 trillion industry worldwide. In 2014, the US companies earned more than $128 billion in intellectual payments from outside the United States. Turning intellectual property payments into royalties allows creators to access funding from future royalties. They access the capital they need to do what they do best. The assets can be categorized so that investors can choose which industries they feel more comfortable investing in. They get to take advantage of steady income to provide regular returns. • Resource Leases During the North Dakota oil boom, much of the land used for oil drilling and oil extraction was leased land. It was leased from individuals and companies. Subleases were also made. These leases paid royalties based on the amount of oil extracted from the land. The ongoing income generated is a perfect candidate to be an asset-backed security. Leaseholders are able to get paid up front for lease payments so that they are able to better utilize the income in the form of a lump sum payment. Investors are able to take advantage of oil lease royalty payments. Since the risk is spread out among many different leases, payments are more stable and better reflect the oil market. • Solar Projects Solar projects are income-producing assets and provide a relatively stable income over the life of the project. Solar City saw an opportunity where they could convert the income from a solar production project into

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Table 10.1 Global structure Finance Volumes Global structure finance volumes(bn) United States ($bn) • ABS • CMBS • CLO • RMBS-related Total US new issue US CLO reset Canada (bn C$) Europe (Bil. Euros) Asia-Pacific (bil. $) China Japan Australia Total Asia-Pacific new issue Latin America (bil. $) Approximate Global New Issue Total (Bil.$)

2015

2016

2017

2018

2019

183 101 98 54 436 10 16 77

191 76 72 34 373 39 18 81

229 93 118 70 610 167 20 82

239 77 129 86 531 155 24 106

245 80 110 100 536 110 21 95

97 38 24 159 11 700

116 53 17 186 12 670

220 48 36 304 17 930

292 55 23 370 9 1040

310 58 26 394 18 1050

a security. Since solar projects are capital intensive investments that yield steady returns over a long-term basis, these steady returns are perfect for those looking for a long-term investment. Unfortunately, these projects tie up a lot of capital that could be invested into more projects. By securitizing these solar projects, investors get the long-term investment returns they are looking for and the solar companies get the capital needed to build new green solar projects (Table 10.1).

10.6

Types of Securitization

Securitization types are defined based on the type of the underlying pool of assets: • Mortgage loan: MBS Mortgage-backed Securities (MBS) are bonds that are secured by homes or real estate loans. MBS are created when a large number of such loans are pooled together, and then the pool is sold to a government agency like Ginnie Mae, Fannie Mae, or to a securities firm who will use it as collateral for another mortgage-backed security.

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• Consumer loans: ABS Asset-backed securities (ABS) are bonds that are created from consumer debt. When consumers borrow money from the bank to fund a new car, student loan, or credit cards, the loans become assets in the books of the entity (usually a bank) that is offering them this credit. The assets are then sold to a trust whose sole purpose is to issue bonds that are backed by such securities. The payments made on the loan flow through the trust to the investors who invest in these asset-backed securities. • Corporate loans: CLO A collateralized loan obligation (CLO)6 is a single security backed by a pool of debt. In general, these are corporate loans that have a low credit rating or leveraged buyouts made by a private equity firm to take a controlling interest in an existing company. A collateralized loan obligation is similar to a collateralized mortgage obligation (CMO), except that the underlying debt is of a different type and character—a company loan instead of a mortgage. With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk in the event that borrowers default. In exchange for taking on the default risk, the investor is offered greater diversity and the potential for higherthan-average returns. A default is when a borrower fails to make payments on a loan or mortgage for an extended period of time. • Corporate bonds: CBO Collateralized Bond Obligation (CBO) are investment-grade bonds backed by a collection of junk bonds with different levels of risks, called tiers, that are determined by the quality of junk bond involved. CBOs backed by highly risky junk bonds receive higher interest rates than other CBOs. Collateralized bond obligations (CBOs) are issued as a form of debt financing that transforms junk bonds into investment-grade assets.

6 Troy Segal (2020): Collateralized Loan Obligation, Investopedia.

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10.7

Conclusion

Though the need for securitization market is real, it still presents some risks. Policymakers need to address regulatory, institutional, and product design issues, such as extending the maturity of asset-backed securities and easing the hedging of prepayment risk, to invite greater sponsorship from European insurers and pension funds, both of which are underutilized potential sources of long-term capital.7

7 IMF (2015): Reform Securitization to Improve Growth, Financial Stability.

CHAPTER 11

Sovereign Wealth Funds

11.1

General

A sovereign wealth fund is an investment pool of foreign currency reserves owned by a government. Sovereign wealth funds have been around since the 1950s. Since the last decades or so, many new SWF have been created by oil rich countries and countries with excess of currency or excess of BoP due to their exports. Sovereign wealth funds are special purpose investment funds which national governments establish as a way to protect and stabilize their economies, to diversify from nonrenewable commodity exports, to earn significant returns, and to increase savings for their future generations. SWFs differ from pension funds and insurance companies in that they seek to invest larger portions of their portfolios in long term and alternative style investments. The Sovereign Wealth Fund Institute currently ranks sixty-five individual funds in terms of assets under management with a total asset pool of $5.2 trillion. The amount of money held by the largest sovereign wealth funds has more than doubled since September 2007, from $3.265 trillion to $8.1 trillion in 2019. A study conducted by Morgan Stanley estimates that by 2025 SWFs will command financial assets of approximately $12 trillion in total,

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 F. I. Lessambo, International Finance, https://doi.org/10.1007/978-3-030-69232-2_11

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Fig. 11.1 Top 10 largest sovereign wealth funds

divided evenly between oil funds and other SWFs.1 As of May 2019, the Norwegian Government Pension Fund was the largest sovereign wealth fund (SWF) globally, with managed assets amounting to almost 1.1 trillion US dollars. These government-related funds are active in the global markets to achieve national objectives, and provide liquidity to firms in need of dire liquidity (Figs. 11.1 and 11.2).

11.2

Types of SWFs

Several classifications of SWFs have been proposed: (i) Petrodollar Oil Funds, and (ii) Currency Reserve Funds. Oil funds are either stabilization funds or saving funds. Currency reserve funds fall into two categories, based on the source of the foreign exchange assets: commodity funds (established through commodity exports, either owned or taxed by the government); and non-commodity 1 Morgan Stanley, ‘Currencies: how big could sovereign wealth funds be by 2015?’, http://www.Morganstanley.com, accessed 3 May 2007.

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Fig. 11.2 SWFs by funding and region (Source Sovereign wealth fund institute)

funds (established through transfers of assets from official foreign exchange reserves). The IMF identifies five possible types of SWF: (i) stabilization funds, where the primary objective is to insulate the budget and the economy against commodity (usually oil) price swings; (ii) savings funds for future generations, which aim to convert nonrenewable assets into a more diversified portfolio of assets, and (iii) reserve investment corporations, whose assets are often still counted as reserve assets, and are established to increase the return on reserves; (iv) development funds, which typically help fund socioeconomic projects or promote industrial policies that might raise a country’s potential output growth; and (v) contingent pension reserve funds, which provide (from sources other than individual pension contributions) for contingent unspecified pension liabilities on the government’s balance sheet. 11.2.1

Stabilizations Funds

Certain countries derive the bulk of their fiscal revenues from nonrenewable natural resources or commodities. In general, these revenues are highly volatile, notwithstanding the temporarily relative price stability. Stabilization funds aim to reduce the effects of volatile revenues to the countries and preserve their economies from external conditions. A country can do so by setting up a stabilization fund. Capital flows into the funds when prices are high, and the government enjoys a surplus. Put differently, stabilization funds, allow countries/states to set aside surplus

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revenue for use during unexpected deficits. The surplus revenues are invested into the market to yield profit. Stabilization funds are more reactionary in their investment strategies than savings or development funds. In general, their investment portfolios hold a significant portion of liquid investments, allowing them to stay flexible.2 11.2.2

Saving Funds

Saving Funds (a.k.a. intergenerational savings funds) are often set up by commodity-rich countries to save a portion of their resource wealth for the future generations. Saving Funds pursue decades-long investment horizons by converting today’s resource wealth into renewable financial assets in order to benefit generations of tomorrow. Saving Funds construct their portfolios specifically to offset commodity price exposures and, therefore, invest heavily in developed markets, where they purchase highly rated fixed-income securities (i.e., bonds) and publicly traded equity. Because the investment horizon is long term, stabilization funds purchase assets with long durations and extended payback periods.3 Pension reserve funds, such as Australia’s Future Fund, the New Zealand Superannuation Fund, and Chile’s Pension Reserve Fund, typically invest to build capital that will help defray their sponsoring government’s future pension obligations. 11.2.3

Reserve Investment Corporation

Reserve Investment Corporations strive to reduce the opportunity cost of holding excess foreign reserves by pursuing investments with higher returns. These funds typically have the most-aggressive risk profile and

2 A few examples of SWFs funded by excess natural resource revenues include: Norway Government Pension Fund Global, Abu Dhabi Investment Authority (ADIA), Saudi Arabia’s Public Investment Fund (PIF), Alaska Permanent Fund, Chile’s Economic and Social Stabilization Fund. 3 Alex Musatov and Josh Zorsky (2013): Sovereign Wealth Funds Allow Countries to Invest for more than the Long Term, Reserve Bank of St Louis, Vol. 8, No. 10, October 2013.

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are the most secretive. It is not uncommon for reserve investment corporations to go beyond alternative investments and to take direct equity stakes in firms and use borrowed funds to leverage their investments.4 Examples of such funds include: Singapore’s Temasek Holdings, the Qatar Investment Authority, and Abu Dhabi’s Mubadala Development Co. 11.2.4

Strategic Development Funds

Strategic Development Funds aim to promote national economic or development goals, rather than commercial objectives. Some Strategic Development Funds invest in domestic asset(s) or domestic firm(s) to stabilize aggregate asset pricing, create domestic jobs, and/or prevent entity insolvency. Others may acquire a direct stake or total control of business in order to gain access to know how, or strategic technology transfer. Others acquire a direct stake or total control of firms in which the home country needs for economic or development purposes. 11.2.5

Contingent Pension Reserve Funds

Contingent pension reserve funds are SWF that build up assets to offset unspecified pension liabilities on the government’s balance sheet. Liabilities are obligations of the government resulting from prior actions that will require financial resources. The most significant liabilities reported on the balance sheets are federal debt securities held by the public and accrued interest, and federal employment.

11.3

The Dominant Petrodollar-Oil SWFs 11.3.1

Oil Funds of the Persian Golf

In 2008, the Persian Gulf region holds 60.6% of the world proven oil reserves. Its share of global oil production is 30%; its share of consumption is only 5.4%. The large gap between production and consumption and the massive proven reserves underscore the region’s current and

4 Alex Musatov and Josh Zorsky (2013): Sovereign Wealth Funds Allow Countries to Invest for More Than the Long Term, Reserve Bank of St Louis, Vol. 8, No. 10, October 2013.

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future potential for generating oil revenues. Between 2000 and 2005, GCC countries injected an estimated $542 billion of international assets into global capital markets, and most of these investments were made by oil funds. 11.3.2

Kuwait

Kuwait was one of the first countries in the Persian Gulf (indeed, one of the first in the world) to set up an oil fund. In 1953, eight years before gaining independence from the United Kingdom, Kuwait founded an Investment Board Fund (IBF) in London to invest its surplus oil revenue. Shortly after oil was discovered, the state took on an increased role as provider of basic services (such as education and health care) to meet the needs of a rapidly growing population. In an effort to bring order to this expanded realm of public finance, the General Reserve Fund (GRF) was established in 1960 as the main treasurer for the government. The GRF received all revenues (including all oil revenues) accruing to the government, and disbursed all the state’s budgetary expenditures. In 1976, Jaber al-Ahmed al-Jaber al-Sabah, deputy emir of Kuwait and crown prince, issued Law No. 106, under which the Future Generations Fund (FGF) was established. Article 2 of the law stated: “A special account shall be opened for creating a reserve that would act as an alternative to oil wealth. An amount of 50% of the available State’s General Reserve Fund is to be added to this account.” Article 1 stated: “An amount of 10% shall be allocated from the state’s General Revenues every year.” In 1982, the Kuwait Investment Authority (KIA) was established to manage the significant increase in oil revenues allocated for investment by the government. The KIA assumed responsibility for managing and developing the financial reserves of the IBF as well as the FGF. The holdings in the former are mostly invested locally and regionally, while those in the latter are spread across a more diverse range of locations and sectors. The purpose of the KIA is to achieve a long-term investment return in order to provide an alternative to oil reserves, which would enable Kuwait’s future generations to face the uncertainties ahead with greater confidence. The KIA holds stakes in large corporations such as DaimlerChrysler and British Petroleum. In February 2008, the KIA announced its intention to invest $3 billion in Citigroup and $2 billion in Merrill Lynch as the two US banks scrambled for capital. In July 2007 for the first time the KIA revealed the value of its holdings—$213 billion.

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This policy of investing oil revenues has proved crucial both for Kuwait’s financial welfare and for its political survival. By the late 1980s, the country was earning more from these overseas investments than it was from the direct sale of oil. Oil revenues were suspended in 1990– 91 as a result of the Iraqi invasion and occupation of the country, and for a time the government and population in exile relied exclusively on investment revenues. These revenues were also used to cover the international coalition’s expenses, postwar reconstruction, and the repair of the oil infrastructure. 11.3.3

The United Arab Emirates

The United Arab Emirates with approximately $875 billion in assets in 2007, the Abu Dhabi Investment Authority (ADIA) is the wealthiest oil fund in the world. ADIA invests the oil surplus of Abu Dhabi, the richest city-state within the UAE (which also includes Dubai). It was established in 1976 by Sheikh Zayed bin Sultan al-Nahyan, the founder of the UAE, and is currently chaired by his son and successor Sheikh Khalifa bin Zayed al-Nahyan, the country’s president. The goal was to invest the Abu Dhabi government’s surpluses across various asset classes. At the time, it was novel for a government to invest its reserves in anything other than gold or short-term credit. In February 1977, the Abu Dhabi Investment Company was established by decree of the Emir. The company was majority-owned by ADIA and the National Bank of Abu Dhabi for 30 years until 2007, when ADIA’s shares were transferred to Abu Dhabi Investment Council (ADIC). ADIC was established in 2006 with a mandate to focus on domestic and regional investments. Its portfolio includes 100% ownership of Etihad Airways (the national airline company) and major holdings in the National Bank of Abu Dhabi and Abu Dhabi National Bank. Mubadala is another state investment vehicle. It was set up in 2002 with the goal of delivering strong financial returns and economic diversification. Its portfolio includes stakes in Ferrari, Carlyle Group, Rolls-Royce, and General Electric. ADIA’s portfolio has always been diversified across regions and asset classes; in recent years, like other oil funds, it has taken a special interest in emerging markets, particularly in China and India. While the recent decline in the value of the dollar is making investment in the US cheaper, many investors are holding back out of fear that the dollar will decline further, diminishing the value of their dollar holdings.

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In addition, some oil investors are worried about a potential political reaction. In 2006, DP World in Dubai, which is not a sovereign fund but a state-owned company, was blocked from taking over management of American ports. ADIA has learned from this experience and is not likely to put itself in a similar situation. ADIA has always adopted a low-profile investment strategy. In 2007, it invested in Carlyle Group, a private equity giant, and the chip-maker Advanced Micro Devices. These large deals were subjected to intense scrutiny. In late November 2007, ADIA agreed to invest $7.5 billion in Citigroup—and indeed, would have been keen to invest more. The deal gives ADIC 4.9% of the New York-based bank, making it the largest shareholder, just below the five percent level which triggers a compulsory investigation by the US Federal Reserve. 11.3.4

Iran

Like the other Persian Gulf states, Iran has enjoyed massive oil revenues since the early 2000s. But, unlike its Arab neighbors, the Islamic Republic has been subject to stringent US economic sanctions since the 1979 revolution, and more recently has been the target of UN sanctions as well, applied in response to the country’s advancement of its nuclear program. These sanctions have had negative consequences on the country’s economic outlook, particularly in the energy sector. Iran’s Oil Stabilization Fund (OSF) was established in 2000 to achieve two objectives: • to stabilize the government’s annual budgets, and • to provide loans to private and cooperative entities carrying out projects in the priority sectors identified by five-year plans. These objectives, however, have largely been ignored. The tightening of economic sanctions in recent years has given rise to an increased need for loans and credit from foreign banks, which has not been easy to acquire. In December 2006, the country’s oil minister, Seyed Kazam Vaziri Hamaneh, said: “Foreign banks are refusing to grant us capital or to participate financially in oil industry projects under various pretexts.” This lack of foreign investment, in conjunction with the need to finance

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populist policies (particularly under Ahmadinejad’s administration), has led to a substantial proportion of the OSF being lent to the government. Information on the actual level of the fund is difficult to come by, for the government has been drawing on it for various purposes. The OSF does not show up in Iran’s national budget. It is run as an account at the Central Bank by a handful of senior government officials. In January 2008 Tahmasb Mazaheri, governor of the Iranian central bank, announced that the OSF holds $10 billion, a much smaller amount than other oil funds. This lack of transparency and the high level of uncertainty have attracted investigation by the State Inspectorate Organization, which has examined how OSF funds have been withdrawn and spent during the fourth five-year development plan (2005–2010). In mid-May 2008 the OSF board of trustees, consisting of seven top government economists, was dissolved, and the Government Economic Committee was made responsible for overseeing the OSF. This move was meant to strengthen government control over the fund. Meanwhile the Expediency Council, led by former President Ali Akbar Hashemi Rafsanjani, approved a plan to convert the OSF into a national development fund. The proposed new fund will not lend money to the government unless oil prices fall below $70 per barrel. Instead, loans have been extended only to the private and nongovernmental sectors, to expand production and development. The proposal has yet to gain the approval of the parliament and the Supreme Leader Ayatollah Ali Khamenei. 11.3.5

Qatar

Qatar’s oil fund, the Qatar Investment Authority (QIA), was founded in 2005, headed by the country’s Prime Minister, Sheikh Hamad bin Jassim al-Thani. It manages approximately $50 billion. The fund invests in international public markets, private equity, and real estate as well as local strategic sectors outside the energy field. Its investment targets have included several high-profile companies in Europe and the United States, including Crédit Suisse, the London Stock Exchange, the Nordic bourse operator OMX, the British supermarket chain J. Sainsbury, the European Aeronautic, Defence and Space Company, and Nasdaq. In addition to investments in Europe and the United States, QIA seeks investment opportunities in Asia, particularly China, Japan, Korea, and Vietnam. According to Kenneth Shen, head of strategic and private equity at the QIA, “Historically, we’ve been heavily invested in the US

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and Europe and we’ve been underweight in Asia. We’re going to increase our investments there, though not necessarily at the expense of Europe or the United States.” 11.3.6

Saudi Arabia

Although Saudi Arabia is the world’s largest producer and exporter of oil, unlike most of the other big oil exporters it has not rushed to set up an oil fund. Instead, the kingdom’s portfolio of foreign assets is largely held by the central bank and the Saudi Arabian Monetary Authority (SAMA). SAMA’s investment policy has been conservative and largely limited to investment in bonds, especially US Treasury bonds and shares. About 85% of foreign exchange reserves are invested in dollar-denominated fixed-income securities. Nevertheless, the growing tendency of oil funds in other GCC states to make more aggressive investments was finally echoed in Riyadh when in July 2008 the Saudi government approved the setting up of a new state investment vehicle, called Sanabil al-Saudia, with an initial capital of 20 billion Saudi riyals ($5.3 billion). The relatively small size of the Saudi fund’s initial capital reflects a desire to avoid the kind of backlash other SWFs have generated in recent years. Unlike the other GCC states Saudi Arabia has a large population (over 20 million, including both nationals and expatriates), which means the kingdom has a greater capacity for domestic absorption of oil revenues than its fellow oil exporters in the Gulf. Finally, given its large holding of dollar-denominated securities, Riyadh cannot easily offload its dollar assets in favor of less liquid investment, for such a move would signal a lack of confidence in the US dollar, with negative impact on both the American and the Saudi economies. Sanabil al-Saudia is wholly owned by the Public Investment Fund (PIF) and acts as a portfolio manager with a focus on maximizing longterm returns, with investment in Saudi Arabia and overseas across various sectors. The PIF, which falls under the Finance Ministry, was established by royal decree in 1971 in order to provide financing for “certain productive projects that are of a commercial nature and are having a significant importance in developing the national economy.” Several conclusions can be drawn from this brief review of oil funds in the Persian Gulf. First, the high and sustained oil prices since the early 2000s have convinced oil exporters of the need to set up oil funds and have substantially added to their financial assets. Second, there is more

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diversification in investment paths than there was in the 1970s and early 1980s. In other words, Persian Gulf investors are increasingly moving away from safe but low-return bonds to invest in alternative assets such as real estate, private equity funds, and hedge funds. Third, more money is remaining within the Middle East, broadly defined. Several developments have contributed to this outcome. The growing privatization of public enterprises in several Middle Eastern countries has created investment opportunities; the proliferation of Islamic financial institutions has attracted capital that would have previously been invested abroad; and the concern about a potential political backlash against Muslims and Arabs following terrorist attacks in the United States and Europe. Nevertheless—the fourth point—although investments are now more widely geographically spread, the bulk of them are still located in the United States. According to Hank Paulson, the US Treasury Secretary, since 2006 the number of acquisitions in the United States by Gulf investors has risen “by more than 100%, while the value of the deals rose by more than 400%.” Europe, too, continues to be a prime recipient, while Asia (particularly China and India) is emerging as an attractive target for both economic and political reasons. Fifth, a recent study by the IMF concludes that most oil funds lack a clear comprehensive investment strategy, and that transparency and accountability practices differ substantially from one fund to another. This conclusion applies to most, if not all, oil funds in the Persian Gulf. Very little official information is made public on their investment portfolios. Most of their financial deals are pursued with little, if any, scrutiny by public or legislative bodies. This lack of disclosure of oil funds’ assets mirrors general attitudes to public sector transparency in these countries. By contrast, Norway has always been seen as a model to be followed. However, the business culture in Norway has been more open than that of the Gulf and other oil exporters. It is to this case that I now turn. 11.3.7

Norway Oil Fund

Norway has a well-developed economy that has benefited greatly from the utilization of its hydrocarbon resources. The country holds the largest proven oil reserves in Western Europe and in 2008 is the world’s fourth-largest oil exporter (after Saudi Arabia, Russia, and the United Arab Emirates). In 1990 the Norwegian government created the State Petroleum Fund (SPF), which was activated in 1995 following the

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achievement of overall budget surpluses. In 2005 the SPF was renamed the Government Pension Fund—Global (GPF). The fund was set up to manage Norway’s petroleum wealth in a sustainable manner and to help meet the rising national expenditure on pensions and health care. In 2008, the fund is valued at more than $350 billion. The Ministry of Finance has delegated the operational management of the fund to Norges Bank, a part of the Norwegian Central Bank. A management agreement, which further defines the relationship between the Ministry of Finance as delegating authority and Norges Bank as operational manager, has also been drawn up. In managing the fund’s assets Norges Bank has adopted a high-return and moderate-risk investment strategy. Accordingly, the fund’s portfolio is divided into 54.6% fixed-income securities and 45.4% equities. The return on investment has averaged 4.6% since the fund’s inception. Norway’s experience with its oil fund is different from that of most other countries in its strong emphasis on ethics and transparency. In November 2004, the government appointed a Council on Ethics, which established ethical guidelines for the fund. Comprehensive accounts and data on the fund’s operations are readily available. The quarterly and annual reports provide detailed information on portfolio valuation, composition, returns, management, transfers to and from the budget, market trends, risk exposure, and administrative costs. Kristin Halvorsen, minister of finance, emphasizes the significance of transparency: “We believe transparency is a key tool in building trust. It helps build public support and trust in the management of Norway’s petroleum wealth. Openness about the fund’s management can contribute to stable financial markets and exert a disciplinary pressure on managers.” 11.3.8

The Stabilization Fund of the Russian Federation

Since the late 1990s, Russia has emerged as one of the world’s primary energy suppliers. In 2008, Russia is the world’s second-largest producer and exporter of oil (after Saudi Arabia) and the largest producer and exporter of natural gas. This prominent and growing role of the energy sector in Russia’s economy has raised concern about the most effective way to make use of the massive oil revenues that have been accumulated since the early 2000s. The Russian government’s response to such concern was to establish a Stabilization Fund (SF) in 2004. Three important developments

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laid the ground for the creation of the SF. First, whereas under Yeltsin’s administration the state had sold some of the major oil companies to the oligarchs, under Putin’s more assertive regime the main emphasis was on restoring the state’s power and ownership in the energy sector (the so-called renationalization or de-privatization). Second, Putin’s administration enjoyed substantial oil revenues as a result of soaring and sustained oil prices. Third, several Russian economists voiced their concern that the country’s deepening dependence on energy wealth was transforming it into merely a provider of raw materials for the rest of the world and damaging the competitiveness of other economic sectors, particularly manufacturing. The challenge was (and still is) how to manage this expanding pool of oil revenues. Founding the Stabilization Fund was considered the answer. Following lengthy debates, the law establishing the SF was approved in December 2003. Several sources contribute to the fund’s revenues: a portion of the export duty on oil and petroleum products; part of the revenue from the severance tax on mineral resources; and a portion of the surplus of the federal budget at the beginning of the fiscal year. The law also set the base price at $20 per barrel of Urals oil, above which revenues start accumulating in the SF. The fund is managed by the Ministry of Finance. In 2008, the SF’s assets are approximately $157 billion. From its inception an intense debate about the appropriate strategy for investment of the fund’s resources has surrounded the SF. Business leaders and regional governors spoke out in favor of boosting pensions and social benefits. They also called for the SF’s assets to be deployed in various investment projects and distributed in the form of development loans. Former Prime Ministers Mikhail Fradkov and Yevgeny Primakov were prominent advocates of such an approach. On the other side, Deputy Prime Minister and Finance Minister Alexei Kudrin and many other economists opposed using the SF’s assets in investment schemes, arguing that such spending would produce inflation, leading ultimately to the evaporation of the fund itself. Instead, they called for the surplus revenues to be put toward the early repayment of Russia’s foreign debt. The IMF supported the second approach, suggesting that saving oil revenues has served Russia well “as it has prevented even stronger inflationary pressures and much faster real ruble appreciation.” Former President Vladimir Putin and current President Dmitry Medvedev expressed similar approval. In his budget address in March 2007, then President Putin called for the SF to be transformed into two funds—a Reserve Fund and a National

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Welfare Fund. This split took place in February 2008. The former fund performs the same function as the old SF (accumulating energy profits and holding them in conservative investments to cushion the economy if energy prices fall), while the latter is used to fund shortfalls in the pension system and invest in riskier assets with higher returns, such as corporate bonds and shares.

11.4

Conclusions and Policy Implications

There is no consensus among analysts on the benefits of setting up oil funds. Few studies have empirically tested the efficacy of these funds in their own countries. A recent study by the IMF concludes that oil funds have limited fiscal benefits and are largely redundant. Oil funds have not been effective in addressing volatile exchange rates. The IMF suggests that benefits are more likely to be achieved by improving fiscal policy and administration. To ensure sound allocation of oil revenues, oil funds should be integrated with the budget and their operations better coordinated with those of the rest of the public sector; clear and comprehensive asset-management strategies should be adopted, and mechanisms established to ensure transparency and accountability. Equally important, oil funds’ investments abroad have given rise to mounting anxiety over their commercial and strategic impacts. In many respects, these funds are their own worst enemy. “Their air of secrecy has led to rising concern. Oil funds, as The Economist put it, are being ‘set up as the next villains of international finance’. The soaring of their cross-border investment represents a potential structural shift in the global economy.” Accordingly, economists and policymakers seek to assess the implications of this shift and the appropriate response. The challenge western financial markets face is how to ensure the steady inflow of badly needed foreign investment while simultaneously addressing popular suspicion that this investment might be driven by strategic interests. Such suspicion might strengthen calls for protectionism and restrictions on capital flows from oil funds, which would if implemented weaken the global financial markets. With a view to addressing this challenge, finance ministers from major industrial democracies (Britain, Canada, France, Germany, Italy, Japan, and the United States) meeting in October 2007 called for an international code of best practice for government-owned cross-border investments, requiring greater disclosure of assets and actions. They also

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called on the OECD, the World Bank, and the IMF to participate in setting these rules. The United States and the European Union have taken different approaches to the conundrum of how to welcome foreign investment without risking national security. The Committee on Foreign Investment in the United States (CFIUS) is an interagency committee chaired by the Secretary of the Treasury. It seeks to serve US investment policy through reviews that protect national security while maintaining the credibility of the nation’s open investment policy and preserving the confidence of foreign investors and of American investors abroad that they will not be subject to retaliatory discrimination. The Foreign Investment and National Security Act of 2007 (FINSA) became effective in October 2007. It mandates additional scrutiny and higher level clearances for transactions involving foreign government-owned investments. Though American officials state they have not seen any evidence of oil funds seeking political leverage through their investments, the House of Representatives set up a Sovereign Fund Task Force in February 2008 to examine the funds’ transparency and accountability. Nothing was even founded. The EU is the world’s largest exporter of foreign direct investment (FDI) as well as a beneficiary of FDI inflows. Europeans are particularly concerned about Russia’s use of its oil fund to buy pipelines and other energy infrastructure in Europe on behalf of its government-owned oil and natural gas companies. Unlike Washington, Brussels does not have a government mechanism such as CFIUS to scrutinize foreign investment. The European Commission takes the view that the EU and its 27 member states together already have in place comprehensive rules governing the activities of foreign investors. In addition to these rules the European Commission has called for a constructive dialogue with SWFs. In essence, the EU is calling on SWFs to commit to good governance practice, adequate accountability, and a satisfactory level of transparency, and is seeking to institutionalize these principles through multilateral work in international organizations such as the IMF and the OECD. In February 2008, the European Commission adopted a communication proposing these principles. The document was endorsed the following month by EU heads of state and government during the European Council meeting. However, although the European Commission prefers a voluntary approach to a statutory one, the Commission president, Jose Manuel Barroso, said, “We will not propose European legislation, though

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we reserve the right to do so if we cannot achieve transparency through voluntary means.” Many funds resist the pressure to embrace even a voluntary code of best practice on at least three grounds. First, such a code seems unnecessary in light of their track record of abstaining from political interference. Second, they consider the West’s demand for regulation “hypocritical in light of the failure to regulate European and American banks and hedge funds.” In other words, oil funds insist that responsibility for transparency and fair treatment goes both ways. Third, western economies already have mechanisms in place to regulate foreign investment and prevent abuse by investors. Many oil fund managers have recently expressed their frustration at American and European efforts to regulate their investments. Bader al-Saad, director of the Kuwait Investment Authority, said, “All they are talking about is a fear of something that did not happen and will not happen.” Muhammad al-Jasser of the Saudi Arabia Monetary Agency echoed the same sentiment: “It is like the SWFs are guilty until proven innocent.” Finally, Yousef al-Otaiba, director of international affairs for the government of Abu Dhabi, warned, “In a world thirsty for liquidity, receiving nations should be mindful of the signals sent through protectionist rhetoric and rash regulation.” Given that promoting international monetary cooperation is a fundamental goal of the IMF, and that it has great experience in developing guidelines in the areas of fiscal transparency and foreign exchange reserves management, it is not surprising that the Fund has taken a leading role in drawing up a voluntary code of best practice in the management of SWFs. In May 2008, an International Working Group of Sovereign Wealth Funds (IWG) was established to reach a consensus on a set of SWF principles that properly reflects their investment practices and objectives. The IWG comprises representatives from 25 IMF-member countries, and is co-chaired by Hamad al-Suwaidi, director of the Abu Dhabi Investment Authority, and Jaime Caruana, director of the IMF’s Monetary and Capital Markets Department. Since its establishment, the IWG has held meetings in Norway, Singapore, and Chile. In its most recent meeting, in Chile in September 2008, the IWG reached an agreement on general principles called the “Santiago Principles.” The agreement was presented to the IMF’s governing council in mid-October. The major themes of these guiding principles include: (a) maintenance of a stable global financial system and free flows of capital and investment; (b) compliance with all applicable regulatory

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and disclosure requirements in the countries where the funds invest; (c) investment on the basis of considerations of economic and financial risk and return; and (d) the creation and maintenance of a transparent and sound governance structure that provides for adequate operational controls, risk management, and accountability. The IMF will not monitor, let alone police, the way the funds apply the principles. Rather, the funds themselves are likely to set up some kind of loose oversight arrangement. To conclude, it would be a mistake to encourage the perception that foreign investment, even from government-owned entities, nor is a threat to national security. Legitimate caution about SWFs could easily spill over into illegitimate hysteria. Meanwhile, it would be in the funds’ interest to increase voluntary disclosure of information about their assets, portfolios, governance procedures, and investment objectives. The path forward is to strike a balance between western calls for transparency and the funds’ insistence on fair treatment that enables the continued free flow of foreign investment. Ultimately, the more Asian nations and oil exporters invest in the United States and European markets, the higher the stakes will be for all parties in global economic prosperity and political stability.

Glossary of Terms

A Agency Theory: A theory of firms that deals with the conflict of interest between managers and stockholders American Depository Receipts (ADRs): Certificates, traded in the United States, that represent the ownership of foreign stocks American Option: An option that can be exercised at any time prior to the contract’s expiration date

B Balance of Payments: A financial statement prepared for a given country summarizing the flows of goods, services, and funds between the residents of that country and the residents of the rest of the world during a certain period of time. The balance of payments is prepared using the concept of double-entry bookkeeping, where the total of debits equals the total of credits Balance of Trade: The net of imports and exports of goods and services reported in the balance of payments Bretton Woods Agreement: Agreement signed by forty-four nations at Bretton Woods, New Hampshire, in July 1944; basis of the post-World War II monetary system. Each participating nation declared a par value

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for its currency and agreed to intervene in foreign exchange markets to maintain the exchange rate with respect to the U.S. dollar within plus or minus 1 percent of the par value. The United States agreed to the obligation to convert dollars to gold at $35 per ounce. The Bretton Woods fixed exchange rate system broke down in 1971

C Capital account: Is a measure of financial transactions that do not affect a country’s income, production, or savings. It records, for instance, international transfers of drilling rights, trademarks, and copyrights. Clearing house: The organization which assures the financial integrity of futures and options markets by guaranteeing obligations among its clearing members. It registers, monitors, matches, and guarantees trades, and carries out the financial settlement of futures and options transactions. The clearinghouse can be part of an exchange or can be a separate corporate entity Current Account: Represents the balance of payments for a country. It informs economists whether the country is a net importer or net exporter of capital Currency Swap: A contractual obligation entered into by two parties to deliver a sum of money in one currency against a sum of money in another currency at stated intervals. Typically, the exchange of a fixed interest rate (and principal) in some currency for a floating rate (such as LIBOR), and principal, in US dollars

D Derivative: is a bilateral executory contract (a contract under which either or both parties must perform in the future, by delivering property or money) with a limited term (lifespan), the value of which is determined by reference to the price of one or more fungible securities, commodities, rates (such as interest rates), or currencies (an “underlier”) Domestic bonds: Bonds issued and traded within the internal market of a country and denominated in the currency of that country

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E Emerging markets: are economies or markets that are just entering the global arena or do not meet the criteria to be considered developed economies Eurobond: A bond underwritten by an international syndicate of banks and marketed internationally in countries other than the country of the currency in which it is denominated. The issue is thus not subject to national restrictions Exchange Traded Funds: Basket of securities that an investor buys or sells through a brokerage firm on a stock exchange. ETFs are offered on virtually every conceivable asset class from traditional investments to so-called alternative assets like commodities or currencies

F Fixed Exchange Rate System: A system in which the values of various countries’ currencies are tied to one major currency (such as the U.S. dollar), gold, or special drawing rights. The term should not be taken literally because fluctuations within a range of 1 or 2% on either side of the fixed rate are usually permitted in such a system Floating Exchange Rate System: A system in which the values of various currencies relative to each other are established by the forces of supply and demand in the market without intervention by the governments involved. In practice most floating rates are really “managed floating” with periodic ad hoc intervention by central banks Foreign Bonds: Bonds issued by nonresidents in a country’s domestic capital market. Such bonds are subject to domestic regulations and are underwritten primarily by banks registered in the country where the issue is made Foreign Exchange Exposure: The risk that a firm will gain or lose as a result of changes in exchange rates Forward Contract: An agreement to exchange at a specified future date currencies of different countries at a specified contractual rate (the forward Date). Foreign currency traded for settlement beyond two working or business days from today

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G Gold Standard: A monetary agreement under which national currencies are backed by gold and the gold is utilized for international payments. Also called the Gold Exchange Standard

H Hedging: The process of reducing the variation in the value (from price fluctuations) of a total portfolio. Hedging is accomplished by adding to an original portfolio items such as spot assets or liabilities, forward contracts, futures contracts, or options contracts in such a way that the total variation of the new portfolio is smaller than that of the original portfolio

L LIBOR (London Interbank Offered Rate): The interest rate at which prime banks offer dollar deposits to other prime banks in London. This rate is often used as the basis for pricing Eurodollar and other Eurocurrency loans. The lender and the borrower agree to a markup over the LIBOR, and the total of LIBOR plus the markup is the effective interest rate for the loan

M Master Agreement: Used in swaps and other derivative contracts, this bilateral agreement provides a set of terms applicable to any such transaction between the parties. Parties can tailor the transaction by appending specific terms to the master agreement Money Markets: Money market: refers to trading in very short-term debt investments. At the wholesale level, it involves large-volume trades between institutions and traders. At the retail level, it includes money market mutual funds bought by individual investors and money market accounts opened by bank customers Mutual Funds: are investment strategies that allow you to pool your money together with other investors to purchase a collection of stocks, bonds, or other securities that might be difficult to recreate on your own

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O Official Reserves: Government-owned international assets that include convertible foreign currencies, gold and Special Drawing Rights Open-Market Operations: Purchases or sales of securities or other assets by the central bank. Such actions change the monetary base. Usually the term is restricted to purchases and sales of domestic assets (such as government bonds), while purchases and sales of foreign exchange are called “foreign exchange intervention.” Either activity changes the monetary base in a similar way

P Political Risk: is the risk an investment’s returns could suffer as a result of political changes or instability in a country. Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policymakers or military control Repurchase Agreement: is a sale of securities with a simultaneous agreement by the seller to repurchase them at a later date. (For the lender—that is, the buyer of the securities in such a transaction—the agreement is often called a reverse RP.) Reserve Currency: A foreign currency held by a central bank (or exchange authority) for the purposes of exchange intervention and the settlement of intergovernmental claims Revolving Credit: A line of bank credit that may be used or not used at the borrower’s discretion. Interest is paid on the amount of credit actually in use, while a commitment fee is paid on the unused portion Rollover Credit: A bank loan whose interest rate is periodically updated to reflect market interest rates. The interest rate in the loan for each sub-period is specified as the sum of a reference rate and a lending margin

S SDR (Special Drawing Right): An artificial reserve asset created and held on the books of the IMF. At the time of first issue on January 1, 1970, the SDR was defined as having a value equal to 1/35 ounce of gold. The definition was altered in 1974 to specify the value in terms of a portfolio of sixteen currencies. Since 1981, the SDR has

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been defined in terms of the U.S. dollar, German mark, French franc, Japanese yen, and British pound Securitization: is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs) Sovereign wealth fund: is an investment pool of foreign currency reserves owned by a government. Sovereign wealth funds have been around since the 1950s SPV (an): also called a special purpose entity (SPE), is a subsidiary created by a parent company to isolate financial risk. Its legal status as a separate company makes its obligations secure even if the parent company goes bankrupt Sovereign wealth fund is an investment pool of foreign currency reserves owned by a government. Sovereign wealth funds have been around since the 1950s Sterilization: Intervention in the foreign exchange market by a central bank where the change in the monetary base caused by the foreign exchange intervention is offset by open market operations involving domestic assets Statistical discrepancy: Is the official adjustment factor in the National Income and Product Accounts that ensures equality between the income and expenditures approaches to measuring gross domestic product. It is the sum of all of the product-side components less the sum of all of the income-side components Strike Price: The price at which an option holder may buy or sell the underlying asset which is specified in an option contract

U Underwriting Syndicate: The banks, in a new bond issue, that agree to pay a minimum price to the borrower even if the bonds cannot be sold on the market at a higher price

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V Variation Margin: The gains or losses on open futures contracts calculated by marking the contracts to the market price at the end of each trading day (or session). These gains or losses are credited or debited by the clearinghouse to each clearing member’s account, and by members to their respective customers’ accounts Volatility: A measure of the amount by which an asset’s price fluctuated over a given period. Normally, it is measured by the annualized standard deviation of daily returns on the asset

W Warrant: A call option to buy a stated number of shares of stock at a specified price

Bibliography

Bruner, M. Christopher (2010): Power and Purpose in the Anglo-American Corporation. Virginia Journal of International Law, Vol. 50, No. 3, p. 599. Cohen, J. Benjamin (2008): “Bretton Woods System,” in Routledge Encyclopedia of International Political Economy. Cook, Q. Timothy, and Robert K. LaRoche (1998): Money Markets, Federal Reserve Bank of Richmond Richmond, Virginia, p. 5. DeGennaro, P. Ramon (2005): Market Imperfections, The Federal Reserve of Atlanta. Eun, Cheol S., and Bruce G. Resnick (2007): International Financial Management, 4th edition. McGraw-Hill, p. 30. Fergusson, Niall (2008): The Ascent of Money: A Financial History of the World. New York Penguin, p. 305. Hall, E. Robert (2018): Low Interest Rates: Causes and Consequences, Hoover Institution and Department of Economics, Stanford University, National Bureau of Economic Research. IMF (2013): BoP and International Investment Position Manual (BPM6) Chapter 8-Financial Account, p. 133. IMF (2015): Reform Securitization to Improve Growth, Financial Stability. Jobst, Andreas (2008): What Is Securitization, IMF Monetary and Capital Markets Department. Kennon, Joshua (2019): What Is the Nasdaq, The Balance.com. Kirk, A. Jason (2019): China and the AIIB. Lee, Seung Jung, Lucy Qian Liu, and Viktors Stebunovs (2016): Risk Taking and Interest Rates: Evidence from Decades in the Global Syndicated Loan Market, IMF Working Paper 1716, p. 4. © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 F. I. Lessambo, International Finance, https://doi.org/10.1007/978-3-030-69232-2

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Lessambo, Felix (2020): The US Banking System: Laws, Regulations, and Risk Management. Palgrave Macmillan, p. 2. Mosbacher, Robert A., A. Robert, Michael R. Darby, Allan H. Young, and Carol S. Carson (1990). Musatov, Alex, and Josh, Zorsky (2013): Sovereign Wealth Funds Allow Countries to Invest for More Than the Long Term, Reserve Bank of St Louis, Vol. 8, No. 10, October 2013. Ocampo, Jose Antonio (2005): “The Democratic Deficit in International Arrangements,” in Protecting the Poor: Global Financial Institutions and the Vulnerability of Low Income Countries, pp. 117–118. OECD (2015–2016): Globalization—FDI and Balance of Payments. OECD (2019): OECD Equity Market Review of Asia. Reinert, A. Kenneth (2012): An Introduction to International Economics: New Perspectives on the World Economy. Cambridge University Press-New York, Chapter 17. Reinhart, C.M., S. Horn, and C. Trebesch (2019): China’s Overseas Lending, NBER. Report of the High-Level Commission on Modernization of World Bank Group Governance, p. 8. Schrimpf, Andreas (2019): Sizing Up Global Foreign Exchange Markets, p. 21. Scott, J. Brian (2019): Global Equity Investing: The Benefits of Diversification and Sizing Your Allocation, Vanguard Research, p. 6. Silimano, Andres (1999): Can Reforming Global Institutions Help Developing Countries Share in the Benefits from Globalization? Washington, DC, The World Bank Paper. Taylor, Allen (2018): Demystifying Securitization, Lending Times. Thakor, Anjan (2015): International Financial Markets: A Diverse System Is the Key to Commerce, Center for Capital Markets, p. 22.

Index

A Agency approach, 48, 52 Asian Infrastructure Investment Bank (AIIB) capital structure, 20 governance structure, 21 operations, 19, 24 purposes, 20 B Balance of payments’ accounts capital account, 29, 33, 38 current account, 29, 33, 34, 43 financial account, 29, 39, 43 official reserve account, 42, 43 Bankers’ acceptances, 73 Banks central, 8–10, 40, 42, 43, 62–64, 70, 71, 74, 77, 88, 95, 147, 148 commercial, 62, 63, 69–72, 75, 98, 108, 110 investment, 18, 20, 39, 62, 63, 73, 94, 95, 98, 108, 111–113, 131

Bonds domestic bonds, 92, 93 Eurobonds, 92–94 foreign, 39, 65, 91–93, 148 Bretton Woods, 7, 8, 10, 12–14, 20, 65 institutions, 7, 8, 12, 13, 15 post, 12 Brokers, 62, 63, 71, 73–75, 93, 110, 124, 131 Business Judgment Rule (BJR), 50 C Certificate of deposit (CD), 75 Commercial paper, 72, 75 Contracts, 2, 38, 55, 57, 61, 66–69, 83, 97, 100–105, 107–109, 113, 122, 123, 130 forward, 2, 61, 67, 68, 100, 101, 105, 109 futures, 66–69, 101, 102, 105, 123 Corporate governance, 13, 15, 45, 46, 52, 53, 58, 82 Corporate responsibility, 53

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 F. I. Lessambo, International Finance, https://doi.org/10.1007/978-3-030-69232-2

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INDEX

D Derivatives, 1, 5, 41, 97–99, 106, 111, 114, 115, 123, 124 Discount window, 72, 74, 76

E Enhanced opportunities, 2 Equity market, 79, 80, 83, 88, 90 Exchange Bombay, 90 Deutsche Borse, 87 Euronext, 83, 85, 86 Hong Kong, 62, 89 London Stock, 83, 86, 147 Nasdaq Nordic, 86, 88 NYSE, 80, 81, 83 Shanghai, 89 Exchange trading funds (ETF) purchase, 118, 122 redemption, 118 types, 119–121

F Factor income, 29, 90 Fiduciary duties duty of care, 48–51 duty of loyalty, 48–50 good faith conduct, 50 Foreign currency, 1, 37, 42, 61, 65–69, 102, 106, 109, 122, 139 Foreign direct investment (FDI), 1, 38–40, 153 Foreign exchange (FX) gap analysis, 64 management, 64 market participants, 62 rate duration analysis, 64, 65 rate simulation analysis, 64, 65 rate volatility analysis, 64, 65 risks, 63

H Hedging, 2, 64, 102, 105, 107, 138

I International financial institutions, 7, 10, 13 features, 64 legitimacy, 15 Investment, 1, 2, 18, 20, 24, 29, 32, 33, 35, 38–41, 43, 52, 73, 75, 76, 86, 91, 107, 112, 117–121, 123, 124, 127, 130, 132–137, 139, 141–155 other, 29, 38, 39, 41, 65 portfolio, 33, 39, 41, 79

M Market imperfections, 2–4 Markets bonds, 5, 87, 91–95, 121, 125 derivatives, 97–99 equity, 79, 80, 83, 88, 90, 112, 113, 119, 130, 147 ETF, 83, 117–123 Merchandise trade, 31, 33, 34 Municipal notes, 77 Mutual funds, 71, 73, 117–119

N New Development Bank (NDB) funding, 16 governance structure, 16, 21, 155 objectives, 15

O Options, 57, 64, 67, 68, 83, 87, 97, 98, 102–107

INDEX

P Plaza-Louvre Accord, 11 Portfolio investment, 3, 29, 38–41, 52, 117, 119, 142, 145, 149, 155 Post-Bretton Woods, 12 R Rating agencies, 52, 54, 55, 130, 131 Repurchase agreement, 74, 76 Risks currency, 2, 3, 64, 92, 98 foreign exchange, 2, 64, 65 political, 2, 3 S Securitization, 125–131, 133, 136, 138 Service account, 33, 36 Sovereign wealth fund (SWF), 139–141, 143, 148, 153–155

169

Special drawing rights (SDRs), 42 Swaps commodity, 99, 108, 111 credit default, 99, 109–111, 114, 115 currency, 108, 109 equity, 99, 108, 111–113 interest rate, 99, 108, 109

T Treasury bills, 71, 72, 74–76

U Underwriter, 94, 95, 130, 131 Unilateral transfer, 30–33, 35, 36

V Valuation, 2, 32, 35, 86, 150