Response to Taxation and Regulation

We have seen that much financial innovation and security creation may be viewed as a natural market response to unfulfilled investor needs. Another driving force behind innovation is the ongoing game played between governments and investors on taxation and regulation. Many financial innovations are direct responses to government attempts either to regulate or to tax investments of various sorts. We can illustrate this with several examples.

We have already noted how Regulation Q, which limited bank deposit interest rates, spurred the growth of the money market industry. It also was one reason for the birth of the Eurodollar market. Eurodollars are dollar-denominated time deposits in foreign accounts. Because Regulation Q did not apply to these accounts many U.S. banks and foreign competitors established branches in London and other cities outside the United States, where they could offer competitive rates outside the jurisdiction of U.S. regulators. The growth of the Eurodollar market was also the result of another U.S. regulation: reserve requirements. Foreign branches were exempt from such requirements and were thus better able to compete for deposits. Ironically, despite the fact that Regulation Q no longer exists, the Eurodollar market continues to thrive, thus complicating the lives of U.S. monetary policymakers.

Another innovation attributable largely to tax avoidance motives is the long-term deep discount, or zero-coupon, bond. These bonds, often called zeros, make no annual interest payments, instead providing returns to investors through a redemption price that is higher than the initial sales price. Corporations were allowed for tax purposes to impute an implied interest expense based on this built-in price appreciation. The government's technique for imputing tax-deductible interest expenses, however, proved to be too generous in the early years of the bonds' lives, so corporations issued these bonds widely to exploit the resulting tax benefit. Ultimately, the Treasury caught on and amended its interest imputation procedure, and the flow of new zeros dried up.


What are derivatives anyway, and why are people saying such terrible things about them?

Some critics see the derivatives market as a multitrillion-dollar house of cards composed of interlocking, highly leveraged transactions. They fear that the default of a single large player could stun the world financial system.

But others, including Federal Reserve Chairman Alan Greenspan, say the risk of such a meltdown is negligible. Proponents stress that the market's hazards are more than outweighed by the benefits derivatives provide in helping banks, corporations and investors manage their risks.

Because the science of derivatives is relatively new, there's no easy way to gauge the ultimate impact these instruments will have. There are now more than 1,200 different kinds of derivatives on the market, most of which require a computer program to figure out. Surveying this complex subject, dozens of derivatives experts offered these insights:

Q: What is the broadest definition of derivatives?

A: Derivatives are financial arrangements between two parties whose payments are based on, or "derived" from, the performance of some agreed-upon benchmark. Derivatives can be issued based on currencies, commodities, government or corporate debt, home mortgages, stocks, interest rates, or any combination.

Company stock options, for instance, allow employees and executives to profit from changes in a company's stock price without actually owning shares. Without knowing it, homeowners frequently use a type of privately traded "forward" contract when they apply for a mortgage and lock in a borrowing rate for their house closing, typically for as many as 60 days in the future.

Q: What are the most common forms of derivatives?

A: Derivatives come in two basic categories, optiontype contracts and forward-type contracts. These may be exchange-listed, such as futures and stock options, or they may be privately traded.

Options give buyers the right, but not the obligation, to buy or sell an asset at a preset price over a specific period. The option's price is usually a small percentage of the underlying asset's value.

Forward-type contracts, which include forwards, futures and swaps, commit the buyer and the seller to trade a given asset at a set price on a future date. These are "price fixing" agreements that saddle the buyer with the same price risks as actually owning the asset. But normally, no money changes hands until the delivery date, when the contract is often settled in cash rather than by exchanging the asset.

Q: In business, what are they used for?

A: While derivatives can be powerful speculative instruments, businesses most often use them to hedge. For instance, companies often use forwards and exchange-listed futures to protect against fluctuations in currency or commodity prices, thereby helping to manage import and raw-materials costs. Options can serve a similar purpose; interest-rate options such as caps and floors help companies control financing costs in much the same way that caps on adjustable-rate mortgages do for homeowners.

Q: How do over-the-counter derivatives generally originate?

A: A derivatives dealer, generally a bank or securities firm, enters into a private contract with a corporation, investor or another dealer. The contract commits the dealer to provide a return linked to a desired interest rate, currency or other asset. For example, in an interest-rate swap, the dealer might receive a floating rate in return for paying a fixed rate.

Q: Why are derivatives potentially dangerous?

A: Because these contracts expose the two parties to market moves with little or no money actually changing hands, they involve leverage. And that leverage may be vastly increased by the terms of a particular contract. In the derivatives that hurt P&G, for instance, a given move in U.S. or German interest rates was multiplied 10 times or more.

When things go well, that leverage provides a big return, compared with the amount of capital at risk. But it also causes equally big losses when markets move the wrong way. Even companies that use derivatives to hedge, rather than speculate, may be at risk, since their operation would rarely produce perfectly offsetting gains.

Q: If they are so dangerous, why are so many businesses using derivatives?

A: They are among the cheapest and most readily available means at companies' disposal to buffer themselves against shocks in currency values, commodity prices and interest rates. Donald Nicoliasen, a Price Wa-terhouse expert on derivatives, says derivatives "are a new tool in everybody's bag to better manage business returns and risks."

Source: Lee Berton, "Understanding the Complex World of Derivatives," The Wall Street Journal, June 14, 1994. Excerpted by permission of The Wall Street Journal © 1994 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

16 PART I Introduction

Meanwhile, however, the financial markets had discovered that zeros were useful ways to lock in a long-term investment return. When the supply of primitive zero-coupon bonds ended, financial innovators created derivative zeros by purchasing U.S. Treasury bonds, "stripping" off the coupons, and selling them separately as zeros.

There are plenty of other examples. The Eurobond market came into existence as a response to changes in U.S. tax law. Financial futures markets were stimulated by abandonment in the early 1970s of the system of fixed exchange rates and by new federal regulations that overrode state laws treating some financial futures as gambling arrangements.

The general tendency is clear: Tax and regulatory pressures on the financial system very often lead to unanticipated financial innovations when profit-seeking investors make an end run around the government's restrictions. The constant game of regulatory catch-up sets off another flow of new innovations.

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