Business Ethics and Financial Derivatives
|Author: Mark Miceli-Farrugia|
|Last Edited: 4 years ago|
BUSINESS ETHICS AND FINANCIAL DERIVATIVES
The Significance on Main Street of Business Ethics and Financial Derivatives
In early 2009, during my diplomatic tenure in Washington DC, my wife and I were confronted with a humanitarian problem relating to an Embassy employee. The Embassy’s gardener ‘Singh’ had became homeless. His credit cards had been called-in and, since he could not meet his home-loan repayment programme, his house was foreclosed.
Yet it should have been obvious to the realtors who sold him his home and to the bank that funded his loan that Singh would never meet his mortgage repayment programme. In purchasing his new home, Singh bound himself to a monthly repayment of US$2,300, when his monthly salary only amounted to US$1,700. Logical thinking and business ethics would normally have flagged the discrepancy. After all, Singh was also expected to feed and clothe his family from his monthly salary.*
This notwithstanding, both realtor and lending bank remained unfazed. The realtor earned his commission and proceeded to complete his next sale. The lending banks sold-on the interest-only mortgage to the security-insurer Federal National Mortgage Association (FNMA a.k.a. Fannie Mae). Fannie Mae, in turn, resold the mortgage in a package of other interest-only mortgages on the secondary market, and so on.
All proceeded fine until July 2008 when the subprime mortgage crisis overwhelmed Fannie Mae’s ability to guarantee all those bad loans. The banks called in their loans and poor Singh and millions of badly mortgaged fellows throughout the US faced foreclosure and destitution!
* When, 30 years earlier, my wife and I had purchased a house in Canada, our bank would only offer a repayment programme based on no more than one-third of our combined salaries!
What is Business Ethics?
Business ethics is a set of corporate values and codes of principles, which may be written or unwritten, by which a company evaluates its actions and business-related decisions. (1) As a rule, Companies pursue accepted business ethics in order to gain public acceptance (2) and are often guided in their activities by law.
What is a Contract on Financial Derivatives?
A contract on financial derivatives is a complex and often risky financial contract between two parties to buy or sell an asset or item (commodity, property, security) at a fixed price on or before a certain date. (3) The contract is intended to minimize the future risk for one party by blocking a fixed interest payment, while offering a potentially higher, albeit riskier, future return to another party at a variable return. (4) A contract on financial derivatives may either be traded on an exchange or over-the-counter (OTC).
There are four main types of contract on financial derivatives (5), each offering peculiar attributes and risks:
- Futures: A Futures contract is an agreement to buy or sell a specified quantity of something at a set rate at a predetermined point in the future. Futures can be traded only on exchanges.
- Forwards: A Forward contract is a commitment to trade a specified item at a predetermined time in the future. Forwards can be traded between two individuals in whatever form is agreed between the parties concerned.
- Options: An Option is a less binding form of Derivative. It conveys a right, but not the obligation, to buy or sell a particular asset in the future.
- A Call Option gives the investor the right to buy a particular asset at a set price on delivery day.
- A Put Option gives the investor the option to sell a particular asset at a set price on the settlement date.
- Swaps: A Swap occurs when two parties agree to exchange one stream of cash flows against another one. Swaps can be used either to hedge risks by swapping a variable interest loan with a fixed interest loan or to speculate on the changing prices of commodities or currencies by swapping a fixed interest rate for a variable one.
1.0 What are the Ethical Risks associated with Financial Derivatives?
The ethical risks associated with financial derivatives result from:
1.1 The failure of investment managers and traders to explain to investors – especially small and inexperienced investors - the inherent complexity and risks associated with financial derivatives – especially the highly risky credit default swaps;
1.2 The rapaciousness of investment managers or traders, who become so enrapt by the profitable commission on the sale of financial derivatives that they inflate the attractiveness of investing in such financial instruments without highlighting to investors the real financial risks; and
1.3 The avidity of certain trading companies who entrust defective financial derivative products for sale by traders without providing due diligence as to the level of risk.
Why are Ethical Risks so High in the Case of Financial Derivatives?
In view of the complexity of financial instruments like derivatives, the intermediate broker (investment manager or trader) should clarify the risks involved in investing in them.
The intermediary is therefore duty-bound to explain and record the following:
- The conditions included in the financial contract which specify dates, resulting values, and definitions of the underlying assets, the parties’ contractual obligations, and the notional amount.
- The value and relative risk between the assets underlying the contract, including commodities, stocks, bonds, interest rates and currencies.
2.0 What is the difference between making a bad business decision associated with derivatives and engaging in unethical conduct using derivatives?
The first is a self-determined, albeit unintended, risk of doing business in a free market economy. Owing to the intrinsically risky nature of financial derivatives, it is always possible for a party to make a bad investment decision.
The second is a heightening of business risk due to misleading, unethical behavior by third parties. In such an instance, investment managers and traders exploit the trust and wellbeing of investors by embarking in above-described behaviours 1.1 – 1.3 out of personal self-interest.
3.0 What kinds of investment decisions drove Barings Bank, UBS, Bear Stearns, and Lehman Brothers to financial disasters?
Each of these financial disasters might have been avoided had the American financial sector then been inspired by stronger principles of business ethics and governed by more effective oversight. (6)
Barings Bank: The Barings Bank disaster was brought about by reckless trading on the futures market by a bank employee with the collusion of complacent superiors at the bank.
In the 1980s, Barings Bank’s Futures Trader Nick Leeson bet on small differences between contracts by buying and selling futures simultaneously on two different stock exchanges. The key to Leeson’s strategy was the knowledge that the Tokyo market was slower in processing trades than was Singapore’s, thus profitting from small discrepancies on large tradings. Although risky, this strategy can be highly profitable in stable markets. However, when Tokyo’s stock exchange plummeted following the Kobe earthquake, Leeson lost a lot of money, including $1 billion invested by Barings.
UBS: The UBS disaster was induced by injudicious dependence on unsafe derivatives and mortgage-related securities compounded by fraudulent reporting of client tax returns by bank executives and inordinately lavish executive compensation schemes.
In the late 2000s, UBS came under scrutiny by the US Internal Revenue Service for hiding in offshore accounts $20 billion assets of American clients to avoid the payment of at least $300 million in Federal Taxes. UBS were also accused of advising clients to destroy bank records and of helping clients to file false tax returns. Besides, UBS suffered from the subprime crisis due to heavy dependence on derivatives and mortgage-related securities. When the Swiss government allocated an aid package of $59 billion to the ailing bank, the company’s CEO and top executives were obliged to return some of their excessive compensation.
Bear Stearns: The Bear Stearns disaster was caused by the bank’s excessive dependence on unsound derivatives and mortgage securities, and was compounded by misrepresentation of these derivative packages and of clients’ loan application forms.
In 2008, Bear Stearns was acquired by JP Morgan after it lost $1.6 billion in derivatives and $1.2 billion in mortgage securities. It has been suggested that Bear Stearns widely misrepresented clients’ information on loan applications to make them appear more desirable mortgage recipients. Besides, the company was found to have packaged and sold unsafe debt as securities to other institutions. Two senior executives face criminal charges for misleading investors by concealing that hedge funds were failing as the mortgage market crumbled.
Lehman Brothers: The Lehman Brothers disaster was provoked by undue dependence on and sale of risky subprime mortgages and credit default swaps (CDSs) and was aggravated by unjustifiable executive bonuses.
In 2008, Lehman Brothers filed for bankruptcy with $613 billion in debt. To employees’ relief, Barclays plc agreed to purchase much of Lehman Brothers for $1.75 billion. The investment bank had depended too heavily on subprime mortgages. It had helped bundle millions of dollars in mortgages into derivative instruments for First Alliance. It had also acquired several very risky CDSs passing these on to its creditors, including AIG, to hedge against Lehman’s bankruptcy. Following Lehman’s bankruptcy, these investments contributed to the massive financial crisis. As the bankrupt company sought government aid, Lehman Brothers executives continued to pocket millions in dollars in bonuses, causing public outrage.
4.0 How can an ethical corporate culture with adequate internal controls, including ethics and compliance policies, prevent future disasters in financial companies?
- US Initiatives – Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 (6)
The American Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 have legislated investment services guidelines designed:
To promote financial stability by improving accountability and transparency in the financial system;
To protect taxpayers by ending bailouts; and
To protect consumers from abusive financial services practices.
- EU Initiatives – MiFID II 2012 (7), MiFIR 2012 (8), & EMIR 2012 (9)
The EU’s Markets in Financial Instruments Directive (MiFID II 2012) and Markets in Financial Instruments Regulation (MiFIR 2012) developed on earlier American initiatives. However, the 2012 European Market Infrastructure Regulation on derivatives (EMIR) 2012 - introduced new requirements to improve on transparency and reduce the risks specifically associated with the derivatives market. EMIR also established common organizational conduct of business and prudential standards for Central Counterparties (CCPs) and trade repositories. The new regulation requires entities entering into any form of financial derivative contract:
To report every financial derivative contract they enter to a trade repository;
To implement new risk management standards, including operational processes and margining, for all bilateral over–the-counter (OTC) derivatives i.e. trades that are not cleared by a CCP; and
To clear, via a CCP, those OTC derivatives subject to a mandatory clearing obligation.
Nine Voluntary Compliance Elements (10)
Yet it is generally recognized that laws cannot alone ensure ethical business behavior. A professional American body – Global Compliance Services – has identified nine voluntary elements necessary for achieving an effective compliance programme to detect and prevent criminal conduct and promote ethical behavior:
- Establish a Code of Ethics or Conduct: These represent a series of constantly updated, supporting rules that define the good practices expected from stakeholders including officers, employees, contractors, vendors, etc.
- Top-Down Example: The Board and Management should consistently stress and exercise oversight of the companies ethics and compliance programme.
- Education and Training: The organization needs to constantly update its Compliance Officers both about the complexity and the risks involved in the different derivative products but also with the widening standards and laws governing accountability and transparency in the financial sector.
- Outsourced (Anonymous) Hotline: Companies should employ an anonymous hotline or webline that allows employees and other stakeholders to report misconduct, fraud, incidents, and other concerns without fear of retribution.
- Centralized Data Depository: The organization should employ real-time data repository and retrieval system to house allegation reports.
- Data Management System: A reporter should be assigned a case number and security PIN to follow up on allegations and to communicate with organizational investigators during the investigation.
- Investigation and Action: Organizations must ensure timely and accurate investigative actions.
- Ability to Query and Generate Reports: Organizations should systematically collate and analyze data collected from their hotline and case-management system.
- Validation and Background Checks: Background checks on prospective employees should serve to prevent the hiring of persons with a history of unethical behaviour. Validation systems need to be constantly updated.
18th December, 2012
(1) Christine Gruble, Business Ethics Review, 21/06/2011
(2) Laczniak & Murphy, Ethical Marketing Decisions: The Higher Road, 1993, p. 5
(3) Adapted from Fraedrick, J. Ferrell O.C., & Ferrell, L., Ethical Decision-Making for Business, 2011 – Banking Industry Meltdown Case Study.
(4) Fraederick, J. Ferrell, O.C., & Ferrell, L., op.cit. p. 340
(5) Fraederick, J. Ferrell, O.C., & Ferrell, L., op.cit. p. 340
(6) Fraederick, J. Ferrell, O.C., & Ferrell, L., op.cit. pp. 341 - 345
(8) www.aima.org / Markets Regulation
(9) ec.europa.eu / internal Market / Financial Markets Infrastructure