The Corporate Derivatives Slander? Or The Big Derivative Secret?

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Despite what Glenn Beck’s chalkboard says, George Soros is one of the world’s most successful capitalists, and a major advocate for more regulated markets. Today, in the Financial Times, he repeats a claim that I have been hearing a lot lately, without much substantiation.

The five big banks which serve as marketmakers and account for over 95 per cent of the US’s outstanding over-the-counter transactions are likely to oppose it because it would hit their profits. It is more puzzling that some multinational corporations are also opposed. The only explanation is that tailor-made derivatives can facilitate tax avoidance and manipulation of earnings. These considerations ought not to influence the legislation.

That seems like a rather explosive claim, and it is not the first time I have heard it. At a press conference Tuesday with Maria Cantwell, one of the speakers hinted that the so-called “end-users” who are seeking further exemptions from derivatives regulation might have these same less-than-honorable motivations. In recent weeks, the Wall Street Journal has reported on big banks use of the repo market to hide its debts whenever they need to report to investors. Could it be that large non-financial corporations want to keep the derivatives market in the dark because they use derivatives to deceive investors or the IRS? And if so, who is doing this?

I don’t know a way to answer that question right now, though hopefully the SEC is looking into it. In January, the New York Times reported on one way derivatives could be used to dodge tax payments–by allowing banks to buy synthetic things that behave like stocks but are not taxed like stocks. The practice of buying or selling derivatives to hedge earnings volatility is also well known within the industry, and also not necessarily malicious. After all, this is essentially what airlines are doing when they buy hedges on the prices of jet fuel to protect their bottom line. But what happens when that behavior crosses a hard-to-define line from smart investing to non-transparent manipulation?

How would this work? Well, we can look at Greece for a sense. In that case, Goldman Sachs helped the company conceal its debt by selling currency derivatives to the country. NPR explains how it worked:

The allegations involve what are called cross-currency derivatives sold to the Greek government nearly a decade ago. At the time, Greece was lobbying to get into the European Union. The derivatives sold by Goldman helped Greece conceal the extent of its debt from EU regulators and investors by taking it off the government’s books. Tim Backshall, chief strategist at Credit Derivatives Research, says these transactions aren’t illegal, but they are not usually used by sovereign governments, and the fact that they were has helped undermine the market’s confidence in Greece.

The Federal Reserve is now investigating the Greece deals. It is unclear how many similar deals might have been structured for large corporations. But the fact that Soros is laying out the claim so baldly in the Financial Times is sure to raise eyebrows.