Accounting road-block

Twenty-five years after it all started, the over-the-counter derivatives market remains the most innovative and fastest-growing business in financial services.

The size of the industry is easily quantified. The Bank for International Settlements estimates that derivatives notional outstanding hit $220 trillion last year.

While this impressive number catches the headlines in the mainstream press – not always for the best of reasons – what’s really important is the fundamental impact the derivatives market has had on companies, insurers, asset managers and banks – and even individuals. Not to mention the benefits derivatives have brought in terms of improved financial stability, if you believe Federal Reserve chairman Alan Greenspan.

The vast array of mass customised mortgage products available on the market would not exist without derivatives innovation (see Ron Dembo’s column on page 58). Equally, the lay-off of credit portfolio risk through derivatives instruments allows banks to better fulfil their main public service: to lend money to spur economic growth.

Getting to this stage has not been easy. Along the way, a number of scandals have threatened to derail the unregulated derivatives juggernaut. Indeed, in the mid-1990s only the efforts of a small number of leading market practitioners blocked efforts by politicians to stifle market development by imposing onerous regulation. Efforts to draft self-regulating guidelines through the G-30 report in 1994 proved a critical foil to pressure from regulators. Would there be a credit derivatives market today, had these efforts failed?

But a new breed of bureaucrats has emerged that threatens the lifeblood of the OTC market. They come in the form of accounting standards setters. In the main, these senior accountants are trying to protect shareholders from some of the extremes of Enron-style bad practice that sometimes takes place in the market. But new accounting standards are materially weakening the ability of honest company executives to best manage their business.

Our cover story on page 38 looks at the concerns of leading loan portfolio managers at banks around the world. They say accounting rules are hampering their ability to hedge exposures. Meanwhile, a contribution by RBS Group’s Stanley Myint highlights some of the accounting problems faced by corporates – something that’s an increasing concern, particularly in Europe.

The good news, as our cover story unveils, is that the message seems to be getting through – at least to some of the US accounting standards setters. But this momentum must continue, especially in Europe. Former Federal Reserve chairman Paul Volcker once highlighted how easily instruments designed for hedging could become instruments for speculation. But the accounting standards setters have taken this message a step too far.