CVA, fraud and settlement risk

CVA, fraud and settlement risk

CVA guessing game tires Europe’s banks

DEXIA faces fraud charges over ‘hidden costs’ in swaps deal

SETTLEMENT RISK hasn’t gone away


COMMENTARY: Long memories

The initial swap lasted only a year – the hangover has been a lot longer. In 2002, the small Italian city of Prato embarked on a series of rate swaps with Dexia aimed at reducing the fixed-rate interest payment bill on some of its €177 million ($190 million) total debt.

As with so many other articles on that include the phrases ‘municipal debt’ and ‘derivatives transaction’, this story does not have a happy ending. Dexia and one of its former employees are now facing charges of aggravated fraud, with the verdict due in the Prato Criminal Court later this month. Unlike many previous municipal-derivatives cases, this doesn’t revolve around wiping out losses from a mis-sold swap – though the final swap in the series did end up significantly out of the money after the financial crisis intervened. Instead, the city argues the swaps included charges that were not made clear to the city’s treasurer at the time of purchase.

The trial could go either way – an earlier case in the High Court in London ruled that Prato was a retail investor, and that the hidden charges were therefore unfair, though Dexia is appealing. But on the other hand, an earlier similar case involving the city of Milan, also (like the Prato case) seen as a possible gateway for dozens of others to follow, was overturned on appeal in 2014 after an initial success for the city.

The Prato case doesn’t have the scale of the Metro do Porto case, in which an interest rate swap called “a contender for the worst deal of all time” ended up with its counterparty, a Portuguese local rail utility, €459 million out of the money (impressive work for a deal with an €89 million notional). But it is the latest in a long series of cases in both Europe and the US in which major banks were, at best, aggressively short-term in pushing their (often overconfident and inexperienced) public-sector customers into transactions that did not work out well. 

It’s not just that the banks seemed to regard a sale this month as far more important than a possible customer loss, or the loss of a customer, in five years’ time – though this sort of focus on short-term sales above all has been behind many other massive losses, including the immensely costly payment protection insurance scandal in the UK. It’s also that the banks seem to have taken far too constrained a view of their potential liabilities under the derivatives deals, and ignored the possibility of reputational damage and litigation costs once one of their less-sophisticated counterparties takes a loss and hauls them into court.

Many banks made the same mistake back in 2008, when they belatedly realised that in practice there was no such thing as an off-balance-sheet vehicle if letting it fail would harm the parent bank’s reputation. Perhaps, in the years since the crisis, they’ve learned better; we’ll find out sooner or later.



The four largest derivatives central counterparties hold a total of $171 billion in initial margin for over-the-counter trades, and $191 billion for their exchange-traded derivatives business



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