Information asymmetry

Editor's letter

As corporate derivatives litigation activity intensifies in the region, with cases flaring up from India through to South Korea, a number of common themes are starting to emerge. Perhaps the most striking is the expectation that hedging, which is designed to act as a form of insurance, comes for free.

This conceptual flaw lies at the heart of the problem with many trades that were put on to hedge against, say, the further appreciation of a home currency against the US dollar or the price rise of commodity inputs such as energy or metals. Instead of just paying a premium to cover the cost of insurance against a possible unfavourable currency or commodity price move, corporations decided they could do trades far more cheaply by taking on another risky position where they would receive a guaranteed premium but may need to pay out should the position work out against them - they effectively offered hedges to banks.

Many of the region's airlines, shipping companies and exporters put on these trades. Some companies are now trying to extricate themselves from these costly contracts by claiming they did not fully understand what they were signing up to. Bankers, meanwhile, claim companies must have known that nothing comes for free.

Clearly there are issues regarding information asymmetry. Can a mid-sized corporate really understand exotic options positions as well as a major dealer? For a start, the corporate is unlikely to have access to anything like the amount of flow information available to a bank. The term 'buyer beware' also takes on a new meaning when, as our cover story mentions, some Korean corporates claim they didn't even understand the word 'buyer' in English in their knock-in, knock-out derivatives agreements. Are risks really being passed to the people that are best placed to manage them?

Despite the occasional scare in places such as South Korea, dealers have the odds stacked firmly in their favour from a legal perspective. Even savvy, native English-speaking hedge fund managers whose trading abilities are arguably better than many bank counterparts were caught out by standardised legal documents in September last year when Lehman Brothers went bankrupt.

Being legally in the right, however, is not the same as being ethically correct. While some dealers deserve credit for refusing business to clients that fail to meet rigorous suitability tests, these institutions can't force such practices on their peers. And this ultimately undermines all efforts to promote self-regulation.

Christopher Jeffery.