CPC ordered to pay over hedging deals – They did ‘what’?

Saturday, 16 July 2011 00:00 -     - {{hitsCtrl.values.hits}}

This ‘poli-socionomic’ dialogue

It was Shatner (playing Capt. Kirk of the Star Ship ‘Enterprise’) who ventured “where no man has gone before”. In proposing various subjects under this theme of discussion, similar feelings arise, particularly where it will hit or worse, boomerang!

It is an ‘unknown word’ coined specifically for this series of discussions.

‘Social-Economics’ is a discipline studying the reciprocal relationship between ‘economics’ on the one hand and sociological pursuits like philosophy and ethics (broader political sciences) on the other, aimed at social reconstruction and improvement.

Of these two disciplines, admitting my lesser knowledge of the former and a relative plus of the latter, I thought of placing some everyday issues that we hear on a “political-socio-economic” lab table and analysing them under this hybrid theme of ‘poli-socionomics’; aimed at (hopefully) the realisation of some good for some of us at least, if not greater good for more of us!

Thus dictated by conscience this series of writings will come your way periodically, dealing with various ‘poli-socionomic issues,’ published (if some like-minded editor would do so) and if not; via the cost-effective medium of electronic mail and my address book.

My usual disclaimer precedes, that you may read, delete, agree, disagree, comment or criticise as your free-will moves you; all of which you are constitutionally entitled to do as ‘free citizens’ of this ‘Democratic Republic’.

Brief abstract

When newspaper headlines carry such titles, naturally every conversation countrywide centres round it, which therefore made it an obvious choice for our first ‘poli-socionomic dialogue’.

Around October 2008 Sri Lanka experienced a controversial ‘policy decision’ leading to a divergence of opinion between its Organs of Government; the Executive and the Judiciary with implications on the Legislature.

The sovereign power of this Republic being reposed ultimately in the citizen, with these organs only being its ‘temporary custodians in trust,’ some of us went to Court and pleaded so on behalf of some of those citizens; and this article discusses some aspects of the issue, from the perspective of that citizen who is said to hold the sovereign power of this great nation.

CPC’s public importance

The Ceylon Petroleum Corporation (CPC) is constantly the subject of many discussions, since understandably its actions have a direct correlation to our everyday lives one way or another; be it the fuel we pump into our vehicles (with or without water), the liquid petroleum gas that lights up our dinner, the electricity that is primarily generated by fuel-run turbines or even the simple case of citizens ‘Bandara, Silva or Sinnadurai’ (as the case maybe) who purchase that one pint of kerosene oil to light up their solitary kuppi lampuwa in order that their kids may read their lessons.

However the term ‘hedging’ may not be such common jargon for everyone; what the dickens is it, what have they gone and done, how exactly will that cause losses to state coffers are just some of the questions I’ve heard from several quarters. It may be useful therefore to share a few thoughts on this first, at least for a basic elucidation of ‘derivatives’ or commonly used hedging mechanisms, particularly in the larger financial capitals.

As I’ve not been privy to the specific contract terms upon which CPC engaged in these deals, nor those that have now been interpreted by a court of law in favour of the banker, I will refer to the subject generally.

The term ‘derivative’ and ‘hedging’ have also been used loosely and interchangeably although technically, as for instance where a contract based upon the future delivery of a product is discussed, the term ‘derivative’ is not generally used since it is more a ‘financial contract’ with ‘actual delivery’ envisaged; a ‘derivative’ technically does not contemplate such ‘physical delivery’.

Also most references may be to UK and US practices, as for instance the references to documents like ISDA (International Swaps and Derivatives Association), since these are what I am familiar with mostly; I am unaware of any similar regime dealing particularly with the derivatives market domestically.

What are derivatives?

A basic insight and definition can be drawn by reference to some of their common features:

nDerivatives are commonly used to protect against (or ‘hedge’) a risk;

nThey are financial instruments/transactions, usually a bilateral contract/payment exchange mechanism ‘deriving’ (as the name implies) its value from an underlying asset, rate or index;

nIt is used to ‘hedge’ against market risks such as interest rate volatility in the financial markets or as in our case, oil price fluctuation

nThese risks are generally economic (such as commodity prices) but legal issues may also form the basis of a derivatives

nThe ‘reference asset’ is the source from which the derivative derives its existence and usually precedes the name, such as a ‘security derivative’

nThe derivatives market usually comprises of:

=Those seeking to hedge an underlying risk (e.g. Sri Lanka or the CPC)

=Those trading in derivatives (bank or other financial institution), and

=the speculators who deal in them with a view to gaining a profit (could be individuals, corporate entities and various others)

The theory, though not this simple in operation, could perhaps be explained at a basic level through a few illustrations:

Illustration (i)

A person contemplating on borrowing some funds in six months time (in the future) but fearful of prevalent economic trends or interbank lending rate fluctuations, may wish to ‘fix his interest rate’ now at some figure that he would like to borrow against six months hence, and to do that would use an instrument referred to as a ‘swap’ or an ‘option’ to lock that interest rate.

Illustration (ii)

A producer who expects his product to be ready for sale in six months but fearful of market volatility or speculating a drop in price, may wish to secure a fixed market price now and thus enter what is referred to as a ‘futures contract’. Now this is technically a ‘financial contract’ and not a ‘derivative’ per se, since physical delivery of an item is actually intended; however the principle of operation remains the same.

The ISDA recognises several kinds of derivatives, which may loosely be categorised as (a) exchange traded futures and options (those traded in exchanges such as the LSE) or OTC (over the counter risk solving derivatives). To get a rough idea on how these derivatives operate, let us note some quickly discernible criteria of some OTCs.

Interest rate swap

If company X can only borrow at a floating rate of LIBOR (London Inter Bank Offer Rate) + 0.75% and at a fixed rate of 8% interest and if Company Y has better credit ratings (borrowing ability is dependent on your ‘credit rating’) could borrow at LIBOR +0.5%, and fixed at 7.25%, then X & Y could enter what is referred to as a ‘swap’ whereby ‘Y’ would end up paying ‘X’ only LIBOR + 0.25%, gaining a benefit of 0.25%

Equity swaps

There is no exchange of principal but of cash flows, at least one of which is determined by reference to performance of a particular stock or more frequently a stock index like the FTSE. An investor requiring urgent cash flow, but not wishing to realise some stock for it (say due to market commissions or possible taxations) may wish, alternatively, to enter into a ‘swap on his equity’.

If his stocks mirrored the FTSE, then he would guarantee either the stock (at a price) or the FTSE fluctuation for six months, in return for a six months guarantee on the LIBOR, which would allow him to borrow the money he needs without actually disposing of his stock, at the same time not exposing himself to a risk on interest rate.

Similarly an investor in the Sri Lankan stock market wishing to move his business to UK could, technically, without going through the process of selling stock here and buying it there, enter into ‘a swap’ for the change in the FTSE index for a change in the equivalent Sri Lankan index.

Commodity swaps

Having thus gained a basic idea of hedging mechanisms, let us now turn to commodities dealing of oil. They follow the same pattern of other swaps, a series of payments based on the price of a commodity.

The CPC could insulate itself against a continuously rising fuel cost by entering into a swap, where it would agree with a dealer on a ‘fixed rate,’ thus whilst actually receiving or paying on the ‘spot rate’ (or prevailing price), if prices go up it would ultimately regain that difference between the ‘spot rate’ and the ‘fixed rate’.

Although in the case of many other swaps the price is fixed to a given date, it is common for commodities such as oil for the prices to be fixed by reference to an average over a period of time; thereby alleviating room for sudden upward or downward fluctuations that may be unrealistic on the longer scale.

The concepts could perhaps be illustrated as shown in table 1.

Could CPC have ‘hedged’ against its own ‘hedging risks’?

Now since we all have a basic idea on what happened since CPC entered the hedging deal, that although it expected the oil prices to keep rising but they in fact dropped, let us for a moment ponder on whether it could have ‘hedged’ against that scenario.

Let me use the above example to illustrate this. You ‘hedge’ the risk (though some dealer-bank) at the present time of having to pay more in the future by an upward price fluctuation, by agreeing to some rate (be it at FPI or fixed rate), thus if things go as per your speculation then you gain by what you have provided for.

However as we are well aware (particularly in this paradise isle of ours) things don’t always seem to go right, do they? After all, hedging is also considered by some to mirror gambling, it is taking on a ‘calculated risk’ at most; some countries they bring it under ‘speculative dealing/trading’ and at times attract ‘anti gambling/gaming regulations’ due to its very nature based on speculative gain (or loss to another). The bottom line is that these are funds invested based on ‘speculation’.

There is a connected matter (which I shall deal with in passing, saving it perhaps for a future dialogue for more in depth discussion) as to whether we, the Sri Lankan citizen can be said to have granted the CPC such authority to enter ‘speculative dealing’ with our monies? Citizens ‘Bandara, Silva or Sinnadurai’ might actually equate it in common village parlance to a ‘suuduwa’ (gamble), and they may not be far wrong.

Hedging is a highly technical ‘playing field’ and in the larger commercial capitals, only professionals with expertise on it enter it; and even they get it wrong sometimes. Like marriage, it must not be entered into ‘lightly’ or with ‘little knowledge’ as hedging does not completely remove a risk of what you fear, it will at most only even things out; that too only if things go according to ‘your speculation’; but what if it doesn’t?

The derivatives market itself has come up with certain solutions allowing its players to negate this ‘speculative element’ as much as possible. Speaking generally, the ISDA Master Document provides its own ‘Risk Reduction Methodology’ for financial derivatives, for events such as counterparty bankruptcy or your own insolvency; and advocates concepts such as ‘termination netting’ or ‘close out netting’.

There is also provision to provide for ‘termination events’ or ‘early termination’ in the contract itself, where in certain circumstances the derivatives contract stands terminated, and the rights and obligations as at such date is settled, set off or netted. In particular to commodity trading (such as oil) similar methodologies are available.

(The author is a practitioner in Sri Lanka. He obtained a Master’s Degree in Laws (Hons) from King’s College and was thereafter granted conversion to the UK Bar. He also holds a Bachelor’s Degree in Political Science, Int. Relations & Journalism from the University of Colombo and a Postgraduate Diploma (Hons) in Int. Relations, Political Science & Conflict Resolution from the BCIS. He is a life member of the Bar Association of SL (BASL), a member of the International Bar Association (IBA) & the Association of Sri Lankan Lawyers UK (ASLLUK). He was awarded ‘The Outstanding Young Person’ (TOYP) in 2008 in the Legal Category. He may be contacted on chrishmalw@gmail.com for any clarification on his writings.)

As I am unsure as to whether such things were discussed by CPC with its dealers or what advice it obtained beforehand, I do not wish to be an armchair critic and pontificate on the subject; but simply note down a few methods by which the risks inherent in such derivatives can be minimised:

Forwards and options

If someone anticipates a need to purchase in the future and wishes to hedge against any depreciation, he may enter into a ‘forwards’ agreement, this will oblige him to purchase at a particular rate but not avail him the benefit of any appreciation in the intervening period.

In contrast however if he were to enter into an ‘option,’ that would allow him to purchase if he still needs to, but for whatever reason (such as market depreciation) he is disinclined to do so, then he can exercise his ‘option’ not to do so.

For this added flexibility in this type of hedging, you are usually charged a premium by whoever underwrites that option, but it is still better than losing more at the end. There are several hybrids of this type of hedging referred to by some wonderfully imaginative terminology such as ‘put options,’ its converse the ‘call option,’ ‘knock in’ or ‘knock out,’ etc., which possibly may be a digression of our present theme to discuss.

Caps, floors and collars

A ‘cap’ is where in the event the index (commodity price) exceeds a specified limit, the dealer will only have to pay that difference between that ‘capped amount’ pre-designated and the actual rate; as at a predetermined day when the derivative is deemed to materialise.

A ‘floor’ is the converse of the above, to provide for that commodity index falling below a specified amount, such as providing for oil prices making a downward fluctuation beyond that predetermined price. In laymen terms, you obtain professional advice as to what you would estimate the price to fall at its lowest and name that as your ‘floor’ rate.

These two can also be used together and is referred to as a ‘collar,’ which is a combination of the ‘cap’ and the ‘floor’. We can hedge against the oil prices moving upwards beyond what we perceived as an unmanageable amount for us and also hedge against the risk of it falling below our estimates; thus not allowing ourselves to be placed in a situation where we would end up losing our advantage of the hedging itself and not having to pay the difference between a steep fall; as we seem to be in a situation now.

What can ‘Citizen Me’ do other than just watching?

This is that ‘passing question,’ which I shall deal with briefly. If indeed there has been some financial mismanagement or failure to adopt sufficient safeguards in Government spending or it is felt that such ‘speculative dealing’ should not have been ventured into at all by our elected representatives and their appointed State organ, do our citizens Silva, Bandara or Sinnadurai have any control over such spending?

Is there a way in which we can hold them accountable in the interim, until such time democracy prevails and they get an opportunity to vote them out? Can one question such spending before courts of law? What is the rationale behind it? I daresay this article would be complete without at least a passing reference to these questions.

There has always been a ‘policy argument’ of Constitutional impropriety based on the principle of separation of powers – that courts must not adjudicate upon the merits or demerits of policy; which ideally must be left in the hands of those elected for that purpose (the executive and legislature).

However an equally cogent but contrary argument lies that the citizen has specifically vested all powers of adjudication in the judiciary of a country, which is not limited to disputes between private individuals but also includes the acts of the State; however the argument not in favour of judges (and courts) evaluating upon policy can be summarised in ‘Quis custodiet ipsos custodes’ – who is then going to judge that judgment?

Traditionally particularly the English Administrative Courts have maintained that unless based on accepted grounds of review such as illegality, irrationality and procedural error, other ‘policy issues’ will generally remain a ‘no go area’ for courts and judges; however latterly the law on its own, based (I sincerely believe) on the need of the hour, has found timely ways of counteracting attempts by governments to immunise themselves against review by shrouding behind this very ‘policy argument’; primarily through the advent of some innovative approaches in ‘Public Interest Litigation’ (PIL), where traditional levels of locus standi are not evaluated as rigorously, allowing even reasonably affected citizens to bring ‘public matters’ before courts exercising administrative jurisdiction over public authorities. However this is the subject of a future discussion!

(The author is a practitioner in Sri Lanka. He obtained a Master’s Degree in Laws (Hons) from King’s College and was thereafter granted conversion to the UK Bar. He also holds a Bachelor’s Degree in Political Science, Int. Relations & Journalism from the University of Colombo and a Postgraduate Diploma (Hons) in Int. Relations, Political Science & Conflict Resolution from the BCIS. He is a life member of the Bar Association of SL (BASL), a member of the International Bar Association (IBA) & the Association of Sri Lankan Lawyers UK (ASLLUK). He was awarded ‘The Outstanding Young Person’ (TOYP) in 2008 in the Legal Category. He may be contacted on chrishmalw@gmail.com for any clarification on his writings.)

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