INTERNATIONAL CAPITAL: Circumventing Prudential Regulations and Capital Controls 2

Posted by Connie R. Aponte on July 30, 2014 in INTERNATIONAL CAPITAL |

Structured Notes

As shown earlier, structured notes are investment vehicles with coupon payments and principal repayments driven by formulas that can leverage the initial capital invested. Nevertheless, in value accounting systems they can be booked as normal investments and in the currency denominated in the prospectus. More than simply magnifying the usual market risks associated with investment positions, structured notes provide an easy method for circumventing prudential regulations on currency positions or interest rate mismatches further

In the context of the last section’s example, booked as claims of Mexican institutions with dollar principal and dollar payoffs, these notes in fact were currency bets that created a short dollar and long peso currency position to take advantage of positive interest rate spreads between peso and dollar money markets.13 The notes were reported by Mexican banks as dollar assets, allowing them to offset short dollar positions in meeting regulatory limits on net foreign currency positions. In addition, some banks could count it to satisfy their liquidity coefficient required for foreign currency denominated liabilities because its short maturity allowed it to be classified as a liquid deposit. In the event of a depreciation of the currency, banks might have a much larger net short dollar position and greater losses than regulators had realized.

Held in this way, the structured note of the example is a financial engineering device to circumvent prudential regulation. Only the principal was booked, in accordance with value accounting principles. The structured note payoff formula component was not booked-it is an off balance sheet item. That is the accounting trick-one can alter the nature of the booking through a complicated payoff formula. The use of the trick, however, requires an outflow of capital in the form of principal. Thus, a net inflow of $20 million takes the form of a gross outflow of $10 million and a gross inflow of $30 million.

Equity Swaps

As a means of taking a position in stocks, the market in equity swaps can be used to avoid financial market regulations against such positions. Such regulations may ban buying securities on margin or short selling or limit the share positions of foreign addresses.

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