Alternatively, a foreign program trader may acquire the domestic stock index in the cash market while selling forward in the offshore OTC index market. On net, he has a zero position in equities but in the balance of payments accounts appears as a portfolio investor in domestic equities. If the opposite positions are taken by a domestic residents—a sale of equities in the cash market and a forward purchase in the derivatives market, the net equity risk position for domestic residents is unchanged, though domestic residents are now in effect short term foreign currency borrowers so.
To the extent that they start with zero replacement values as in the case of swaps and forwards, derivative products do not affect measured net capital inflows or outflows but they blur the information in sub-categories of the capital accounts. Specifically, they make a mockery of the use of capital account categories to attempt to measure the aggregate short foreign currency position of an economy.
From the explosion in the use of derivative products has emerged a blind spot in both national and international surveillance of capital markets. Through derivatives both individual institutions and financial systems can be put at risk in magnitudes and from directions completely unknown to regulators. This problem arises because derivatives are ideal means of avoiding prudential regulations, given the universally slow adjustment of accounting principles to the advent of these products. On a more parochial level, the accounting principles on which the balance of payments data gathering exercise is based have are being made increasingly obsolete. For each country, the extent of the problem is unknown because comprehensive data on derivatives are gathered only at long intervals, and even the triennial BIS data are not broken down into those relevant for emerging market countries.
The optical illusion created by viewing the flow of capital only through the on-balance sheet lens creates a dangerous potential for misinterpreting the implications of major events in capital markets. The information conveyed by the balance of payments accounts on the riskiness of the national balance sheet is confounded, so the susceptibility of an economy to capital flow reversals cannot be known. When capital flows suddenly reverse, it is difficult to know which players are driving the flows and therefore to determine the appropriate short and long term policy response.
This paper has provided several examples to illustrate how readily the existence of derivative products can change the meaning of capital flow data, how the derivatives may automatically generate liquidity demands in response to triggering events in financial markets, and how easy it is to attribute such responses to structural flaws elsewhere in the financial system.