5.5. USING FORWARD CONTRACTS (4): MINIMIZING THE IMPACT OF MARKET
IMPERFECTIONS 205
are not mentioned at all.
The termsecurityis not used.If the contract involves private firms rather than
two central banks, the firm’s shareholders need not be explicitly informed about the
implicit right-of-offset clause in a swap because a forward contract is not even in
the balance sheet (see below). In contrast, if there had been two loans, the financial
statements would have had to contain explicit warnings about the mutual-security
clause.^14 In some countries, the clause must even be officially registered with the
commercial court or so. Providing security may also be contractually forbidden if
the company has already issued bonds or taken up loans with the status ofsenior
bonds or loans: giving new security would then weaken the position of the existing
senior claimants. Bond covenants may also restrict the firm’s ability to provide
new security. All these problems are avoided by choosing the swap version of the
contract.
The termInterest is not used.Similarly, also the word interest is never men-
tioned in a swap contract; there is only an implied capital gain. This can be useful
for tax purposes, as we saw before. In the example below, the reason is religious
objections against interest.
Example 5.31
In the Middle Ages, the Catholic Church prohibited the payment of interest; swap-
like contracts were used to disguise loans. Eldridge and Maltby (1991) describe a
three-year forward sale for wool, signed in 1276 between the Cistercian Abbey of St.
Mary of the Fountains (N-England) and a Florentine merchant. The big “margin”
deposited by the merchant was, in fact, a disguised loan to the Abbey, serviced by
the deliveries of wool later on. The forward prices were not stated explicitly, because
the implied interest would have been made too easy to spot.
The termloanordepositis not used.A parallel loan would have shown up on
both the asset and liability sides of the balance sheet. In contrast, a forward deal
is off-balance-sheet.^15 This has several advantages: (i) it does not inflate debt, so
it leaves unaffected the debt/equity ratio or other measures of leverage; (ii) it does
not inflate total assets, so it leaves unaffected the profit/total-assets ratio. Under
the oldBISrules (“Basel I”), capital requirements on swaps were less exacting than
those on separate loans and deposits (see box in Figure 5.11).
(^14) Anybody involved with the firm has the right to know what assets have been pledged as security:
this would mean that the firm’s asset are of no use to the ordinary claimant if and when the firm
defaults on its obligations.
(^15) This accounting rule is not unreasonable. There is indeed a difference between a swap and two
separate contracts (one asset and one liability). In the case of the swap, default on the liability
wipes out the asset. For that reason, accountants think it would be misleading to show the swap
contract as if it consisted of a standard separate asset and liability. The inconsistency is, however,
that once an asset has been pledged as security, it remains on the balance sheetexceptfor forwards,
futures, swaps etc.