Major changes have taken place in the international financial markets during the past few years. Not only has the volume of international transactions increased sharply, but a plethora of financial instruments has appeared, some of which are now commonplace but barely existed a decade ago.1 For balance of payments compilers, this process of innovation has given rise to problems of how to classify and value transactions in these instruments appropriately and how to surmount the increasing difficulties in collecting data on such transactions. The purpose of this paper is to examine the implications of these developments for the recording and classification of these financial instruments in light of the guidelines recommended in the IMF's current Balance of Payments Manual (BPM).
It would be impractical to examine every new instrument that has recently become available. Therefore, this paper will focus on the characteristics of the most important new financial instruments (Section I) because variations in these characteristics are more likely to differ in form than in substance. Section II details the implications of these characteristics for balance of payments recording. Section III offers some considerations on the extent that the present BPM could be elaborated to increase its usefulness as a guide for the balance of payments compiler in coping with continuing changes in the international financial markets. Finally, Section IV presents some conclusions.
I. Characteristics of Financial Instruments
The most important new financial instruments at present are note issuance facilities, swaps, options and futures, forward rate agreements, Eurobonds of various types, and other bonds. This section provides an overview of the main characteristics of these instruments.
Note Issuance Facilities
A note issuance facility (NIF) is a contractual commitment by a bank or group of banks to fund any notes that a borrower issues in his own name and the bank is unable to sell to a third party. The commitment is typically for five to seven years, during which the participating banks are obliged to purchase the unsold notes or to provide stand-by credits. The notes themselves are short term, with maturities of up to one year. The borrower pays an underwriting fee as long as the facility is not drawn. This facility is in effect a revolving credit, which enables a borrower to obtain financing according to his needs and, at times, favorable to the borrower. The paper issued under these facilities is known as a promissory note or, more commonly, as a Euronote, except where the borrower is a bank. In the latter case, the bank's liability is known as a certificate of deposit. The participating banks obtain the notes at a discount, which the banks themselves can hold or distribute to other investors.
Several techniques have been developed to enhance the attractiveness of the NIF. For instance, under the technique known as the revolving underwriting facility (RUF) a lead manager is solely responsible for placing the notes. This technique is attractive to banks because they are virtually assured of making a profit. Under the tender panel technique, a group of banks join together to bid for any notes that are issued. The underwriters, which are separate from the panel but might include banks participating in the tender panel, then take up any notes not bid for or extend loans for the amounts not bid for. A third technique is known as the multiple component facility. This facility allows the borrower to draw funds in a variety of forms instead of in one form, usually Euro-notes. The choices available include short-term advances, bankers' acceptances, and “swing lines.” Swing lines are facilities for short-term funds that can be drawn at short notice to cover the period between the offer of notes and the receipt of funds.
Increasingly, a number of additional facilities have been arranged that either are not, or are only partly, underwritten. The non-under-written facilities, also known as Eurocommercial paper programs, typically take the form of a general undertaking by banks to place the notes for the borrower, if ever required.
Swaps
Swaps are transactions in which two parties agree to an exchange of a stream of payments over a period of time. The streams of payments subject to the exchange usually are interest payments (interest rate swaps) or include both interest payments and amortization of principal (currency swaps). Currency swaps differ from the swap arrangements undertaken for purposes of monetary or exchange rate policy, in which the sale of one currency is arranged against the sale of another currency with the understanding that the transaction be reversed at a future date.
Interest Rate Swaps
Interest rate swaps involve the exchange of interest payments only; the principal remains unaffected over the entire period of the exchange. The exchange of interest payments could involve the use of different currencies, as well as interest payments calculated at fixed or flexible interest rates. All streams of payments, however, are exchanged according to predetermined rules and are calculated on the basis of an underlying “notional principal” amount. Three main types of swap are distinguished.
Coupon Swaps. Under this arrangement a stream of fixed-rate interest payments is exchanged against a stream of floating-rate interest payments. Both are denominated in the same currency.
Basis Swaps. Under this arrangement, one stream of floating-rate interest payments is exchanged against another stream of different floating-rate interest payments. For example, interest payments based on a Eurodollar London interbank offered rate (LIBOR) are exchanged for interest payments based on the U.S. commercial paper composite rate. No exchange of currencies is involved.
Cross-Currency Interest Rate Swaps. This arrangement involves the exchange of interest payments in different currencies as well as different interest rate bases. In general, this transaction involves the exchange of nondollar interest payments at a fixed rate against dollar payments at a floating rate, but an exchange on the basis of two different floating rates is also possible. Arrangements such as these are usually treated as a single transaction, but separating the transaction into an interest rate component and a cross-currency component also occurs.
Currency Swaps
A currency swap refers to a transaction in which two parties exchange with each other specific amounts of two different currencies at the outset and repay over time according to a predetermined rule. The repayments reflect both interest payments and amortization of principal. In these contracts, fixed interest rates are normally used. In some cases, there is no exchange of principal either initially or at maturity.
Options and Futures
An option can be defined as a contract that provides the purchaser with the right, but not the obligation, to buy or sell a specified amount of an underlying asset at a specified price within a given period. The underlying asset could cover a wide range of items, which might include equities, foreign currencies, interest rate instruments, commodities, and the like. The seller (or writer) has the obligation to complete the transaction if the buyer (or holder) exercises the option. In a typical transaction, the buyer of the option generally pays a premium (the price of the option) to the seller for his commitment to sell or buy the underlying instrument when demanded by the buyer. Options are either listed on an exchange or traded “over the counter” (not traded on organized exchanges). The latter type of trading usually involves negotiations among parties on all details of the transaction or some agreement on certain simplifying market conventions. One can further distinguish the American-style option, which permits the buyer to exercise his right to buy or sell at any time before the expiry date, and the European-style option, which may be exercised only at the expiry date.
Options are divided into two categories: “call” options and “put” options. For instance, under a contract to purchase a foreign currency, a call option provides the buyer with the right to buy an agreed amount of foreign currency at a specified price. The writer thus has the obligation to deliver the foreign currency if a call option is exercised. In contrast, a put option provides the purchaser of the option with the right to sell an agreed amount of foreign currency at a specified price, and the writer is therefore under obligation to take delivery of the foreign currency. The specified price is called the strike price.
In contrast to options, a futures transaction is a contract that provides the buyer with the obligation to take delivery of, and the seller with the obligation to deliver, a specified amount of an underlying asset at a fixed price at a set future date. A futures or forward contract thus entails a binding obligation, irrespective of subsequent changes in prices, exchange rates, and the like. The parties to a futures contract can, however, transfer their obligations to others by trading in the futures market.
Forward Rate Agreements
A forward (future) rate agreement is an agreement between two parties who wish to protect themselves against interest rate movements during a specified period. To this end, both parties agree on an interest rate covering a notional amount of principal. Neither party is committed to lend or borrow this amount of principal. At the end of the agreed period, on the settlement date, only the difference between the agreed interest rate of the agreement and the then current interest rate is paid. If the then current interest rate is higher than the agreed rate, the party wishing to protect itself against a rise in the interest rate, being the buyer of the forward rate agreement, receives payment of the difference from the counterparty. Vice versa, a party wishing to protect itself against a fall in interest rates (the seller of the forward rate agreement) receives payment from the counterparty when the then current interest rate is lower than the agreed rate of interest of the forward rate agreement.
Eurobonds
A Eurobond is an international bond issued and sold through a syndicate of banks or other financial institutions in various national capital markets on behalf of a foreign corporation, a foreign government, or an international agency. These bonds are usually issued as an unsecured obligation of the borrower. As a result, only borrowers of good quality are able to issue such bonds, so that in some cases state enterprises and municipalities require a government guarantee. Six main types of Eurobonds are distinguished.
Straight (Fixed-Rate) Bonds
Straight bonds carry a fixed rate of interest, normally paid annually, with maturities ranging from 3 years to as long as 25 years. Eurobonds with maturities shorter than 5 years are often known as notes.
Floating-Rate Bonds
In response to rising inflation and often volatile rates of interest in the international financial markets, a growing number of Eurobonds have been and are being issued at a variable rate of interest. The rate of interest depends on the conditions in the market and is usually set at some margin over the prevailing LIBOR, depending on the quality of the borrower. This rate applies to a predetermined period (normally six months), with the interest usually payable semiannually. The rate of interest changes when LIBOR changes, but the margin remains the same.
Convertible Eurobonds
Convertible Eurobonds carry a fixed interest rate but are convertible in the sense that they give the holder the right to convert these bonds into equity shares (common stock) of the issuing company. The bonds carry fixed redemption dates, but the conversion right stipulates that bonds may be converted into stock either on a series of given dates or at any time in the future between specified dates. The price at which equity may be purchased through conversion is normally fixed at a premium over the share price prevailing at the time of issue. Convertible bonds are attractive to the borrower because the rates of interest are usually lower than those paid on straight bonds. In addition, the borrower may receive cash for the shares to be issued when the bond holder uses his or her option to convert. Convertible bonds usually specify conversion features in terms of the number of shares into which the bond is convertible.
Eurobonds with Warrants
Eurobonds with warrants are similar to convertible Eurobonds, except that it is not the Eurobond itself but the warrant that can be used to purchase shares of the borrowing company. The warrants are physically separate from the bonds, may be detached from them, and can be traded as securities in their own right. The warrant therefore represents an option to purchase rather than to convert into shares, since additional cash must be advanced if the warrants are exercised. The value of the warrant is usually only a small fraction of the share price but is highly dependent on changes in the share price. In addition, warrants can also be issued independently by a borrower, giving the investor the opportunity to buy a wide range of securities.
Option Eurobonds
Option Eurobonds are essentially straight Eurobonds that provide the bond holder with the option to receive interest or principal (or both) in a currency that differs from that in which the bond is denominated. The rate of exchange at which interest is paid is normally determined by the exchange rate prevailing a few days before interest is due.
Zero-Coupon Bonds
Zero-coupon bonds are bonds on which no interest payments are made during the lifetime of the loan but which are issued at a substantial discount from their par value. The difference between the value at which the bond is issued and the par value is usually considered as income accruing to the investor over the life of the bond. In some countries this income is regarded as a capital gain rather than as regular income. Deep-discounted bonds are similar to zero-coupon bonds except that they carry a very low rate of interest instead of a zero rate of interest.
Other Bonds
In addition to the categories of Eurobonds mentioned above, two other types of bond merit description.
Junk Bonds
Junk bonds are high-yielding bonds that are rated below investment grade. Investment-grade securities are generally rated at or above “Baa” by Moody's Investors Services or “BBB” by Standard & Poor's Corporation. At times, junk bonds have been used as an instrument in corporate takeovers or buy-outs.
Indexed Bonds
Indexed bonds are debt securities, the redemption value or the interest (or both) of which are linked to some price index in order to defend the debt against inflationary depreciation.
II. Classification and Recording of Financial Instruments
The diversity of the financial instruments now available in the international capital markets and the enormous increase in transactions in these instruments has confronted the compiler of balance of payments statistics with two problems: that of classification, and that of obtaining data. Guidelines for the classification of these transactions are clearly needed. This section therefore explores how these instruments fit into the classification system of the present BPM. A detailed discussion of problems encountered in the collection of data for transactions in these instruments would be beyond the scope of the paper. Occasionally, however, suggestions will be made about what type of data should be collected in order to conform to the recommendations in the BPM.
Note Issuance Facilities
For a balance of payments compiler, three aspects of a NIF are of concern: the payment of interest, the payment of fees associated with the operation of the NIF, and the issuance of the notes and their repayment by the borrower. The BPM recommends that fee payments be classified in the account for other goods, services, and income; therefore, the classification of fees associated with the NIF in this account would be appropriate because these payments are made for the service of operating the NIF.
As far as the issuance of the notes and their repayments are concerned, the BPM recommends that entries accounting for these transactions should be recorded in the balance of payments, to reflect actual changes in the assets and liabilities of the transactors. But no entries should be made for the contractual commitments of participating banks. Only when this commitment is called upon and the notes have actually been sold to the banks that have underwritten the NIF, or to other investors, should the transaction be recorded as a balance of payments transaction. The sale of the notes will appear both as a liability in the balance sheet of the borrower and as an asset in the balance sheets of the banks (if held by the banks themselves) or of other investors.
Another important problem associated with the recording of NIFs is the valuation of the notes acquired by the participating banks at a discount. The BPM recommends that, for debt securities (such as bonds and notes) originally issued at a value different from the stated fixed sum received by the holder unconditionally at maturity, the premium or discount should be regarded as negative interest or interest, respectively, rather than as a capital loss or gain. This treatment would seem to be appropriate for notes acquired by banks at the time of issue and held in their own portfolio, but when notes are placed with investors other than the banks that have underwritten the NIF, the difference between what those investors pay and the amount received by the issuer represents a fee earned by the banks.
Finally, because the original term to maturity usually is less than one year and the BPM recommends the classification of securities as portfolio investment only if they have an original contractual maturity of more than one year, it would seem appropriate to classify transactions in these instruments in the category of short-term capital movements.
Swaps
In principle, the classification of swap transactions should pose no problems for a balance of payments compiler. Streams of interest payments should be recorded in the current account, and streams of principal payments in the capital account, irrespective of the currency or the rate of interest at which these flows are paid or recorded. In the case of an interest rate swap, where typically the two interest payments that have been swapped are made on the same day, entries should be made for the flows of interest only. To the extent that the dates do not match, there will presumably be an amount due from one transactor to the other that will entail an entry in the capital account. In the case of a currency swap, where an exchange of both interest and principal takes place, and again assuming that payments are matched, entries should be made for the flows of interest as well as the repayments of principal.
The appropriate entries in the balance of payments also depend on whether the transactor is acting for his or her own account, and making a profit, or acting as an agent, and earning a fee.
The flows between the two parties engaged in a swap agreement do not represent interest payments, but an exchange of capital items and, to the extent the flows are not equal, a payment for a service. Assuming that the capital flows take place at the same time, the capital account entries would net out.
Options
For options, two aspects are important for a balance of payments compiler: the premium to be paid at the signing of the contract and the acquisition of the underlying security, valued at the strike price, if and when an option is exercised.
Because options are marketable, it would seem that trading in options, as well as the payment of the premium for the acquisition of an option, should be recorded in the capital account. But the seller of an option does not incur a financial liability, so an option represents a real, not a financial, asset. Therefore, the acquisition of the option and subsequent trading in the option should be recorded in the current account.
At any rate, if the option is exercised, the purchase of the underlying financial instrument should be entered in the capital account. If commodities instead of a financial instrument are acquired, however, the acquisition of the goods should be entered in the merchandise account.
For the valuation of options, it is recognized that, from the time of the purchase of the option to the date of its exercise, the option represents an asset for the holder. For instance, an investor has purchased an American call option on £10,000 with an exercise price of US$1.20, giving him the right to buy £10,000 at the rate of US$1.20 per £1 anytime between the signing of the contract and the expiration date. If during this period a strengthening of the pound sterling had taken place and the market price of sterling had risen above the exercise price, the holder of the option would have benefited because his option would have increased in value. Even though an option represents an asset that might change in value, the underlying commitment should be viewed as a contingent asset for the purchaser of the option and a contingent liability for the seller, until the option is exercised. Only entries for premium payments, and subsequent trading in the options, would be recorded in the balance of payments, unless and until the options are exercised.
Forward Rate Agreements
Balance of payments entries associated with forward rate agreements are limited to current account transactions only, as principal amounts are never exchanged. However, the recording of the difference between the agreed rate of interest of the forward rate agreement and the prevailing interest rate is a problem. In essence, this difference does not represent interest but is more like an insurance premium or some other service.
The flows in the balance of payments associated with a forward rate agreement are illustrated in the following example. Suppose a bank commits itself to extend a 9 percent loan to be drawn sometime in the future. It covers itself by entering into a forward rate agreement at 8½ percent with a nonresident. If at the time of the extension of the loan the prevailing interest rate is 11 percent, the bank will receive from the seller of the agreement the difference between the prevailing rate of 11 percent and the forward rate of 8½ percent. In the balance of payments the receipt of that amount should be recorded as a credit in one of the current account items, as discussed in the preceding paragraph.
Eurobonds
The classification of Eurobonds does not pose problems within the existing framework of the BPM. Because these bonds are issued with an original maturity of more than one year, they should be classified as portfolio investment. In the case of convertible Eurobonds, the conversion of bonds into equity does not change their character as portfolio investment. The BPM provides for the explicit showing of these conversions as changes in both bonds and equities separately. The valuation of transactions in which bonds are exchanged for equities should be at market values. Although different approaches are possible, warrants appear to be similar in nature to options and therefore might be classified in the same way.
Other Bonds
Considerations pertaining to the treatment in the balance of payments of junk bonds, indexed bonds, and zero-coupon bonds are provided in Chapter 14 of this volume.
III. Methodological Implications
From this review of the emergence of the new financial instruments, two features of importance to a balance of payments compiler can be observed. One is the movement away from syndicated bank loans to the securitization2 of debt, and the other is the increasing importance of off-balance-sheet transactions.3 In addition, although not related to the emergence of a new financial instrument, attention has been focused increasingly on debt capitalization programs under which debt is converted into equity. This section offers some considerations that might be taken into account if it is deemed necessary to review the classification framework of the balance of payments.
Securitization of Debt
Bonds and floating-rate notes are the most common examples of securitized long-term credits, and NIFs are the main facility in which short-term credits are securitized. At present, the BPM classifies long-term bonds and corporate equities, other than those included in direct investment and reserves, as portfolio investment. Bonds are defined to have an original maturity of more than one year. Therefore, transactions in securities identified separately in the balance of payments are limited to long-term instruments. Transactions in securities that are originally short-term are at present indistinguishably included in categories other than portfolio investment.
The question arises as to whether transactions in securities originally issued as short-term should be identified separately. Specifically, it can be argued that sales and purchases of securities, both long-term and short-term, are influenced by more or less the same factors. Under the present recommendations of the BPM, transactions in short-term securities can only be made explicit as a nonstandard component. In the balance of payments statements of some industrial countries, however, transactions in short-term instruments are identified separately.
Securitization has also resulted in an increase in the negotiability of the banks' conventional assets. These efforts are focused mainly in two areas: the outright sale of loans (with or without recourse) and the converting of loans (notably mortgages) into marketable instruments. From the standpoint of classification, the question is whether these instruments should be classified in the portfolio investment account: should the securitization of loans, for instance, continue to be classified as drawings and repayments of loans, or should these transactions be classified as portfolio investments?
Off-Balance-Sheet Transactions
Off-balance-sheet transactions can best be described as transactions in which one party is committed to act when called upon, but the need for action is uncertain at the time the contract is made. For instance, under a NIF, a group of banks might be called upon to fund whatever notes they were not able to sell for a corporate borrower. Similarly, in an option, the seller faces the obligation to act if the buyer exercises his option. In all these cases, the action to purchase notes by the banks or the honoring of the option by the seller is uncertain at the time the contract is made. The question therefore arises whether a contract to undertake possible future action should be considered as a transaction appropriate for inclusion in the balance of payments. As defined in the BPM, transactions refer to any exchanges of assets that by convention are to be shown in the balance of payments. Other than the payments of fees, premiums, and the like, it cannot be said that an actual exchange has taken place at the time the contract was entered into. Therefore no capital transaction, in the sense of the BPM, could have occurred. Capital transactions will be recorded when, in the case of NIFs, the notes are placed with investors or purchased by the banks for their own accounts or when, in the case of options, the purchaser exercises his or her rights.
Debt Capitalization
Debt capitalization is not a new development, but recently its use has become more widespread as a result of mounting difficulties faced by many developing countries in servicing their external debt. Typical of debt capitalization is the conversion of external debts, payable in foreign currencies, into equity capital, denominated in local currency. The framework in the BPM for the classification of transactions that convert external debt into equity is fully adequate and poses no problem. The main problem associated with these conversions is the valuation of the transactions.
The BPM recommends that transactions in debt instruments be recorded at their market value. It is likely that, at the time a debt capitalization program is being negotiated, part of the loans or bonds to be converted are already being sold or traded at a value below their face value. The loans or bonds that are being converted into equity should therefore be recorded in the balance of payments at their reduced value. This treatment regards the difference between the market value and the face value as a realized capital loss from the creditor's point of view and as a realized reduction in the value of a debt from the debtor's point of view. The value of the equity capital should, of course, be the same as the value at which the loan or bond is considered to be repaid or redeemed.
IV. Conclusions
In recent years innovations in the international financial markets have brought into being a multitude of financial instruments. The emergence of these instruments has led to uncertainties about the collection of data for transactions in these instruments and about their classification. In general, it can be said that the guidelines for classification under the present BPM are sufficient to ensure a proper classification of these instruments. The shift away from syndicated loans to securitization of debt, however, raises some questions about the analytical usefulness of the present definition of portfolio investment in the BPM. In addition, the BPM definitions of long-term and short-term capital have tended to become less important from an analytical point of view because of the increased marketability of these financial instruments. To market participants, the original term to maturity has become less important. Instead, other considerations prevail, such as hedging interest rate exposures, the possibilities of earning fees, the management of interest rate risks, the remaining term to maturity, and so forth. In addition, the distinction between temporary, reversible movements and more permanent, less volatile movements has become more difficult as long-term instruments have become subject to volatile movements and reversals.
1
See Bank for International Settlements, Recent Innovations in International Banking (Basle: BIS, April 1986).
2
The term most often used to denote the process by which bank assets, mainly loans or mortgages, are converted into negotiable securities.
3
A widely used term to refer to banking activities that do not involve booking assets and taking deposits.
