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Dangers and Disasters; Profits and Principles

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by Warren Edwardes, Chief Executive of Delphi Risk Management Limited.

This article updates and forms the basis of chapter 13 of the book by Warren Edwardes

"Key Financial Instruments: understanding and innovating in the world of derivatives" 4 February 2000 Financial Times Prentice Hall ISBN 0273 63300 7 London  link

key financial instruments. understanding and innovating in the world of derivatives - warren edwardesWarren Edwardes is CEO of Delphi Risk Management, the London-based financial product creativity, communication and control consultancy.

Warren was previously on the board of Charterhouse Bank and has worked in the treasury divisions of Barclays Bank, British Gas and Midland Bank. He first researched into what were later to be called "derivatives" in 1975 and was part of the team that executed one of the world's first currency swaps in 1981. Since then he has devised and transacted numerous structures that form part of the history of derivatives. Warren can be contacted via

Warren Edwardes <note  spelling of edwardes> is author of best seller "Key financial instruments: understanding and innovating in the world of derivatives" which includes an appendix on Islamic Banking.  see

Edwardes is a Board Governor of The Institute of Islamic Banking & Insurance

In business a reputation for honesty and fair dealing is the key to success. If you can fake that, you have got it made! – Groucho Marx

Over the past decade a tsunami of scandals and scams purportedly relating to derivatives has washed over the financial markets. Or so it would seem from reports in the press. Complexity in financial markets sometimes leads to strains in ethical standards. There is always the possibility that a relatively simple scam is heavily structured into a complex financial instrument with the sole purpose of confusing the client or the client’s management. Because of this complexity it is vital to deal with a firm, bank or corporate you can trust. In short – know your counterparty.

Sometimes it is not the bank that breaks the contract. In the mid-1990s were cases where the corporate client alleged that it did not understand the derivatives contract. And this was only after the corporate had profited from earlier contracts. But the vast majority of the large losses have had very little to do with derivatives. But derivatives have proved an easy scapegoat.

Retail clients

One fraud has already been illustrated in Chapter 6  “Derivatives for the Retail Client”. I reported on how in Spain firms of unscrupulous brokers sold futures investment schemes to small investors. In Albania, the failure of pyramid get rich quick schemes led to angry investors. Even in sophisticated markets such as the UK it is strange indeed that mortgage lending business is outside the scope of regulation by the Financial Services Act. A UK government "announcement" on future regulation is expected in early 2000. Structured derivatives-linked savings products have been launched with inadequate training given to staff in attempt to keep costs down.

The next time you see a mortgage advertisement ring up and ask for an explanation and justification of the mortgage rate quoted Annual Percentage Rate (APR). You’ll get a straight answer of course but not much help. I recently saw an interesting quasi-fixed rate mortgage product advertised by a UK bank. I entered in some details into an Excel spread sheet an attempted to cross-check the APR that the advertisement quoted. On failing to get an answer close to the quoted rate I phoned the customer service number quoted. A very pleasant voice told me: “I am sorry I cannot tell you. It just comes off the computer print out. And I can’t get a computer print-out without entering full details of the property you wish to mortgage along with your salary details.”

In the case of Retail clients, regardless of the strict legal position, we have plenty of examples of adverse publicity destroying a business. So extra care must be taken when launching new retail financial instruments with embedded derivatives. In my opinion, it is advisable to launch these via the internet only so that any technical queries can be answered by competent staff via e-mail and then added to the Frequently Asked Questions WebPages.

Corporate business

In terms of Corporate business, there have been a few instances in the derivatives market where a financial institution deliberately sought to mislead a corporate client about a contract. But if the client is an execution-only purchaser of a financial product from a bank rather than being advised by the investment bank, the onus is on the client to satisfy himself that at the agreed price, the contact is appropriate for his firm. If a bank selling a structure makes an “unhealthy” or “excessive” profit out of a transaction is it necessarily unjustified? If the structure, in the considered opinion of the purchasing corporate client, reduces its risk or is appropriate to its financing or investment needs then it is in its own interests to value the transaction from its own perspective. The perspective and profitability of the selling bank is only relevant in so far as knowledge of the bank’s valuation and pricing methods might aid in the negotiation of terms or the construction of the product by alternative means. The ingenuity of an investment bank required to come up with desirable financial instruments has to be paid for.

If an investment bank shows a proprietary product to a corporate client is it acceptable for the client to show the product to other banks for pricing purposes? No, it is not acceptable without the express permission of the bank offering the product. Pricing of financial products is not particularly complicated. It is the identification of the problem or opportunity that is the most valuable. But current legal developments should make the protection of financial product intellectual property rights more secure.

My word is my bond

All too often now if a man says his word is his bond, one would be well advised to insist on taking his bond.- Sir Anthony Grant MP, in the debate on the UK Financial Services Bill

"My word is my bond" seemingly just does not apply to the financial markets as it used to. In some countries contracts are merely a basis for re-negotiation. There are cases where a sale price is agreed when a market is distressed. And then when the market improves the seller has sought to renegotiate the price. In some cultures this is deemed to be quite ethical on the grounds that the original price was agreed under duress and therefore unfair.

Cutting out the middle-man

Fifteen years ago, as a junior trader at a bank, I concluded a swap transaction with a US bank via a broker. The broker happened to be my firm’s US subsidiary. A few weeks later I did another deal direct with the US bank bypassing the broker. All hell broke out and I was rightly accused of being unprofessional.

What is the relationship between two principals once the first deal is struck between via a broker? After how many deals via a broker can one deal direct? Middle-men, brokers and agents perform a very useful service in putting two parties with equal and opposite interests together. 

It is useful to draw on parallels with other industries that use intermediaries.

Some airlines have sought to set up their own discounting "agents" under discreet names or more openly sell direct to the public via the internet. Quite naturally this annoys the existing agents who the airlines use to sell their tickets. Depending on your bargaining power you have to be extremely careful about cutting out intermediaries who may be needed in the future.

Many internet portals and free service providers base their financial plans on an increasing flow of commission income from linked retailers. The retailers soon build up a substantial database of customers through such referrals. Some such stores market direct to “their” customers via e-mail providing an internet link which bypasses the partners after the initial referrals. They advise partners who complain along the lines of “Our intention is not to cut off your relationship with your customer.” But they inconsistently rely on legalese such as “Our terms and conditions are clearly stated and you as a partner have agreed those terms ....". Relationships are not about using legal small print. One internet store said: “You could compare what you and we do to a cosmetics counter within a department store. You as a specialist have your ways of keeping customers, but that does not preclude us from promoting our extended range of products to any customer who has purchased from our store.” But Chanel, Dior etc. do not build up a database of cosmetics customers gained through department stores and then mail them suggesting that they should deal direct by mail order (and effectively no longer with the department store). No doubt the internet store would be aggrieved if wholesalers, in turn, placed forms in every product suggesting that end-purchasers buy direct from them.

So before using a broker or intermediary establish the ground rules clearly. Would the broker accept direct contact between the introduced clients after the first deal?

Herstatt’s Forex contracts

One of the earliest cases of unexpected loss in the derivatives market occurred in the foreign exchange markets in June 1974. Spot and contracts are settled for value spot and because of the short time to settlement most banks did not impose credit limits to cover settlement risk. Settlement risk occurs in spot and forward contracts because different time zones lead to different settlement times for each leg of the currency exchange. The German bank Herstatt had a number of maturing spot and forward contracts where it received D-marks and had to pay out US Dollars. Herstatt had run into difficulties. In the six hours after it received the D-marks and had to pay its US Dollar obligations in New York, Herstatt went into liquidation.

Tender trap

A particular European bank provided tender to contract foreign exchange contracts. These forward contracts with corporate clients involved the sale of foreign currency against the home currency. There was no option involved but there was conditionality. If the corporate client won the export contract order then it was obliged to enter into a forward contract to sell the foreign currency for the home currency at the pre-agreed rate even if unfavourable. If the client did not win the contract then it had to abandon the contract even if it turned out to be well in-the-money.

Well a strange thing happened with one major client. The client found that its substantial tender-to-contract policy was unfavourable. It studied the documentation. As with most export orders, the exact specification of the order had changed very slightly since the inception of the bidding process and the contracting with the bank. The client claimed that the contract won was not the same as that specified under the tender-to-contract policy and therefore it was not obliged to enter in to the forward contract. The bank was rightly not amused. Was this ethical on the part of the corporate client? Far from it in my opinion.


Some time ago a minor futures exchange launched a futures contract in an illiquid and not easily observed index. However, the market struggled to gain volume. In an attempt to demonstrate activity a prohibited circular trading “ring” was set up. Apparently certain traders traded with each other to boost the volume of the market and thereby tempt genuine hedgers into the market. Soon after the scandal broke not only did the particular futures contract stop trading but the futures exchange itself went out of business.

The lessons here are two-fold. Beware of surprisingly active futures markets. Secondly, exchange traded futures, and to a slightly lesser extent derivatives in general, should be based on a recognisably liquid index or commodity with fully transparent and frequently observable prices. These conditions do not appear to be present in the credit derivatives market.

UK Local Authorities

The Hammersmith & Fulham case (Hazell v Hammersmith and Fulham London Borough Council, House of Lords 1991 2 WLR P372) has been mentioned in chapter 10 and elsewhere in this book. In the late 1980's UK municipalities entered into derivatives with banks which were subsequently declared unauthorised or ultra vires.

The precise motivation behind the local authorities' operations in these derivatives market is unclear. But it is common knowledge that UK local authorities in the late 1980’s were set strict external financing controls by Margaret Thatcher’s Conservative government. Opposition Labour party controlled local authorities sought to raise income to fund their spending objectives. Several financial engineering schemes were employed to raise funds whilst meeting the letter of the law.

Many local authorities sold options on interest rates in the form of interest rate caps and swaptions to banks. These operations generated cash in the form of premium income.  The schemes proved extremely popular amongst several local treasurers and their banks and premiums soon fell to levels well below the market. But interest rates rose and the local authorities well called on to meet their obligations under the interest insurance policies sold. Some local authorities sought to extricate themselves from these liabilities and the episode culminated in the structures being declared ultra vires. Local authorities were deemed not to have had the authority to enter into such transactions.

Banks, who had believed that they had been dealing with an arm of the UK Government and thus with entities with an implied AAA rating were, were taught a salutary lesson. There was no default. But the legal validity of the transactions was not checked, or if it was, a business risk was taken in view of the large profits to be made. The most successful of the banks were those that took on the initial deals and then sold their positions on to other banks.

As in so many such cases, would the derivatives trading have been declared ultra vires if interest rates had fallen and the local authorities had made money? Unlikely I believe. The time to closely examine financial engineering practices is when they are successful. Any highly profitable trading business should be dissected, understood and explainable. Why is the large profit available? Is there a tax angle? If somebody is being misled what are the chances that the counterparty will complain? Can you pass the deal off to some other bank whilst top-slicing the profit? What are the due-diligence liabilities, if any, of a broker who passes on the deal? It is also interesting to note that the vast majority of local authorities had not indulged in balance sheet window dressing and had used swaps for perfectly legitimate hedging purposes. But their swaps too were deemed ultra vires.

Banks must tread carefully when assisting with regulatory arbitrage.


Around the same time as the local authority swap disaster, the Bank of Credit and Commerce International was closed down for a number of reasons. I do not know if there were any market losses due to derivatives they held some municipalities suffered as a result of money market deposits held with BCCI. The local authority had used a broker to place its funds with any bank on the Bank of England list of authorised banks at the highest rates available. The rates being offered by BCCI just before it was closed by the Bank of England were amongst the highest for banks in London. Many banks had had suspicions for some time about the operations of the bank. The broker was mandated to obtain the highest rates possible for the local authority from a list and business drifted to BCCI.

Although the case had nothing to do with new financial instruments, there is a moral to be learned here. As was the case with local authority swaps, management accounting and performance objectives can often lead to the closing of risky trades. In this case there was no performance bonus involved so not a hint of greed dominating money market operations. But there is always a clear and present danger that business moves to the highest return and often higher than acceptable risks. Dealing objectives and mandates should be drawn up carefully.

Orange County

The case of the treasurer of Orange County, Robert Citron has been illustrated in earlier chapters. The voters of Orange County in California were rich but parsimonious. For many years he had won voters’ support because of his profitable investments which led to low local taxes. Few questions were asked. But he under increasing pressure to increase returns and lower taxes still further. His ability to deal in derivatives directly was restricted. But he bought bonds that had currency derivatives embedded within them. Many of the bonds were highly rated and issued by quasi-government mortgage bodies. Orange County suffered its losses not because its treasurer had done anything illegal. After years of making profits for the taxpayers, he claimed ignorance of the true nature of the bonds that he had bought -  "Due to my inexperience, I placed a great deal of reliance on the advice of market professionals ... I wish I had more training in complex government securities".

The reasons behind apparent outstanding performance should always be examined carefully.

Bankers Trust

Perhaps Bankers Trust began its route into the Deutsche Bank Group as a result of its loss of reputation following sales of highly structured derivatives to Procter & Gamble and Gibson Greeting in 1994. Both cases were settled out of court. Fairly or unfairly, the rights and wrongs of Bankers Trust’s actions in selling the swaps which were highly profitable to them are irrelevant. They were labelled as 'sharp' operators and it would take an extremely brave treasurer to do business with them. If problems ensued then it would be easy for a board of directors to point to these cases and question why he had dealt with BT. The upside for dealing with BT with other people’s money was limited.

It may be argued that the treasurer of an eminent corporation should have been qualified to analyse the swaps that he had bought from Bankers Trust. And perhaps his firm was contractually precluded from showing the deals to others or felt it to be unethical to obtain independent advice from a consultant. But they were not compelled to buy the structures. The case shows that even the appearance of being 'sharp' can leave a permanent scar on a bank.

Nick Leeson at Barings

There are six great powers in Europe: England, France, Prussia, Austria, Russia and Baring Brothers. - Duc de Richelieu

It was the 1980s and traders were young. It was a classic rags-to-riches tale. Leeson was the working class son of a plasterer from a Watford, North London who failed his final maths exam and left school with few  qualifications.

Leeson got a job as a clerk with royal bank Coutts, followed by a series of jobs with other banks, ending up with Barings Bank. He quickly made a favourable impression and was promoted to the trading floor. Soon Leeson aged only 26 was appointed manager of futures markets trading on the Singapore Monetary Exchange. The whizz-kid was trusted by his superiors in London, who were delighted with his Midas touch. By 1993, he had generated profits of more than USD 10million  - about 10 per cent of Barings Bank’s total profit that year. Leeson’s team traded large sums and as team leader, controlled the office book-keeping. However in 1994, a mistake by an junior team member started the chain of spiralling losses. A loss of USD 20,000 was covered up in an "error account", 88888, - of which London was apparently unaware.

The markets turned against Leeson, accelerated by the economic aftershocks of the Kobe earthquake. But losses were invisible in this “error” account, so that his trading team in Singapore would always appear in profit.

As the losses grew, Leeson requested extra funds from the head office treasury to make margin calls on his futures losses to continue trading. He hoped to generate profits to cover his losses. In February 1995, Baring's uncovered USD 850m losses. Barings, the UK's oldest merchant bank, finally crashed and was bought for GBP 1, by the Dutch banking and insurance group ING. Executives who were implicated in the failure to control Leeson resigned or were sacked.

In his autobiography Rogue Trader, Leeson said the ethos at Barings was simple: "We were all driven to make profits, profits, and more profits ... I was the rising star." He earned a bonus of 130,000 on his salary of 50,000.

What seems strange is that Barings was brought down through futures trading and not through any complicated highly structured financial instrument that was difficult to value. In futures markets losses and gains are settled every day as the contracts are re-valued at market. Barings fell not because of Leeson’s losses. The bank started on the slippery slope to disaster when it accepted his methods when he was making profits. A telling comment by a senior Barings executive when he disappeared was “one of our barrow-boys has gone missing”. The sign of a well managed bank is when it carries out a thorough investigation when large profits are made. It is rather belated to investigate unexpected losses.

Joseph Jett at Kidder Peabody

Joseph Jett did not steal any money. He did not indulge in any false accounting. He did not misrepresent any trades. Yet Joseph Jett was, in my opinion, unfairly penalised by Kidder Peabody management for the management accounting system devised by them and not him.

In April 1994, one of Wall Street’s most highly successful bond traders, Joseph Jett, was fired by Kidder. They accused him of faking profits to boost his multi-million dollar bonus. Jett has never faced any criminal charges and his frozen bonuses were released. A Securities and Exchange Commission judge cleared him of fraud but fined him for book-keeping and record-keeping irregularities. Jett appealed against the ruling.

By Jett’s own account he engaged in forward trading of bonds which involved booking profits before they had been realised. A common practice in many trading books. Jett claimed that his managers at Kidder were fully aware of what he was doing.

So was Jett a lone, rogue trader independently exploiting loopholes to produce ghost profits and then systematically covering over his tracks? Whatever the improprieties of his actions there was little attempt at secrecy or concealment. And Jett still claims that his trades were profitable.

Without first hand-knowledge of the details, I can somehow believe him. In the early 1980’s my firm’s performance management system monitoring my profitability left a great deal to be desired, though it did not directly generate bonuses. My US Dollar borrowing on behalf of the firm was measured against US Dollar LIBOR. My US Dollar investments, on the other hand, were measured against the interest rate paid on the firm’s call account, some 1.5 per cent below LIBOR. Beating the flat LIBOR borrowing benchmark was pretty difficult to achieve on a regular basis in the money markets but achieving a deposit rate higher than the benchmark set was no problem. Now Sterling investments and borrowing were somebody else’s problem. If I was paid strictly on profits generated I would have been tempted to eliminate any US Dollar borrowings through USD/GBP foreign exchange swaps. I could have bought US Dollars spot and simultaneously sold US Dollars forward for a week or a month. And that would have almost magically converted my US Dollar borrowing position into a US Dollar investment position. Instead of losing against my management accounting benchmark by more than 0.125 per cent I would have easily beaten the deposit benchmark by nearly 1.375 per cent and often more.

Jett was accused of booking unrealised profits. Many investment or loan portfolios do just the opposite. They do not mark positions to market. Future losses would be the concern of future desk managers. Such supervisory practices have led to the creation of well above LIBOR yielding products with a compensating degrading in value perhaps through embedded options sold to the issuer.

Market squeezing

Canada's Financial Post reported on 12 May 1999 that Credit Suisse First Boston, was fined by the Stockholm stock exchange for attempted stock market manipulation. "The two million Kronor (USD348,000) fine imposed on CSFB related to attempted manipulation of a share index by the three British". Mats Wilhelmsson, the Stockholm Stock Exchange's head of market surveillance, said: 'Mr Archer (a CSFB trader) tried to manipulate share prices of what was one of the oldest companies in the world, Stora'. According to the Financial Times of 12 May 1999 "The CSFB traders hatched and embarked on a series of fictitious transactions in Stora shares in an effort to manipulate Stockholm's OMX index and generate a profit of about Dollars 700,000." Such cash market manipulation is relatively easy to effect in illiquid emerging stock markets.

I have seen fairly small purchases in the Korean stock market make disproportionate changes in the KOSPI, the Korean stock market index. Even in the UK in the early 1990s there appeared to be systematic movements of GBP 3 month LIBOR just before the fixing of the LIFFE Short Sterling interest rate contract. A number of traders who specialised in arbitraging the futures contracts against the FRA contracts found that their expected profitable positions turned rapidly turned sour. It is all very well having sophisticated PhD-generated mathematical models to indicate strategies but when the time comes to collect, the market can completely change character and produce a nasty surprise.

Such market squeezing was also featured in the Sumitomo copper scandal which came to light in June 1996.Yasuo Hamanaka succeeded in losing USD2.6 billion for Sumitomo. According to The Guardian of 4 Jun 1999 "Sumitomo is thought to be planning further writs against institutions it believes provided financial and other help to Hamanaka in his three-year reign as king of the copper market in the mid-1990s. Without clearance from his superiors at Sumitomo, the trader cornered huge amounts of the metal in what US regulators have described as 'one of the most serious world-wide manipulations of a commodities market in 25 years'".

Hamanaka was an unusual case in that his personal bonus was not directly linked to his profits and he acted out of self-pride.

Loan-linked derivatives

Principle. A thing which too many people confound with interest. - Ambrose Bierce

I have come across a surprisingly large number of instances in leverage buy out (LBO) and a management buy out (MBO) financing where the lead banks in the loan syndicate insist on providing interest rate hedging to the borrowers. At first this sounds very altruistic. And of course it is in the lending banks interests that the borrowers maintain their ability to pay interest on the loan. A sharp rise in interest rates could jeopardise such an ability and has been know to push fledgling companies into liquidation.

So what’s the catch? The sting is that the providers of the interest rate insurance obtain a monopoly on selling caps or swaps with no control on pricing other than their conscience. So beware of entering into sole provider agreements with no control over pricing.


There are a many unit trusts that provide guaranteed minimum returns on equity-linked investments. These funds obtain equity market index options or use part of the capital raised to buy zero coupon bonds, thereby ensuring a minimum value to an investor. But there are not many successful funds that can provide a guaranteed dividend of 20 per cent.

India’s biggest mutual fund, the government controlled US-64 got into difficulties in September 1998. The USD5 billion fund found itself with a shortfall of USD1 billion between its assets and liabilities largely because of its practice of providing assured returns to market-based net asset value pricing over a three-year period. The Financial Times of 19 March 1999 quoted a member of the committee that issue the rescue plan: “You cannot have a scheme which invests in equity and gives a guarantee of 20 per cent. It is absurd.”

If you invest in a fund with a guarantee ensure that it is realistic and that the managers have taken steps to manage or re-insure that risk.

Guaranteed annuity policies

In the chapter “hedge choice and performance measurement”, I related how UK annuity providers had provided guaranteed minimum annuity rates in the late 1980’s. But they largely and collectively ignored the interest rate risk in the belief that interest rates would never fall to the rates implied by the guaranteed annuities.

One of the insurance companies with the guaranteed annuity problem, The Equitable Life Assurance Society,  instigated a test case in July 1999 to obtain a court ruling on its actions. The Equitable, a mutual life assurer and incidentally the world’s oldest assurance company, had decided that since they were likely to be called to meet the guarantees on their annuity rates, they were going to include the bonus element as part of the guaranteed annuity rates. They declared that if they paid the guaranteed rates plus the bonuses other members of the mutual would suffer. Quite true but irrelevant. The Equitable won the case but it is under appeal at the time of writing. Why did they not manage the interest rate risk either by altering the duration of their investments in fixed rate government securities or by re-insuring?

Again, be careful when providing commitments and beware of commitments lightly given. Ensure that your clients understand the commitments.

Buy back

For the avoidance of doubt I wish to clearly state that I know of no malpractice or mis-representation, scam or scandal in the case below. I am including it here to illustrate a pitfall for an investor that in this case appears at face value to have been adequately handled.

In May 1999 Formula One Administration, the promoter of Grand Prix racing issued bonds secured by the income on television rights. On 30 June 1999, the Financial Times revealed that the “European Commission had concluded that the TV contracts against which the bonds were issued might have to be renegotiated to comply with European law”. The investment banks that led the issue Morgan Stanley Dean Witter and West LB indicated that they were prepared to buy back the bonds from investors concerned about the legality of the television contracts even though there was no obligation on the part of the lead banks to buy back the issue. The position of the banks that originally sold the issue was not a legal one but one of managing their reputation and protecting future business. No investor would buy another bond from a bank that washed its hands of a bond issue that ran into difficulties.

However a buy-back guarantee is of little real benefit to investors and investors in instruments with such guarantees should not be lulled into a false sense of comfort. A general buy-back offer even in written into the documentation is worthless unless there are clear terms attached such as a minimum price or declared and reasonable bid-offer price spread.


It has often been suggested that companies providing employee options should hedge and crystallise their value through hedging in the market. This at face value sounds pretty good advice. However, it relies on the company in question buying an appropriate hedge.

Marconi appears to have "hedged" its employee share option scheme using forward contracts rather than options ("Marconi faces Pounds 200m loss on option hedge", Financial Times October 7, 2001). Remember that options grant the right but not the obligation to buy or sell something at a predetermined price. But forward contracts incorporate the right and the obligation to exchange at the agreed rate. Hence Marconi's loss.

Elswhere in this book I have stated the obvious: "There is an enormous difference between something being cheaper and costing less money!" Forward contracts do not involve the payment of an up-front insurance premium and appear to be zero-cost or free. But adverse movements can lead to a substantial cost under a forward contract. Things that appear to be free can end up costing more than other things at an apparently higher price.


Oh, what a tangled web we weave when first we practice to deceive. -  Sir Walter Scott

Beware of trades and commissions that appear to be just too good to be true. They are so often just that. Beware of traders keeping too tight a control over information. But that said, genuine information must be paid for. So often a creative deal presented by a bank to a client is then presented around the market by the client for a better price. It is seldom difficult to price a transaction or to solve a problem. The difficulty is in identifying a problem. It is unethical for a corporation to disclose a proprietary structure without permission. After all, the client is under no obligation to enter into the structure with the originating bank.

I recall a highly structured swap marketed by a bank. The bank selling the swap was prepared to do the deal for a margin of 5 basis points per annum. Intense negotiations were pursued for several months. Eventually the bank would agree to a fee of 4.25 basis points per annum. But behind the scenes the bank was making a huge profit of 40 basis points.

But is making a large profit unethical? If the counterparty was another bank or financial institution or indeed a major corporation, then they should have had sufficient analytical power at their command to protect their own interests. Of course a bank providing an advisory service has a duty of care to its client. But just because someone is making a huge profit out of a deal with you does not mean that you are making a loss. You may have been making an opportunity loss but the deal could have been good for you in terms of protecting your interests or eliminating your exposure to a certain kind of risk.

Markets are far from perfect. The key to innovation is to create a composite product that adds value to a transaction benefiting both buyer and seller. But too often when a bank talks about a “needs-driven customer service” the needs referred to are those of its bonus-driven traders seeking new Ferraris. It is just that their needs are deemed to be greater than those of their clients.

In my opinion, one recent financial disaster may not have been a disaster at all but turned into one. Metallgesellschaft apparently lost money when hedging long-term oil contracts using short-term oil futures contracts. There are indications that the original “losses” were largely accounting losses. But when management took firm action in closing the books in the face of adverse publicity, real losses materialised as the markets anticipated the unwinding of the positions and moved against Metallgesellschaft. Sometimes life does imitate the art of many management accounting systems.

As the Internet spreads to the financial markets the credibility implied by a professional-looking Website and a address may well trap the unwary. If the firm’s virtual presence does not match its supposed physical presence keep away. My e-mail in-box receives dozens of “hard-to-resist” offers of bonds and stock every week. No doubt some are genuine but I’m sure some are as ephemeral as the 1866 issue of Port of Cordova, Argentina bonds described by Ken Follett in his book “Dangerous Fortune”

And finally …

The few cases illustrated here show that the majority of losses have had nothing to do with derivatives or new financial instruments. Some have resulted from just plain old-fashioned greed and a lack of control. And imprecise management accounting schemes used to pay personal “performance” linked bonuses can easily be used to generate profits by any trader worth his place in the trading room. There is insufficient cross-checking and bosses can be lulled into taking a lenient approach when their own income is correlated with the performance of their staff.

Finally, always remember that free lunches are very hard to find. If you don’t understand the reasons behind that extra special deal, keep away from it. It could be a gamble or a rip-off.