Managing Eurocurrency Risk and Offshore Financial Centers

Introduction

The global financial system has inherent risk in financial instruments associated with financial assets. Market risk is a measure of risk that the market value of a financial instrument will decline over time due to a result in changes in exchange or interest rates. (1) It involves understanding the aspect of risk that determines there is a risk that price will fluctuate in one or more components of a financial transaction.

It is the risk of price fluctuation of property purchased, funds borrowed, or currency that is utilized. The fact that changes in exchange or interest rates has such an impact upon market risk necessitates a fundamental understanding of the term exchange rates and the influence of the dual component of interest rates. The basic principles of foreign exchange rates are entwined with currencies. Understanding those principles enables a more comprehensive management of their market risk.

Currency Generally

A fluid understanding of currencies involves international banking. It is a basic three-step process establishing the link between internal financial markets to external markets to explain the role that they play in the concept of currencies and the international monetary system.

There are two basic financial markets, the internal market commonly referred to as the internal-domestic market and the external market commonly referred to as the external-eurocurrency market. Those two financial markets are linked together and comprise an integral working of currencies and the international monetary system. The interaction of linkage between the internal-domestic market and the external-eurocurrency market is the third element in the process.

An internal-domestic market is a sovereign internal market that is linked to the external-eurocurrency market. That consists of a country’s banking system normally regulated by a central banking authority. The United States banking system governed by the United States Federal Reserve would be an example. The United Kingdom has as its central bank, the Bank of England. The Bank of Japan is the central banking authority for Japan. The European Central Bank is the governing central bank of the European Community.

To facilitate an understanding of the requisite fundamentals necessary to provide the connection between the internal-domestic market and the external-eurocurrency market, a skeleton of the mechanics of the sovereign banking system provides the best insight. Though internal-domestic financial markets have similar fundamental characteristics consisting of regulation, supervision, and enforcement, each have their own idiosyncrasies.

Internal-domestic, external-eurocurrency, and foreign are terms of art in the international financial system. Importantly in defining these terms, external-eurocurrency markets are financial markets in which financial transactions are denominated in currencies other than in the currencies in which transaction takes place. Such financial activities as defined as external-eurocurrency market activities, embrace by way of example, deposits, borrowing, and issuance of bonds.

External-eurocurrency markets are to be differentiated from a characterization of an international market. An international market is one in a foreign sector for an internal domestic market in which the financial transactions are denominated in the currency of the country in which the transaction is exacted. These international markets are a sector that the financial transaction takes place in residence and non-residence. (2)

External-eurocurrency financial markets contrast to internal domestic markets with respect to their regulation and interest rate determination. These are markets that are basically outside of the internal domestic financial centers. The term external-eurocurrency markets’ is synonymous with euro-financial, euro reflecting the geographical location of the markets origin. (3)

The term market as applied to internal-domestic, foreign, and external-eurocurrency markets should be distinguished; these markets are delineated pursuant to which payments are made and credit is extended. Currency is of national origin, being produced by a particular government. Because currency is of national origin, the exchange of currencies is necessary to make payments in another currency. The underlying concept of the market for foreign exchange is derived because it is based upon the market in which different national means of payments are traded. (4)

The external-eurocurrency market consists, in terms of currency markets, as those funds that are intermediated outside the country of the currency in which funds are denominated. If it is a credit market transaction rather than a foreign exchange market transaction, it consists of a lending transaction in a currency not of the country in which it is being transacted.

Therefore these two basic markets that consist of an internal-domestic market and an external-eurocurrency market are in relationship each to the other by the third component, the linkage effect between the two. The relationships are influenced by interest rates, regulation, and public policy of the internal-domestic markets, among others. Those are the influences of essence that comprise the linkage.

Each internal-domestic currency of developed economies imparts interest rate, regulation, and public policy influences. It is the reason it is necessary to provide to the reader basics of an internal-domestic currency system of a particular sovereign to enable the reader to appreciate how the mechanics in the internal-domestic system can commence a transmission affect to the external foreign exchange market.

Integration of External-Eurocurrency

The external-eurocurrency market is integrated to the internal-domestic financial markets by the international transacting of global foreign exchange. This writing developed a very skeletal foundation of understanding of the external-eurocurrency market of currencies and that they are subject to different regulation and requirements of the sovereign from which they are derived. The purpose of this segment is to expand upon the mechanism which functions to integrate the two currency markets in the international market place and explore the influences that are exerted from the internal-domestic markets to influence the eurocurrencies in general.

To connect the relevance of external markets to internal-domestic financial markets, it is important to differentiate them from the internal-domestic markets. It requires exploring the mechanism by which internal-domestic markets and external-eurocurrency markets have by their very existence, inter-dependence. This inter-dependence facilitates a need to understand the effects of deregulation in the external market, the effects of internal-domestic monetary policy, internal-domestic public policy, and internal-domestic fiscal policy transmissions to the external-eurocurrency markets. The interaction that results between these two financial markets casts enormous influences on the international monetary system.

Through out the 1980’s globalization, financial market integration and deregulation, the financial markets provided new efficiencies. The efficiencies have been dramatic and enabled cost reduction, increased the velocity of transactions, and provided a new liquidity element. But in process, it has added risks. The efficiency and speed has added volatility and volatility promotes increased risk. That results from increased volumes of capital flows.

This risk is compounded with the integration of financial institutions in terms of systemic risk. Integration allows for the possibility that a problem in one place may well bring havoc upon the entire international monetary system. Those types of systemic affects can cause an abrupt halt in credit flows that in turn serve to impact and transmute an additional shock to the global financial community. Global systemic shocks of this sort decrease the support to deficit countries.

Interbank Transactions

An external markets’ transactional character is reflected in what is known as the interbank market. (5) This is the primary market that serves the foreign exchange market that facilitates the international monetary system. Of primary importance is how and why it functions.

The interbank market is a market dominated by the world’s largest banks. It is an institutional market, not a retail market. It is a spot and forward market. (6) Spot markets deal in currency contracts at current rates for forward delivery periods of time. It is the most significant force in the foreign exchange market.

The forward market deals in currency contracts at specified future dates, but of relatively short durations. Ninety day and one hundred eighty day contracts for delivery are ordinary. It is a wholesale market in terms of size and types of customers. Transactions normally are in excess of one million US dollars. The rate of a particular currency contract will always reflect expectations about the future price of the currency. International markets for interest rates impact interest rates; the exchange rate and interest rates are governed in many ways as they inter-relate, one to the other.

The interbank market services these contract expectations of exchange rates between currencies. It is unique, relying totally upon technology. There is no floor or exchange per se as is normally associated with regulated markets. Trading centers are normally located in major national market areas such as London, New York, and Tokyo. Telecommunications enables it to perform an enormous amount of activity between trading arenas.

Eurocurrency Markets in Motion

External-eurocurrency banks are more of a function than an institution. Their function is to borrow or accept deposits and lend. In the absence of regulation, it attracts mediation from external-eurocurrency markets. The location of external-eurocurrency markets is in countries that do not regulate foreign currency intermediation. Most host countries do not.

The euro-currency market is perceived as attracting funds, creating intermediation businesses, and increasing employment. Many countries believe that the external-eurocurrency markets have negligible affects upon domestic monetary policy. However, there is an absolute link between external-eurocurrency markets and internal-domestic markets. It manifests itself in interest rate relationships, risk tolerance, and public policy. The euro-currency markets are closely linked to the respective domestic-internal market through international transactions. (6)

The effect of interest rate relationships is promoted through deeply developed external-eurocurrency markets. It serves to integrate markets in terms of interest rates. Interest rates translate into price and that tends to impact developments in the internal-domestic markets. This linkage of interest rates of the internal-domestic market and the external-eurocurrency market directly influences currency values. It is perhaps the most influential monetary aspect that governs currency values from day to day.

Risk in the credit markets is grounded in the probability that an obligation to repay a deposit or to lend funds on specified terms will not be honored. External-currency markets factor risk with the presence or absence of government regulation. External-eurocurrency transactions are by their very nature subject to potential intervention of two sovereigns, the host country and the home country.

The main risks that are accounted for in the differential of internal-domestic and external-eurocurrency interest rates pertaining to deposits and lending are the absence of nonresident convertibility by the home country, the confiscation of assets, and liabilities of external-eurocurrency banks by host authorities where they operate. Additionally and a chief component of these risks collectively is the factor that a central bank may not function as the lender of last resort for external-eurocurrency banks. (7)

Between internal-domestic markets and external-eurocurrency markets arbitrage insures equality. There are interest rate differences between internal-domestic markets and external-eurocurrency markets for a given currency. The foundation of the differences originates in regulatory costs, reserve requirements, account insurance requirements, liquidity requirements, and no allocation with respect to lending restraints. These reflect factors of comparative and competitive advantages of one market to the other.

Important to be gleaned from this linkage is that it functions to facilitate a worldwide interest rate. A rise in the interest rate of a major economy resulting from monetary policy or otherwise, results in an equal rise in the external-eurocurrency of that national economy. In turn, such an increase in interest rates in the external-eurocurrency will provide a ripple effect as an increase in other external-eurocurrency currencies.

It follows that it is necessary to appreciate how exchange rate expectations function to equalize the effect of interest rates in external-eurocurrency markets and simultaneously preserving nominal differences in rates. This is directed to expected interest rates as opposed to real interest rates. Expected interest rates are the real return after costs as opposed to nominal rates that are the rates quoted by financial institutions.

Exchange rate expectations are reflected in forward exchange rates; if exchange rate expectations change by arbitrage, external-eurocurrency interest rates change. By virtue of speculation of arbitrage, the forward premium or discount is inclined to equal the expected rate of change in the exchange rate. And by speculation, the expected rate of change of the exchange rate is inclined to equal the external-eurocurrency interest rate differential. (8)

Borrowing, lending, and hedging is included to insure that the interest rate differential between two external-eurocurrency markets, equals forward premium for discount on foreign exchange contracts and equal the expected exchange rate change expressed as an annual rate. It is this speculation that enforces these relationships. A change in interest rate differentials between two currencies and the forward premium will result in an almost automatic equilibrium. Change with respect to the expected rate of change of the exchange rate that has not found equilibrium is advanced through arbitrage and then results in a change in the forward exchange contract rate.

Instruments of Market Risk Management

Market risk is influenced by credit risk that is the risk that a counter-party will not perform to contract for financial reasons. Market risk can be distinguished from credit risk because it is a risk pertaining to price variability. Price variability is present in a transaction regardless of a particular debtor’s financial status or the nature of a particular contractual arrangement. (9)

The financial instrument risks used in the management of risk involve currency swaps, interest rate swaps, currency and interest rate options, as well as spot and forward contracts. Spot and forward contracts are probably most important in international trade and banking. Market risk fluctuations associated with currency and interest rate options, currency swaps, futures contracts often serve more complex risk management.

The spot contract and forward contract have become a prerequisite to an enterprise engaged in international trade. The fluctuations of exchange rates require assurance of exchange stability on each transaction. A spot market exists in foreign exchange markets and allows for the purchase of foreign exchange and delivery on the second business day subsequent to purchase date. However, it is the forward contract marketed in the interbank market that is the main source of currency hedging for future fluctuations. (10)

The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to by the parties but with an actual exchange or delivery-taking place at a specified time in the future. The premium or discount of the purchase of the instrument is the annualized percentage of difference between the spot and forward exchange rates.

Banks and businesses alike to hedge future cash flows in foreign currencies to protect against exposures involving transactions utilize the forward exchange market. The forward contract guarantees an exchange rate at which currencies will be sold or bought on the anticipated date. It is intended to eliminate the change of exchange rate losses for any specific transaction. These are the basic currency contracts and general purposes. (11)

The futures contract is a contract traded on an exchange providing for the delivery at a fixed date in the future of a specified amount of a particular grade of commodity by financial instrument. Contracts are basically standardized and the trades agree to price and number of contracts traded. A trader’s position is maintained at an exchange clearing house, the clearing house then becoming a counter-party to each trader upon the trade clearing at the end of each day’s trading session. Members holding positions at a clearinghouse must daily post margin marked to market. Most trades are unwound prior to delivery. The interposition of a clearinghouse facilitates the unwinding and eliminates the need for a trader to locate his original counter-party. (12)

The option contract, which is the purchase of a right to buy or sell foreign currency in the future, is technically defined as a contractual right. However it is not an obligation to purchase or sell a specified amount of a financial instrument at a fixed price prior to or on a designated future date. A call option confers on the holder a right to purchase a financial instrument. A put option involves the right to sell a financial instrument. (13)

The last type of transactional instrument to be addressed is the currency swap. A currency swap is a transaction in which there are two counter-parties exchanging specific amounts of two different currencies from the onset and effect repayment over a period of time in accordance with a predetermined rule. That rule is designed to reflect interest payments and can be structured to incorporate amortization of principal. The payment flows occurring in currency swaps are generally similar to those in spot and forward transactions. Payments are based upon fixed interest rates in each currency. (14)

These specific financial instruments are representative of the type utilized in risk management efforts. More importantly, they represent words of art and definitions used in international taxation of foreign currency transactions. (15) In utilizing the benefits of Offshore Financial Centers, understanding the tax consequences associated with currency and transactional risk management is crucial. The taxation of foreign currency gains and losses is perhaps best approached by the nature of the character of the gain or loss, the timing at which the transaction is deemed taxable, and the source of the gain or loss.

The acquisitions and dispositions of foreign currency or positions in foreign currency, forward contracts, futures contracts, and options are taxable events in which character of gain or loss is defining. Foreign currency is in many transactions characterized as a capital asset by virtue of an Internal Revenue Service Revenue Ruling. (16)

Because only the United States dollar is characterized as money, (17) foreign currency is characterized as property. (18) Though foreign currency is generally characterized as a capital asset, (19) that is not the case when held by a dealer (20) or as an accounts receivable from the sale of inventory. In those instances, it is not deemed a capital asset. (21)

Foreign currency characterization is significantly affected by the Code definition of a Section 1256 Contract. (22) These financial instruments frequently are companion to a business transaction and utilized to manage the market risk of currency fluctuations.

One party to a transaction may anticipate a currency to accelerate in value and purchase a currency contract reflecting that expectation. Contrarily, a counter-party may sell a currency contract anticipating a currency will decline in value. The gain or loss occasioned by that type of underlying companion transaction is deemed to be a separate taxable transaction. (23) It is the gain or loss on the exchange of the underlying transactions pertaining to the characterization, timing, and source that are of importance.

The making or receiving of the delivery of currency with respect to a forward contract, futures contract, options contract, or other similar financial instrument is a taxable event. (24) The character of the gain or loss of a Section 988 Contract is computed separately and treated as ordinary income or loss. (25) A taxpayer may elect to treat as a capital gain or loss any foreign currency gain or loss attributable to a forward contract, a futures contract, or an option deemed a capital asset in the hands of the taxpayer. It cannot be deemed to be part of a straddle to receive this election treatment. Additionally, the taxpayer is required to elect this treatment and must identify the transaction before the close of the day on which the transaction is entered into. (26)

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Footnotes

1. The impact of financial innovation of financial stability, Chapter 1, page 189, Recent Innovations in International Banking, Prepared by a Study Group Established by the Central Banks of the Group of Ten Countries, Bank for International Settlements. (April 1984).

2. Gunter Dufey and Ian H. Giddy, The International Money Markets, Prentice-Hall, Inc. 1978 at 1.

3. Id. at 2.

4. Gunter Dufey and Ian H. Giddy, The International Money Markets, Prentice-Hall, Inc. 1978 at 5.

5. Id. at 4. at P. 222-223.

6. Gunter Dufey and Ian H. Giddy, The International Money Market, Prentice Hall, Inc. 1979, The Need for Controls, P. 180.

7. Id. at 6 P. 61.

8. Supra at 6. P. 62.

9. The financial system can be vulnerable in the event large concentrations of the normal market and credit risks arise in credit transactions. For these purposes, it is of importance to distinguish between market risk that in the aggregate amounts sum to zero and credit risk that by its nature cumulates in direct proportion to the volume of financial contracts outstanding. In other words, most all financial contracts are two-sided with respect to market risk. The holder of a fixed rate bond has at least a paper gain if interest rates fall, while the issuer of that bond has an equal and offsetting loss. From a systemic perspective, there is no net change. In the same contract, the credit risk is one-sided subsequent to the asset having been issued. Events that affect the ability of the debtor to pay have an implied impact on the creditor, while there is no reverse exposure. (The Impact of Financial Innovation on Financial Stability, Chapter 1, page 203, Recent Innovations in International Banking, Prepared by a Study Group Established by the Central Banks of The Group of Ten Countries, Bank for International Settlements. (April 1986).

10. Gunter Dufey and Ian H. Giddy, The International Money Market, Prentice-Hall Foundations of Finance Series, Prentice-Hall, Inc., Englewood Cliffs, New Jersey (1978).

11. Id. at 9 at pages 63-64. See IRC Section 1256 (b) (2) (1986).

12. The Impact of Financial Innovation on Financial Stability, page 260, Recent Innovations in International Banking, Prepared by a Study Group Established by The Central Banks of the Group of Ten Countries, Bank for International Settlements. (April 1986).

13. Id. at 12 at page 264. Also see IRC Section 1256 (b) (1986).

14. The Impact of Financial Innovation on Financial Stability, Chapter 1, page 257, Recent Innovations in International Banking, Prepared by a Study Group Established by The Central Banks of the Group of Ten Countries, Bank for International Settlements. (April 1986) Also see IRC Section 1256 (b) (1986).

15. IRC Section 985 – 989 (1986).

16. Revenue Ruling 76-7, 1976-1 C. B. 179.

17. Gillin v. United States, 423 F.2d 309 (Ct. Cl. 1970).

18. Revenue Ruling 75-447, 1975-447, 1975-2 C. B. 113.

19. Supra at note 16.

20. IRC Section 1221 (a) (1) (1986).

21. IRC Section 1221 (a) (4) (1986).

22. IRC Section 1256 (b) (1986).

23. Williard Helburn, 214 F.2d 815 (1953); Revenue Ruling 78-281, 1978-2 C. B. 204. See also America-Southeast Asia Co., 26 T. C. 198 (1956).

24. IRC Section 988 (1986),

25. IRC Section 988 (a) (1) (A) (1986).

26. IRC 988 (a)(1) (1986).

In accordance with Circular 230 Disclosure

William Richards is a Sole Practitioner in Orlando, Florida, USA 32626. Attorney at Law, Legal Advisor. 1978 – Present

PUBLICATIONS: International Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2012, 378 pages. The Handbook of Offshore Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2004, 266 pages; Offshore Financial Centers and Tax Havens, Archives of Tulane Law Library, Tulane Law School, Tulane University, New Orleans, Louisiana, Copyright, 1996, 512 Pages.

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