Financial Instrument and the Old Good Financial Theory

Moscow, July 27, 2019 — Business Systems Consult. What principles govern the modern financial system, what are their conditions, what may change and what is the role of IFRS 9 in all this staff.

Financial system provides the economic agents with redistribution technology (the basis for redistribution are the exchanges in space), co-measurement technology for different resources, and saving technology (exchanges in time). An efficient financial system should be for its participants

• Pareto-optimal, that is the distribution of goods among economic agents has to satisfy the condition, that no economic agent can be improved without any other damaged;

• Nash equilibrium (no economic agent is better off in declining from the system alone).

Quantitively, efficiency measure may be built on the basis of dead-weight losses concept, well known to everybody from the textbooks on microeconomics: the less these losses the more efficient is the financial system.

There should be some medium of exchange, an instrument to realise these functions of the financial system. This instrument should be accepted by all the economic agents as a certificate of equality in exchanges. In the economical textbooks, this instrument is associated with money. However, these textbooks lack the definition of money as a “ding an sich selbst betrachtet“ (thing-in-itself and self-understood). This leads to the big problems with understanding how the modern financial system is functioning. To fill the gap in money definition, it is proposed to take a simple and colloquial definition as a compact, relatively rare and precious rather useless pieces (coins) as well as debt vouchers of respectable market participants accepted as a coin equivalent in accordance with fiat or market practice.

But the cornerstone of the modern financial system is not money. The cornerstone is financial instrument.

A Boring But Necessary Definition

According to p. 11 of International Accounting Standard (IAS) 32, financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability (that is, the obligation to give to the other entity a financial asset) or equity instrument of another entity. The similar definitions can be found in Basel documents on capital adequacy (§§RBC25.2, MAR10.5 in Basel III document d457 on market risk, §686 in Basel II foundational document bcbs128 “International Convergence of Capital Measurement and Capital Standards”).

A financial asset is

1) cash or equity instrument of the third party,

2) or any derivative from the (1): termed delivery of cash or equity instrument, delivery subject to some predefined condition, delivery on the discretion of one of the entities involved in the contract, etc.

Examples include

• a loan is an obligation to deliver cash in time moments specified by the contract;

• an equity in a portfolio is an equity instrument of the third party;

• an FX forward is an exchange with predefined amounts in different currencies (the ratio of these amounts is an exchange rate), because it is a derivative of cash in different currencies;

• an FX option is an exchange with cash in different currencies on a discretion of one entity.

The key property of the financial instrument is that it “can be settled net in cash or another financial instrument or by exchanging financial instruments” (p. 2.5 in IFRS 9). To that extent, if an entity is not specialising in grain trading (that is, it is neither grain elevator nor grain mill) and it receives a consignment of grain as a result of enforcement of a charge, this grain may be potentially treated as a financial instrument. Actually, grain is a commodity traded in exchanges, and this entity definitely practices “settling similar contracts net in cash or another financial instrument … and selling it within a short period after delivery for the purpose of generating a profit” (see p. 2.6 in IFRS 9).

Financial instruments are described by their interest rate, which is a time value of money and a cost of credit risk (see pp. B4.1.7A, B4.1.9A— B4.1.9E in IFRS 9), or their fair value in terms of cash. Credit risk of a financial instrument is a risk of loosing the ability to be a medium of exchange. Market risk is a risk of mutual oscillations of market value of several financial instruments.

If interest payments are crucial characteristics of a financial instrument, it should be accounted at amortised cost. If the investment in a financial instrument is focused on the value growth, it should be accounted at fair value through profit and loss.

Sometimes, financial investments have other purpose than listed above. In this case, they are accounted at fair value through other comprehensive income. This option is similar to the fair value accounting through profit and loss, but includes credit risk assessment (p. 5.5.1 in IFRS 9), that can not be neglected. In essence, these instruments are financial only to a certain extent.

A simple example demonstrating the differences between accounting methods is as follows. A “milking cow” should be accounted at amortised cost. “Cattle” is accounted at fair value through profit and loss. A “decorative rabbit”, “miniature pigs” are accounted at fair value through other comprehensive income.

In a similar way, the characteristics of financial instruments are applied to other instruments. For example, inventories are accounted at the lower of two values: at cost or at net realisable value, that is fair value (pp. 9, 10 IAS 2). Actually, such inventories have substantial value which is not disclosed in financial reporting. Another example is advances which are considered as financial instruments although they are not part of financial exchanges. Moreover, there is no settling on a net basis in cash or other financial instruments in advances.

In this way, financial instruments become a mirror of the real economy. The financial system based on the money did not have this characteristics. All diversity of types of economic activities, risks, needs is reduced to a restricted set of market quotes (the first property of distinction).

Financial System Based on a Financial Instrument Concept

Financial instrument as a concept allowed to blow up the volumes of exchanges in the economy. Instead of cash, the exchanges are based on the financial instruments, creating the Russian doll of money aggregates. Risks, returns, term, legal restrictions grow from the centre to periphery, while liquidity decreases.

Financial instruments make the system of redistribution of investment resources cheaper. The real characteristics of operational activities of enterprises are replaced with interest rates, equity quotes, volatilities, default probabilities. The faith in information efficiency of the market makes this simplification applicable.

The sustainable functioning of system of exchanges based on the financial instrument concept requires a standardised legislation. The bundles of rights should be similar among various interrelated financial systems. To invest abroad, an investor should only know basic concepts of the financial markets. Property rights, their registration and confirmation are presumed to be equal. Investment process is separated from the legal structurisation and enforcement of rights (the second property of distinction).

Free exchange of financial instruments is provided by burses. Risk mitigation is based on the variation margin and other funds to cover risks. Who benefits from these mechanisms, how it operates, how it is linked to money emission — that is the subject of the other article. The topic of money aggregates in economic textbooks is usually built as a movement from cash to derivatives through money multiples. How the financial instruments give birth to additional cash required to cover risks, that is the reverse process, lies beyond the scope of textbooks. The stability of the system with positive feedback is an interesting issue.

To be continued…

Russian Version

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Опубликовано 27 Jul 2019 Author Magister ludi

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