Companies regularly use derivative products to hedge financial risks. Among products that are commonly used are interest rate swaps and foreign exchange derivatives. Interest rate swaps are typically used to hedge against interest risk from floating rate loans, effectively converting the floating interest rate into a fixed interest payment. Foreign exchange derivatives, on the other hand, are typically used by companies with operations in multiple countries to hedge their currency exposures. 

When used appropriately, these products can provide an effective hedge against the financial risks faced by companies. However, these products are complex in nature, and business managers buying them on the recommendation of financial intermediaries may not fully understand the risks they are taking on. This could leave companies exposed to significant losses in the event of market volatility.

The mis-selling of derivative products was a key issue for businesses, particularly small and medium enterprises, in the aftermath of the global financial crisis. Recent news, market reports and our own experiences with clients suggest that the practice remains a problem even now.
 

Interest rate and foreign exchange derivatives  

To fully grasp the mis-selling of these complex financial derivative products, we must first understand what these products are, and how they can be used responsibly by sophisticated market professionals.
 
Interest rate swaps are a type of derivative product where parties periodically exchange a fixed interest rate against an interest rate based on a floating rate benchmark. Typical benchmarks used include the London Interbank Offered Rate, known as LIBOR, and the Secured Overnight Financing Rate, or SOFR. These swaps are commonly sold alongside loans where the repayment plan is based on the floating rate benchmark. As the floating rate payable on the loan is cancelled out by the floating rate received from the swap, it results in fixed net payments. Interest rate swaps can be useful as they reduce exposure to interest rate fluctuations and generate a predictable cashflow. 

The extent to which a company’s interest rate risk is hedged is determined by the parameters of the swaps, such as notional amount, maturity, interest rate benchmark, payment frequency and callability. The swaps are generally placed on a proportion of the loan value, for a length of time equal to or shorter than the maturity of the loan, to provide a degree of hedge against economic uncertainty such as volatile interest rates. These parameters need to be carefully discussed and agreed with the company’s management. However, these contracts are often added to the loans made by financial institutions under standard terms without any discussion with management. 

In some cases, the contracts can have additional complex clauses that act in favour of the issuer. For example, we have reviewed derivative contracts that have clauses that allow the issuer to recall the contract if the product becomes unfavourable for them. This has the effect of exposing the company to interest rate risk just when they needed the hedge. 

Foreign exchange futures and options can also be useful, especially for companies that have operations in multiple countries. For example, a U.K.-based company selling its products in the  European Union may make a substantial portion of its earnings in euros. It might want to use foreign exchange derivatives to hedge the risk of the pound’s devaluation against the euro or simply fix sterling-denominated revenues for corporate planning. A straightforward way to fix the pound to euro rate is to use foreign exchange futures, which enable the company to exchange euros for pounds at a future date (i.e., the date on which company may be receiving euros from their customers), at a rate agreed today. 

We advised the management of a company that faced an analogous situation. In this case, the company was advised by their broker to utilise complex foreign exchange derivatives that offered a more favourable GBP/EUR exchange rate than the rate offered by the futures. However, the company management did not realise that these complex foreign exchange derivatives included clauses under which the company might suffer huge losses on the options if the GBP/EUR rate were to experience large fluctuations. Though the derivatives provided a better exchange rate, they also included higher risks in the case of volatile market movements. This company suffered substantial losses on the foreign exchange derivatives market in the aftermath of the Brexit vote of 2016, when the pound slumped against the euro.

In our experience, companies often buy such complex products because they are enticed by the attractive exchange rates while lacking a strong understanding of the risks they are exposed to. Financial institutions offer these solutions to clients, who often demand attractive exchange rates, but may at times be motivated to sell such products for the fees they can earn on them, which tend to be higher than the fees charged on relatively straightforward derivative products such as futures.
 

History of mis-selling

These derivative products were commonly mis-sold in the period before the global financial crisis in 2007 and 2008. When the financial crisis hit, market volatility increased markedly, and major central banks dropped interest rates to all-time lows. As a result, the buyers of these mis-sold products suffered from adverse mark-to-market movements that were not appropriately offset by their underlying businesses, resulting in large realised losses.

The U.K.’s financial regulator indicated in the years after the crisis that it had found serious failings in the sale of derivatives, called interest rate hedging products (IRHPs), to SMEs. The IRHPs were sold by banks on the basis that they would protect the SMEs’ loans from interest rate charges. In reviews that the banks agreed to conduct, findings showed that, out of roughly 31,000 IRHP sales, around 65% were sold to non-sophisticated investors. This resulted in a redress offer totalling a value of around £2.2 billion and several companies privately pursued litigations against the banks, leading to further claims against the mis-sold IRHPs.
 

Current climate and potential claims

Our experience with clients and recent market news suggest that the potentially inappropriate selling of these products has not ceased in the aftermath of the financial crisis. Moreover, the current macro environment may bring about a new wave of potential claims against mis-sold derivatives products. 

The low interest rate environment that persisted in the decade following the financial crisis meant that lenders have been able to write derivative contracts, especially interest rate swaps, assuming such low interest rates would persist. For example, as late as January 2022, the 20-year yield on U.S. Treasury securities was 2%. This yield has now exceeded 5%, suggesting that market expectations of long-term interest rates have shifted dramatically over the past couple of years. This means that interest swaps bought as a hedge only a few years ago may now have large open exposures if the hedges were not effectively executed.

We saw this recently with a Middle Eastern client that had purchased callable range accrual swaps — interest rate swaps where the buyer is betting that a benchmark interest rate will stay within a specified range — which we determined were inappropriate for the client’s situation. When the benchmark interest rate is within the range specified in the contract, the parties exchange a fixed rate for a floating reference rate. When the interest rate falls outside of the range, the buyer receives nothing but is still liable to pay the reference rate on the swap. In our client’s situation, when interest rates soared, they fell outside the range specified within these contracts and resulted in payments to the issuer exceeding 400% of the original loan payments. The payments were also exacerbated due to the nominal amount of the swaps being multiples of the original loan without obvious justification. 
 

Options for potential recipients of mis-selling

This situation is not unique to our client — many business owners have found themselves in a similar predicament. For any company that has purchased complex derivative products, we recommend the following possible courses of action:

1. Seek advice: The company may want to seek external advice on any existing complex derivative products in place that it does not fully understand. It is important that advice is sought as soon as possible, even if no losses have been realised on these products. It is preferable to act pre-emptively and close any exposure to unsuitable products before any losses. We consider that a crucial step is to replicate the derivate product economics and model the future cashflows in varying macroeconomic environments. This can then be mapped onto the company’s balance sheet to quantify the impacts of various scenarios. Once the exposure is better understood, the company can assess the different options available to manage any unwanted exposure.
    
2. Mitigate losses: The company needs to consider other, more suitable hedging instruments, albeit with appropriate information on the associated risks from qualified finance professionals. The alternative hedging products would protect the company from further losses in a worsening macroeconomic environment — such as deteriorating currency exchange rates or the risk of further interest rate rises — and may mitigate the impacts of the unsuitable hedges already in place. If the company were to engage in legal proceedings against the issuer or advisor of any unsuitable products at a later stage, it may have a legal duty to pre-emptively take such mitigation actions.
    
3. Recover losses: If losses have arisen from products deemed unsuitable, a potential claim against the issuer or advisor of the products may be explored. Under the European Union’s Markets in Financial Instruments Directive 2014 (MiFID II) legislative framework, firms have a duty to conduct a suitability assessment when providing advice on an investment product to an investor. In this case, two important things to consider are the sophistication of the buyer and the relationship between the buyer and the seller. Under the COBS 4.12 rules specified by the U.K.’s Financial Conduct Authority, a certified sophisticated investor is an individual that has been assessed by the seller as having sufficient understanding of the risks associated with a product. An unsophisticated buyer is deemed to not understand the risk of the products and therefore may not be liable for any losses suffered. Additionally, the buyer may have an advisory relationship with the seller, where the seller provides hedging advice for the buyer to rely on, making it liable for provision of inappropriate advice. On the other hand, the seller may have an execution-only relationship with the buyer where the seller simply executes transactions on buyer’s instructions and where no advice is provided. In this situation, a mis-selling claim may not be warranted.
    

Conclusion

Mis-selling continues to cast a shadow on the sale of financial derivatives to corporates and investors. Recent shifts in the macroeconomic environment have created conditions where any mis-sold derivatives are likely to create huge exposures for counterparties. We recommend such counterparties have their positions reviewed by experienced financial services professionals who have the capability to undertake complex analysis to determine the impact on balance sheets. If a party finds that it has unwanted open exposure, there are both short- and long-terms options available to manage their cashflow and mitigate the impact of the mis-selling.