A public backlash against derivatives as dangerously risky instruments is in full swing in Poland, after scores of companies suffered heavy losses on ill-judged currency hedges.

The public debate is thick with sensational language about “Satanic contracts”. The president of the Polish Business Roundtable, Zbigniew Jakubas, fulminated: “It is a product from hell,” and then discovered a manager in his own railway engineering company had staked €160m on a currency hedge, losing over Z100m.

Economy minister Waldemar Pawlak called on February 10 for legislation to cancel damaging derivatives deals – a move that some fear could undermine confidence in Polish commercial contracts and further weaken the derivative market.

Krzysztof Pietraszkiewicz, head of the Polish Banking Association, hit back, saying “This is not the proper way of resolving disputes in a law-abiding country that guarantees free commercial activity,” Reuters reported.

Fortunately, the idea of allowing companies to wriggle out of unfavourable derivatives deals looks unlikely to become law. On February 17 the prime minister, Donald Tusk, told reporters he had agreed with Pawlak not to “take any actions that would transfer the effects of the options to the state”, as could happen if the options were cancelled and banks then sued the government.

But the scandal has done huge damage to the reputation of derivatives in Poland.

The roots of the crisis lie last summer, when over 100 Polish companies engaged in contracts designed to protect them from a stronger zloty, which was eating up the value of the euros they earned from selling goods and services in Europe. But the unexpected slump in the Polish currency since September has left many of them stuck in painful positions.

The Financial Supervision Authority, Poland’s financial watchdog, estimates that 99 Warsaw-listed companies concluded the option deals last summer. Various private firms have been exposed too.

The authority estimates the hedges could cost these companies an estimated Z15bn (€3.3bn), if closed at today’s exchange rate. But some analysts believe the losses could even grow higher if the zloty continues to weaken.

The currency has lost nearly 30% of its value against the euro since July 2008.

Market in turmoil

As more and more companies keep revealing losses on currency options, the entire derivatives market is growing anxious. Potential users and investors with little knowledge of the product have grown reluctant to hedge risk, dismissing options as an unreliable instrument, synonymous with speculation.

Grzegorz Zalewski, a derivatives specialist at BOS Brokerage House in Warsaw, says the situation could deter companies from currency hedging and lead to further revenue shortfalls if the zloty rises again.

Polish companies have lost trust in banks and it will take huge work to regain it, says Piotr Mielus, an economist at the Warsaw School of Economics. “The investors are generally unwilling to enter not only more complex hedging deals, but also other investments such as structured products,” he says.

The exchanges, too, have noticed a new aversion to derivatives. Artur Zur, a member of the management board at the Warsaw Commodity Exchange, says the market has started viewing currency options of any kind as “evil”. “Many companies are terrified at the moment and are waiting for what happens next,” he says.

The exchange, which lists currency futures and options, has suffered a fall in trading volume, though Zur stresses this is due to other factors too.

From hedging to speculation

The story of options gone wrong involves at least 100 companies, including public enterprises such as switchgear and metering equipment maker Apator, household goods manufacturer Zelmer, and Ropczyce, a chemical company.

Most of Poland’s leading banks – including ING Bank Slaski, Millennium Bank, Fortis Bank Polska and Citi Bank Handlowy – are reported to have provided the instruments to clients.

Last summer, the zloty steamed to a record high, reaching Z3.20 to the euro in July. Companies were desperate to protect their euro export revenues, which threatened to be swamped by fixed costs in zlotys.

Banks presented them with instruments to help manage the risk: they could buy put options, obliging the banks to buy euros from them at an agreed rate.

Normally a company would pay an up front premium for such an option to the bank. To reduce or avoid this cost, the companies agreed to simultaneously sell call options, obliging them to sell euros at a specified rate.

In an ideal world, such an arrangement would leave the company with complete certainty about the rate it would receive for its euros. If the zloty turned out to be higher than the option strike prices, it would buy zloty through its put option; if the Polish currency fell, the hedger would convert its euros through the call option.

The premiums on the two contracts would cancel each other out.

Skewing the hedge

But, Mielus says, “a risk reversal occurred with the leverage”.

In many cases the company wanted or the bank convinced it to obtain the put options based on the best exchange rate possible. But to obtain a better rate for the put options, the two counterparties would exchange options at different strike prices and for different quantities of currency.

That broke the integrity of the hedge, opening the customer up to a world of pain if the zloty moved the wrong way.

For example, a company expected its export revenues to be €100m, but feared that after a few months the zloty would have strengthened from Z3.30 to the euro to Z3.10. So the bank would sell it a put option enabling the company to sell €100m at a favourably weak rate of Z3.50.

If all had gone well and the zloty had climbed to Z3.20, the company would have sold its €100m for Z350m, making Z30m of extra profit above the market rate. And indeed, some companies were reported to be profiting from the deals.

But to finance this transaction, the company would sell a call option, obliging it to sell €300m – more than its entire euro revenues – for Z3.50. The bank would of course only exercise this option if the zloty was weaker than Z3.50, but everybody expected the zloty to keep rising.

Unfortunately for the companies involved, everybody was wrong. As Jacek Maliszewski, chief economist at Warsaw-based Alpha Financial Services, a broker specialising in currency and interest rates, puts it: “If we hedge more money than we expect from our revenues, then that’s speculation.”

The transactions remained zero cost, but instead of protecting firms, they exposed them to risk.

Zloty weakens

In mid-September the unexpected happened – the zloty started to weaken. It fell from around Z3.20 to the euro to around Z3.40. Today one has to pay around Z4.50 for one euro.

The banks’ call options are deeply in the money, giving them – to the extent that they are unhedged – the prospect of huge profits from buying euros cheap and selling them in the spot market. Not surprisingly, they are demanding the euros from the companies.

Mielus, who until recently was managing director for financial markets at Bank BPH, the Polish subsidiary of the UniCredit Group, says most options are to be settled in the second half of 2009 and the actual losses are not on balance sheets.

But as the volatility of the zloty began to rise, the banks requested that customers post collateral against their forward contracts or options. They want a guarantee in case the companies become insolvent.

Firms that have positions exceeding their export revenues and cannot pay the collateral have had to close their options prematurely and negotiate with the banks. That explains the reported losses, Mielus says.

Companies torpedoed

But the real losses are still to be determined. The Financial Supervision Authority said the transactions could be paid for if companies make higher export revenues. Unfortunately, the global recession is making that less likely.

So far, at least three companies have gone bust. Elwo, a maker of gas cleaning equipment and filters, and foundry maker Odlewnie Polskie were the first to file for bankruptcy. In early February, Krosno, a glassworks company, went the same way.

Other firms have lowered their revenue forecasts, and on the stockmarket, the shares of companies involved in options have plummeted. Several enterprises have threatened to sue the banks that advised them on the transactions.

But in many cases, the banks are no winners either. The probability of their clients’ insolvency is forcing them to create reserves.

Worse still, most banks have hedged their own risks through open positions with other banks. Their obligations towards those banks mirror those of their own clients.

Apart from ING Bank Slaski and BRE Bank, majority owned by Commerzbank, all the Polish banks are understood to have acted as brokers between their clients and another bank outside Poland. JP Morgan and Merrill Lynch are often mentioned.

In December Jakob Stott, JP Morgan’s chief operating officer for EMEA, told the Polish newspaper Rzeczpospolita: “We have contacts with many Polish banks. They have clients which want to protect themselves from exchange rate risk and come to the Polish banks for such products. We are merely an issuer of options, which a local bank asks us for. Very rarely it happens that Polish clients buy options directly from us. Our role is to quote a price for a bank, which may agree to it or not.”

A spokesperson for Merrill Lynch in London declined to comment.

Who’s to blame?

Many companies accuse the banks of not warning them about the high risks carried by the transactions and their potential for huge losses.

According to Poland’s Ministry of the Economy, which set up a hotline for the troubled companies, businesspeople often complain that the banks were pushy and aggressive in selling them the instruments.

Maliszewski says each case is different, but many companies have turned to Alpha Financial Services for advice and he has seen that “in many cases, it was the bank’s fault”.

Zalewski says every party is partially guilty. “Market participants failed to understand what option hedging involved and naively believed it was a way of generating profits,” he says. But he also stresses the role of auditors that failed to assess the risks involved.

“It is a lack of carefulness,” Mielus argues. “It is as if to give someone a fast car and not to say it has weak brakes, because nobody has asked about them and there is no legal obligation to talk about it.”

A spokesperson for Millennium Bank in Warsaw said the bank had issued such options, and that they were a standard product offered by many banks in Poland. The bank had issued options with leverage, he said, but the ratio was no bigger than 2:1. He said Millennium Bank had presented information about the risks to its clients.

He would not comment on reports that Millennium Bank had used Merrill Lynch as an options provider.

“Some of these options work normally and there is no need to change the deals or dissolve them,” the Millennium spokesperson said. “In some cases, due to the weakening of the zloty, there was a need to close these deals and this is done through mutual understanding with our clients.”

Jan Bujak, vice-president of the management board of Fortis Bank Polska, told FOW: “The majority of our clients hedged currency risk properly and so from their perspective the deals concluded with the bank were beneficial. I’d like to draw attention to the fact that the decisions about the option deals were made by firms’ executives, financial directors and managers. I confirm that 10 to 20 of our clients profoundly felt the consequences of the steep devaluation of the zloty. We are talking to them; in each case we analyse their situation and together we are searching for a consensus. We see a few alternatives to exit this situation and we are discussing them.”

For ING Bank Slaski, a press spokesperson in Warsaw emphasised that the bank had informed its clients properly of the risks of financial instruments, and had even introduced in late 2007 a MiFID-based approach to categorising its customers and informing them if a transaction was inappropriate for them.

Citi Bank Handlowy did not reply to requests for comment, while BRE Bank was unavailable for comment.

Maliszewski says that with the EU’s Markets in Financial Instruments Directive (MiFID) in place, 95% of these transactions would not have happened.

The directive would oblige banks to show all the risks linked to a product and ban them from selling complex financial products to clients with little knowledge of a market or insufficient capital.

The courts will no doubt have to rule on this matter, but both Maliszewski and Mielus say that without MiFID, these transactions were legally correct.

Poland was behind many other countries in implementing MiFID, even before September 2008, when President Lech Kaczynski vetoed a crucial bill that would have introduced it. The Act on Trading Financial Instruments, which would also change the rules for the ownership of the central bank and Warsaw Stock Exchange, is now before the Constitutional Tribunal.

Talking their way out of trouble

The best hope now for companies and banks tripped up by badly structured currency hedges is to negotiate.

In December, Ropczyce, a chemical producer, agreed with Millennium Bank to settle its currency options. The company paid most of its commitment and is scheduled to repay the rest in monthly instalments over the next five years. Others may follow suit. Analysts believe this is the best solution available.

One consolation may be found in the experience. Zalewski says that without today’s crisis, enterprises would have continued to take out the deals and probably raised the stakes, inflating the speculative bubble even more – threatening the stability of the financial system.

Zalewski says the Polish market will have to do the homework that the US went through in the 1990s. He cites the cases of Orange County and Procter & Gamble – scandals in 1994 and 1995 that showed how severely a treasury team can lose money by misusing derivatives.

Many countries’ derivatives markets have been through a shocking scandal that damaged the reputation of the product for years, but ultimately, perhaps, taught market participants how to use derivatives more successfully.

As Zalewski says: “We will all have to learn – the banks, institutions, enterprises and market observers – how real hedging looks and how it doesn’t.”