Danger in the derivatives boom

ONE of the less widely noticed statistics to emerge recently from the Inland Revenue is that the tax raised from stamp duty on securities is running at something like half the level anticipated by the Treasury.

There is just one reason for this - professional City investors are cutting back on their dealing in shares and, wherever possible, using a derivative, which gives them the equivalent exposure but has three advantages. It does not attract the tax, it is usually easier to take a large position without creating significant market impact and it is discreet. Derivatives are booming as a result.

The investors who handle pension funds have for the most part too great an exposure to equities to be compatible with the risk they want to run in their funds. But rather than sell the shares and use the money to buy bonds, they prefer - when they are allowed to by their mandates - to adjust their position through the derivatives markets. Similarly, companies or individuals seeking to launch a takeover will take a position in the target stock through contracts for differences.

It has not emerged yet as public information but it would be no surprise if Philip Green, currently stalking Marks & Spencer, or some of his advisers have some contracts for differences in the shares of the stores group. It would add considerably to their leverage when it comes to negotiations, so the surprise will be if he turns out to have none. In the old days, bidders would first try to build up a strategic stake in the stock market - and the resultant price movement was what often gave the game away.

Even the private investor has found an alternative. Many of the individuals who once would speculate in shares as a matter of routine now bet on shares moving up and down through spread-betting firms.

This is doubly tax free - no stamp duty and no capital gains tax - although there is betting tax.

Many of these derivatives contracts require some offsetting purchases or sales on the Stock Exchange as part of the process, and indeed by some measure almost half the trading in equities is in some way derivative-related. It does seem discomforting, however, that a relatively small amount of equity trading - often in thin markets with no great depth or liquidity, is supporting ever more ambitiously structured derivatives put together out of sight in the over-the-counter markets.

It means the Stock Exchange only sees a great deal of the business at one remove - yet all these prices are struck with reference to its quotations, albeit they reflect only a proportion and often a minor proportion of the activity taking place.

It raises questions, too, for the future role of the Exchange - given that the big investment banks which put together these contracts for differences are mini exchanges in their own right. Currently it suits them to have the Stock Exchange - but it might not always be so.

AWG Agony

THE figures today from AWG, once better known as Anglian Water, are testament to the fact that there is no business, however boring and stable, that cannot be screwed up by a lethal combination of pushy investment bankers, an over-ambitious chief executive and a compliant board.

When it was privatised along with all the other water businesses, Anglian Water had a boring stability and predictability. It had infrastructure spending to finance plus environmental responsibilities for its miles of coastline and a bit of waste disposal. Rocket science it most certainly was not. But egged on by analysts wanting a story to set the group apart from the others, the management under previous chief executive Chris Mellor went looking for higher returns in non-regulated businesses at home and overseas.

In what had to be his supreme folly, Mellor even paid more than £100m in advisers' fees to ring-fence the water business, the better to pursue his ambitions elsewhere - and his board nodded it through. The result was predictably disastrous. Mellor eventually paid for it with his job, Anglian's shareholders paid for it with massive write-offs and destruction of value and Anglian's customers would have paid for it in higher charges were it not for the watchful eye of the regulator.

With the latest round of writedowns accompanying today's reduced profits, it is barely an exaggeration to say that everything Mellor bought has been sold at a loss or closed, as the group is pared back to the regulated water business it should never have left.

The fact that new management is now clearing up the mess should not disguise the fact that this is a shameful story from which only the City advisers have emerged with a profit.