We have to go back to basics on this one. Essentially, derivatives are a type of financial product which derive their value from something else (such as an asset or an interest rate), but which have no intrinsic value themselves. They are a way of betting against the movements in a ‘real market’ and can win you loads of money if you know what you’re doing (or are lucky) or even lose you more money than you originally wagered. So they’re risky, but pretty useful if things go your way.
So, according to a leaked Italian Treasury report, back in the Nineties, when Italy was preparing to get into the euro, it used some derivatives investments attached to debt to try and reduce its deficit figure. This was in order to qualify for the single currency. It worked to begin with – between 1995 and 1998 Italy’s deficit contracts (which were done through various foreign banks) successfully massaged the deficit figure, and Italy entered the euro in 1999.
A decade later, at the height of the eurozone crisis, interest payments on the contracts fell due with very bad timing. It now emerges, because of the same leaked report from the Italian Treasury, that Italy managed to get the contracts for repaying the debt renewed at the height of the eurozone crisis, delaying them, but now the debtors are coming to call again.
The problem is that, since this leaked document already appears to be heavily redacted, no-one really knows how heavily Italy exposed itself when getting these derivatives in the first place, or exactly what the contracts are. Consequently no-one knows exactly how much money it owes to clear its debt on them. It's worth noting that Mario Monti is claiming that everything was above board and that there was no deception or jiggery-pokery involved in using derivatives at the front end.
It is thought, though, that the exposure could be huge. This is because in 1995, Italy’s budget deficit was running at 7.7%. Just three years later, in 1998 (the year of its being approved for the euro), this figure had dropped to 2.7% despite a negligible rise in tax revenues and a marginal fall in government spending.
Given that Italy’s financial situation already looked dire earlier this week – without the trouble of derivatives debt – these revelations could be catastrophic. The estimate is that the interest payments total about €8bn, which isn't that much in the grand scheme of things, but the political fall out and the possibility that this is the thin edge of the wedge (and other countries may have been at it, too) is a frightening prospect.
And it looks like this is just the start of this story. For one thing, Mario Draghi, the guy currently in charge of the European Central Bank was actually the director-general of the Italian Treasury when the derivatives were first bought. He masterminded Italy’s apparently dodgy entry into the euro, and now sits at the top table of Europe’s financial machinery. He certainly has some questions to answer.
Still, this is the European Project, and Brussels has spent the last 15 years showing thinly veiled contempt for the idea of accountability. With each day it looks more likely that Italy is going to need a bailout, and as long as Germany keeps quiet and stumps up the cash, no heads need roll, eh chaps?