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August 01, 2006

Reader Comment on Settlement Charges and Thoughts on Swaps

Ted Weitz is a very smart guy who was Chief Counsel for ITXC when I was CEO.  It was Ted I emailed when preparing my post on settlement rates to make sure time and age hadn’t addled my memory of the details.

In a comment on that post, Ted brings up a possible connection between the arbitrary nature of accounting rates and the arbitrary accounting that inflated and then crushed the valuations of many telecoms.

“Of course there is another wrinkle to the entire complex pricing structure that turned out to be very important. When Carrier A and Carrier B trade traffic, internationally or domestically, they are really engaged in a swap in which the accounting rate (or its equivalent) is a highly artificial number, and money may or may not change hands. When Wall Street pressures for revenue mount, the temptations to play with the revenue number increase, and the essence of the enormous accounting scandals at WorldCom and Qwest was that they established artificial prices for various swaps and then reported them as revenue. Going back to Tom's example at the outset, the accounting rate structure produced $4 million a day in revenue for each carrier. But if the accounting rate had been halved, the revenue would have been only $2 million a day. In domestic exchanges, or where there was no regulatory agency involvement, the carriers could adjust the accounting and alter their revenue. Indeed, the accounting for such exchanges was so complex even auditors discussing them in good faith could not fully agree. And everyone suffered in the long run.”

The “swaps” Ted is talking about are the notorious swaps of IRUs (indefeasible rights of use) which companies like WorldCom, Qwest, and Global Crossing engaged in seemingly to create both revenue and profit out of thin air (or, at least, dark fiber).

Did you ever wonder what a swap is.  Louise Lazard, fictional wife of fictional CEO Larry Lazard in my novel hackoff.com: an historic murder mystery set in the Internet bubble and rubble was probably just making conversation at the World Economic Forum in Davos when she asked the telecommunications CEO next to her: “What’s a ‘swap’? I read about them in The Wall Street Journal and I couldn’t help overhearing you gentleman talking about them earlier.”

“That’s an easy one,” says the CEO, also looking up. “We swap capacity on each other’s networks. That gives us both a presence in a place where we might not have built out and lets us turn our building expense into income. We both have a lot of extra capacity because of the way we build so we can do a lot of swaps.”

   

“Why does the way you build give you over-capacity?” asks Larry. “Why don’t you build just what you need for the near future?”

   

“When you’re laying fiber, most of the expense is in the actual digging or laying of an undersea conduit. There is no significant extra expense in filling that conduit up with fiber, especially if we don’t light it. So that’s what we do. We are probably putting in from twenty to fifty times as much capacity as we need right now. But, with the Internet doubling every three months or whatever it is, that’ll all be a good investment. But, of course, Wall Street is very impatient…”

 

“I’ve noticed,” says Larry.

   

“So we need to get some income now from the extra capacity we’re putting in to feed the quarterly earnings and growth monster. Swaps help us do that.”

   

“How?”

   

“When we swap capacity, each of us is actually selling something to the other. We’re selling the right to use capacity forever or at least for twenty years, which is the same thing. So we’re entitled to book a sale at the time we make a deal. The cost of the construction, of course, is written off over twenty years, so there’s a healthy profit for both of us in the quarter the sale is made.”

   

“Sounds good,” says Larry. “Is that legal? I mean…”

   

“Our accountants have examined these deals thoroughly and blessed them,” says the chairman.

********************

Good point, Ted.

For the record, ITXC did not do swaps.  Ted and I only have second-hand knowledge of them.

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