Sub-prime crisis holds out lessons for Indian market

WITHOUT CONTEMPT

Capital and money markets worldwide are in a tizzy. Investors are again bracing to deal with the worst. Suddenly, hedge funds, often labelled as smart, mean and wicked investors, who profit at the expense of entire market systems, have become victims.

Some have frozen fresh subscriptions and redemptions on their units, while others have sullied their spectacular track records of providing super-normal profits to their investors.

The sub-prime debt crisis that began in the United States now has left its footprints across the rest of the world including Asia. These developments have a range of lessons for the Indian market and her regulators.

First, while equity markets tend to be minutely regulated (equity markets are blatantly risky and therefore closely watched and overseen by regulators), debt markets have always tended to be under-regulated (not considered as risky as equity, and usually entails involvement of primarily or sophisticated "big boy" investors). Sophisticated structured products can often appear logic-defying and yet stay clear of regulatory oversight.

For instance, a lender could sell loans from its books to itself to issue unitised interest in the loans to investors. The lender selling the loan would do so in the capacity of a lender, and the same entity could act as a buyer, acting in the capacity of trustee of the investors holding unitised interests in the loan pool.

The loans being bought and sold in such structures could be mixed and matched, and different types of anticipated money flows could be strung together to diversify the exposure of the investors to the pool of loan assets.

Concurrently, sophisticated over-the-counter derivative instruments could provide a hedge against the most probable types of risks "" for instance, one could execute a derivative to bet that the equity markets would go up and thereby hedge against a fall in bond prices. At times like now, when both calls could go wrong, someone could lose a lot of money.

The sub-prime debt crisis has its roots in judgment calls of this nature going wrong. The lesson for Indian regulators is not to write regulations and putting such transactions to inhibiting terms, but to study such developments even more closely and get to understand what can go wrong and become more aware of potential systemic risks.

The second, and perhaps the most-important lesson from the current crisis, is that hedge funds are not immortal devils that pick on emerging market systems and profit ruthlessly.

Hedge funds themselves can go horribly wrong in their judgment, and could lose money just the way any other investor, say a mutual fund, could lose money. The sub-prime crisis has suddenly shown the feet of clay among hedge funds, with many losing a lot of money for their big-boy constituents.

Today, despite the Securities and Exchange Board of India's best efforts, the old guard in the Indian regulatory system has systematically ensured that hedge funds are kept away from directly investing in Indian paper.

The belief that refusing to register hedge funds as foreign institutional investors will ensure that the Indian market is insulated from investment decisions of hedge funds is fallacious.

Such funds would still be able to take exposure to Indian paper, thanks to those who are permitted direct access to the Indian market feeling the need to be de-risked, and therefore writing over-the-counter derivative instruments to distribute the risk to other investors. Enabling hedge funds to directly register would instead bring them to the doorstep of the Indian regulator, and within the jurisdictional reach of Indian regulators.

So far, there is no sign of the sub-prime crisis having been the result of a scam. The usual reaction of all political systems that appoint and oversee regulators anywhere in the world is to make political capital out of such crises, and take positions about how they would smoke out the bad guys from their caves. Regulators then issue notices and get into pursuit, and at times have to get reprimanded by courts for chasing their own shadows.

Therefore, regulators would do well not to get trigger-happy with show-cause notices to the top sellers in recent days when the market crashed.

The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own.

somasekhar@jsalaw.com