A V Rajwade: Complex derivatives

In the Indian market, one sees an explosion of complex currency and interest rate derivatives.

The international derivatives market has exploded in volume in the last few years. Both the growing volumes and complexity of derivatives are raising regulatory concerns about the potential impact on financial stability of any major problem in the market. An introduction of ever more complex derivatives, whether or not they serve any underlying economic objective (other than filling the pockets of the structures), has now invaded the credit derivatives segment, following its older siblings, the currency and interest rate markets. The evolutionary path is that somebody innovates a new financial instrument""for example, the pioneering currency swap was transacted between IBM and the World Bank back in 1981. The more sophisticated commercial and investment banks quickly develop the tools and mathematics of pricing and hedging such derivatives, and earn attractive margins in the initial years. However, as more and more players learn the financial mathematics, the product becomes commoditised and margins become increasingly slimmer. This, in turn, spurs the introduction of newer "structured, proprietary" products whose pricing is non-transparent, and therefore allows fatter margins. And, "rocket scientists" (highly qualified Ph Ds in mathematics and physics) with cheap and powerful computers, are in good supply to facilitate the development. The dealers too often know little more than how to fill in the blanks in the menu-driven systems!

In the field of complex currency and interest rate derivatives, there have been many landmark cases abroad: Orange County, Procter and Gamble, Gibson Greetings, etc. readily come to mind. The result has been that most active banks have prescribed internal transaction appropriateness standards, which lay down rules for what type of derivatives to be marketed to which kind of counterparties. Regulators from the US to the UK to Singapore too have prescribed guidelines on the subject. We too need to follow suit. As of now, I have an impression that some foreign banks offer products to Indian companies through Indian banks, which they may not offer on their own, being inappropriate. The Korean authorities recently came down heavily on some foreign banks for marketing complex derivatives: the Japanese had done so a few years back, in cases of complex derivatives used to hide losses.

As in the case of other derivatives, complex credit derivatives too are leading to disputes and losses. Recently, Barclays settled a case with a German bank, as BankAm reportedly did with an Italian one. (In my article dated February 6, I had referred to the case of a complex credit derivative resulting in a loss for Deutsche Bank. The article gives an impression that the transaction was the subject of an investigation by the Financial Services Authority in London. This is not so, and I stand corrected.)

Supervisory concerns about credit derivatives arise on two counts. For one thing, the market has grown so rapidly that back-office and settlement systems lagged behind. One measure of the extremely rapid growth in the basic derivative, namely the credit default swap (CDS), is that the amount outstanding has grown from less than a trillion dollars in 2001 to around 15 trillion dollars in 2005.

The other problem is complexity. The Financial Stability Review of the European Central Bank (June 2005) has expressed concerns regarding "mispricing, inadequacies in risk management, excessive reliance on rating agencies, and ... the challenges CDOs create for public authorities in tracking credit risk around the financial system owing to the opacity of the market."(Incidentally, the Deutsche Bank case was one of mispricing.) A CDO comprises debt securities issued by a special purpose vehicle, in various tranches and carrying different credit ratings, backed by a corporate bond or loan portfolio""synthetic CDOs are backed not by loans or bonds, but by credit default swaps. Synthetic CDOs have become popular because liquidity in the CDS market is much deeper than in the underlying cash instruments. The generally accepted estimate of the outstanding CDOs is $800 billion, a number used also by the BIS. This amount includes both cash (i.e. backed by loans/bonds) and synthetic CDOs. Some analysts believe that this figure is a significant underestimate as it includes only the transactions which the structuring banks have been able to off-load in the market""they suspect that the more complex transactions are being continued on the books of the structuring banks, and not included in this generally accepted number. The fact is that the market is opaque.

Meanwhile, the introduction of newer and more complex products continues""like synthetic forward debt obligations backed by (what else?) forward start CDS. One should also be hearing more of so-called ABCDS (the last letter is not E, as in the alphabet)""these are credit default swaps (CDS) on asset-backed (AB) securities, and hence the abbreviation. As South Korea and India issue an ever larger number of convertible bonds in the international market, CDS based on convertible bonds are also gaining popularity.

But to come back to the synthetic CDO market, another problem is that the same corporate names, underlying the credit default swaps, appear in too many transactions. Thus, one major default could lead to a series of downgrades. Another problem is that the notional principal of outstanding CDS exceeds the principal of the underlying bond, often by several times, leading to many settlement problems""in principle, to claim the default protection, the buyer of the CDS had to deliver the underlying bond. ISDA has recently persuaded participants to make cash settlements, without insisting on delivery of the bond.

If complexity in the credit derivatives is worrying regulators in Europe and the US, in the Indian market, one has seen an explosion of complex currency and interest rate derivatives. In principle, the regulator bars the writing of options on the part of companies, or their receiving fees. Many structures seem to evade the restriction""by describing option-based structures as swaps, by paying fee through off-market exchange rates, etc. The so-called range accrual swap, for example, even in its simplest form, involves the client to write a series of binary options. One has also seen cases of losses on some out-of-the-money derivatives being hidden by new and riskier option-based structures. I sometimes wonder whether the market is not heading for a major case""and inviting the heavy hand of the regulator.

avrco@vsnl.com