We need a Financial Products Safety Commission to vet derivatives and their suitability for clients, to reduce the asymmetry in knowledge between buyers and sellers.
In his address delivered on September 10, ‘Financial Stability: Issues and challenges’, the RBI Governor stated that “Unlike many countries, India has had established procedures for regulation of derivatives.” This is true of course: There are elaborate regulations covering the use and sale of currency derivatives in the over-the-counter (OTC) market. Besides, in April 2007, the RBI issued Comprehensive Guidelines on the subject. To be sure, there are some anomalies: Hedge effectiveness standards have been defined for (safer) exchange- traded derivatives, but not for far more complex and risky OTC derivatives which are supposed to be used for hedging. The absurdly low capital charge on credit risk is another anomaly. Besides, the question is whether the elaborate regulatory and guidance framework is being properly implemented on the ground.
As a consultant in risk-management, over the last couple of years, I have had occasion to study several hundred structured derivatives with specific reference to their conformance or otherwise to the regulatory framework. And, if my firm alone has seen hundreds of such highly complex and speculative contracts, the aggregate number must be much, much higher. And, these contracts seem to contravene not only regulations but even the most rudimentary suitability and appropriateness criteria. In my view, most of the derivatives which have led to large losses to hundreds of end-users, many of them from the relatively unsophisticated small and medium enterprises (SME) sector, do not seem to fall within the definition of a ‘hedge’, the purpose for which derivatives are allowed to be used. It is enough to note that a genuine hedge would not result into a loss, except perhaps in an accounting sense, as, by definition, the mark-to-market value loss on the derivative should be compensated by a corresponding gain on the underlying.
To quote from my column published on March 10, 2006 (‘Complex derivatives’), “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 (for) … receiving fees. Many structures seem to evade the restriction … by paying fee through off-market exchange rates, etc. I sometimes wonder whether we are not heading for a major dispute — and inviting the heavy hand of the regulator.” (This was a year and a half before the first case got publicised.) The regulator’s hand remained light and highly speculative transactions continued to be marketed until early this year. In fact, some banks argue that the RBI has inspected their books, and has never raised such issues; that, by implication, the transactions were regular.
Two conclusions are inevitable:
- The knowledge base of the companies; their understanding of the difference between hedging and speculation; the internal controls on forex operations, were in many cases less than adequate;
- The banks either did not know the difference between hedging and speculation (but surely they should have), or were greedy about the fat margins in complex structures. In many cases, they have also mismanaged the credit exposures arising from such structures.
Globally, there is a move, endorsed recently by the G20 summit (and the UN Commission) to move trading of all plain-vanilla derivatives to exchanges. For example, in India, currency options (and indeed interest rate and currency swaps), which are mostly cash-settled, can easily be moved to electronic trading and guaranteed settlements, by the Clearing Corporation of India Ltd. The RBI Governor has also referred to the need for “introducing central counterparties in derivatives trading” in the speech I have cited.
Coming to complex, structured products, it is a myth that these are needed by the end user to mange risks: In fact, most often, they are structured by banks to create risks, hide fair prices, and monstrously skew the risk-reward relationship against the client (one has seen structures with pricing margins of 5-6 per cent of the notional!). While such products are promoted as ‘innovations’, Jagdish Bhagwati contrasts the ‘destructive creation’ in much of financial innovation with the ‘creative destruction’ of innovation in the real economy. Satyajit Das recently argued (The Economic Times, September 14) that “The complexity of modern derivatives has little to do with risk transfer. Traders invent complex variations to delay competition, prevent clients from unbundling products and generally reducing transparency.” Lord Turner, Chairman of UK ’s Financial Services Authority, said in a speech in January 2009: “Much of the structuring and trading activity involved in the complex version of securitised credit, was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between and users of financial services and producers … financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated, very large returns.” John Kay argued in his column in the Financial Times in January 2009 that “There was never an economic rationale for structured products on the scale on which the financial services industry created them. They were the result of a frenetic search for commissions and bonuses.” While the comments are about structured credits, they are equally applicable to complex currency derivatives.
One has seen too many speculative products being marketed in reckless disregard of the client’s interests, in pursuit of a quick kill and bonuses. One alternative is to ban all structured products (as Indonesia has recently done); another is to require banks to recover initial and mark-to-market (MTM) margins on structured products, from clients daily. This has two advantages.One, the client is aware of the gain and losses on an ongoing basis. Besides, the banks are protected against credit exposures.
If Goldman Sachs was recovering cash margins even from AAA counterparties like AIG from whom it was buying credit default swaps, why can’t banks recover daily MTMs on complex structures from Company A in, say, Tirupur? Financial Times recently (October 16) reported that 70 per cent of OTC trades in derivatives are collateralised. Supervisors of OTC derivatives in the US, the UK and Europe have agreed on a major overhaul of bilateral collateralisation.
If this is considered too drastic, at the minimum, we need a Financial Products Safety Commission to vet the products and their suitability for clients, to reduce the asymmetry in knowledge between sellers and buyers of complex derivatives, as proposed by Elizabeth Warren of Harvard Law School and Chairman of the Congressional Oversight Panel, overseeing the Troubled Assets Relief Program in the US.
