Jamal Mecklai: How not to use derivatives

MARKET MANIAC

The article in the press last week regarding a public sector company that complained to the RBI about the unfair pricing of an interest rate swap sold to it by a foreign bank was the result of a classic case of how not to use derivatives.

The company had bought""or had been sold, depending on how you look at it""an interest rate swap, which converted a fixed rate interest payment into a floating rate; market rumour has it that the transaction involved a fairly complex benchmark. In any event, it is clear that the company sought to reduce its interest costs by taking on cash risk (rather than the more classic use of swaps to reduce cash risk). The complaint, at least as reported in the press, said that the bank had overcharged the company at the time of doing the deal. I found this a bit surprising; in my experience, I have found that banks sometimes charge extravagant margins at the time of exit from complex transactions, and the more complex the transaction, the higher the exit cost.

Nonetheless, I find the complaint unconscionable. First of all, since the company was clearly looking to profit by taking on risk, it should have been particularly meticulous in understanding the product and the pricing. If a senior finance person in the company had bought the product at a bad price or took a decision that ends up costing the company too much, that person should be penalised and, depending on the damage, could/should end up losing his (or her) job. On the other hand, if the decision was taken by someone not senior enough to understand the risks and the costs, the failure is that of the board of directors of the company, and changes are needed in the company's processes.

Secondly, the company has signed an agreement with the bank and needs to honour it; the fact that it is a public sector company makes the honour code that much more important""the Indian government has never defaulted on an obligation and all that. Of course, if it is clearly determined independently (and not by the regulator) that the bank deliberately misled the company and as a result the company suffered exceptional losses, the company should simply not deal with that bank again, and should write to the global chairman of the bank and the media.

Going crying to the regulator for redress is meaningless and may, in fact, further disadvantage the company. The regulator's job is to lay down rules and not to adjudicate between counter parties. However, if a complaint is brought and the regulator discovers that the structure that the bank sold and that the company bought is against regulations""say, the structure involved the company earning a premium (by way of a carry) for a sold option""both buyer and seller should be taken to task.

I understand that the RBI, which wields too much of a nanny-like attitude in its job as regulator, has already asked some foreign (and private) banks for details of the transactions they have undertaken with corporate clients. Insofar as this is to ensure that all transactions are in line with current regulation this is OK; and any push the central bank can provide in the direction of increased disclosure will be all to the good. The concern is that increased regulator scrutiny could drive the just-waking-up derivatives market into (yet another) deep sleep.

Derivatives are a necessary""in some cases, critical""tool for companies to manage both risk and opportunity, and a deep and liquid derivatives market is necessary for continued deregulation of the economy. In particular, derivatives are of great importance to infrastructure companies, which need them to manage their raw material (i.e. money) costs pro-actively. All companies need to learn how to use these products effectively and put in place policies that guide their use and protect against abuse, either by their own personnel or by predatory banks""make no mistake, I am not downplaying the role of some banks on the issue.

The policy should routinely prohibit certain complex structures; we have, for some of our more active clients, developed a filter to weed out derivative structures that we would not recommend, irrespective of pricing. (This filter should be reasonably flexible""on the one hand, to take care of new exotics that bank sales teams come up with and, on the other, to account for increasing skills at the company.) Needless to say, any structure that goes against current regulations""e.g. receiving a premium under any other name""should not be permitted, however narrow-minded and constraining the regulations may be (as currently).

On the other hand, the policy should encourage the use of a wide array of not-so-exotic structures that are less risky and where, importantly, pricing is transparent. For instance, range forwards, participating forwards, sea-gull strategies, strip leverages with low buy-sell ratios are some structures that provide excellent risk management, and at the same time the downside (including a quantified worst case value) is known right on day one. The policy should also build in standard safeguards and controls, require internal (or independent) verification of pricing, and have a regular mark-to-market and risk assessment capability, again either through internal skills or on an outsourced basis from an independent authority.

Such a policy would doubtless have prevented the incident reported, which, though minor, could turn out to be a bellwether for the healthy development of derivatives markets in India.