Centralised counter party necessary in forex-derivative deals

The recent forex derivatives crisis provides us with ample opportunity to analyse the systemic risks involved in a highly oligopolistic business such as over the counter (OTC) derivatives.

The huge amount of losses due to transactions in OTC forex contracts raises questions that beg to be answered: When existing policies preclude the possibility of naked/ speculative transactions, how could transactions be created that significantly enhanced risk and placed the unlimited risk on to the corporates and were in complete violation of the extant rules be conducted in the first place?

How could such transactions, though having the seeming respectability of a signed International Swaps and Derivatives Association (ISDA) agreement behind them, have left such huge trails of litigation in their wake? Is this an advance warning to the regulatory bodies to contemplate stronger and decisive action to preclude systemic risk that can potentially hit the economy in future?

True, the loss suffered by corporates isn’t small in magnitude. But, the potential effect in future cases could be much larger in magnitude if appropriate regulatory framework is not put in place.

Most of the disputed contracts are signed under the aegis of the ISDA Master Agreement. This is a standard agreement used globally and is clearly subject to the extant laws of the land. It does allow itself to be modified, especially with regard to terms and clauses regarding the extant laws of the land. In fact, the ISDA Master Agreement is supposed to have a clause stating the same explicitly.

A lacuna of the ISDA agreements, especially from the perspective of the small and medium enterprises (SMEs), has been that the ISDA Master Agreement is just a framework. The agreement is silent about the details of the contract. Ensuring that the contracts conform to the laws of the land becomes the responsibility of the drawing party/ banker to a large extent.

This very fact lends itself to abuse, as has been alleged in the 2007-08 cases of forex derivative contracts disputes in India. Most of the allegations pertain to the opacity of the contractual terms, lack of awareness of what could be modified or negotiated, whether the contracts were actually drawn in line with the extant laws of the land, etc.

Most SMEs also allege that the contracts are usually presented as non-negotiable on the legal aspects and purportedly written with their best interests in mind. The plight of the SMEs is similar to the plight of a small investor —- differences in levels of awareness and negotiation powers tend to work to their disadvantage and in some cases get abused. This has been the major bone of contention and the biggest challenge with the OTC system of derivative contracts since it leaves the sustainability of the contracts in the hands of individual parties.

Somewhat ironically, though extant laws of the land were clearly violated, the moment litigation happens it becomes tough for any body to take a decision either way. This may be why action against the erring banks was not taken despite violations from their side, as per submissions made to the Orissa High Court.

It is also clear that the moment the number of participants in the markets increases; it becomes very tough for the local regulator to enforce extant laws, especially since some of the counter parties may not even be physically present in the country.

These then are some strong reasons for a centralised mechanism of clearing and a system whereby there is utmost transparency in operations and mitigation of potential systemic risks.

It is surprising that in the forex derivatives market in India, a market that trades volumes much bigger than the stock and commodities markets put together, there is no single exchange or a single central counter party in the country to facilitate the clearing of transactions between various parties in an effective manner.

The concept of a centralised counter party (CCP) derives strength from the fact that it can facilitate multilateral netting as opposed to bilateral netting in the current scenario, thereby reducing the systemic risk. The CCP will also force the creation of standardised contracts and insist on more stringent margin requirements, thereby reducing the possibility of extreme levels of naked speculation. Therefore, a CCP will improve price transparency and market liquidity.

The CCP also becomes a central point to ensure (albeit to a limited extent) that extant laws are not flagrantly violated and that SMEs are not unduly disadvantaged in their forex hedging operations.

Considering the OTC market in India and elsewhere in the world is today an oligopoly of sorts, a smooth transition through providing incentives of various types can also be conceptualised to facilitate the same.

A strong clearing house that ensures standard products and consistent terms is an imperative, too.

It is also important that there be legislations so that banks are not directly involved in the derivatives and other similar businesses directly. It is then that the interests of all participants, especially those who provide employment and create tangible value for our economy, shall be protected.

The writer is a practicing chartered accountant and former president, Institute of Chartered Accountants of India. Views are personal.