Many a lesson to be learnt from the derivatives crisis

The continuing saga of the forex derivatives and other recent developments throw up interesting questions about the true nature of the international financial markets, the market participants, their roles and responsibilities, as also the challenges before sovereign financial policymakers in the light of the immense growth and volatility in the market.

The world economies and their financial institutions are more integrated than ever, of which the derivatives markets are a huge portion and are also the “foundation” on which robust trade markets are set up. However, in recent times, the size of the derivatives markets has outgrown the trade economy that it was supposed to support. The unbridled growth of derivatives, especially the synthetic and the exotic variety, has had huge impacts on economies and caused immense global outrage.

Even the more sophisticated and mature financial markets of the West have been caught on the wrong foot by the developments.
The basic functions that derivatives markets are supposed to perform are: to help in management of risk inherent in underlying assets; provide tools to facilitate globalisation and global trade; provide liquidity to financial market; help minimise transaction costs; and promote a price discovery process. However, the behaviour of the markets seems to have been overtly in conflict with their raison d’etre. The markets seem to be driven by a trading mentality and a profit maximisation motive.

In fact, the price discovery process (of which trading is an integral part) typically has ended up being a very predatory exercise where participants have gone to extremes, often exacerbating economic flux into full-blown economic crises.

The forex derivatives case in India is not an isolated instance —- many small and medium enterprises globally have been affected by the same malaise of inappropriate derivatives sold to them. Together, firms in Brazil, Hong Kong, India, Mexico, South Korea and Taiwan posted at least $30 billion of losses on foreign exchange derivatives in 2008-09, according to corporate filings, testimony to regulators and research reports released in the 12 months ended February, 2009.

The profiteering motives of participants are highlighted by the fact that noted economist and Nobel laureate Robert F Engle, in a deposition in a Korean court, claimed that the KIKO was designed to benefit banks whereas companies which subscribed to the contract suffered massive losses because of its unfair structure. This is the very same premise on which the Indian corporates are currently litigating against the banks.

Let us look at additional instances in derivatives markets apart from forex derivatives to see if there are other lessons that Indian regulators can learn. This may be particularly meaningful since derivatives markets globally are very oligopolistic in nature. Being concentrated in a few hands, the business leads to similar behaviour across the derivatives market segments.

In the infamous subprime crisis, as early as in 2004, the FBI indicated that fraud in the mortgage industry had increased sharply and that the US was staring at an “epidemic of financial crimes” by suspect mortgage brokers, appraisers, short-term investors and loan officers, which if not curtailed would become a huge liability for American tax payers.

What was feared happened. In fact, the Securities and Exchanges Commission filed in April, 2010 a civil lawsuit against a reputed global investment banking firm, charging the bank with creating and selling mortgage-backed securities (collateralised debt obligations or CDOs) that were intended to fail. According to the complaint, the bank let a prominent hedge-fund manager select mortgage bonds that he wanted to bet against because they were most likely to lose value and packaged those bonds into CDOs, which were then sold to investors like foreign banks and pension funds.

Predictably, the securities plunged in value and hedge fund made money on negative bets, while the bank’s clients lost billions of dollars. The CEO of the bank while deposing in senate submitted that the list of the underlying securities was given to the client —- so it was for the client to figure out if any of the underlying securities was unsuitable.

A parallel with the forex derivatives crisis in India begs to be drawn. Products were created in a fashion that capped profits to exporters where the losses were potentially unlimited. Banks hard sold the products to unsophisticated SMEs through incentives previously unheard of in the banking industry in India. When the deals turned sour, the justification was that the corporates signed the deal and it was therefore their responsibility to have understood the deals they signed and not the banks to have explained the same.

The moot point in both the cases is that the seller of the products flatly denied any fiduciary responsibility —- something that is simply a level of conduct unbecoming of any financial institution of repute.

“The current crisis is really caused by the private financial sector. The lesson I take from it is that we have to make sure that we don’t allow the private sector to engage in that kind of excessive risk and not give them what they did,” Nobel Laureate Josesph Stiglitz said in a recent interview in India.

To discuss who is at fault in the various crisis mentioned above would be futile and a never ending exercise given the opacity of the market trades. Further, the opacity of the global forex markets implies that it is a problem that transcends our national boundaries. This is perhaps the most compelling reason why the Indian government should order a probe by a competent unbiased agency to get into the root of the genesis of the forex derivatives crisis —- and not end up looking at the crisis through coloured lenses hoping it will blow over and die a natural death.

What should also be very clear is that the primary responsibility of sovereign governments is to ensure that there is very little scope for speculators and for highly leveraged tools like derivatives to cause damage to the economy and the social fabric of the country.

“There seems to be an illusion here and everywhere else that stronger regulations would have stopped the (KIKO) crisis. But there is no evidence that is the case at all,” Stephen A Ross, professor of financial economics at MIT, said. “We don’t need more regulations. We need smarter regulations.”

The author is a former president of the Institute of Chartered Accountants of India. Views are personal.