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Derivatives: The time bomb in our financial system
March 14, 2008
'We view them as time bombs, both, for the parties that deal in them and the economic system. In our view derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.' -- Warren Buffett
In a brilliant plot in a Malayalam movie, the villain seeks to murder a low-ranking police officer who has some incriminating evidence against him. To ensure that he covers his tracks, the cop is killed while on duty along with the chief minister. The net result is that the probe focuses on the assassination of the chief minister and not on the killing of the policeman.
The Rs 60,000-crore (Rs 600-billion) waiver contained in the Budget is akin to the assassinated chief minister, drawing our critical response. Then pray, who is the low ranking cop?
The answer to the above question is contained in para 97 of his Budget Speech. The finance minister seeks to "move forward to expand the market for corporate bond." Accordingly, he "seeks to take measure to develop the bond, currency and derivatives markets that will include launching exchange-traded currency and interest rate futures and developing a transparent credit derivatives market with appropriate safeguards."
In his fetish to integrate the Indian financial sector with the global, the hon'ble finance minister has fixed a time bomb for the Indian financial sector. Taking 'forward' the R H Patil Committee report, the hon'ble FM has proposed that the government would take steps to create an exchange-traded market for corporate bonds.
This, in my considered view, has the potency to dynamite our banks, financial institutions and other participants in the financial markets.
As if on cue from the finance minister, the Reserve Bank of India [Get Quote] had brought out a report on the interest rate futures on March 4, 2008. Just as the RBI was hosting the report on its Web site, the hon'ble Minister of State for Finance Pawan Kumar Bansal reported in Parliament that ICICI Bank [Get Quote] had been visited by a loss of approximately Rs 1,000 crore (Rs 10 billion) while dealing with exposure to credit derivatives.
The coincidence could not have been more startling.
Gambling, thy name derivatives?
To explain the issues involved, let me introduce the reader to the concept of derivatives which are financial instruments that have no intrinsic value. These contracts basically hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, wheat, rice, stocks or bonds. Nowadays it includes interest rates of for that matter even weather.
Further, there are two main types: futures, or contracts for future delivery at a specified price, and options that give one party the right but not the obligation to buy from or sell to the other side, for a small price.
Strangely, this rise of the financial futures' market coincided with the collapse of the Bretton Woods system of fixed exchange rates when the United States suspended the convertibility of the dollar to gold.
In fact, till then the US dollar was pegged to the gold at the rate of $35 per ounce and all other currencies were pegged to the US dollar at a fixed rate of exchange.
And when the US dollar was allowed to float in 1971, it first implicitly backed the US dollar with crude instead of gold. Then when that was found to be inadequate, the US ensured that its dollar was sustained through a global trade regime. In effect, till 1971 it was the gold standard, then an implicit crude standard and then subsequently multi-product standard that has supported the US dollar.
But that was not sufficient to sustain the value of the US dollar. It needed something more -- the need to convert the currency into a commodity and ensure huge trade of that commodity to sustain its value.
This is what triggered a rise of the financial sector and with it the derivatives game estimated to be in excess of three trillion dollars per day, i.e. more than one-hundred times the average trade in global trade of goods and services.
In simple terms that meant that ensuring 'managing the dollar value' became far more important that the ensuring national growth for the US.
And at a mundane level managing treasury operations became more important than manufacturing, the profits of the former more important than the latter.
Where the Noble laureates failed
And when currencies or prices of commodities or stock exchange indices gyrated against each other, often violently, traders faced newer and higher risks. And in the process newer theories were introduced, instruments revealed, and in the process of neutralising higher risks once again newer theories were written -- a classical case of catching the tiger by the tail.
It is in this connection readers may recall that the Black-Scholes Model for determining the value of options was published in the eighties. The net consequence was that many financial institutions involved with derivatives were employing mathematicians to design ever more sophisticated financial instruments!
What is further interesting to note here is that Merton and Scholes, were awarded the Noble prize in economics in 1997 for developing a formula for the valuation of stock options.
And within a year after Merton and Scholes received the Nobel Prize for their 'pioneering work,' their firm, Long Term Capital Management (LTCM), faced the dubious distinction of going belly up, merely because they could not handle derivatives. Surely, it was far easier to device a model and be awarded a Noble Prize rather than handle the same in real life.
In fact, their firm had to be rescued at a cost of $3.5 billion by the US government as it was feared that its collapse could have had a disastrous effect on financial institutions around the world.
The lessons from the fall of LTCM cannot be dismissed by any intelligent person or nation. Crucially, if Noble laureates have failed in handling these instruments, what can be expected of lesser mortals?
Importantly, no one can master them, not even their inventors.
It may be noted that Enron -- till then hailed as an aggressive user of many of these exotic products -- had made extensive use of energy and credit derivatives. Subsequently, it suffered huge losses and became one of the largest American firms to go bankrupt in history after systematically attempting to conceal huge losses.
And 2008 seems to be a blast from the past. In January 2008, a French bank -- Societe Generale -- is estimated to have lost $7.5 billion (about Rs 30,000 crore) in unauthorised futures trading.
But in this entire melee, what has been forgotten is the fundamental characteristic of these contracts. What is trading in index numbers if not a wager? Is it not speculation per se packaged in sophisticated language, exotic terms and backed by legislation and regulators?
And now the virus spreads to India
One understands that some of these contracts are not legally recognised in India. Consequently, these contracts are entered into by Indian corporates -- mostly foreign banks and the new generation banks -- often under the lure of significant profits, outside India.
As already explained ICICI Bank has incurred a loss in the current financial year by indulging in such transaction.
And ICICI Bank is not alone. In fact many corporates in India (as well as banks) are said to be having huge exposures to forex derivatives with concomitant risks.
What is galling is the fact that many of these contracts are entered into by corporates without any underlying need or requirement.
Naturally, in this connection crucial questions arise and need to be answered:
The Bank for International Settlement (BIS) has pegged the aggregate outstanding value of all these derivatives in mid-2007 at about $500 trillion! And their net impact on the global financial system is indeterminate as on date.
But, for long, these cannot remain underground. With many of these contracts made under an assumption of a strong dollar, it is quite likely that many of the corporates or banks would see significant losses shortly.
And in India experts have estimated the loss arising from such transaction could run into several thousand crore rupees.
While one is not privy to the exact methodology by which the experts have calculated these figures, one is certain that there could be something significant. And this has the potency to dynamite the Indian financial sector.
Crucially, it is time to revisit the subject of derivatives in the Indian context. Do we need these weapons of mass financial destruction? Watch out this space, for Warren Buffett -- the world's richest man -- is no fool.
The author is a Chennai-based chartered accountant. He can be contacted at firstname.lastname@example.org.