In the early part of this decade, Lehman Brothers pushed the volumes in global derivatives market by vigorously marketing over-the-counter and exchange traded instruments amounting to billions of dollars. Investing firms across the globe considered them as the best ?weapons? for hedging and managing risk from interest rate fluctuations, corporate bond defaults etc.
At the same time Warren Buffet wrote in his company?s annual report-?I view derivatives as time bombs, both for the parties that deal in them and the economic system. Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. A pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply huge cash collateral to counter-parties. This demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.? In hindsight Buffet seems to be the Nostradamus who predicted the future of derivatives. But now the billion dollar question is: ?Will the world ever again see a surge in derivatives marketing?? Considering the fact that investors have burnt their fingers in the Lehman fire, there is scope for boosting the derivatives trade but due caution needs to be exercised now.
First, the use of customized contracts should be discouraged altogether by requiring higher capital levels for firms holding them (this is also meant to discourage dealers from deliberately creating customized contracts as less-regulated proxies for standardized contracts). Secondly, a mandate should be passed that trades in customized contracts be reported to a regulated trade reporting facility, in order to provide some level of transparency in this portion of the market. A move towards transparency would mean better future for derivatives trading. Transparency would come in two forms?detailed position and trade information available to the regulators, and aggregated information available to the market. It should be noted, however, that merely making the information available does not by itself solve the transparency problem. Someone has to review the data, spot the problems before they become too large, and take appropriate action. This would certainly present a considerable burden to the regulatory authorities as well as to market participants.
Finally, an important aspect of supporting derivatives market is to encourage relationship marketing between providers and customers, rather than individual transactions. For at least 15 years commercial banks have pursued relationship banking programmes to target key corporate and institutional clients. This concept can be extended to the derivatives industry. Enough care should be taken to boost the levels of trust, interdependence and profitability. On the whole it can be concluded that the future of derivatives marketing lies in having smart regulation that offers security but doesn?t stifle innovation.
?The author is from the 2010 batch of IIM Lucknow and can be reached at mishra.praneet@gmail.com