Derivatives no different from an axe or matchstick – depends on how we use it

Published: June 14, 2019 12:10:09 AM

Having a big domestic market for derivatives furthers the goal of an international financial hub. Liquidity brings more liquidity.

No single derivative type might suit every business and every requirement, just as a single pre-determined strategy would not serve every military situation (Illustration: rohnit phore)No single derivative type might suit every business and every requirement, just as a single pre-determined strategy would not serve every military situation (Illustration: rohnit phore)

By Rahul Ghosh

There have been media reports about possible liberalisation in the OTC currency derivative market. The reference is to structured products and complex derivatives. After the 2008 crisis, such derivatives had been banished from domestic markets.

The entire derivative market rests on end-users, i.e., businesses/corporates. The remainder of the market exists to either serve them (dealers) or exploit opportunities created by them (arbitrageurs and speculators).

Businesses face currency exposures, to bring down which risk, they employ derivatives as a hedging tool. Among derivative types, plain vanilla derivatives might suffice for almost all scenarios, as long as the end-user is prepared to pay related costs, i.e., option premium cost, or lost opportunity cost, in case of forwards. But every corporate has to deal with its own set of requirements—defining how much risk it wants to carry in an asset, what controls it should deploy, its budget for risk control versus its loss absorption capacity, etc. Therefore, no single derivative type might suit every business and every requirement, just as a single pre-determined strategy would not serve every military situation. Businesses also employ strategy-based derivatives—a combination of vanilla derivative contracts that offer customisation in costs and extent of risk reduction. For instance, management of some specific exposures may do better with instruments such as barrier options. This kind of option is a complex derivative by category; using it for another category of exposure, to which it is unsuited, would yield undesirable results. Here lies the problem—as one steps into ‘sophistication’ or use of complexity, the line between what is useful and what is risky can get fuzzy.

In the years leading to the ‘2008 crisis,’ businesses in India had entered into vanilla and complex derivatives. Corporations ran up large losses when exchange rates moved sharply in the wake of the ‘sub-prime’ crisis. Several corporates experienced large losses in derivatives, culminating in complex derivatives being blamed for their plight.

In this period, perhaps not all derivative contracts used by corporations were aimed at risk reduction. Had that been the case, then losses on derivatives would have been matched, at least in some measure, by gains on underlying exposure. Corporations need to be mindful not only of the instruments they use but also of the strategies they apply. After all, many losses from this period involved vanilla derivatives. If not used well, vanillas lose money, too, as many players in the F&O segments of exchanges would know.

The corporate losses of 2008 also bruised derivative dealers, bringing down their appetite for this business. A client’s market risk on derivatives converts itself into credit risk for the dealer, who is exposed to the risk of corporate counterparty being unable to pay up. Thus, dealers need to be mindful of counterparty credit risk in derivatives.

The good news is that on the corporate governance front, the environment today is more conducive than ever before. Prescribed norms exist for business’ management of risks. At a median level, disclosure practices on risks and derivatives have shown improvement. International accounting norms on derivative instruments and their underlying risk exposures have been adopted. The regulator is likely to insist on bilateral margining of derivative contracts for large firms at some point in time, sooner rather than later, requiring firms to take greater control of their derivatives activity and deepen skill levels. Together, these developments provide a better chance to prevent future accidents.

On the dealer side, the issue of counterparty credit risk is being taken head-on globally. Vanilla derivatives in OTC markets have been moved to central clearing in many countries. While non-vanilla derivatives are harder to standardise and dealers must manage the risks themselves, the central bankers’ body, Bank for International Settlements (BIS), has suggested a standard for managing counterparty credit risk through the mechanism of bilateral margining between dealer and client, which is expected to be operational in India sometime soon.

That should be the single biggest step forward. Dealers that would manage counterparty credit risk through dynamic risk-based models of potential future exposure (PFE), should be in the best position to deal in derivatives. In managing client derivative exposures, it must be kept in mind that claims on derivatives need not be the same as an outstanding debt.

For end-users, the biggest change has to come from within. It is here that most of the action can be expected. SEBI has mandated the top 500 listed corporates to constitute Risk Management Committees to manage their risks in a more structured manner. A structured approach at the top, to deal with identification of risk, its measurement, mitigation and organisation, would be the best bet for preventing derivative misuse and avoiding accidents, and would equip companies to navigate the open waters of financial markets. After all, many Indian companies, through offices and subsidiaries, already operate in markets of developed countries where derivative varieties are available freely.

For a dealer, despite all efforts to make the assessment of the appropriateness of a derivative transaction for a given customer objective, the real fitment can only be assessed by a skilled and experienced dealing staff. This, too, requires a structured approach to understanding a potential client’s business. Lastly, only those dealers that have developed their own capabilities to value, price and structure the derivatives being sold to the end-user, would be able to offer value to customers and generate revenues sustainably. This argument also extends to the so-called ‘back-to-back’ deals. For example, if X were a dealer and was about to sell a derivative product, purchased from a large/expert dealer, to its end-user client, X can sense its suitability for the client and the risks involved (including counterparty credit risk) only if X can value the deal, understand it from inside and structure it by oneself, if such need arose.

At a larger level, having a big domestic market for derivatives furthers the goal of an international financial hub. Liquidity brings more liquidity. With some significant amounts of rupee-based derivatives trading at international non-deliverable venues, we could certainly do with a larger market here, attracting more instruments and participants. At some level, however, the increasing sophistication, and risk-centric skills and programmes at corporates and banks would also require matching augmentation at the regulatory end.

There has rarely been a balanced debate around the use of derivatives. Derivatives are darlings when things are good, but turn into villains when things go wrong; in reality, they should be treated as neither. Derivatives are just a tool, perhaps no different from an axe or matchstick—it is up to us how we use it.

The author is Independent risk management professional

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