Are Derivatives Disastrous?
Disasters involving derivatives have captured the attention of the financial sector worldwide. Names like Barings, Proctor & Gamble, Orange County, etc. have come to symbolise the "dangers of derivatives". As derivatives grow to have an increasing importance in India's economy, what does this mean for us? A single trader brought down Barings Bank -- is State Bank similarly vulnerable? Specifically, on the equity market, where the first exchange--traded derivatives are likely to commence trading in early 1998, what new pitfalls lie in store for us?
The first question that we will address is whether there is truly a rash of disasters. Ever since the first financial futures started trading in 1972, the worldwide derivatives industry has seen enormous growth rates, with trading volumes doubling every three years for the following twenty years. The outstanding derivatives positions that exist today typically run into many trillions of dollars. In this situation, in the early nineties, we have seen disasters involving a few billion dollars. This is not a large "failure rate".
An analogy might perhaps be made with the airline industry: the number of plane crashes per year seen in the early nineties is enormously larger than what was seen in preceding decades. This only reflects the fact that many more planes fly today as compared with previous times. Derivatives are like aircraft in that they are very useful most of the time, and generate front--page disasters when things go wrong. Yet, a focus on plane crashes would not accurately convey the extent to which thousands of planes fly safely every day.
The worldwide banking industry has run up hundreds of billions of dollars of losses on bad loans (especially in Japan and East Asia). If we measure losses per unit transacted, then the banking industry is hundreds of times more risky than the derivatives industry. An analogy may be made here about the risks of planes versus cars. Most laymen think that planes are riskier than automobiles. This impression is wrong : the risk of an accident, per unit kilometre travelled, is much smaller when flying. The difference between planes and automobiles is the difference between derivatives and banking: in the former case, losses make headlines.
In this discussion, it is useful to demarcate two categories of derivative contracts: those which are traded at an exchange, and those which are privately negotiated (called "over--the--counter" or OTC derivatives). Exchange--traded derivatives are intrinsically safer in many directions: they ensure that users get a fair price on all trades, they involve almost zero risk of default through the role of the clearing corporation, and there is a high level of transparency. In contrast, OTC derivatives involve many difficulties: there is a risk of default by one or the other party, the price that is negotiated might not be a fair price, the complexity of the contracts often generates unsavoury sales practices and high fees for intermediaries, and the transactions are not publicly visible. Many of the famous international disasters have taken place with OTC derivatives.
In India, on the equity market, SEBI is quite clear that the development of the derivatives industry should focus on exchange--traded derivatives. In the area of commodities also, the developments of the last two years in India have centred around exchanges. It is in interest--rates and currencies, where OTC derivatives presently dominate in India, that these concerns about fairplay and credit risk are more serious.
India's equity market has been the centre of bitter debates. One argument which is often heard runs as follows: "Derivatives are highly leveraged instruments, hence the proposal to create index futures and options should be viewed with great caution". This statement is inconsistent with a remarkable fact about exchange--traded index derivatives in India: they involve less danger than the existing spot market.
- Payments crises
- The index, being a diversified portfolio, is less volatile than individual securities. After taking volatility into account, the leverage that NSE's index futures market will offer is less than that available today on NSE's existing "cash" market, which is a one--week futures market. Hence the risk of payments problems are smaller on NSE's proposed index futures market than on the existing cash market. The reduced risk of NSE's index derivatives market is even more pronounced when compared with other stock exchanges in India, which lack intra--day exposure limits, charge smaller margins, and have much smaller deposits from brokerage firms.
- Market manipulation
- The index, with a market capitalisation of Rs.2.2 trillion, is much harder to manipulate than individual securities. Hence the dangers of market manipulation are smaller on an index derivatives market as compared with the existing cash market.
- Insider trading
- Individual companies are characterised by a sharp asymmetry of information, between company insiders and external investors/traders. In contrast, the index is about India's macroeconomy, where there is much less asymmetry of information. In this sense, there is less scope for malpractice on a market which trades the index.
- Fake certificates
- Trading involving physical certificates in India is fraught with dangers of fake/stolen share certificates. Index derivatives are cash settled, which makes them as safe as trades on the cash market which settle through the depository.
On balance, derivatives are a new technology. Like all new technology, there is the promise of useful applications -- in this case, the major benefit is the fluency of transfer of risk across individuals and firms in the economy. As with all new technology, there are risks of damage. The introduction of aiplanes into India was viewed with suspicion by those who watched newspaper headlines about plane crashes. As the actual evidence about automobiles, banking or the existing equity market suggests, these fears are not appropriate in comparison with risks that we live with today.
Yet, as is the case with all new technology, derivatives do pose a challenge of skills development. Individuals with expertise in trading one--week futures on the existing equity market will need to understand the role for index futures in their risk management and trading. Risk measurement, operational controls, and a "compliance culture" are more important today than ever before. Exchange and regulators will need new skills in crafting regulations, and high standards of honest and thorough enforcement of these regulations. The growth of derivatives markets and the growth of these skills will go hand in hand.
The experience of India's dollar--rupee forward market -- the largest derivative market in existence in India today -- is an example of how this might proceed. When this market first came about, it had a fairly restricted usage. Today, use of the forward market is routine and commonplace amongst hundreds of importers and exporters. These are firms with core competences such as exporting garments or importing crude oil: they are faced with currency risk and do not view trading in the rupee as being a core competence. The forward market enables them to proceed with their core competences while using the forward market to eliminate currency risk. The dollar--rupee forward market has typical daily trading volumes like $1.5 billion, which makes it one of the biggest financial markets in India today. Even though it is an OTC market, it has not known any serious disaster. This is a success story of regulation and skills development.
Back up to Ajay Shah's media page