The Indian derivatives market

Traders, whether of goods or financial services, always look for two things only - larger volumes and larger commissions. But there is a problem, and had my name been Taylor I would have formulated a trite 'rule' as well, namely, that they can't have both at the same time unless they are a monopoly.

So, if trading commissions can't be increased, and indeed have to be lowered because of competition, how does a trader increase volume? Simple: he looks around for more products to trade in.

Until the mid-1980s, this golden rule didn't apply much to money. But since then, the ever-increasing amounts cash that the US has been pumping into the world by virtue of being the provider of the world's signature currency has resulted in a spate of new financial 'products'. They have exactly the same characteristics as physical products: unless traded, their value is zero or almost zero.

One of these new products is called a derivative which, when you peel the onion down to the pip, is basically a bet on a bet. Thus, if you bet that a dollar will be worth Rs 40 in December, then you can sell that bet to some sucker who thinks he can sell it onwards and make some money at the margin. In short, you trade in bets.

Around 2002, soon after the effects of the dotcom collapse ebbed away and Alan Greenspan flooded the world with cheap credit, another form of betting became possible. This was the credit derivative. You loaned money and then sold the thing off to some fund or the other and got it off your books partly - or if you were clever, entirely.

The process was dignified by fancy names: slicing risk, repackaging risk, and so on. Overall, the theory went, if you distributed risk amongst lots of fellows or funds, everyone would be less at risk. It was exactly the same as one man lifting 100 kilos and 10 men lifting it.

The idea was so seductive that only did money start chasing its own tail, it also started betting on itself in ways that make no sense at all because all this frenetic activity actually leads to absolutely nothing useful being produced, not even the much claimed "efficient and optimal allocation of resources".

Instead, it produces a potential for systemic turbulence that can be devastating. Imagine ten pallbearers and that one of them stumbles badly. Get the picture? That's what the sub-prime crisis is all about.

So what you need is some sort of crutches and in a recent speech*, Shyamala Gopinath, a Deputy Governor of the RBI, has described what sort are needed in India. It is worth reading if only to avoid complaining later about that no one knows how the RBI looks at the whole business of derivatives.

"While derivatives are very useful for hedging and risk transfer, and hence improve market efficiency," she said, "it is necessary to keep in view the risks of excessive leverage, lack of transparency particularly in complex products, difficulties in valuation, tail risk exposures, counterparty exposure and hidden systemic risk." In short, a pallbearer with well hidden multiple fractures.

"There is need for greater transparency to capture the market, credit as well as liquidity risks in off-balance sheet positions and providing capital for it. From the corporate point of view, understanding the product and inherent risks over the life of the product is extremely important.

"Further development of the market will also hinge on adoption of international accounting standards and disclosure practices by all market participants, including corporates."

The message: look before you leap because, to quote her again, "insufficient transparency at the firm level probably undermined ex ante market discipline. These issues, which have been well-known to the regulators and the industry for some years become pressing mainly in a crisis.

Lending institutions find it difficult, if not impossible, to simultaneously review in a thorough manner a large proportion of their exposures. How effectively ex post market discipline is allowed to operate
will have a significant impact on the future conduct of financial firms."

*Keynote address delivered by Shyamala Gopinath, Deputy Governor, RBI, at the Euromoney Inaugural India Derivatives Summit, 2007, Mumbai on Oct 24.