Why derivatives are weapons of mass destruction

As financial markets remain volatile, Warren Buffet's description of derivatives as 'weapons of mass destruction' is turning out to be more and more apt for banks and theircorporate clients. As for the former, in the last few weeks alone Deustche Bank has reported a loss of $400 million on equity derivatives; and Caisse d'Epargne, a French bank, has sustained a loss of euro 600 million, also in trading equity derivatives. This is the third major trading loss reported by a French bank this year, the earlier two being Societe Generale (euro 4.9 billion) and Credit Agricole (euro 250 million).

Another large potential loser is Gulf Bank in Kuwait. However, this loss seems to be in the nature of a credit risk rather than in proprietary trading, since the transaction was on a back-to-back basis with a corporate client, who is now refusing the bear the loss.

Major losses on currency derivatives have also been reported from Latin America and Hong Kong. Commercial Mexicana, the third largest retailer in Mexico, has declared bankruptcy after sustaining a loss of $1 billion on currency derivatives. Cemex, the cement major, has also sustained mark-to-market losses of $650 million; so have Alfa ($200 million) and Gruma ($700 million).

Many of these seem to be accounting losses, and should be compensated by equivalent gains in the value of the underlying if the transactions were genuine hedges. In the case of Comercial Mexicana, the derivatives were obviously not hedges as otherwise there would be no need of a bankruptcy filing. The Mexican central bank governor has publicly criticised the banks who sold the derivatives, saying, "The investment banks that accepted as a counterpart a company that had nothing to do with the type of products it was handling well -- that to me suggest lack of professionalism, to put it mildly."

The Mexican securities market regulator has also warned that banks could be called to account if they were selling derivatives without sufficiently explaining the risks involved. He has claimed that "the people who were selling these instruments should have known better. These are not the standards that we want to see in our markets." Losses on a similar scale have also been reported by Brazilian companies.

The biggest single loss ($2 billion) by a corporate was reported last month by Citic Pacific, the Hong Kong-listed company promoted by China International Trust and Investment Corporation. Citic Pacific has had to seek a $1.5 billion line of credit from its Chinese parent. Reading the details of Citic Pacific's transactions gave me a sense of deja vu.

While Citic Pacific has claimed that the objective of the derivatives was to 'fix its cost in USD,' in effect it had written put options on the Australian dollar and the euro -- a curious way of achieving the objective, to say the least. As the US dollar appreciated, the sold options have resulted in a $2 billion loss. The terms of the contracts were such that the company would have made a very limited gain had the dollar fallen, but was liable for unlimited losses on its rise.

The sense of deja vu arises from so many similar cases one has come across in the Indian market.

Clearly, this seems to be the year of derivatives, the biggest loser of course being banks in US and Europe. In his latest book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, George Soros has criticised central banks for permitting the banks they supervised to take on risks that the regulators could not calculate, a point I had made in an earlier article (Financial meltdown: Asleep at the wheel). The key issue is whether banking regulators in the US and Europe had the specialised skills in mathematical finance to analyse and judge the internal models the banks (and rating companies) were using to measure risks.

One wonders whether a similar question can be raised in respect of our own central bank, given what has happened in the currency derivatives market in India over the last one year. In terms of the information placed before Parliament, the aggregate mark-to-market losses have been Rs 27,300 crore (Rs 273 billion), but that they 'do not pose a systemic risk.' Surely a part of the MTM losses are on genuine hedges of underlying risks but, equally surely, half or more could well be on speculative trades marketed by authorised dealers to their corporate clients.

To my mind, given the great asymmetry in knowledge about derivatives, between banks on the one hand and corporate clients on the other, considerable responsibility lies on the shoulders of the banks who marketed the speculative trades, arguably in violation of exchange regulations. And, authorised dealers are, in effect, agents of the central bank for implementation of the regulations: This is the reason why, under FEMA, one party to any foreign exchange transaction has to be an authorised dealer.

Let me quote a few examples of derivatives which, my banker friends tell me, they are using for the last several years with no objection from the supervisors:

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