Mumbai: The beginnings of India’s controversial derivatives muddle can be traced back to a period of extraordinary and beguiling calm in the global financial markets. But it was actually the calm before a storm that has sunk many ships.
The International Monetary Fund (IMF) had noted in the April 2006 edition of its Global Financial Stability Report: “Low nominal and real interest rates and the environment of low volatility…has continued to encourage risk-taking and leverage.” A four-year global economic boom that was aided by low borrowing costs had lulled bankers, investors and company treasurers around the world into believing thata few extra risks would do no harm.
Data collected by the Bank of International Settlements (BIS), a central bankers’ club based in the Swiss town of Basel, shows that the size of the global derivatives market more than doubled between 2004 and 2007, to touch $516 trillion. India, too, saw explosive growth.
How Hedges Became Messy (Graphic)
Dramatic Growth (Graphic)
There was another factor at play in India. The sharp rise in the rupee after April 2007 had eaten into the profits of many small exporters. “Exporters tried to protect their earnings by going in for exotic foreign exchange derivatives,” says veteran financial consultant A.V. Rajwade. “To my mind there was a lot of mis-selling and gross transgressions of RBI (Reserve Bank of India) regulations,” he adds.
The subprime crisis had already reared its ugly head in the US mortgage markets. But the overall outlook appeared sanguine. So it seemed safe to make all sorts of risky derivative bets.
And then a lot of things went horribly wrong. The credit crisis struck in August. By the end of the year, large parts of the Western financial markets were shut for business, central banks were doing stuff they had never done before to save embattled financiers, and currencies, bonds and equities were bouncing off in completely unexpected directions.
Twelve months later, in April, many Indian companies and banks are battling each other in the courts to decide whether various derivative deals are within the law. The Institute of Chartered Accountants of India (Icai) has asked its members to ensure that the firms they audit keep aside money for potential derivative losses. And informal estimates of how much money Indian companies could lose in case they sold their derivatives right away—what accountants call mark-to-market losses—have climbed to Rs20,000 crore.
So, what went wrong?
The second half of 2007 was not a replica of the first half.
An imperfect guide
The Indian companies that are now nursing derivative losses had failed to remember an old rule—the past is an imperfect guide to the future. They got into derivative deals believing that the prices of currencies, bonds and commodities would remain on the straight path of predictability. There were, however, a few sharp turns in the road, thanks to the global credit crisis. Many companies did not anticipate these turns and have thus ended up in the ditch.
Derivatives are contracts whose value is derived from another price. So a currency derivative derives its value from the price of the currencies on which it is based. Similarly, there are derivatives on bonds, interest rates, equities, commodities and much else. A move in the underlying price usually leads to a change in the price of the derivatives that are based on it.
Consider the way the US dollar and the Swiss franc have moved against each other. This particular exchange rate is important because three of the misfired derivative bets that have landed in the Indian courts over the past few weeks were based on the relationship between the two currencies.
Between September 2006 and September 2007, the dollar-franc exchange rate moved in a tight band of 1.20 to 1.27. That’s all of seven basis points (a basis point is a hundredth of a percentage point). Bloomberg data shows that there were a mere 13 days during these 12 months that the dollar stepped outside this narrow corridor. So, anybody looking at that currency chart in the middle of last year would have been tempted to conclude that this remarkably stable relationship would last over the coming months and years.
It seemed a fine time to make a few “safe” bets on the dollar price of a Swiss franc. Actually, it wasn’t.
On 22 June 2007, the Swiss franc traded at 1.2355 to a dollar. That was the day when Rajshree Sugars and Chemicals Ltd entered into a complex derivatives deal with Axis Bank Ltd. The derivative was based on the movement in the exchange rate between the US dollar and Swiss franc. Two other deals that are in the courts—between Sundaram Multipap Ltd and ICICI Bank Ltd and between Sundaram Brakes and Linings Ltd and Kotak Mahindra Bank Ltd—are also based on the dollar-franc exchange rate. All three deals have a similar structure of pay-offs. Sifting through the details of such deals tells us a bit about what went wrong.
Mint showed the documents, presented to the Madras high court by Rajshree Sugars and Chemicals, to a foreign exchange adviser who has requested anonymity. He explains that the deal was based on three scenarios.
First scenario: In case the dollar-franc rate moves by 30 basis points on either side of the spot price on 22 June 2007—either to 1.2385 or 1.2325—the bank pays the company $100,000.
Second scenario: If the rate touches 1.2385, the deal gets “knocked out”. It ceases to exist and neither company nor bank has any liability.
Third scenario: If the exchange rate touches 1.1250/1.200, the company has to buy $20 million from the bank at the rate of 1.33 francs for every dollar. Thus, 1.1250/1.200 is the rate at which the derivative deal “knocks-in”.
It is in the third scenario that the company loses money on the deal. It has to buy dollars at 1.33 to a franc from the bank, when the market rate is far lower. But, as we said earlier, the Swiss franc seemed unlikely to touch that rate against the dollar when the deal was signed at the end of June 2007, since it had moved in a tight corridor in previous months.
But the Swiss currency did leap outside this corridor against the dollar, as the US greenback fell after the US Federal Reserve slashed interest rates and the world’s largest economy headed into a recession.
The sudden drop in the value of the US dollar did not surprise economists who had been predicting this for quite some time. But the financial markets had taken a very sanguine view about the scars in the US economy—a huge fiscal deficit, a growing trade gap, a housing bubble and lax lending standards in the financial system. The drop in the dollar singed many investors, including Indian companies that had bet on its stability by looking at the recent past.
There were similar unexpected movements in other asset markets, including the price of emerging market bonds. Another sort of price tumble—of emerging market bonds—hit ICICI Bank which announced mark-to-market losses of 264 million on credit derivatives in early March.
Financial turbulence led to a global sell-off on all sorts of assets that have higher risk, such as bonds issued by companies in India. The credit derivatives that are based on them also saw price declines.
“Until August, there was no real widening of spread and so, there was no erosion in the market value of the portfolio. In the September quarter, the spreads widened and we first booked losses. We are aware of our portfolio and every quarter we need to follow the accounting practice of marking to market. It will all depend on the spread,” ICICI Bank joint managing director Chanda Kochhar told Mint in early March.
How serious is the problem?
No doubt about it: The raw numbers seem mind-boggling. But what do these numbers really tell us about the risk to the Indian financial system?
Ever since finance minister P. Chidambaram told Parliament that banks in India had a total derivatives exposure of Rs127.86 trillion, there have been concerns that there is an unlit derivatives bomb in bank balance sheets. After all, the derivatives held by banks are more than three times India’s trillion dollar gross domestic product (GDP).
“The financial sector as a whole has evolved a lot and the banking industry is coming up with newer and newer instruments which are complex. Unfortunately, regulators have not kept pace with the developments happening. The gulf between players introducing ever newer and more complex instruments and the regulators is widening to the disadvantage of the public,” says Rajeev Chandrasekhar, the member of Parliament who asked the parliamentary question that Chidambaram replied to.
There is other data to show that Indian banks and companies have been having an intensifying love affair with derivatives. BIS tracks the growth of derivative markets around the world through a triennial survey of central banks. The 2007 survey shows that daily trading in over-the-counter derivatives—those that are privately negotiated between two parties and are not traded on public exchanges—has grown at explosive rates in India since 2001.
Daily turnover is an indication of market liquidity rather than the size of the local derivatives market or the amount of risk in the system.
Average daily turnover shot up from $2 billion in 2001 to $4 billion in 2004 to $27 billion in 2007, according to BIS. Foreign exchange derivatives have led the charge, going up from $2 billion in 2001 to $3 billion in 2004 to $24 billion in 2007. The rest comes from interest rate derivatives. Should we worry? Not necessarily. To understand why this is so, it is useful to know what these numbers are really all about.
Chidambaram was referring to the nominal value of derivatives outstanding in the investment books of banks operating in India. BIS explains in its notes to the 2007 triennial survey of central banks that nominal amounts outstanding is a measure of market size, and not of risk. “Nominal amounts outstanding provide useful information on the structure of the OTC derivatives market but should not be interpreted as a measure of riskiness of these positions,” says BIS. For example, a bank may hold two types of currency derivatives. One will make money if the dollar zigs while the other will make money if it zags. The overall risk could be low in such as “hedged position”. Yet, both derivatives will be added to calculate a bank’s total exposure.
“Neither notional amounts nor gross market values are good measures for the risks transferred through derivatives. Notional amounts can be far larger than the amounts actually transferred through derivatives, in particular in the case of interest rate contracts. Gross market values give a snapshot on how much it would cost to replace all existing contracts at prevailing market prices at a given point in time. They, thus, refer to the “mark-to-market” of these contracts, which is quite independent from the potential exposures that could arise if prices were to move further. Ideally, we would like to have some measure of potential future exposures, but there is no accepted methodology for computing this,” says Christian Upper, head (monetary policy and exchange rates) of the monetary and economics department at BIS, in an e-mailed response to a Mint questionnaire.
In short, there is little correlation between the size of the nominal amounts of derivatives outstanding (which is the oft-quoted number) and the risk in the system (which is the primary worry about derivatives).
Further, a huge chunk of the nominal amounts outstanding as far as foreign exchange derivatives go were relatively less risky forward contracts. In a speech given at a seminar on the Indian derivatives market in Mumbai on 24 October 2007, RBI deputy governor Shyamala Gopinath gave some hints about the nature of derivative positions in bank balance sheets. She said the total amount of foreign exchange contracts outstanding amounted to Rs44 trillion. Of this, “almost 84% were forwards and the rest options”. The outstanding notional amounts for cross-currency swaps were another Rs 2,24,000 crore. Rupee swaps—which are largely between banks—were another Rs64 trillion.
The fears that toxic derivatives could choke the financial system and harm the entire economy seem overblown. RBI governor Y.V. Reddy said in a statement in April that while RBI is monitoring the situation and is in “constant dialogue” with some banks, there are no systemic risks.
Counting the damage
It is now time to count the damages.
How the losses will be totted up will depend on the precise nature of the derivatives that companies and banks have entered into. The easiest ones to deal with are what are called exchange-traded derivatives. These derivatives have a daily market quote, similar to the daily price of a listed share in the stock exchange, so marking them to market is not much of a problem.
The OTC derivatives that have been privately negotiated and are not traded will present more difficulties to accountants. The most popular way to put a value on them is to use the Black Scholes option-pricing model that is used the world over. “Unless options are listed and traded in the market, the Black Scholes model will be used to value what companies and banks hold,” says Gautam Nayak, partner in audit firm Contractor, Nayak and Kishnadwala.
This iconic valuation model was unveiled in 1973 by financial economists Fisher Black and Myron Scholes. Their widely used formula—which Indian accountants are likely to use—takes many factors into account: the price of the underlying asset, the strike price of the option, the risk-free rate of interest, the time in years for the expiration of the option contract and the implied volatility.
Rising interest rates and higher volatility in the financial markets could lead to steeper falls in the notional price of options in the months ahead. The global derivatives market continues to gasp for air—and banks with credit derivatives will have to keep more money aside as provisions.
We have not yet seen the end of the great Indian derivatives mess.
Venkatesha Babu in Bangalore contributed to this story.