Are Indian companies and banks prepared to jump into the complex world of derivatives?
There is a good reason why we are asking this question right now. The Reserve Bank of India (RBI) said in the new monetary policy announced on Tuesday that the Indian financial system could soon see a range of new derivatives—from currency futures to credit default swaps. The market for various interest rate futures and swaps, too, is to be strengthened. Earlier, Mint had reported on 17 April that the government was planning to ensure that rupee-dollar futures contracts would be traded on the stock exchanges. The Percy Mistry committee to look into how Mumbai can become an international financial centre, too, recommended several boosts to derivative markets.
We welcome each of these initiatives. They are inevitable steps in our journey towards becoming an economy with a sophisticated financial system.
As the Indian economy globalizes, the volatility of financial prices is bound to increase. And companies and investors will need a robust derivatives market to manage various risks that arise when interest rates and the value of the rupee bob up and down.
An interventionist system has stable interest rates and exchange rates—but this stability is tricky. The central bank squeezes volatility out of the system, though this often means that the adjustments in financial markets are brutally sudden when, as in Asia in 1997, central banks cannot suppress market fundamentals any longer. A market-driven financial system rarely sees huge swings in financial prices, though there is far more short-term volatility.
It is well known that derivatives can be a double-edged sword, and there are well-known examples of global companies, investment banks and hedge funds which have bled to death (or almost did) because of the leveraged positions they took in various derivative markets. Think of Barings, Sumitomo and Long Term Capital Management (LTCM). This is not to suggest that derivatives are, to use legendary investor Warren Buffet’s evocative term, weapons of financial destruction. Derivatives slice risk, rather than increase it.
Yet, there is a lot to be done before Indian companies, barring a handful of exceptions, can actually use derivatives to their advantage. One immediate issue is ignorance. Banks and financiers who have a far better understanding of the risks involved in them, compared with the companies that participate as counter-parties, often sell financial derivatives. There is a clear case of information asymmetry—one party knows more than the other. There have been enough cases of the companies in the US and Europe later complaining of being victims of the resultant inappropriate sale of derivatives. Indian companies will have to go through a long period of training and education before they know what they are doing with options, swaps and the like.
The other big challenge will be governance. The board of directors, as well as senior management, has a very large role here, to ensure that rogue traders do not make wild bets, as Nick Leeson did when he destroyed Barings in 1995. Indian companies will have to evolve a very clear policy of how risk is to be managed and how derivative positions are to be reported. Each company will have to decide its overall risk profile and tolerance. There should be a clear system of compliance. And there should be internal expertise in assessing derivative portfolios and running them through various stress tests, to figure out what would happen if the bets were off the mark.
How many Indian companies are in a position to do all these things? Not many. We are convinced financial derivatives are important weapons in the battle against risk. But you need to be trained and prepared to use these weapons effectively, or they may blow up in your face.
Are Indian companies ready to use derivatives? Write to us at email@example.com