Blaming derivatives for financial losses is akin to blaming cars for drunk-driving fatalities, according to Christopher Culp, adjunct professor at the University of Chicago’s Booth School of Business. The Reserve Bank of India (RBI) seems to concur. It has come to the view that the right response to the forex derivatives muddle isn’t banning exotic derivative products.
Instead, it seems to be attempting to ban the equivalent of drunk drivers in the over-the- counter, or OTC, forex derivatives market. According to a report in The Economic Times, the central bank plans to restrain banks from selling exotic derivative products to companies with scant disclosures, inadequate understanding of risks, and balance sheets below a certain size. But even this partial ban (for small companies) is a poor response. For one, companies such as Wockhardt Ltd and Hexaware Ltd, which lost heavily from wrong derivative bets, weren’t small. It’s wrong to assume that only small companies will act recklessly.
Illustration: Shyamal Banerjee/Mint
Secondly, mis-selling by banks was equally responsible for forex derivatives mess. Even their role should be addressed while providing a solution. RBI’s draft guidelines on OTC forex derivatives, released in late 2009, has a good suggestion to tackle mis-selling, such as quantifying the maximum loss/worst downside in various scenarios in the term sheet signed by customers. But more needs to be done to avoid a repeat of what happened in 2008, when banks were forced to go to the courts to recover losses on derivative contracts from their clients.
One major reason for the problem was the lack of a comprehensive risk management system. Banks, unlike clearing corporations of exchanges, don’t normally follow the concept of mark-to-market margins. If daily mark-to-market margins were imposed on each forex derivatives position, exotic or otherwise, the problem wouldn’t have reached the level it did. Instead, margin calls were made late in the day, after losses had already reached unmanageable levels.
Banks should adopt a daily mark-to-market system, which can be audited by the regulator, to mitigate the risk from writing derivative contracts.
Needless to say, there will be resistance from banks and their clients to such a proposal. But once there is a diktat from the central bank, banks and companies will get used to the new system. With a good risk management system in place, banks and companies will have the freedom to deal in derivative products of their preference. This would be a better solution compared with putting restrictions on some sections of the market.
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