The Reserve Bank of India last week fined as many as 19 public, private sector and foreign banks for contravening its norms on the use of over-the-counter derivatives. The list of banks includes the largest in the country such as State Bank of India, ICICI Bank Ltd, HDFC Bank Ltd, Axis Bank Ltd, Citibank NA and Standard Chartered Bank.
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There’s a nice little story going around in commercial banking circles to describe the situation: There was once a classroom with 22 children, each of who turned out to be ill-disciplined at the end of their school term. In such a situation, rather than holding all the students responsible, wouldn’t the finger of blame point towards the teacher?
By penalizing 19 banks, the central bank has effectively said that almost all the banks offering over-the-counter (OTC) derivatives to customers stand guilty of violating its rules. It’s valid, therefore, to ask the question: What was the central bank doing when its regulated entities were flouting rules en masse?
It’s important to note here that the central bank’s formal observation on the whole forex derivatives mess comes more than three years after the problem had reached its peak. At the end of its long investigation, RBI has concluded: “These banks contravened various instructions issued by the Reserve Bank in respect of derivatives, such as, failure to carry out due diligence in regard to suitability of products, selling derivative products to users not having risk management policies and not verifying the underlying or adequacy of underlying and eligible limits under past performance route.”
The central bank is known for its tough inspection process and it’s unfortunate that the above missteps went unnoticed or were ignored when the alleged mis-selling of derivatives products was happening.
But the larger problem, as pointed out in this column before, is that the central bank fostered a non-transparent OTC market for currency derivatives, instead of encouraging a more transparent exchange-traded market. True, India now has a relatively liquid exchange-traded currency futures and currency options markets. But remember that work on this began thanks to a push from the ministry of finance and initiatives by the Securities and Exchange Board of India.
The messy legal battles between Indian banks and their corporate customers to deal with losses in the derivatives market could have been avoided if the trades were either exchange-traded or even centrally cleared to ensure that margins were being collected systematically. Even now, the central bank’s new guidelines on OTC derivatives fail to address the need for a more comprehensive risk management system. It has taken measures to safeguard the system against misselling of products and has restricted the sale of structured derivative products to listed companies and unlisted companies with a net worth of Rs 100 crore.
But while the world is moving towards centralized clearing and settlement, the central bank doesn’t yet seem to be convinced about its utility. It can be argued here that adopting central clearing for structured derivatives would be difficult. But it must be noted that this isn’t an impossible task, since complex derivatives can be broken into pieces and those pieces can in turn be margined. Importantly, the practice of collecting mark-to-market margins brings the needed discipline into the markets that no amount of inspection can achieve.
Of course, the role played by the Clearing Corporation of India Ltd (CCIL) can’t be ignored here. It already acts a central counterparty for forex forwards and short duration swaps. And in the options segment, CCIL will soon start a trade repository which will gather details of transactions in the segment. As and when volumes pick up, it will start settling these trades on a non-guaranteed basis. But it has stayed away from structured products.
Thankfully for users of currency derivatives, a rather robust exchange-traded market has now developed. The market has reached a size where even large Indian companies can meet some of their hedging needs. While this is a great development, there is also a need for an OTC derivatives market and the central bank needs to consider improving the risk management framework in this market further.
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