Former derivatives trader and author Satyajit Das suggests that we lean on the mangled wisdom of Donald Rumsfeld to understand the derivatives mess that is unfolding in India. “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know,” said the former US secretary of defence, when he had explained the situation in Iraq to a confused press corps.
Rumsfeld won a “Foot In Mouth” award for that one— and rightly so. But his three categories of knowledge and ignorance could actually help make sense of the snowballing legal cases against banks that are now accused of dumping toxic waste on Indian companies. Mint reported on Monday that estimates of mark-to-market losses on derivative contracts are between $2 billion and $7 billion.
The legal battles will be about who is to bear the losses—the banks that sold derivatives or the companies that bought them? When Small Company X bought currency swaps from Big Bank Y, what was it thinking about—known unknowns or unknown unknowns? In other words, did the company know what it was getting into or didn’t it? Was it willingly misled?
There will be no generalized answers. Most derivatives were structured to meet the needs of specific companies. Sorting out cases of wrong bets and cases of mis-selling will have to be done with care, derivative contract by derivative contract. Coming down on banks with a regulatory bludgeon will serve no purpose at all.
Separating the two types of derivatives losses will help drive home a larger point. Currencies and interest rates will fluctuate, and there will be a need for derivatives to transfer the risk from these fluctuations. But we need a set of rules on how derivatives are bought and sold—as well as a good dose of common sense.
Most of the companies that will cry foul in the months ahead should have known better than punt in markets they did not understand. They should never have dived into the pool of unknown unknowns.
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