Derivatives - Livemint.com

Market making: Sebi slaps show-cause notice on BSE

Anirudh Laskar — Sun, 08 Nov 2009 18:17:00 GMT

Mumbai: India’s capital market regulator has issued a show-cause notice to Asia’s oldest bourse, the 134-year-old Bombay Stock Exchange (BSE), for allegedly violating regulations related to market making.

The Securities and Exchange Board of India (Sebi) issued the notice to the exchange for artificially creating volumes in the derivatives segment in 2008 through market makers without acquiring approvals from the regulator, according to a Sebi official who didn’t want to be named.

Asked why: Without getting Sebi approval, BSE artificially created volumes in the derivatives segment in 2008 through market makers. Ashesh Shah / Mint

A show-cause notice is not an indictment. It seeks an explanation from an entity for certain activities, typically within a time frame.

Kalyan S. Bose, head of corporate affairs at BSE, declined to comment on the issue.

Zia Mody of AZB and Partners, a Mumbai-based law firm, is drafting BSE’s reply to the show-cause notice, according to people familiar with the situation who didn’t want to be named.

Market making is an activity to infuse liquidity by way of two-way quotes given by jobbers or market makers. A market maker quotes both a “buy” and a “sell” price in a financial instrument or commodity, hoping to make a profit on the bid/offer spread.

In 2007, a market-making scheme was approved by the BSE board, chaired by its then managing director and chief executive officer Rajnikant Patel, to ramp up the volumes in derivatives trading, in which its younger rival, the National Stock Exchange (NSE), is the leader.

BSE appointed two of its corporate broker members—Delhi-based SAM Global Securities Ltd and Hyderabad-based Apollo Sindhoori Capital Investments Ltd (later acquired by Aditya Birla Nuvo Ltd)—as market makers, which helped generate trading volume.

Patel resigned in August 2008 and M.L. Soneji, the exchange’s chief operating officer, was given the charge of acting chief executive officer until Madhu Kannan, its current managing director and chief executive officer, was appointed in May.

In July 2008, the exchange withdrew the market-making arrangement after the exchange’s audit committee found some loopholes in its implementation and PricewaterhouseCoopers (PwC) was appointed to look into it.

According to media reports, PwC noted that the way in which the trades were conducted through market making were inappropriate and recommended recovering the amount the exchange lost during the market-making process from SAM Global and Apollo Sindhoori.

The average daily turnover of derivatives trading on BSE in the first quarter of calendar year 2008 was around Rs1,000 crore. It started slipping in April and fell to Rs41 crore in July, according to the BSE website.

In August 2008, trading volumes fell to Rs10 crore while its rival NSE was clocking a turnover of at least Rs44,000 crore.

At present, BSE’s share in the derivatives segment is almost nil, but in the cash segment its market share is around 24%.

Indeed, market-making activities are not banned by Sebi, but it seems that the exchange did not seek the regulator’s clearance before introducing them and allegedly violated some norms.

In an effort to provide liquidity to relatively less traded but fundamentally good stocks, Sebi had in 1999 constituted a committee headed by G.P. Gupta, former chairman of the erstwhile Unit Trust of India, to study the concept of market making.

It issued guidelines to the exchanges to allow brokers to take up market-making activities, following the recommendations of the Gupta panel.

Incidentally, in March 2008, Yogesh Mehta, a former member broker of BSE, filed a petition against the exchange for carrying out the market-making activity to create artificial volumes in the derivatives segment without obtaining permission from Sebi.

Mehta claimed that the profit made out of artificially created volumes in the derivatives segment of BSE should be transferred to its investors’ protection fund (IPF).

He also claimed that BSE incurred a loss of Rs85 crore by appointing two market-maker firms to create volume on its derivatives segment, without Sebi’s permission. Mehta could not be contacted for his comments for this story.

BSE had in 1996 declared Mehta a defaulter. In 2004, after a high court order, Mehta’s BSE membership was withdrawn.

Mehta has filed many appeals with Sebi and the central information commissioner (CIC) against the exchange for not providing information about the stocks and funds remaining in IPF under the Right to Information (RTI) Act.

In November 2008, Sebi’s whole-time member M.S. Sahoo passed an order seeking information about IPF from BSE, under the securities laws.

BSE, however, did not oblige and argued that though various sections of the RTI Act do provide citizens the right to get information, which is under the control of a public authority, it does not provide the same right to the public authority to collect information from private bodies.

In July this year, CIC asked Sebi to collect information from BSE on IPF and give it to RTI applicants.

Sebi has not done so and instead moved the Bombay high court challenging the CIC order, saying it is a regulator and not an information provider.

anirudh.l@livemint.com

RBI not willing to budge, wants to be sole regulator

Anup Roy — Thu, 22 Oct 2009 19:07:00 GMT

Mumbai: The Reserve Bank of India, or RBI, has made a strong pitch for holding on to its turf of being the sole regulator for the financial sector. This, according to the Indian central bank, is essential to ensure financial stability.

Admitting that the global financial meltdown has led to a debate on the regulatory structure best suited to safeguard financial stability, RBI’s Report on Trend and Progress of Banking in India, an annual publication that provides a detailed account of policy developments and performance of commercial lenders in the country, said: “...The responsibility for financial stability cannot be fragmented across several regulators; it has to rest unambiguously with a single regulator, and that single regulator optimally is the central bank.”

Turf war: The RBI building in New Delhi. The central bank has made clear that it is not ready to concede ground to Sebi. Harikrishna Katragadda / Mint

It also said, “There is need for coordination across regulators on a regular basis and for developing a protocol for responding to a crisis situation”.

The RBI report said that the present arrangement of regulating over-the-counter (OTC) derivatives products, or products not traded on exchanges, is well established as only those derivatives where one party to the transaction is an RBI-regulated entity, have legal validity.

By saying this, the Indian central bank has made it clear that it is not ready to concede ground to the capital market regulator Securities and Exchange Board of India or Sebi and intensified the turf war that RBI governor D. Subbarao hinted at in September by coming down heavily on two influential reports that suggested transfer of power to regulate all financial instruments to Sebi.

The exchange-traded products are regulated by the Sebi anyway and hence, “...unlike many countries, India has established procedures for regulation of OTC derivatives”, the RBI report said.

Both the Percy Mistry committee report on making Mumbai an international financial centre and Raghuram Rajan panel report on financial sector reforms had suggested Sebi as the sole regulator of derivatives transactions.

Also Read Banks’ exposure to derivatives, LCs falls 26.4% on slowdown

While there are several models where the central bank’s role is limited as a pure monetary authority with bank regulation and supervision vested with another agency, “post-crisis, the emerging view is that the crisis was caused, at least in part, by the lack of coordination and communication between the separate bodies and that it is optimal, in the interest of financial stability, to entrust the function of regulation of banks and non-banks also to central banks”, RBI report said.

“It is worth noting that some advanced economies where regulation and supervision are with an agency other than the central bank are themselves revisiting their regulatory structures and contemplating some unification”, it added, referring to the latest debate in the UK where lobbying for dismantling the Financial Services Authority, or FSA, is getting stronger by the day.

FSA regulates the financial sector while Bank of England is the monetary authority in the UK.

The report reiterated the governor’s statement last month that unlike equity prices, interest rates and exchange rate are key macroeconomic variables with implications for monetary policy and overall macroeconomic stability.

By regulating banks, which dominate the interest and exchange rate markets, RBI is in a position to take advance action to maintain financial stability at the systemic level.

“This is an arrangement that has stood the test of time, has protected financial stability even in the face of some severe onslaughts,” and hence “it may be desirable to continue with the present arrangement in the interest of pre serving financial stability.”

The report also does not endorse the stance that the high level coordination committee on financial markets—that consists of many regulators and the finance secretary— should have a formal structure. The current structure, according to the central bank, enables free exchange of positions, views and opinions, and a formal structure to the forum will make it excessively bureaucratic and “detract from its other value adding features”.

The report also touched upon the “tension between fiscal and monetary policies” and said it “could potentially militate against financial stability”. It said high fiscal deficits could make a central bank’s job of maintaining price stability difficult, which is a “necessary condition” for financial stability.

Since September 2008, after the collapse of US investment bank Lehman Brothers Holdings Inc, RBI has initiated various measures to make liquidity available in the system and bring down interest rates. It has brought down its policy rate from 9% to 3.25% now and commercial banks have been parking about Rs1 trillion worth of excess funds with RBI daily. Still, the loan rates of banks have not come down substantially as the government needs to borrow Rs4.51 trillion from the market to bridge a 6.8% fiscal deficit. In that sense, the impact of RBI’s monetary policy has been nullified by the fiscal constraint of the government.

The RBI report also said that managing trade-off between financial stability and growth is a challenge.

The central bank has traditionally been using a variety of prudential measures such as specifying exposure norms and pre-emptive tightening of risk weights and provisioning requirements to protect over-heating of the financial system.

“But these measures are not always costless. For instance, tightening of risk weights tempers the flow of credit to certain sectors, but excessive, premature or unnecessary tightening could blunt growth.”

anup.r@livemint.com

Banks’ exposure to derivatives, LCs falls 26.4% on slowdown

Anita Bhoir — Thu, 22 Oct 2009 18:53:00 GMT

Mumbai: Contingent liability or the off-balance-sheet (OBS) exposure of banks, which includes derivatives, letters of credit and guarantees, declined 26.4% to Rs107 trillion at the end of March 2009 from Rs145 trillion last year, driven by the economic slowdown and Reserve Bank of India (RBI) regulations on OBS.

This decline comes after the exponential growth that banks saw in the last three years. The OBS exposure of banks had increased nearly 88.44% to Rs145 trillion in 2007-08 as more companies rushed to hedge their foreign exchange contracts to tide over the volatility in currency markets, according to RBI’s annual report on banking. The increase in 2007-08 was over and above the 80.2% growth seen in 2006-07.

While OBS items are not directly funded by banks, they remain as liabilities on the books of banks, which need to honour the commitment if the client companies fail to do so.

“The economic slowdown had affected corporate activity in 2008-09,’’ said the corporate banking head of a private sector bank who did not want to be quoted as he is not the official spokesperson of the bank. “Expansion, investments and borrowing plans of corporates had slowed down hence the number of forward contracts entered by corporate India saw a dip which also led to a drop in exposure.”

Another corporate banking head of a foreign bank who also did not wish to be named as he is not authorized to speak to the media said: “Banks have stayed away from the derivative business after some companies took legal action against banks’ mis-selling of exotic derivative products on account of which companies had to incur huge losses.”

Many private banks including ICICI Bank Ltd, HDFC Bank Ltd, Axis Bank Ltd, Yes Bank Ltd and Kotak Mahindra Bank Ltd were sued by corporations for the mis-selling of derivative products.

Foreign banks’ exposure to derivatives, letters of credit and guarantees declined 31.2% to Rs70 trillion at the end of March 2009 from Rs102.1 trillion last year. New generation private sector banks’ exposure to such products dipped 29.7% to Rs16.25 trillion from Rs23 trillion. The exposure of public sector banks to OBS items, meanwhile, has risen 2.3% to Rs19.09 trillion from Rs18.66 trillion.

“Foreign and private banks in 2008-09 on account of the liquidity crunch and rising non-performing loans were reluctant to take exposure on corporates,” said a senior general manager in charge of corporate credit in a Mumbai-based public sector bank. “Corporates were forced to come to public sector banks and hence the rise in guarantees given on behalf of corporates and forward contracts.’’

The Reserve Bank of India, on 30 May, modified the guidelines on OBS items to check the rapid growth in banks’ exposure to guarantees and derivatives. The new norms proposed modifications in conversion factors, risk weights and provisioning requirements for specific off-balance-sheet exposures of banks. It also said restructuring of the derivatives contracts, including foreign exchange contracts, should be carried out only on a cash-settlement basis.

In derivatives transactions, any amount of receivable that remains unpaid for 90 days from the specified due date for payment should be classified as a non-performing asset of the bank. These modifications came into effect from fiscal 2009.

The banks were, however, given the option of complying with the additional capital and provisioning requirements arising from these modifications in phases, over four quarters, ended 31 March.

anita.b@livemint.com

Did RBI tightening contribute to the domestic credit crunch?

Mark to Market | Manas chakravarty, Ravi Ananthanarayanan and Vatsala Kamat — Sun, 11 Oct 2009 19:45:00 GMT

The accompanying chart plots the year-on-year growth in money supply (M3) with the growth rate in quarterly gross domestic product (GDP) at current prices in India. The difference between them can be taken as a measure of “excess liquidity”.

That’s not too different from the way Morgan Stanley measures excess liquidity on a global basis—the difference is that it takes a narrower measure of money supply (M1).

Notice from the chart how excess liquidity (the difference between the M3 and nominal GDP growth line charts) completely drained away in the September 2008 quarter, which led to a severe credit squeeze. But the impact of the collapse of Lehman Brothers Holdings Inc. was felt only in the December 2008 quarter. That raises the question whether the credit crunch in the fourth quarter of 2008 was due entirely to international factors or whether local factors such as the restrictive monetary policy then being used to fight inflation also played a role. The chart also shows how the extraordinary steps taken by the Reserve Bank of India (RBI) to infuse liquidity in the fourth quarter of 2008 bore fruit, with “excess liquidity” increasing phenomenally. Earlier, “excess liquidity” spiked in the December 2007 quarter, which was also the quarter that saw the stock market run up sharply higher and also led to a big rise in property prices.

Graphics: Yogesh Kumar / Mint

Domestic liquidity conditions were very different when the economy was coming out of the last recession in 2003. In 2003-04, M3 growth at the end of every quarter ranged between 11.4% and 15.8%, while “excess liquidity” was much lower. Simply put, we’re currently going into a recovery with a huge monetary overhang, which means the scope for asset price inflation is much higher. Of course, stock prices in India are primarily dependent on global liquidity.

Morgan Stanley economists Spyros Andreopoulos, Joachim Fels and Manoj Pradhan, in a recent report, say that excess liquidity has risen to a new high both in the G5 (France, Germany, Japan, the UK and the US) and the Bric (Brazil, Russia, India, China) economies. They point out that “with rates in the major economies unchanged for some time to come and QE (quantitative easing) still ongoing, we see no early end in sight for the global liquidity bonanza”.

For RBI, though, this could be a serious headache, as capital inflows lead to a rise in the rupee. Tightening policy too soon could only lead to a further rise in the currency, as seen from what happened to the Aussie dollar after the Reserve Bank of Australia raised its policy rate. On the other hand, intervening in the currency markets to buy dollars, as is being done by several Asian central banks, will only add to the liquidity glut and fuel inflationary pressures.

StanChart, sugar group in legal battle

Mayank Bhardwaj / Reuters — Thu, 24 Sep 2009 18:07:00 GMT

New Delhi: India’s leading sugar trading firm and Standard Chartered Bank are locked in a legal dispute over derivatives trading losses, according to industry officials and sources.

The Indian Sugar Exim Corp. (ISEC) says it has suffered losses in currency hedging and blames Standard Chartered for bad advice. A bank executive, who did not want to be identified, said clients were always clearly advised about the risks in derivatives trade.

A spokesman for the bank’s South Asia operations declined to comment, saying the bank would not discuss the matter as it is being dealt with by a court in Mumbai.

J.B. Patel, chairman of ISEC, which is jointly owned by the Indian Sugar Mills Association (Isma) and the National Federation of Cooperative Sugar Factories Ltd, said the company had suffered losses from derivatives trading, and was seeking legal remedies.

“It came to the notice of the committee members in April that the organization had entered into derivatives trading which led to losses which must be in crores” of rupees, Patel said on Thursday.

He said ISEC was not responsible for the losses. “Standard Chartered is an authorized agent in foreign currency hedging. They did not offer us a good product for trading. We were expecting good advice from Standard Chartered, which it did not render,” he said.

Guarantees set to boost derivatives trading volume

Anup Roy — Tue, 07 Jul 2009 15:41:00 GMT

Mumbai: The company that settles all bond and foreign exchange transactions in the country, Clearing Corp. of India Ltd (CCIL), will soon offer guarantees on two of the most traded over-the-counter (OTC) derivatives in the country—interest rate swaps and currency forwards—in a move that will likely boost trading volumes.

Between them, interest rate swaps and currency forwards account for about 85% of OTC derivatives trading in India. The outstanding trading volume of the swap market is Rs35 trillion and that of currency forwards is about $500 billion (Rs24.25 trillion). The markets are expanding at about 35% annually, according to CCIL.

CCIL initiative gains importance in the context of growing defaults and shrinkage in volumes last year

An interest rate swap is a transaction in which a floating rate loan is exchanged against a fixed rate loan. An entity uses swaps to hedge or manage its exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than it would have been able to get without the swap.

A currency forward is a contract between two entities to exchange currencies at a future date and at a specific price and quantity.

CCIL will start guaranteeing the products from the point of a deal till its settlement, assuring that the transaction would be honoured, said two senior CCIL officials involved in developing the products. This would help banks save on capital requirements and reduce settlement and operational risks associated with such transactions.

CCIL chairman R.H. Patil spoke about plans to introduce the guarantees at a seminar in Mumbai, the Business Standard had reported on 17 May.

In the absence of a guarantor, these derivative deals can be risky and banks are required to set aside capital to take care of any possible defaults. According to Indrani Rao, chief forex officer of CCIL, banks can save at least 80% of their capital when CCIL starts guaranteeing the deals.

“Banks can also get rid of a lot of operational issues. For instance, they can do away with the department that looks after swaps and forwards markets. Counterparty limits and capital layout will no longer be the constraint,” said Rao.

The CCIL initiative to guarantee OTC derivatives trading assumes significance in the context of growing defaults and shrinkage in trade volume last year after an unprecedented credit crunch hit global markets.

The outstanding trade volume in the interest rate swaps market was Rs70 trillion in August. After the collapse of Wall Street investment bank Lehman Brothers Holdings Inc. in September, the volumedropped to less than half. Daily trading volume also fell sharply from an average Rs30,000 crore to Rs5,000 crore. Having a central counterparty will help restoring confidence, said CCILofficials.

OTC market operators are enthusiastic about the development. “With CCIL guarantees, the volume should go up in these markets. It may become as popular as trading government bonds on NDS-OM (a platform where dealers strike deals anonymously) as there is no counter-party risk involved,” said Arvind Sampath, director of rates trading at Standard Chartered Bank.

Currently, CCIL settles and clears currency forward deals by extending the guarantee only for two days before the actual settlement. Interest rate swap deals are settled without extending any guarantee.

While guarantees for currency exchange forwards will come into force in about a month, guarantees for interest rate swaps will take some more time, said CCIL officials.

OTC deals are largely bilateral in nature, signed between two parties, and can be of any size. Banks and corporations use the OTC market as the sizes of these contracts can be customized in accordance with their needs. In contrast, the contracts for exchange traded products have a standard size and specific maturity dates.

The OTC deals are done mainly over the phone or through trading terminals. CCIL may launch a trading platform for these products, said CCIL’s chief risk officer Siddhartha Roy.

According to CCIL officials, even though the monthly volume of trade in the forwards market is around $90 billion, the cash required to be exchanged at the end of the month, after taking into consideration firms’ payment obligations and receivables from other firms, also known as netting, is only $1-1.5 billion.

Although CCIL did not disclose the exact margin requirement for offering such guarantees, a back of the envelope calculation puts the requirement at around 0.40% of the size of each deal. The margin will also depend on the size and nature of the contract. “The risk profile of the counterparties will be considered for the margin,” said Roy.

“If the margin is high, people will not go for the guarantee,” said Sampath.

For margin requirements, CCIL will accept liquid government bonds and cash. Typically, for interest rate swaps, the most popular benchmark used is the Mumbai interbank offered rate, an overnight rate at which banks borrow money from each other. The duration of such swaps can be up to 10 years.

The interest rate swaps market is largely controlled by 20 major entities. Collectively, they account for about 75% of the trading volume. There are many players in the currency forwards market, with banks dominating the scene.

Overseas, “dark pools” or exclusive clubs of large banks, control interest rate swaps. They trade between themselves in an informal OTC market and the transactions are cleared by a central counterparty.

The concept is yet to pick up in India because of the relative low trading volume, but once CCIL starts guaranteeing these products, the volume will rise and such exclusive clubs of large financial institutions may also emerge, according to foreign exchange dealers.

Tata Group hopes to close $1 bn fund by December

Reuters — Wed, 27 May 2009 08:12:00 GMT

Mumbai: Tata Group hopes to close a $1 billion infrastructure fund by the end of the year and plans to invest it through its realty and infrastrucure unit, a senior official said on Wednesday.

“This will meet a large part of our equity and debt requirements... elections were a decisive factor and investors are very excited,” Tata Realty and Infrastructure chief financial officer Kishore Saletore said.

The fund opened for subscription in mid 2008.

Tata Realty plans to invest Rs200 billion ($4.2 billion) over three years, he added. Tata is among India’s most diversified business groups, with interests in areas such as food, steel, auto, chemicals and software.

Sebi’s approach to derivatives market needs a reassessment

Mark to Market | Mobis Philipose — Tue, 24 Mar 2009 18:45:00 GMT

The final report of the derivatives market review committee appointed by the Securities and Exchange Board of India (Sebi) doesn’t have much to add to the preliminary note, called “New products in futures and options segment”, released last year. The earlier note suggested mini contracts, long-dated options, derivatives on a volatility index, options on futures, derivatives on a bond index, currency derivatives and exchange-traded products involving various strategies. The final report includes the following additional suggestions—exchange-traded credit derivatives; over-the-counter (OTC) products; and exchange-traded third-party products—apart from making slight modifications to the existing ones.

To have credit derivatives trade on an exchange platform is something the ministry of finance has been considering for sometime now. Talk of OTC derivatives, again, isn’t new. Sebi itself has been talking of it since the ban on participatory notes in October 2007. The only new suggestion seems to be exchange-traded third-party products, which are essentially covered calls or structured products issued by institutions holding large stock of a listed firm. As the committee report notes, these institutions may not be able to trade these shares owing to internal policy/directives, effectively reducing the free float in the market. If institutions are allowed to issue structured products with the shares as underlying and these instruments are traded on the exchange, it would not only enable them to generate additional income from their holdings, but also result in effectively increasing the liquidity of the underlying shares.

The only new suggestion is on third-party, bourse-traded products

On OTC derivatives, the committee has laid rather stringent guidelines on who can participate, with a minimum networth restriction of Rs500 crore at the client-level. Needless to say, structured products are best left for entities who are able to not only understand the risks involved, but also weather large losses. But one requirement that OTC contracts are to be used for non-standard products could be done away with. One of the committee’s members, the deputy managing director of the National Stock Exchange, has suggested that OTC contracts should not be identical to the contracts traded on exchanges. It’s interesting to note here that the currency futures contract launched last year is identical in its pay-off to the OTC forward contract, which has existed for years. It seems odd to say that the reverse won’t be allowed. While it’s a healthy trend for more and more products to move to the exchange platform, given the benefits of transparency and centralized clearing, it’s unfair to put restrictions on the OTC market.

The OTC segment, in fact, can act as competition to exchanges and keep them on their toes. To restrain them in terms of product design will be effectively killing competition, which is undesirable. Not that exchanges have to worry much. Traders first worry about liquidity, which is available in plenty on exchanges rather than on the OTC platform. It’s unlikely that OTC products with a similar pay-off will be able to pull a large section of exchange users, since the transaction cost would be much higher.

Apart from new products, the committee has some other suggestions such as an increase in the marketwide position limit allowed for single-stock derivatives. The committee has recommended that the limit should be doubled to 40% of the available free-float. Given the high leverage the derivatives market provides, this seems like a risky proposition. The aim of keeping the limit low was to rule out the possibility of manipulation of share prices using the derivatives market. While memberwide and clientwide limits ensure that positions aren’t concentrated in the hands of a few, the marketwide position limit ensures that manipulation is difficult even if traders collude. The committee goes on to suggest that the limit should eventually be removed.

The committee has also tightened the selection norms for permitting derivatives in single stocks. It has raised the bar both in terms of minimum free-float market cap and liquidity. Similarly, the norms for sectoral indices that qualify for derivatives trading have been made more stringent. This seems to be needless interference. As long as necessary safeguards such as position limits are in place, it should be left to the exchanges to decide which stocks and indices they want to introduce new contracts on. In fact, experts point out that new product introduction is best left to market forces. The current manner in which the regulator approves products is akin to the licence raj, says an exchange official on condition of anonymity. Hopefully, with the anticipated increase in competition among stock exchanges, the policy approach to new product introduction in the derivatives market should also improve.

Write to us at marktomarket@livemint.com

Exporters ask RBI, Finmin to settle derivatives dispute

PTI — Sun, 22 Mar 2009 12:02:00 GMT

New Delhi: Exporters have asked the RBI and finance ministry to resolve their (exporters’) row on derivatives with banks resolved, or else the disputed amount of Rs1,500 crore may turn into non-performing assets in lenders’ accounts closing on 31 March.

Rejecting the banks’ offer for converting the exporters’ losses on complex derivative products into term loans, the Federation of Indian Export Organisations (FIEO) has approached the RBI and the finance ministry for dispute resolution.

ICICI Bank, ABN Amro, Axis Bank, Standard Chartered, State Bank of India are among those which sold currency-related derivatives to about 250 exporters from October 2007 onwards, when the rupee was appreciating fast, FIEO president A Sakthivel said.

While exporters said they bought complex financial products to cover their currency-related risks, they suffered losses when the rupee made a U-turn from early this fiscal. From Rs39 to a dollar, the Indian currency has depreciated to over Rs50 between October 2007 and 20 March 2009.

Almost all of them have refused to pay their loss amounts, stating that banks did not explain to them the complexities of the products. Sakthivel said the agreements signed with banks could not be enforced since they were in violation of RBI rules.

“Banks are also in a dilemma because there are no clear instructions (from the RBI) what they should do ... After a few days it (Rs1,500 crore) would become NPA,“ Sakthivel said. Banks are due to close their annual books this month-end.

Sakthivel said, “Banks want us to convert them (derivative losses) into term loans ... but we will not agree”.

For now, the RBI has asked the banks to show the amount in a separate account.

Asked why agreements signed with banks should not be honoured, the FIEO president said most of the exporters did not understand how the currency movements across the globe could affect the derivative deals.

For instance, the products sold to exporters had a feature whereby the fluctuation between the dollar and Swiss franc would also hit them, he said.

But can ignorance be an excuse for not honouring a contract?

Sakthivel said it can be, because banks did not conform to RBI rules. “One of the exporter’s turnover was Rs5 crore; the derivatives sold (to him) (were of) Rs10 crore,” he said, adding that the RBI guidelines provide checks and balances, which were not included in the contracts.

Ask Mint | Making sense of the chaotic world of options and pricing

Real Simple | Shailaja and Manoj K Singh — Sun, 11 Jan 2009 19:42:00 GMT

Options, one of the most common derivative instruments, can be full of surprises. That’s the reason pricing of options is one of the most challenging jobs. However, we have different pricing models, which try to bring some order in an otherwise chaotic world of options. But these models use complicated equations which are beyond the reach of our friend Johnny. So let’s try to learn, in the language of a newbie, what goes into the pricing of options.

Jinny: Hi, Johnny! I see you are in a lighter mood. What’s up?

Johnny: I remain in a lighter mood whenever I am thinking about something serious.

Jinny: Really? Can I also join?

Johnny: Of course, you can. In fact, I was just wondering whether we can make a mathematical model for catching a fish. I am sure if we are ever able to make such a model, it would not be as complicated as some of our options pricing models. What do you say?

Jinny: Well, I can’t talk much about models for catching fish, but I can surely explain how options are priced without going into complicated details of models, if that is what you want to understand.

Johnny: That’s right, Jinny. But let’s get into the basics first.

Jinny: Options, as you know, are contracts in which the option buyer acquires the right but no obligation to buy from or sell to the option seller the underlying asset at a predetermined price called “strike price”. Options that give the right to buy are called “call options” and options that give the rights to sell are called “put options”. Further, options can be classified as “European options”, which can be exercised only on the expiry date, and “American options”, which can be exercised on or any day before the expiry date. As if these two were already not enough, we also have “Bermuda options” and “Asian options”, which we will ignore for now to avoid confusion.

Also Read Shailaja and Manoj K. Singh’s earlier columns

In options of any kind, the option buyer is under no obligation to exercise his option. However, once he chooses to do so, the option seller is bound to honour his promise. To avail this kind of one-way ticket, the option buyer has to pay a price called “option premium” to the option seller.

Illustration: Jayachandran / Mint

Now, we come to the crucial part. How do we decide the option price that is good enough to induce the option seller to undertake all the risk? Well, we can use any of the option pricing models such as the Black Scholes model or Binomial option pricing model or any one of the other variants for determining the option premium. These models no doubt use complex mathematical equations that look very intimidating to beginners. But once you understand their basics, you can use them like playthings.

Johnny: So far, so good. Tell me, Jinny, how is the price of an option determined?

Jinny: The pricing of an option revolves around two components—one is called the “intrinsic value” and the other is called the “time value”. “Intrinsic value” represents the true worth of your option at present. This value does not remain constant but keeps changing over the life of your option. In fact, its value may fluctuate between zero and infinite positive numbers.

What, you may wonder, if the intrinsic value gets into negative territory? Well, an option having intrinsic value in negatives is only as bad as an option having zero intrinsic value. Why? That I will explain in a while. Just keep in mind that at worst you can lose the bird in hand. You can’t lose more than what you actually had.

Johnny: How can we find out the intrinsic value of an option?

Jinny: For finding out the intrinsic value, there is no need to use complex mathematical equations. You simply need to find out whether the strike price of the underlying asset of your option is higher or lower than its current market price.

For a call option, a strike price lower than the current market price means you can buy the underlying asset at a lower price than the current market price by exercising your option. Such options have a positive intrinsic value which you can find out by subtracting the strike price from the current market price.

Suppose you hold a call option for buying a single share of company X at a strike price of Rs100 per share before the expiry date and the same share is presently trading at a higher price of Rs120. The intrinsic value of the present option is Rs120 minus Rs100, or Rs20. The benefit of such a situation is obvious. You can earn a profit of Rs20 by exercising an option having an intrinsic value of Rs20. In technical terms, we can also say that your option is “in the money” by Rs20.

Johnny: But what if the strike price of the call option is higher than the current market price?

Jinny: Well, that’s something you can think about till we meet next week.

What: The price of an option or option premium consists of “intrinsic value” and “time value”.

How: We can know the intrinsic value by comparing the current market price of the underlying asset with its “strike price”.

When: A call option is “in the money” when the strike price of the underlying asset is lower than its current market price.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com

Barclays seeks arbitration on Sanghi dues

C.R. Sukumar and Baiju Kalesh — Tue, 30 Dec 2008 18:25:00 GMT

Hyderabad / Mumbai: In the latest case of derivative bets gone sour, Barclays Bank Plc. has dragged Hyderabad-based cement maker Sanghi Industries Ltd to the London Court of International Arbitration for alleged non-payment of Rs179 crore following losses from transactions executed between January and April, executives from both firms said.

Also See Concrete Loss (Graphic)

Sanghi Industries, on its part, claims the transactions were fraudulent and in violation of the Reserve Bank of India (RBI) and Foreign Exchange Management Act guidelines.

Barclays Bank has charged the promoters of Sanghi Industries with breaching an agreement signed on 22 May 2007, under which they were to repay any losses from so-called derivative transactions.

The bank has demanded $36.95 million (about Rs179 crore) plus interest.

Barclays’ case against Sanghi Industries is the latest in a line-up of disputes between banks and clients

In November, the bank served notices to the promoters of Sanghi Industries, the flagship company of the Rs3,000 crore Sanghi group, through its solicitors Allen and Overy Llp. Mint has reviewed copies of the notices.

“Barclays Bank confirms that it has begun arbitration proceedings against Sanghi Industries due to their failure to make payments to Barclays Bank in respect of derivatives transactions,” Clare Williams, a spokeswoman for the bank, wrote in an email. She added that Barclays completely “rejects any claims that it has acted in an inappropriate or non-transparent manner in its dealings with Sanghi Industries.”

Bina Engineer, Sanghi Industries’ chief financial officer, said in an email to Mint that her company “will pursue legal remedies available to it including a claim on the bank for the loss and defamation suffered by it”.

Barclays’s case against Sanghi Industries is the latest in a line-up of disputes between banks and their clients over the legality of such products.

Several firms had entered into contracts with banks in an effort to shield themselves from fluctuations in the foreign exchange market, but found themselves at the wrong end of the deal after strong currency fluctuations. These firms have alleged that they were “mis-sold” the products by the banks involved.

As defined by RBI Act, a derivative is an instrument to be settled at a future date, and whose value is derived from change in interest rate, foreign exchange rate and other securities including interest rate swaps, forward rate agreements, foreign currency swaps and options. The debate is whether these products were sold for hedging or speculation.

In October, the Madras high court had ruled in favour of Axis Bank Ltd in a dispute between it and Coimbatore-based Rajshree Sugars and Chemicals Ltd, saying derivative contracts were not wagering, and thus not illegal, and the lender could approach the Debt Recovery Tribunal.

Earlier in September, the Bombay high court had asked Sundaram Multi Pap Ltd to pay to ICICI Bank Ltd the dues arising out of contracts for structured derivatives the two had signed, but hadn’t gone into the legality of the instruments.

Sanghi Industries, which owns a 2.6 million tonne cement plant at Kutch, Gujarat, has hired senior counsel Harish Salve to argue the case in London and will file a case in India as well, Engineer said.

Engineer of Sanghi added that Barclays Bank had approached Sanghi Industries, which has export earnings of at least $50 million, last year recommending certain derivative transactions to reduce its cost of debt and hedge forex risk. The rupee was then trading below 40 against a weak US dollar, but started depreciating since April.

Engineer said Sanghi Industries had asked Barclays Bank to review the risk in these trades several times and, later, to terminate them, but the bank had advised it to continue with the trades.

“There were very complex trades with multiple currency exposure which were based solely on the Barclays’ recommendation and advice,” Engineer said.

Barclays Bank served its first notice on Sanghi Industries on 3 November asking it to clear its dues by 6 November. Non-payment would be considered an “event of default” under the terms of the master agreement, the bank said in its notice.

When the dues were not cleared, Barclays Bank served another notice intimating 20 November “as the early termination date in respect of all outstanding transactions under the master agreement”.

Sanghi Industries, already embroiled in a legal battle among four Sanghi brothers over the control of the company, has seen its share price fall 67% in 2008. It has a market capitalization of Rs560 crore and paid-up equity capital of Rs304.82 crore.

cr.sukumar@livemint.com

Is India more socialist now?

Mark To Market | Manas Chakravarty and Mobis Philipose — Mon, 22 Dec 2008 18:06:00 GMT

The 1970s was the era of big government and socialism in India, right?

So how is it that the share of government expenditure (centre plus states) in gross domestic product (GDP) has gone up from 25.12% in 1970-71 to 34.78% in 2007-08?

It’s also widely accepted that liberalisation started from the Rajiv Gandhi era in the early 1980s. But it was in 1986-87 that the share of total government expenditure to GDP reached its peak at 40.43%.

What has been the record since 1990-91, when the government made a decisive shift to relying on the private sector as the engine of growth?

In 1990-91, the percentage of total government expenditure to GDP was 38.13%. This went down to 31.75% by 1996-97 and then started to go up again, reaching 38.83% in 2003-04, even higher than what it was in 1990-91. Thereafter it went down again to 32.59% in 2005-06 before inching up again.

Also See Spending Spree (Graphic)

Nevertheless, the Union government’s share in GDP has actually fallen since 1990-91. It was 20.44% in that year and was down to 15.39% in 2006-07, although that was still well above the 13.08% share of GDP that the Union government had way back in 1970-71, during the so-called “socialist” heydays. But state government expenditure as a percentage of GDP has not fallen and indeed has gone up a bit since 1990-91.

How do we reconcile these numbers with the undeniable fact that there has been a sea change in the Indian economy since 1990-91?

What seems to have happened is that there has been plenty of deregulation, the private sector has been allowed into many new sectors and a few privatizations have taken place, but subsidies too have gone up substantially and the net result is that there hasn’t been much of a difference in the total ratio of government expenditure to GDP. Moreover, a lot of the ups and downs in this ratio seem to be taking place because the denominator, ie GDP, goes up and down disproportionately—for instance, the ratio falls when GDP growth is strong.

How does India compare with other countries on this metric?

OECD data for 2007 show that “General government expenditure to GDP” was 37.4% for the US, 44.6% for the UK and 53.8% for Sweden. But comparisons may not be right, because of the different ways in which government expenditure has been computed—for instance, it includes local government expenditures also in the US.

It’s also worth noting that these countries also have extensive social security programmes, unlike in India. But if government expenditure is taken as an indicator of socialism, then we’re more socialistic than we were in 1970.

Write to us at marktomarket@livemint.com

Pyramid Saimira: Sebi needs to look sharp

Mark To Market | Manas Chakravarty and Mobis Philipose — Mon, 22 Dec 2008 16:48:00 GMT

Corporate governance issues are flying thick and fast in India.

According to various reports, one of the promoters of Pyramid Saimira Theatre Ltd, P.S. Saminathan, has been asked to make an offer to minority shareholders for flouting takeover norms. The news sent the company’s share price soaring in early trades on Monday. But later the company wrote to stock exchanges that it hasn’t received any such order from the Securities Exchange Board of India. As a result, the stock gave up all its gains and in fact ended the day 10% lower.

One of the reports, by the DNA newspaper, said: ”A Pyramid Saimira spokesperson told DNA Money on Saturday the company just received the notification and is looking into the matter.” It’s interesting that the company and this promoter say on Monday that they hadn’t seen the order.

But the bigger issue is that the said order from Sebi hasn’t been sent publicly by the regulator. Journalists at various newspapers got it from market sources. What makes this case all the more suspect is that Monday was supposed to be the day Saminathan was to pick up a 23% stake in the company from a co-promoter. The price at which the deal was to be struck was the lower of Rs 200 and the ruling market price. The fact that the news of the open offer was leaked to the media for publication on this very date raises questions. While Sebi is on the Pyramid Saimira case, it would be worthwhile to get to the root of all this. At the same time, the regulator also needs to do some internal checks to find out how such price sensitive information got leaked, before its public announcement.

Write to us at marktomarket@livemint.com

Market meltdown restricts complex debt issuances

PTI — Mon, 15 Dec 2008 13:55:00 GMT

By rys

Mumbai: Rating agency Crisil Ltd has said that there has been a fall of 80% in the issue of “complex” instruments during November amid difficult conditions in the financial markets.

Crisil categorizes different instruments issued by the companies for fund raising based on their complexity.

It said in a statement on Monday that “the relatively sophisticated ‘Complex’ and ‘Highly Complex’ categories accounted for more than 60% of the 139 instruments issued in October. However, the share of these categories plunged to only 18% of 83 debt issuances in November”.

Crisil said the sharp fall in complexity of debt instruments was attributable to uncertain financial market conditions, with a meltdown in the equity market, tight liquidity in the debt market, and a cautious approach to credit by lenders due to expectation of an economic slowdown.

Crisil categorizes financial products by the ease of identifying and understanding their risks such as simple, complex and highly complex. It launched this service, a global first, to help investors gauge the level of sophistication and due diligence required before investing in an instrument type.

Crisil said highly complex issuances in October largely comprised equity index-linked debentures (47%) and pass-through certificates related to securitization transactions (45%).

The looming slowdown in capital formation

Mark To Market | Manas Chakravarty and Mobis Philipose — Sun, 30 Nov 2008 17:35:00 GMT

Despite the robust investment numbers for the September quarter, the drying up of external funding has already started to take a toll on domestic investment. It’s true that India has, in the past few years, seen an impressive improvement in its savings rate and rate of capital formation. The gross savings rate rose from 23.5% of gross domestic product (GDP) at market prices in FY02 to 36.2% in FY08. Similarly, gross capital formation went up from 22.8% of GDP at market prices in FY02 to 37.4% in FY08.

In July, the Prime Minister’s economic advisory council had said that the domestic savings rate would decline to 34.5% in FY09 because of increased subsidies which would erode government savings and on account of lower corporate profits that would slow corporate savings. The investment rate, however, was expected to remain at a high 37.5%, the shortfall resulting in a higher current account deficit.

But with the appearance of the credit crunch in India, analysts are taking a relook at these estimates. They point out that much of the rise in capital formation was the result of the surge in capital inflows that was the direct result of the global credit bubble.

Also See Foreign Funding (Graphic)

A recent Citigroup Inc. report says that net inflows in the capital account were equal to 24.6% of gross capital formation in FY08. Citi analysts write: “What does all this mean? Simplistically, large capital inflows have meaningfully supplemented domestic savings and effectively bumped up India’s investment and growth momentum. We believe such capital inflows, if reduced or negative, would have implications for investment-driven growth.”

Merrill Lynch and Co., Inc. analysts have estimated that the gap between corporate savings and investment was 7% of GDP in FY08. Of this gap, 3.7% was contributed by bank credit, the rest coming from external commercial borrowings and the capital market. The drying up of other sources of funds will hurt corporate investment.

But will the savings and investment rate go back to where they were in the early 2000s? FY08 was rather exceptional, because of very strong net capital inflows. In FY07, for instance, foreign capital inflows were 13.8% of gross domestic capital formation and in FY06 they amounted to 9.1%. That’s almost the same as in FY2000, when capital inflows were 8.7% of gross domestic capital formation.

So what is the likely extent of the slowdown? A note by Centrum Broking says: “Following a prolonged expansionary phase, spreading over 2003-2008, we expect the investment rate (gross domestic capital formation or GDCF/GDP, both in nominal terms) to realign with the falling savings rate (nominal savings/GDP). We now expect savings rate to fall marginally below 30% by FY10 from 38% in FY08 (estimated). The realignment of investment rate will be stronger due to lack of external capital flows. Hence, we now expect investment rate to gradually decline to 33% from our earlier estimate of 35% (39% actual in FY08).”

Note, however, that’s still well above the rates of growth of capital formation during the last downturn.

Write to us at marktomarket@livemint.com

Funds sell record Rs22,271 crore of debt in Oct

Ravi Krishnan — Sun, 26 Oct 2008 16:41:00 GMT

Mumbai: Indian mutual funds sold debt worth Rs22,271 crore in the first three weeks of October because investors are reluctant to infuse fresh money to replenish outflows caused by a surge of redemptions in a volatile market.

The industry is hopeful that investors will come back once the liquidity situation gets better

Analysts say the measures taken by the Reserve Bank of India (RBI) to ease a cash and credit crunch will take time to soothe the Rs5.29 trillion mutual fund industry, but inflows should return soon with the overnight inter-bank money market rate declining to around 6.5% from around 20% at the peak.

Higher call rates encourage investors in debt funds, particularly banks, to withdraw money from mutual funds and lend in the overnight call money market to earn more.

RBI has cut its policy rate by 100 basis points and banks’ cash reserve ratio (CRR), or the proportion of deposits that banks need to keep with the central bank, by 250 basis points to release Rs1 trillion into the banking system. One basis point is one-hundredth of a percentage point. Besides, it also created a Rs20,000 crore liquidity window for mutual funds.

So far, mutual funds have drawn only Rs8,800 crore from this window. On Friday, there was no taker.

The Rs22,271 crore debt sale, a record high, is only a quarter of the total sold by fund houses, according to some analyst estimates. Most sales took place through off-market deals, or the over-the-counter market. Capital market regulator Securities and Exchange Board of India collates only stock exchange data and does not take into account off-market deals. Debt funds account for some Rs3.2 trillion in assets under management.

“It is a sign of continued redemption pressure,” said Dhirendra Kumar, chief executive officer (CEO) of Value Research, a New Delhi-based mutual fund tracker.

Following the crash of some US investment banks and the state-sponsored bailout of others, credit market across the globe collapsed.

Foreign institutional investors, or FIIs, have pulled out at least $12 billion, or about Rs60,000 crore, from equity markets so far in India to send money home. This has weakened the rupee and in its bid to stem the fall of the local currency, RBI has been selling dollars, sucking rupee liquidity from the system. On Friday, the local currency fell below the 50 mark against the dollar for the first time.

Overnight inter-bank lending rates rose to as much as 20% in the second week of October, and banks and companies rushed to pull out money from mutual funds, especially liquid or money market mutual funds. These are short-term funds, where banks and companies park their surplus cash.

In the first two weeks of October, an estimated Rs30,000 crore, or about 30% of the corpus of the so-called liquid and liquid-plus schemes, had been withdrawn.

With banks refusing to lend money, fund houses had no option but to sell their debt paper to honour these redemptions.

“The CRR cuts didn’t benefit mutual funds as much as expected,” said Waqar Naqvi, CEO of Taurus Asset Management Co. Ltd.

He says that the main source of funds for asset management companies remains inflows and these haven’t picked up yet.

That the mutual fund industry continues to be under redemption pressure can be seen from the fact that they sold Rs5,189 crore of debt on 22 October, two days after RBI cut its policy rate.

Ritesh Jain, head of fixed income at Principal PNB Asset Management Co. Pvt. Ltd, which manages around Rs10,000 crore, said “it will take time for RBI’s measures to take effect”.

According to analysts, mutual funds typically see increased inflows in October, which marks the beginning of the third quarter of the fiscal year. But this time around, the acute liquidity crunch has led to net redemptions for funds and investors aren’t coming back with fresh money

“Fixed maturity plans keep on maturing. Earlier, people were deploying that money back in mutual funds but now they are not,” said Hemant Rastogi, CEO of Wise Investment Advisors, a financial advisory firm.

“There is too much of negativity all around,” said Naqvi of Taurus. “Till the time investors come back, you will find that mutual funds are net redeemers.”

Still, the industry is hopeful that investors will come back once the liquidity situation improves.

“With call rates remaining low, we should soon start to see inflows,” said Jain of Principal PNB.

Norway fund to put $2 bn in India

Sanjiv Shankaran — Tue, 21 Oct 2008 18:56:00 GMT

New Delhi: In a move that will bring considerable relief to Indian equity markets roiled by the global credit crisis, the Norwegian sovereign wealth fund (SWF), plans to invest around $2 billion (about Rs9,772 crore) in India, primarily in equities, over the next two months because it has increased India’s weightage in its investment portfolio.

According to Thorvald Moe, deputy secretary general in the Norwegian finance ministry, India’s weightage was enhanced recently to 0.94% from the earlier 0.2%. The enhanced weightage will see an inflow into India of around $2 billion, which needs to be invested by the end of this year, Moe said.

This money will come into the country at a time when foreign institutional investors (FIIs), the main driver of Indian stock markets, have taken out close to $11.2 billion from the country since January.

In this period, Sensex, the benchmark index of the Bombay Stock Exchange has fallen by almost 50% to 10,683.39, the level it closed at on Tuesday.

Also Read Centre puts SWF under the scanner

No threat from sovereign wealth funds, says Finmin

An SWF is a global investment fund owned by a government and generally run by it. Unlike a private international investment fund, which is governed by profit motives, SWFs might have national strategic objectives that have made them controversial investment vehicles.

This year, following an internal debate on the security threat SWFs pose, the government decided to follow the finance ministry’s suggestion that India could at this time ill afford to be picky about the kind of overseas investors who bring in money. “There will certainly be an impact here. In a difficult environment, an incremental change makes a difference both ways (buying or selling),” Ved Prakash Chaturvedi, managing director of Tata Asset Management Ltd said on the prospect of a $2 billion inflow.

The Norwegian SWF, dubbed Government Pension Fund-Global, has a corpus of about $350 billion and invests 60% of its corpus in equity, 35% in fixed income and the balance in real estate.

“We expect it (Norwegian SWF) to be $600 billion in two to three years,” Moe said. India and China, with close to 1% weightage, are among the leading emerging markets in the SWF’s portfolio. The largest investments are directed to the US and the UK which have weightages of about 30% and 15% of the corpus, respectively.

The Norwegian SWF is constantly replenished by the country’s petroleum exports.

Markets offer early warning signals

In The Money | Mobis Philipose — Mon, 20 Oct 2008 17:02:00 GMT

Derivatives, especially the exotic kinds, have become a bad name across the world. India, too, has had its share of problems with over-the-counter (OTC) forex derivatives. One good outcome of all this is that the case for exchange-traded derivatives has only become stronger vis-a-vis OTC markets. It has become increasingly clearer to more policymakers and market participants that wherever standardization is possible, a derivatives contract must be listed on an exchange to avail of the benefits of transparency and the elimination of credit risk through centralized clearing and settlement.

In India, the Percy Mistry committee report on “Making Mumbai an International Financial Centre” had emphasised the importance of having exchange-traded markets over OTC even before the current global crisis erupted in mid-2007. The recommendations of the committee with respect to introducing new derivatives markets on an exchange-traded format are strongly endorsed by officials at the ministry of finance, and even by the new chiefs of the Securities and Exchange Board of India and the Reserve Bank of India.

As a result, India now has the distinction of being one of the rare countries to introduce new derivatives markets this year, at a time when most countries are clamping down with bans or more regulations. A new currency futures market was introduced right in the middle of the global financial crisis and the interest rate futures market is only a few months away. All this is good, but the larger lesson to be learnt from the global financial crisis is that markets—exchange-traded or OTC—offer early warning signals, which policymakers can use to take decisive action. Instead, the derivatives market is being demonized and the opportunity to learn this lesson is being missed. Even Indian policymakers are feeling rather smug about protecting the Indian markets from the ill effects of fancy derivatives, reflecting the broad view that the derivatives markets are at the root of the current global crisis.

But it is increasingly becoming clear that the root of the problem is aggressive real estate lending and not the securitization of those loans and the trading of related instruments. J.R.Varma of the Indian Institute of Management, Ahmedabad points to an important statistic in his blog: According to the latest IMF (International Monetary Fund) Global Financial Stability Report, 30% of the estimated financial sector write-downs were related to unsecuritized loans. A year ago, this figure stood at 17%, which means that the percentage of losses attributable to unsecuritized loans has almost doubled.

Varma says, “What we see is that because of the mark-to-market approach, securitized assets show losses earlier while the held-to-maturity approach allows losses on loans to be concealed and deferred. In this sense, the securitized paper was the canary in the mine that alerted us to problems quite early. Policymakers are completely mistaken in believing that absent securitization, we would not have had any problem. All that would have happened is that banks would have been in a state of denial longer.”

In the US, the market for collateralized debt obligations (CDO) gave warnings of a huge problem in the making over a year ago. Back then it was the CDO market and its users that were largely blamed for the mess in the markets. Policymakers went after the messenger (the markets), rather than heed the important message it was carrying. If policymakers had acted decisively since then, perhaps we wouldn’t have been in the current situation.

In India, we’re facing a similar situation with a clarion call by brokers and some politicians to ban short-selling. The pertinent question to ask is: “What is the message current prices of equity and equity derivatives are carrying and is there a cause for alarm?”

According to Varma, the 80% drop in share prices of real estate companies indicates that a 30-40% fall in realty prices from peak to trough is quite conceivable. Already, prices in some parts of the country have fallen by 20%. Real estate developers are hoping for a miracle during Diwali, but the stock markets belie any such notions. If indeed real estate prices drop by 30-40% and this is coupled with job losses and/or salary cuts, both consumer and corporate loans linked to the sector can come under threat. After all, home loans in India offer enormous leverage to the consumer, when compared with the market price of the property. The problem of falling real estate prices and high leverage, which has hit the US financial sector, could hurt the Indian financial system as well.

Already, there are signs of stress visible in mutual funds (MFs), who have lent to real estate firms. With the expected slowdown in the economy and with the days of easy cash over, there could be delinquencies in other sectors as well. In the worst case scenario, Varma says some banks and MFs would have to be rescued by the government.

And all this could happen without derivatives trading in collateralized debt. The problem is that policymakers view the stock markets and more so of the derivatives markets like casinos and little importance is given to the prices they generate. India has been slow on the uptake as far as introducing new markets is concerned. At least, it shouldn’t be lackadaisical about using the warning signals that come from existing markets.

In The Money runs every other Tuesday. We welcome your comments at inthemoney@livemint.com

Also Read Mobis Philipose’s earlier columns

Meeting margin calls costly for hedge funds

Michael Prest / breakingviews.com — Wed, 15 Oct 2008 18:52:00 GMT

It adds insult to injury. Hedge funds don’t just have $65 billion (Rs3.15 trillion) of positions stuck in the wreckage of Lehman Brothers Holdings Inc., the fallen US investment bank. They now also have to meet margin calls on those positions, even if they don’t know where they are or if they can be recovered.

Click here for breakingviews.com

A margin call is a demand from a broker to a customer to bring up the margin deposit — depleted by a fall in the price of the security purchased on margin — to the required minimum level.

The margin calls are adding to the strain on hedge funds. Some may want to close but cannot because they don’t know what assets they have left in Lehman. Overall, the extraordinary mess is contributing to the sector’s most dismal investment performance in 20 years.

Lehman was one of the biggest prime brokers, as well as being a major equities trader itself. The London business had 3,500 clients, of which hedge funds had $45 billion in assets and $20 billion in short positions. Audit firm PricewaterhouseCoopers is now the administrator of the London business.

Makeover: Barclays Capital logos displayed on the facade of the Lehman Brothers Holdings Inc. headquarters building in New York. Gino Dominico / Bloomberg

The mess goes back to the common practice of hedge funds posting collateral with their prime brokers in return for cheap finance. The brokers often used the collateral to lend in their own operations — a process called rehypothecation.

But stock lending under English law is a transfer of ownership. When Lehman went into administration, all these assets were frozen — without their original owners knowing who held them and on what terms. Worse, rehypothecated assets are ranked in the general pool of creditors.

Olivant, the fund run by Luqman Arnold, admitted earlier this month that it could not lay its hands on its $2.78 billion stake in UBS AG, the Swiss bank, which had been lodged with Lehman. GLG Partners Lp. and RAB Capital Plc., both London-based funds, are also among those with assets frozen.

The latest indignity for hedge funds is that they have to go on meeting margin calls on the positions stuck in Lehman — even if they cannot be sure that they still own them. Sorting out who owns what in Lehman could take years. The pressure is likely to swell the growing ranks of hedge fund closures and weigh down the performance of others.

Derivatives: Madras court rules in favour of Axis Bank

Anita Bhoir — Tue, 14 Oct 2008 19:37:00 GMT

Mumbai: In a ruling that could set the precedent for at least a dozen cases between companies that bought complex derivative products and banks that sold them, the Madras high court on Tuesday ruled in favour of Axis Bank Ltd in a dispute between it and Coimbatore-based Rajshree Sugars and Chemicals Ltd (RSCL).

“The high court has held that the derivative contract is not a wagering contract, which means it is not illegal. It has also been held that amount due to the bank (Rs46-50 crore) is a debt as defined under the Debt Recovery Tribunal Act and hence the bank can approach the Debt Recovery Tribunal (DRT),” said a person familiar with the development, who did not want to be named.

Rajshree Pathy, chairman and managing director of RSCL, was in London and could not be reached for comment. Calls to the firm’s Coimbatore office weren’t answered.

“An order has been passed and the stay has been vacated,” said Parthasarthy Mukherjee, president of treasury at Axis Bank, referring to the stay order that had been obtained by the company to prevent the bank from approaching the tribunal.

RSCL is one of several firms that entered into contracts with banks in an effort to protect themselves from fluctuations in the foreign exchange market. Many of these firms found themselves at the wrong end of the deal after the dollar depreciated sharply against the rupee and also against other currencies last year. These firms have alleged that they were “mis-sold” the products by the banks involved.

Also Read Sundaram loses case against ICICI Bank

RSCL had alleged that one of its 10 transactions with Axis Bank was based entirely on the probable fluctuation of the US dollar and the Swiss franc, and “there is no rupee loan swap or a hedge against export in this deal, thereby making it purely speculative”. The firm had alleged that the bank “lured” it to enter into such an exotic contract “with misrepresentations and false promises”.

Indian companies are allowed to hedge their exposure to foreign currencies on account of imports or exports, but the country’s laws frown on speculative hedging for the purpose of playing the market.

“The contract was entered into on 22 June 2007, when the rate was $1=CHF (Swiss franc) 1.2355. On 28 June 2007, the defendant bank paid $100,000 (Rs47.7 lakh today) to the plaintiff, which was duly credited to the plaintiff’s bank account. This was net inflow of premium which the plaintiff received for writing this option in favour of defendant bank,” the firm said in its complaint

“The contract was purely a speculative contract and the plaintiff was lured into a wager or a gamble on the movement of dollar against Swiss franc by entering into the contract,” the complaint added.

On 10 April, rating agency Fitch downgraded RSCL’s Rs60 crore commercial paper programme due to potential losses on account of its derivatives exposure and poor financial performance in the third quarter. “Ruling against the company will result in substantial fresh losses, and put further pressure on RSCL’s credit metrics beyond the current rating level,” the agency said in a note.

RSCL’s net profit for the quarter ended 30 June rose to Rs8.67 crore, against Rs1.20 crore in the corresponding quarter last year. Revenue for the quarter dipped to Rs87.46 crore from Rs94.39 crore in the same period last year.

This is the second instance where Axis Bank has been permitted by a court to approach DRT to recover dues from a company. On 8 September, the Ludhiana district court allowed the bank to enforce its derivatives contract with yarn and steel maker Nahar Industrial Enterprises Ltd. Apart from Axis, several other private sector banks such as ICICI Bank Ltd, HDFC Bank Ltd, Kotak Mahindra Bank Ltd and Yes Bank Ltd are fighting similar cases across India. The value of a derivative is pegged to the value of an underlying stock, bond, currency or some other asset.

In a recent order, the Bombay high court asked Sundaram Multi Pap Ltd to pay ICICI Bank the dues arising out of contracts for structured derivatives the two had signed. The 15 September judgement, however, didn’t go into the legality of the instruments involved, or the motives behind their sale to firms by banks. It merely asked Sundaram to pay up.

On 12 March, ICICI Bank filed a petition in the high court for the “winding up” of Sundaram Multi Pap for “non-payment of a sum of Rs2.94 crore”. The bank filed the case after a cheque for Rs1.52 crore, issued by the firm, bounced.

The Mumbai court is yet to hear a case filed by Sundaram Multi Pap questioning the legality of the instruments sold to it by ICICI Bank.