S. Balakrishnan

THE derivatives market seems to be exercising the RBI — and rightly so since derivative products have been responsible for quite a few bank and corporate disasters — remember Nick Leeson and the downfall of Barings Bank. Warren Buffet, the celebrated American investor, compared them to `toxic waste'. But the equally if not more legendary Alan Greenspan, Chairman of the US Federal Reserve, thought they have a definite role in risk mitigation in the real economy and financial markets.

Close on the heels of the `ban' on MIFOR swaps (since relaxed to allow inter-bank deals — see Business Line issue dated May 31 — the RBI proposes to disallow `quanto' swaps, which are structured around LIBOR and rupee interest rates.

The industry body, FIMMDA, appears to agree that quantos have no place in the market; it is going along with the central bank's decision in this matter unlike in the case of MIFOR swaps.

The two products are, of course, different. MIFOR derivatives trade on the dollar-rupee forward premium and fulfil the need for a long-term currency hedge, whereas quantos are based on the relative movements of US and domestic interest rates. It could be argued that there are straightforward interest rate swap products in both the dollar and rupee markets which enable taking views on the latter.

The problem of regulating the derivatives can be seen from different angles. To the extent they facilitate hedging interest rate and currency risks, they also reduce systemic risk. This might be regarded as the `positive' or `good' side of derivatives. But trading (i.e., without an underlying contrary position in the cash market) smacks of speculation, which is bad. Ergo, allow only hedging derivatives and ban trading.

It is, obviously, not that simple. Unless there are market makers willing to assume risk, pure hedgers would be unable to hedge. Thus, a necessary condition for the existence of a market is the existence of risk takers.

The RBI has, rightly, in recent times, laid considerable emphasis on strengthening the capital of banks in line with the best international standards.

It has also stressed the need for effective risk management. Rigorous application of these requirements and strict supervision should ensure that the derivatives exposures of individual banks and the market do not get out of hand.

Derivatives are innovative products of financial engineering. New products are bound to be invented everyday in response to specific balance sheet needs, market positions, opportunities and outlook.

The best safeguards are `caveat emptor' for product buyers and strong risk management among market makers and proprietary traders.

Besides, who said the cash market is less risky than derivatives? Witness the huge treasury losses of banks last year in the wake of rising interest rates.

From the Governor downwards, the RBI had warned banks innumerable times about interest rate risk in their gilts portfolios (diluted somewhat by their new issues of risk-maximising long-dated gilts).

Severe action in this situation might have been to forbid banks from buying Government securities, a la derivatives!

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