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| AV Rajwade: OTC vs exchange-traded | | There is a case for reviewing the entire regulatory framework on derivatives in the light of the G20 policy. |
| AV Rajwade / New Delhi Dec 21, 2009, 00:43 IST |
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The Group of 20 (G20), at the summit in Pittsburg in September, resolved that it was committed to “Improving over-the-counter derivatives markets: All standardised over-the-counter (OTC) derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the Financial Stability Board (FSB) and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse”. The US and EU authorities have started taking steps in that direction. So have, among others, China and Mexico. Last month, China set up a body to centralise clearing and settlement of financial products traded among banks. Mexico is starting trading of interest rate swaps on the Mexican Exchange on the New Year.
As for the trading of structured products in the OTC market, in “For that perfect hedge” published in this paper on November 7, I had argued that all OTC trades should be collateralised and subject to daily mark-to-market margins. To my mind, this avoids two major weaknesses noticed in several cases in India and abroad: The end-user’s ignorance of the mark-to-market values, and the mis-management of counterparty credit risk by the banks. One was pleasantly surprised to see the same mechanism being proposed by Robert Rubin, former US treasury secretary, and later Vice Chairman of Citigroup, in an article in a special issue of Newsweek published earlier this month. To quote Rubin, “Transactions that are custom-designed would not be exchange traded but would be subject to the same capital and margin requirements as listed (i.e. exchange traded) transactions.” — in other words, initial and daily mark-to-market margins.
Authorities in many countries have also responded vigorously to the losses sustained by many companies from complex derivatives. Perhaps the most virulent reaction has come from a very senior Chinese officials who, in an article, criticised “the intentionally complex and highly leveraged products that were fraudulently peddled by international investment banks with evil intentions … to a certain extent some international investment banks were the chief criminals and the root of ruin for the Chinese enterprises who encountered this financial derivatives Waterloo” (Financial Times, December 4). The South Korean National Assembly is considering a legislation that would require banks to obtain approvals from the regulators before introducing new products. As reported by me earlier, Indonesia has already banned all structured products.
Banks are obviously lobbying strongly against the proposals to collateralise, limit or ban the use of structured products, arguing that this would “kill innovation”. The argument is spurious. For one thing, much of the so-called innovation has been aimed at evading regulations or taxes. (As Paul Volcker said in a recent interview, perhaps only half in joke, that the only innovation in banking which has really benefited the real economy is the ATM — and this was a mechanical, not financial, innovation.) Again, as Satyajit Das wrote in an article, “The complexity of modern derivatives has little to do with risk transfer. Traders invent complex variations to delay competition, prevent clients from unbundling products and generally reducing transparency.” Actually, plain vanilla products can be used to hedge almost any risk. Bankers’ opposition to the reform is, of course, understandable because it is the opaqueness of complex, structured products that gives opportunities for fat margins. Curiously, the European Association of Corporate Treasures (EACT) has opposed the move to exchange-traded derivatives as it would force them to deposit margins: As of now, most of the larger companies are able to do such transactions over the counter without posting collateral or margin. The concerns of EACT are difficult to understand or appreciate and one wonders whether the body is being unduly influenced by their bankers. The reason is that, in exchange traded products, mark-to-market margining would, half the time, lead to inflow of funds, which the end-user should welcome. (To be sure, the initial margin would always be an outflow, but that is generally small and predictable.)
In our own case, while a large number of companies have suffered unaffordable losses on currency derivatives, the reaction of the authorities has been far more muted. To quote from a CBI affidavit in a case in the Orissa High Court, “The RBI has impressed upon the banks active in derivative business to bear in mind the sensitivities… involved in the transaction such as bank-client relationships and it was stressed that the issue needs delicate handling at a higher level and one to one discussions with clients and continuous monitoring of the situation.” The affidavit also mentions that RBI has acknowledged several violations of the regulatory prescriptions.
In an article titled “Currency derivatives” (November 23), I had criticised some of the specific provisions in the draft guidelines on currency derivatives earlier issued by RBI. Perhaps there is a case to review the totality of the regulatory framework on the subject in the light of the G20 policy; the successful introduction of currency derivatives on the exchanges; and the experience of the losses and regulatory violations — rather than doing a routine “cut and paste” exercise.
avrajwade@gmail.com
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