One of the most significant developments in the securities market has been through development and expansion of financial Derivatives. Derivates are the contract which derives its values from the underlying assets and has no independent value of its own. The contract in the derivatives prescribes the conditions which are required to be followed by the parties. The condition in the contract varies from transaction to transaction, although, some common clauses includes dates, the parties to the contract, resulting values, details of the underlying assets etc. The Derivatives are of four type's namely forward, future, Options and Swaps.
It is quite difficult to trace the origin of Derivatives but according to a publication of 1984 of Futures Industry Association on "An Introduction to the Futures markets", it is said that derivative trading dates back to 2000 B.C. It was during that period the merchants made consignment transaction for goods to be sold in India. The writing of Aristotle also depicts that during 350 B.C there was a trading in options contract. Therefore it can be found that Derivatives market was prevalent before the time of Christ. The Royal Exchange of London was the first exchange which permitted forward contracting. However it was Mr. Edmund Eddie O'Connor who is believed to be the person who introduced the instrument of Derivative in the modern market.
The performance of another entity outlines the value of derivatives. These entities are known as "underlying" which are in the form of commodities, stocks, assets, bonds, indexes, interest rates, currencies etc. The change in value of these assets over the period of time over which derivatives run denotes the maturity value of derivatives. Although the underlying assets in derivatives contract is not limited to the above mentioned variables, it can include any component which has some monetary value and which fluctuates with change in market conditions. However, those underlings might add up to complexity in valuation of these instruments.
The derivatives are traded through Over the Counter (OTC) or Exchange Traded Derivatives (ETD). The OTC derivatives are privately traded contracts which do not have any intermediary or any derivatives exchange but ETD are traded only in a derivatives exchange or some other exchange and it is the exchange which controls the regulatory aspect of these derivatives. The swaps and forward are the examples of OTC. The OTC market constitutes the largest market for derivatives and has banks and hedge funds other highly sophisticated parties as the parties. This type of trading is preferred because it does not require any disclosure to be made to any external body and can be concluded through private arrangement between the traders.
The Derivatives trading has been significant in the modern era because people are finding it to be one of the best methods in risk management. It is a tool to hedge against risk and is deemed to be a kind of insurance. Certain other people find it to be a profitable source of investment through short-term fluctuations in the market prices.
But, according to Raghuram Rajan, Governor of RBI and a former chief economist of the International Monetary Fund (IMF) "... it may well be that the managers of these firms [investment funds] have figured out the correlations between the various instruments they hold and believe they are hedged. Yet as Chan and others (2005) point out, the lessons of summer 1998 following the default on Russian government debt is that correlations that are zero or negative in normal times can turn overnight to one — a phenomenon they term "phase lock-in." A hedged position can become un-hedged at the worst times, inflicting substantial losses on those who mistakenly believe they are protected.1"
More rightly pointed out by Warren Buffett, these are nothing but financial instruments of mass destruction. Large losses can follow because of the use of leverage, or borrowings as small movements in the underlying asset's price can allow investors to earn large returns.
But due to, substantial fluctuation of price against them can make the investors lose large amounts. Several instances of massive losses in derivative markets have resulted in erosion of $39.5 billion in the last decade. Starting 1994, the derivatives world was hit with a series of large losses on derivatives trading announced by some well-known and highly experienced firms, such as Procter and Gamble and Metallgesellschaft. Orange County, in California, declared bankruptcy, allegedly due to the use of leverage in a portfolio of short- term Treasury securities.
Unlimited Counter-party risk and huge notional value has also been the criticism factor in Derivatives contract.
Bad turned Worst
According to Forex Derivative Consumers' Forum (FDCF) president Raja M Shanmugam, "It was during the first half of 2007 when there was a steep appreciation of the rupee against the US dollar whereby rupee fell to 39 per dollar from 46 per dollar within a short span of time. During that time, several banks approached the exporters claiming that they had sophisticated derivative products that would save the exporter by making profits which would offset the loss suffered on account of rupee appreciation. The promise made by the banks was that they would look after the fluctuation part of the deal and take care of it so that there are no losses in transactions."
However, by the end of FY2007-08, several exporters across the country started facing huge mark-to-market losses when the bankers started quoting the global financial crisis as the reason behind the fallout. It was also quoted by Mr Raja that only due to the intervention of the Orissa High Court did all these issues came to limelight, whereby the country came to know that the loss projected by the RBI on a particular date was around Rs 31,700 Crore.
As a matter of convention, exporters generally use Plain Vanilla Forward Contracts to hedge their currency risk due to export business but it was in 2007 that these exporters were approached by several banks stating that it was time for them to switch over to more sophisticated hedge instruments such as exotic derivative products to effectively deal with currency risk. The banks in unembroidered sense went on to their doorsteps stating that there was no need for any collateral securities or NOCs – and was just a matter of signature in the ISDA master agreement that would suffice and assuring the rest. Claiming to be centuries old it was banks who have portrayed and promised that they had a well equipped treasury department that would take care of the fluctuations part of the contract so that there will be no loss to the investor's account.
Investors particularly in the nature of hedgers (including exporter making garments, spices, etc for the rest of the world), they had little exposure to these complex products. They have entered into these contracts purely on the advice of the banks that sold them. But they were appalled to find that the banks absolved themselves from any responsibility when losses in crores of rupees started to accumulate. They changed their stance, saying, 'you have signed the contract, so you have to bear the losses'."
Scams that were brewing
Following the onset of the global financial crisis of 2007–2008, Barclays manipulated LIBOR downward by telling LIBOR calculators that it could borrow money at relatively inexpensive rates to make the bank appear less risky and insulate itself. The artificially low rates submitted by Barclays came during an "unprecedented period of disruption."
British Bankers Association (BBA) explains LIBOR as the rate used by many banks worldwide as a base rate for setting interest rates on consumer and corporate loans. According to U.S. Commodities Futures Trading Commission, hundreds of trillions of dollars in securities and loans are linked to LIBOR, including auto and home loans. When LIBOR rises, rates and payments on loans often increase; likewise, they fall when LIBOR goes down. LIBOR "is used for an increasing range of retail products such as mortgages and college loans," while also being used as "the basis for settlement of interest rate contracts on many of the world's major futures and options exchanges,". 2
Many UK-based banks accused of massive mis-selling in Italy estimated to the tune of 35 billion Euros and also in rest of the world including India.
It came in December last year that European Union antitrust regulators fined six financial institutions including Deutsche Bank, Royal Bank of Scotland and Citigroup a record total of 1.71 billion Euros (US$2.3 billion) for rigging financial benchmarks.3
The news on Financial Post also states that authorities around the world have so far handed down a total of $3.7 billion in fines to UBS, RBS, Barclays, Rabobank and ICAP for manipulating rates, while seven individuals face criminal charges.
UBS paid a record fine of $1.5 billion late last year to the U.S. Department of Justice and the UK's Financial Services Authority for rate-rigging.
Whereas In India, 19 banks were penalized to a mere amount of Rs. 5 lac until Rs. 15 lac in India including SBI, ICICI Bank, HDFC Bank, Axis Bank and several foreign banks operating in India, including Citibank, Standard Chartered, HSBC and Deutsche Bank for violating the guidelines of Derivatives. It is to be noted that this violation led to cost India for about Rs. 25L Crore.4
Common features of the deadly Weapons
As quoted by Satyajit das, a famous risk consultant and author of 'Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives' in his article in the Financial Times "How to design derivatives that dazzle and obfuscate'5 , "The process is deliberate. Efficiency and transparency are not consistent with high profit margins on Wall Street and in the City. Financial products must be opaque and priced inefficiently to produce excessive profits."
The profit centric minds of the derivative desk's heads of the investment banks started on to utilize their innovation power at the full capacity, when in 2006 in India there were events from RBI tweaking the regulations, which turned in favor of the banks rather for the investors. The year was July, 2006, when RBI amended its previous Master Circulars on Derivatives by way of allowing 'Zero Cost Option Structures' for the use by the banks and other financial entities. The period often remembered as the "Derivatives Mis-selling Era" that started from July 2006 until the midst of 2008, was a period in which false sale of derivatives begins by the means of rampant marketing and false sale of exotic derivative products, mostly zero cost option structures, to unsophisticated investors across the country begins. The deals were happening whilst enjoying the backwaters massages offered to the Chief Financial Officers and Forex heads of the corporate as a gesture from the selling banks.
"The unique feature about all these exotic contracts then traded in India was that when profits arose, they would be only in small amounts say $10,000, but when losses surface, they would run into crores of rupees. In many cases, the "maximum to investors" to "actual profit ratio for the banks" works out in the range of 1:1000 or 1:5000.
One of the most famous instruments preferred by banks back in 2007-2008 were the contracts, known as knock-in/knock-out, or KIKO, options, that involves two currency levels. Under KIKO, corporate stood to profit from the bank as long as the first currency they are long on strengthened until the capped "knock-out" price. If the currency rose above that value, they have a right to sell second currency at a favorable exchange rate to the bank would be knocked out, ceasing to exist. If the first currency fell below the other capped level, the "knock-in" price, corporate would have to sell more of the second currency to the bank at an unfavorable rate, taking a loss.
Similar case happened with Koreans in 2008, whereby KIKO led the Korean corporation to bankruptcy whereas on the other hand the eight banks that sold the most KIKO contracts reported 2.57 trillion won of profits at market price from outstanding currencyoption contracts as of Sept. 30, 2008, according to the FSC. Those contracts included the currency options contracts the banks sold to their corporate clients as well as those traded among the banks themselves said an article on Bloomberg dated 24th March, 2009.6
1. Raghuram G. Rajan (September 2006). "Has Financial Development Made the World Riskier?"
5. Article by Satyajit Das in Financial Times: "How to design derivatives that dazzle and obfuscate'", dated 8th July, 2009
6. Article on "Korean Corporations Court Bankruptcy With Suicidal KIKO Options" published on Bloomberg
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