Markets: Managing risk with derivatives

By Rahul Ghosh

In 2020, RBI took a step long awaited by the markets—that of liberalising the derivatives business. To regulate the market that thus opened, regulatory directions have been proposed. We are talking of over-the-counter (OTC) derivative contracts such as customisable forward contracts, swaps, options and proprietary products. Here banks act as derivative dealers, and their clients are essentially non-financial business entities.

Derivatives are a great tool for managing risks as well as trading. To be sure, the derivatives market has seen its fair share of mishaps over the last three decades. The proposed directions appropriately come across as one seeking to regulate the derivatives market by trying to avoid accidents.

In the proposed directions, I find two broad pictures.

The first focuses on provisions aimed at ensuring that dealers take their role seriously, i.e. are willing to invest the necessary resources in terms of systems, processes and knowledgeability. The directions relating to this involve provisions such as requiring dealers to undertake only those transactions they can price themselves, expanded due diligence for new product introduction, etc.

The second aims at avoiding mis-selling of derivative contracts. This focus area has some provisions that dealers may find practically challenging to comply with, such as dealers aligning transactions to ‘objective and risk appetite’ of clients, and dealers providing clients with ‘rationale of the transaction’. It would be hard for a dealer to determine objective and risk appetite for a corporate client. Derivatives are fundamentally risk-management tools and the rationale for using these should originate from the end-user (the corporate client, in this case). Another proposed requirement is for dealers to have trades ‘undertaken at prevailing market rates’. Undertaking trades at market rates and generating dealing incomes are mutually exclusive. Fundamentally, any derivative contract when valued at prevailing market rates, at the very moment of it being traded, presents a value equal to zero. Once dealers have embedded their margins into a derivative contract, the contract has a negative value for the client, with the negative value being equal to the dealer’s margin.

Then what could be done to avoid derivatives mis-selling and minimise derivatives-related losses? This is harder to achieve for a banking regulator on its own. To give a parallel, it would be hard to protect a pedestrian (walker) from a potential accident by traffic safety measures alone, unless the pedestrian too exercises alertness and does his own bit to avoid accidents. So, what could be done? The equivalent of putting a pedestrian signal for road crossing would be to apply margining on OTC derivative contracts between dealers and their clients. A careful approach to bilateral margining would help bring at a client’s end discipline, clarity of objectives, and the needed understanding of a product—the attributes required to make derivatives work and to avoid mishaps. This can be approached, for instance, by applying margins above certain threshold values and/or for certain category of transactions and should not be confused with the system of margining at derivative exchanges that involve frequent cash-flow exchanges.

The parallel to an alert pedestrian would be corporate businesses led by risk-based governance and disclosures. For instance, the US Securities and Exchange Commission (SEC) requires companies to make ‘Quantitative and Qualitative Disclosures about Market Risk’ under Section 7A of its annual reporting requirement 10-K for companies. This has led US firms to disclose their market risk exposures in currencies, commodities and interest rates—quantitatively. As a result, there is a better quality of disclosures. Annual disclosure statements from some of these non-financial corporates even have an impact on profitability for stress scenarios/price shocks in currencies, commodities and interest rates. These three asset classes are fundamental to businesses and most non-financial businesses face at least two of these three risks. These are the very asset classes that form the bedrock of OTC derivative contracts, responsible for much of the volumes and outstanding contracts worldwide. India’s capital markets authority has been moving somewhat in this direction, starting with mandating board risk committees for the larger among listed companies. Perhaps this is the way forward.

Author of “End Users’ Guide to Risk Management and Derivatives”, Wiley. Views are personal
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