For a little under a year now the world economy has been shaken by the turmoil in financial markets set off by the sub-prime crisis.  Horst Kohler, a former head of the IMF and now the President of Germany, criticised the international finance industry about a month ago and questioned whether the rapid growth of this industry, the exotic financial products that it purveys and the huge incomes that its managers take home reflect a genuinely useful contribution to the global economy. 

Who is right-Horst Kohler and the many others who have voiced concerns about the impact of the trade in financial derivatives on the stability of financial markets or the market players who believe that wider options for hedging against risk allow a freer flow of borrowing and lending across national boundaries and between counterparties who otherwise may not deal with each other for lack of the trust?  Does the ready availability of insurance actually reduce risk?

Consider an analogy.  Say there is a particularly dangerous pedestrian crossing.  Would the availability of death and accident insurance at the kerbside make the crossing any safer?  Would we consider it proper for by-standers, who themselves are not crossing the road, to buy insurance payable to them if a particular pedestrian does get run over? 

The chances are that most people’s answer to both questions would be to say no. Yet we readily accept risk trading, without the backing of corresponding assets or liabilities, in finance markets for instance through credit default swaps.

Credit default swaps allow companies to buy protection against defaults from a third party who receives a periodic fee as compensation for the risk it takes, and in return it agrees to buy the debt should a default occur. They are like an insurance policy allowing debt owners to hedge against default on a debt obligation. They can be bought even by someone who has not advanced any loan to the entity whose possible default is the event that would trigger the payment by the seller.

According to the International Swap and Derivatives Association data the year-end notional amount outstanding in these swaps has virtually doubled every year from a little under $ 1 trillion in 2001 to $ 62 trillion in 2007.  Just for reference the total amount of international debt securities outstanding at the end of 2007 was $ 22 trillion.

Foreign exchange and interest rate derivatives are much older and developed as a hedge instrument.  Even here the growth in volume is phenomenal and the notional outstanding amounts have increased from just under $ 1 trillion in 1987 to $ 382 trillion by 2007. 

A word of caution is necessary.  Derivatives are contracts between two parties and one party may cover its position by entering into a second contract that offsets the original exposure. Notional amounts outstanding double in consequence, even though the effective market risk position has dropped to zero. Hence the notional amounts may overstate the actual liability of traders at any point in time.  Of course, even though market risk can be covered by off setting contracts the risk of failure by a counter party remains. 

This was the problem that confronted the Federal Reserve when Bear Stearns ran into trouble recently.  With their outstanding derivative contracts of $13.40 trillion (as of Nov 2007) a failure by them to honour these would have led to a domino effect on other players in the market.  Incidentally, in March 2007, Bear Stearns reported that their profits had been boosted by trading in derivatives and the debt of troubled companies and an analyst confidently assured that they had been “more conservative than most other mortgage originators and securetizers, so it’s not as badly affected”.  A year later, in March 2008, this investment bank, which had weathered even the 1929 crash, went under.  That just shows how quickly trouble can strike in highly leveraged financial markets that trade in risk.

Part of the problem is the secretive way in which these transactions are conducted.  A recent news story made available some details about modalities because the parties went to court. UBS negotiated an arrangement with Paramax, a hedge fund, for a credit default swap to cover $1.31 billion in CDOs in return for a payment of  roughly $2 million.  The credit default swap required the insurer to put up collateral whenever the credit was marked down to market.  Within a few months Paramax had to put up nearly $29 million in collateral for this purpose. When the actual default occurred there were claims and counter claims about assurances received about the quality of the debt and disputes about the liability of the insurer.

In India we need better derivative markets for genuine hedge operations.  But already, several private sector banks are already facing law suits arising from contracts in derivatives and this is without any serious involvement in credit default swaps or equity derivatives.   The RBI needs to ensure that we avoid the excessively cute financial engineering that has caused all this turmoil in Wall Street. 

The bespoke part of the derivatives business has three features that the UBS/Paramax case exemplifies:

• The transactions involve serious problems of asymmetric information.
• Transactions are opaque with little known about what lies behind the stated price and often they are conducted off the balance sheet through ad hoc arrangements.
• The liability of the counterparty providing the insurance is not necessarily limited to paying up if there is default and it  has to put up  collateral to cover the gap that opens up if and when the insured asset is marked down to market.

These transactions need to be better regulated and each one of the three points above needs to be addressed through more elaborate disclosure requirements, tighter norms of capital provisioning, a closer look at mark to market requirements and perhaps restricting certain types of transactions like credit default swaps to genuine hedge operations by lenders and borrowers rather than as an open house for all speculators.

The casino capitalism of the derivatives market generates systemic risks that threaten the operation of capital markets.  Curbing the opportunities for gambling in this casino will not hinder but help in the central task of financial markets which is to support the mobilization of savings and their optimal use in investment.