The Hindu Business Line : Will the RBI probe and unravel the derivatives scam?

Complex exotic derivatives were sold to unwary exporters in Tirupur, most of them matriculates or school drop-outs, in what is clearly an exercise in deception. Was it just for the fee? Or did the banks have another motive? S. GURUMURTHY hopes the central bank will soon get to the truth.

The derivatives products merchanted by banks to the Palanisamys of Tirupur are known in forex trade as ‘exotic’. ‘Exotic’ means “strangely beautiful, enticing” also used as an adjective in ‘exotic dancer’ that is, “belly dancer, or the like”. The word ‘exotic’ as prefix to the derivatives poignantly captures how Tirupur’s exporters must have been mesmerised by the banks, rather like teenagers by stripteases and belly dancing.

As a curtain-raiser to how the Tirupur exporters were lured into exotic derivatives, here are some tips on forex derivatives. A derivative is a hedge against a risk; the hedge protects ‘against a fluctuation in the foreign exchange rate, rather than profit from it’.

Experts assert that currency laws in India allow hedging to avoid losses, but not to make profits. Derivative structures that yield profits are void, they say. Where do the Tirupur derivatives stand in this view of law? Start with the forex forward contracts, an undoubtedly permitted hedge. It works thus.

If a Tirupur knitwear maker commits to export when the rupee is, say, 41 to a dollar, he may forward-sell his export income in dollars at Rs 41 so that even if the dollar falls later to, say, Rs 39, the exporter will still get Rs 41. This is known in forex trade as ‘vanilla’ or plain forward, which hedges the risk of fall in forex.

But the derivatives merchandised by the banks to the Tirupur exporters were not that simple. A brief survey of the Tirupur derivatives shows that they were complex, exotic derivatives or seemingly simple ones but not allowed in law.

First, complex exotic derivatives were sold to the unwary exporters, most of them matriculates or school drop-outs, in what is clearly an exercise in deception. Even the most accomplished financial minds cannot fathom such derivatives.

Bewildering jargon

Here is an example of the complex derivatives hawked on Tirupur’s streets in the second and third quarters of 2007. Beware. The next few lines will spin the mind. An illustrative derivative deal dated July 3, 2007 (with ‘Tokyo cut’ ‘European style option’ and ‘American barriers’ as features) expiring on May 23, 2008 reads: “The exporter buys (and the bank sells) USD Call/CHF Put at strike 1.2300 for USD4 million with Knock Out @1.2400; The exporter sells (and the bank buys) USD Put/CHF Call at strike 1.2300 for USD8 million with Knock Out @ 1.24, Knock In @1.12”; “Double One touch option with trigger 1.2270 and 1.2330 with pay off USD 50000 on maturity”

Option legs? European style? American barriers? Tokyo Cut? Double one-touch option? Knock In? Knock out? How would the school dropouts-turned exporters in Tirupur have grasped these bizarre terms? Its effect, which even some experts cannot easily comprehend, is this: (a) if the Swiss Franc (CHF) trades at 1.2270 or 1.2330 to the dollar during a term of the derivative, the exporter would get $50,000 (equal then to Rs 22.5 lakh); (b) if the Swiss Franc trades below 1.12 to the dollar, the exporter is obliged to buy $8 million at 1.23, and incur a loss of $880,000, or Rs 4 crore, which will multiply if the dollar falls, as it actually did, below 1.12 Swiss Franc.

The dollar dipped as low as 1.05 Swiss Franc in May 2008. Every cent’s rise in the Swiss Franc against the dollar meant a loss of Rs 36.37 lakh to the Tirupur exporter under the deal. The Swiss Franc rose by 18 cents, and caused a loss of Rs 6.57 crore to the exporter’s acccount. What excited the exporter was the prospect of a small gain — Rs 22.5 lakh — the belly dance of the exotic derivative.

The law says that such profit-making is illegal, but the banks lured the exporter into the deal by simply dangling this illegal lollypop! QED: the exporter’s profit is limited to $50,000; his losses, unlimited in the deal.

Risk multiplied

Second, the banks advised the Tirupur exporters to go for derivatives that multiplied, not mitigated, their forex risk. In the illustrated case again, not one but three banks — one foreign, another feigning as Indian, and the third, nationalised — had marketed various combinations of derivatives to the same Tirupur exporter during 2007.

Under those derivatives, the exporter effected net purchase of $62.5 million and net sale of other currencies — Euro 6.75 million, GBP 27.75 million, Japanese Yen 167.12 million, CHF 1.10 million, and Rupees 63.95 million. While the three banks had forward-sold to him $62.5 million, he actually needed to sell — not buy — USD, as 90 per cent of his exports were billed in USD.

Here, the purchase of $62.5 million increases, not hedges his risk. The law says that banks should not, by the options they offer, increase the risk of the exporter. Yet this is precisely what the banks have done in Tirupur.

Imagine that a derivatives expert gives unsolicited advice to an uneducated mango-grower not to sell his mangoes in forward but go more for mango deriatives! How criminal would such advice be? The banks’ advice to the ex-farmers of Tirupur, who were generating USD through knitwear exports, to buy more USD was no different from such advice to mango-growers.

Third, the derivative volumes in most cases in Tirupur are many multiples of an exporter’s actual export turnover, while the legal cap for derivatives is only a fraction of it. The illustrative knitwear producer’s average exports for the last three years was $8 million, which is the cap on derivatives. Against this limit, the banks had contracted derivative volumes of $62.5 million — nearly eight times the limit.

A caveat. This limit is applicable only to hedging against losses; not to the purchase of $62.5 million which is not a hedge, but, a pure bet on the dollar. More. The law insists that three-fourths of the contracts for the permitted $8 million are not cancellable and have to be on deliverable basis. Yet all the deals contracted by the three banks were intended to be cancelled, settled without delivery!

Non-deliverable forwards

Fourth, under the deals marketed by them, the banks had contracted to buy specified currencies from exporters in which they had not billed and, therefore, would not get payment.

In the instant case, the three banks had contracted to buy 6.75 million Euro, 27.75 millions GBP, 167.12 million Jap Yen, 1.1 million CHF, from the exporter when he will get or have no Euro, no GBP, no Jap Yen and no CHF to sell, as he has billed his exports in USD and not in those currencies. Where from, then, will the exporter get the Euro, GBP or CHF to deliver to the banks?

The banks knew at the outset that they were not to deliver; so the banks have marketed non-deliverable forwards, not permitted in law. There are at least hundred such cases, big and small, like this in Tirupur alone.

Fifth, under the law, only the bank with which an SME (small and medium enterprise) has regular banking can offer derivatives products to it. And, that too, if the bank is satisfied, after conducting a due diligence check, that the kind of derivative is suitable to the client.

More, globally accepted norms require the banks to offer only derivatives suitable and appropriate to a customers, big or small. The Tirupur exporters are SMEs. Yet, in most cases, the derivative sellers were not the regular bankers of the concerned exporters. And no due diligence exercise was undertaken to assess the suitability of the product to an exporter.

It is not that the Tirupur exporters went to the banks in search of these complex derivatives. It was the other way around — the bankers were chasing, soliciting the unwary exporters to offer the derivatives.

Transferring risk?

Sixth, different banks that marketed their derivatives products to customers never made even basic inquiries as to the derivatives positions taken by the concerned customers with other banks.

Turning a blind eye to the derivative positions of an exporter with other banks, the derivative enthusiasts sold their wares to exporters just getting an undertaking — that he had no derivative position with other banks — on the form sent by the banks themselves by e-mail! Clearly, a false statement solicited by banks for record purposes to sell their derivative wares.

In some cases, the banks seem to have gone further and even did deals for the exporters without their knowledge, later using the signed letters in their possession to regularise the contracts! Undoubtedly, the law has been mercilessly broken in every conceivable way to structure and sell the derivatives to the under-prepared exporters. But why? Just for a fee? Unlikely. A larger motive seems to have been at work.

Having signed up risks in bulk as principals, did the banks recklessly market and retail their risk as market-makers to the unguarded exporters? There is more to it than meets the eye. Undoubtedly, a big scam in the making. Will the RBI wake up, probe, and get to the truth?

(Concluded)

(The author is a corporate advisor. His e-mail is guru@gurumurthy.net)