Derivatives are a blind alley

As expected, my previous article on derivatives has been criticised. In my view, derivatives are a gamble, whereas my critics feel that derivatives are a form of worthwhile investment.

As I had mentioned, farmers have been taking loans on the possible outcome of their crops for thousands of years. That is derivative trading; it is risky; both parties can lose but yet, the game is a fairly well-settled matter. So is the commodity exchange in the Chicago market which too, as a rule, gambles on the prediction of one single commodity.

However, modern derivatives are a different game altogether. Frankly, the owners of the banks who play on derivatives know very little about them. As I shall explain presently even the so-called “experts” cannot know much.

NO WEALTH CREATION

One of my correspondents has pointed out how well NIFTY has performed in spite of speculation on derivatives. He says: There is a cash margin and a daily “mark to market “of positions, which means that if a derivative falls in value by 3 per cent in a day then the holder needs to pay the money lost by the end of the day, or else the exchange has the option to square off the transaction. That is a good safety feature, but yet derivative trading remains a zero-sum game; unlike manufacturing, or even a service business like transport, it does not create wealth. A factory or a traditional service may or may not succeed but that is not as uncertain as derivatives are.

The value of factories and of services may vary day-to-day on the stock market but their intrinsic value does not vary in the same manner. A person who buys shares in such companies for long-term investment is not expected to “square off” every day on any fall in its stock value; unless the person sells and buys frequently, the stock market value is not treated as a pawn in a gamble.

My correspondent says that in year 2008, the NIFTY fell from 6300 to 2700 and yet there was not even a single default. That is good and that happened because NIFTY was exercising regulation, and probably because of that regulation relatively few persons were gambling heavily on derivatives.

Another correspondent complains, “if Nifty derivatives were not available how can an investor who has a bullish view on Infosys and a bearish view on overall market direction take a position.

Through Nifty derivatives he can buy Infosys and sell Nifty futures in a proper hedge ratio, thereby eliminating him from the movements of the overall market”. That is alright so long as it is the investor who gambles with his or her own money. That does not happen in derivatives trading.

RECKLESS BANKERS

A banker – traditionally deemed to be absolutely trustworthy – takes your money and without your leave gambles on it with the connivance of credit rating firms.

The disturbing fact is that officials of the banks and of the credit rating firms get bonuses on the basis of the paper profits they make, but do not pay any penalty when they incur losses. They may lose their jobs but the assets they might have built with their bonuses are their own to keep. This asymmetric system is a powerful force that induces them to gamble recklessly.

For instance, several large firms got A2 and even AAA rating – a level of rating which even the Government of India does not get – a few days before the firms went bankrupt.

Their errors were dismissed as matters of opinion. That creates a cosy relationship: Banks cite credit rating as their excuse and credit rating agencies excuse themselves from any responsibility for faulty rating.

Traditionally, bankers are taken to be conservative and careful to a fault. When they deviate from that prudence, investors' money tends to become worthless. The US government allowing banks to gamble with investors' money was a serious mistake. We, in India, might have escaped the last time but unless there is public pressure, we cannot be sure that the government will not bow down to local or foreign banks. In the US, one of the financial firms leveraged its investments as much as 33 times. If the value of its investment fell as little as 3 per cent, its entire assets would be wiped out and the firm would go broke — which it did. That can happen in our country too.

We know that the credit rating of the largest bank in India, the State Bank of India, has been lowered to junk value. That may be due to excessive caution or it may be correct. However, I do know that banks are at times compelled to make unworthy loans, unworthy in the sense they are never likely to be repaid. Here, as owner of the bank, the government itself can be at times at fault.

PITFALLS OF PREDICTION

The system of derivatives is a system of prediction. As Norbert Weiner the originator of prediction theory has explained, prediction is invariably associated with unavoidable error. So long as the system moves smoothly and the time for prediction is little, the range of error is small.

However, when drastic changes occur, or the time for prediction is large, the error becomes unmanageably large. That is the problem with derivatives: they work only for smooth changes and at the most for very short periods.

Therefore, we need a regulation in which investors are told how risky is the investment the banks make on their behalf, where officials do not get any one-side bonuses and where credit rating agencies cannot escape their responsibility by stating that their prediction is merely an opinion.

(Concluded)

(The author is a former Director, IIT, Madras. Response to indiresan@gmail.com and blfeedback@thehindu.co.in )

This is 317th in the Vision 2020 series. The last article appeared on November 19.

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