More on the Indian Derivatives Saga

While the legalities of several derivative transactions entered into between banks and corporates are pending consideration of courts, it appears that these matters have ended up in court in the first place because of unexpected market movements over the last few months which defied all prior indications and past market history. Livemint has a detailed analysis by Niranjan Rajadhyaksha who examines the transactions which resulted in disputes between the banks and corporates, and the reasons for such disputes.

He also identifies the principal problem with such derivative transactions, which is the inability to assess any losses. He says:

“Counting the damage

It is now time to count the damages.

How the losses will be totted up will depend on the precise nature of the derivatives that companies and banks have entered into. The easiest ones to deal with are what are called exchange-traded derivatives. These derivatives have a daily market quote, similar to the daily price of a listed share in the stock exchange, so marking them to market is not much of a problem.

The OTC derivatives that have been privately negotiated and are not traded will present more difficulties to accountants. The most popular way to put a value on them is to use the Black Scholes option-pricing model that is used the world over. “Unless options are listed and traded in the market, the Black Scholes model will be used to value what companies and banks hold,” says Gautam Nayak, partner in audit firm Contractor, Nayak and Kishnadwala.

This iconic valuation model was unveiled in 1973 by financial economists Fisher Black and Myron Scholes. Their widely used formula—which Indian accountants are likely to use—takes many factors into account: the price of the underlying asset, the strike price of the option, the risk-free rate of interest, the time in years for the expiration of the option contract and the implied volatility.

Rising interest rates and higher volatility in the financial markets could lead to steeper falls in the notional price of options in the months ahead. The global derivatives market continues to gasp for air—and banks with credit derivatives will have to keep more money aside as provisions.

We have not yet seen the end of the great Indian derivatives mess.”

Of course, some of the damage may come to light sooner as companies begin to declare their March 31 results, since the ICAI has issued guidance on the earlier implementation of AS30 beginning March 31 (see earlier post on this blog).

The article contains some oblique references to the failure of regulation that resulted in the crisis with respect to derivatives. It states:

“The financial sector as a whole has evolved a lot and the banking industry is coming up with newer and newer instruments which are complex. Unfortunately, regulators have not kept pace with the developments happening. The gulf between players introducing ever newer and more complex instruments and the regulators is widening to the disadvantage of the public,” says Rajeev Chandrasekhar, the member of Parliament who asked the parliamentary question that Chidambaram replied to.”

The issue of regulating complex instruments such as derivatives is quite a challenging one, with no clear-cut solutions. It perhaps commands an entire blog post by itself. But it may be worth stating a few salient points (at a high level) here for the moment.

Globally, countries follow two broad patterns of regulation of complex financial instruments. At one end of the spectrum is public regulation, which necessitates the government or regulatory authorities to step in and lay down rules and standards for operation of market players, the failure to comply with which will result in adverse consequences. At the other end of the spectrum lies private market regulation, whereby the players in the market who deal in complex financial instruments, exercise diligent market discipline through self-determined systems of checks and balances so as to avert financial crises, without involving any form of government intervention. The optimal approach to regulation should ensure that markets will function in a systematic manner without suffering from financial crises, systemic losses and other impacts that adversely affect the players and stakeholders, but at the same time the regulation should not be so onerous as to stymie financial innovation and sophistication, which form the lifeblood of financial market activity.

In an economy like India that still lacks a high level of financial sophistication (just to give an instance, several corporates that entered into these derivative transactions claim that they did not know the nature of the obligations they were incurring when they signed on the dotted line), pure market regulation may not be the answer. Some level of public regulation seems inevitable. The policy makers in the Government, however, carry the onerous task of injecting the right of level of public regulation that protects the interests of market players without dampening financial growth and market sentiments.

(Update – April 17, 2008: Today’s Hindu Business Line carries two articles on accounting for derivatives exposure. They are Accounting of Derivative Losses and Shocker of a Standard.)