Derivatives are a blind alley
P.V. INDIRESAN
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Investors should be adequately informed about how banks channel their money.
Banks which play on derivatives know very little about them. India
should not allow foreign banks to gamble on investors' money with the
connivance of rating agencies.
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.
P.V. INDIRESAN
Share · Comment · print · T+
Investors should be adequately informed about how banks channel their money.
Banks which play on derivatives know very little about them. India
should not allow foreign banks to gamble on investors' money with the
connivance of rating agencies.
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.
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