Derivatives – a constructive critique

In what i thought could come in as an observation to an earlier post by Kartik – see https://indiacorplaw.in/2008/03/trading-in-futures-financia.html below – turned out slightly differently. so here goes:

In considering law governing derivatives in India, couple or more items are noteworthy:

Firstly, a very significant development in the Indian legal regime governing derivatives was the amendment in 2006 to the RBI Act, 1934.

It introduced a new Chapter IIID, and also specifically ensured that any concerns regarding validity of derivatives (including the concern of whether derivative contracts could be a contract of wager) were obviated by providing expressly for the validity of such contracts when concluded with RBI itself, or with any bank or any regulated entity (regulated under RBI Act, BR Act or FEMA – essentially, NBFCs, Primary Dealers, Authorised Money Changers) notwithstanding any other law – which would extend to the Indian Contract Act, 1872 & section 30 thereof. The amendment act also took a further safeguard – that of making this particular amendment retrospective (and in fact dating back to 1934, when the RBI Act was enacted).

‘CHAPTER IIID
REGULATION OF TRANSACTIONS IN DERIVATIVES, MONEY MARKET INSTRUMENTS, SECURITIES, ETC.
45U. Definitions.– For the purposes of this Chapter,–.
(a) “derivative” means an instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called “underlying”), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the Bank from time to time;
(b) “money market instruments” include call or notice money, term money, repo, reverse repo, certificate of deposit, commercial usance bill, commercial paper and such other debt instrument of original or initial maturity up to one year as the Bank may specify from time to time;
(c) “repo” means an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed;
(d) “reverse repo” means an instrument for lending funds by purchasing securities with an agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent;
(e) “Securities” means securities of the Central Government or a State Government or such securities of a local authority as may be specified in this behalf by the Central Government and, for the purposes of “repo” or “reverse repo”, include corporate bonds and debentures.

45X. Duty to comply with directions and furnish information.–It shall be the duty of every director or member or other body for the time being vested with the management of the affairs of the agencies referred to in section 45W to comply with the directions given by the Bank and to submit the information or statement or particulars called for under that section.’.

Secondly, even prior to the amendment, the legal view on validity had never been in doubt – the conclusive view around has been that as long as one of the parties to a derivatives contract has a genuine business need (whether of hedging, reducing costs or risks or shifting the risks into a different currency/tenor/rate or basis of calculation of interest or risk management), it is not wagering.

Separately, listed companies in India & their Board of Directors, and particularly, the Audit Committee of the Board, are charged with reviewing the company’s financial & risk management policies, as well as mandatorily reviewing regular reports relating to risk management – under the very same Clause 49 that’s had a dramatic change in governance of listed companies since its introduction. This places the onus on the governance framework of ensuring that the management is really both operating and reporting back on what it does – including on derivatives as a tool of risk management – and doing it right. This receives further elaboration – there are to be procedures in place to inform Board members about the risk assessment and risk minimization procedures, which are required to be regularly reviewed through means of a properly defined framework. Lastly, a report on business risks, measures to address and minimize risk, and any limitation to the risk taking capacity of the company, are also required to be furnished on a quarterly basis.

Such governance framework atleast insofar as listed companies are concerned militate against media reports of companies not having understood the risks or undertaken transactions without properly factoring in the risks. Further, given these requirements of governance, a party dealing with the corporates can indeed sustain a claim that corporates have suitable machinery in form of governance standards and framework to adequately understand (and assure the Board/audit committee) of what they are upto. Equally, if corporates held out – by contract or conduct – that they not only understood what they were getting into & also that they had underlying FX exposure to do these derivative deals, and now choose to state that they had not understood nor had underlying FX exposure, and hence that the contracts are ab initio null and void, should probably have their lawyers advising them sent back to law schools for a refresher course – if the corporates held out & it really wasn’t so, then they committed misrepresentation. That entitles the counterparty to decide whether to avoid or continue the contract, and doesn’t render the contract null and void itself.

Also, the very same corporates have participated in and had earnings from derivative dealings – so when the going was good, the legality was not in doubt, and it is when the losses have come home to roost caused them to raise alarm over legal validity. Apart from the hypocrisy, from a legal viewpoint, this is probably unjust enrichment & courts should require dis-gouging of the profits made by way of deposit into courts as a precondition to hearing the matters.

Separately, and a on a deeper level – the point of caution that both Kartik & Mr Warren Buffet (great minds think alike!) seem to make – requires a bit of evaluation & introspection.

To take Mr Buffet’s case – the latest Berkshire Hathaway annual report talks of the derivative contracts that they have undertaken. What it really signifies is that Mr Buffet doesn’t exactly shy away from engaging in undertaking derivatives – or indeed undertake proliferation of WMDs.

His concerns around derivatives are (and for those interested in further details mentioned in the Berkshire Hathaway 2002 annual report, available at: http://www.berkshirehathaway.com/letters/letters.html) the following – am paraphrasing some of this for ready reference:

• Derivative contracts are a lot like reinsurance – which is Berkshire’s main business – in his words: In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability. Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

the real problems, again in Mr Buffet’s words are:

• “Parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.”
• Of course, both internal and outside auditors review the numbers, but that’s no easy job. For example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384 14 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.
• The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”
• I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.
• Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.
• Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times
• Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.
• Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

I would tend to believe that its transparency – in valuing, accounting & indeed disclosure – which derivative dealings require. As again, the accounting profession has stepped up, and introduced AS 30 for Indian companies – under which greater disclosure and transparency as to derivatives is expected – however, this AS is as of now only recommendatory and not binding. For Indian companies following US GAAP or IFRS, this is already mandatory (see http://icai.org/icairoot/announcements/icai_news_section_19mar08b.html)

What Indian derivatives markets doesn’t require is doubts as to legal correctness, validity, enforceability or indeed challenges in courts – it can have a chilling effect on dealings itself; pretty much the effect that sub-prime crisis has had – & which Fed intervention is trying to encourage – drying up of any fresh credit being given.

The chilling effect will deny those corporates and firms – desirous of derivatives as a tool for risk management / cost reduction / hedging / conversion of risk – at a time that they need most, given the turbulent times that the markets have entered, and make them the real victims of a different type of WMDs – welshers making a disaster.