Financial Opportunities Forum (March 23, 2012): Mr. Parag Parikh explains “Derivatives” in an offbeat manner and also dissects the Union Budget in his inimitable way.
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There has been some noise lately about regulating hedge funds in the developed markets. Most hedge funds are structured as Limited Liability Partnerships (LLPs). People say that oversight of the central bank (Federal Reserve) and the securities regulator (SEC) is required as some of these hedge funds can cause “systemic risks”.
By “systemic risks” I presume we are talking about
a) Banks and other institutions (like insurance companies) which raise money from retail depositors suffering losses, or
b) The securities market having large disruptions on account of the large volumes controlled by these hedge funds.
In India these issues have not arisen yet. We have recently passed an act allowing formation of limited liability partnership firms. It is possibly a few months before we start to see the formation of LLPs in India on account of registration and taxation issues.
Just because a few “enterprising” ex-fund managers / investment bankers get a few rich individuals to partner with them in a LLP Hedge Fund to play the markets does not mean that these will become systemic risks to the banking system in India.
The necessary condition for sytemic risks is the lending of money by banks and financial institutions to these entities for making leveraged bets. In India, hedge funds (or individuals for that matter) have severe restrictions in accessing bank funds (against securities as collateral) or in accessing OTC foreign exchange derivative markets (run by banks) or accessing the repo market. In fact, any entity which is not a bank has very limited access to any market governed by RBI. Anybody having anything to do with the stock markets is a financial pariah for RBI. I do not think RBI will have too much problem with LLPs coming in.
My feeling is that SEBI and Forwards Markets Commission (FMC) however will have a tough time. In the race to increase volumes and profitability, stock exchanges have included all sorts of stocks in the Futures and Options segment of the equity markets. Margins are adequate on most days in a year but are found short on days of high volatility. “Black Swan” events are not considered and “Six Sigma” events occur pretty regularly . Currency futures are here and so are commodity futures. FMC currently prohibits “portfolio management” kind of services in the commodities segment. A LLP however would be dealing on its own account and hence technically would not be managing trades for anybody.
Hedge funds starved for funds from banking sources could go amok in the exchange traded markets on the derivatives side. Mutual Funds and Portfolio Managers have strict guidelines on what they can do and cannot do in derivatives. Leverage is prohibited. Hedge Funds would not have such restrictions.
What should be done is that unreasonable restrictions on market access (especially from RBI’s side) should be removed on portfolio managers and mutual funds and hedge funds should bear some restrictions in exchange traded markets.
Do Mr. D. Subbarao, Mr. C.B. Bhave and Mr. B. C. Khatua need to look at this?
Stock market volumes are down, arbitrage is comatose, margin trading is down, lending for IPOs is down, IPOs themselves are down, proprietary investments are down…………….
So what are the hotshot investment banks and brokers up to? They all are busy creating and selling Structured Products. Quarterly earning numbers are to be released after all. We in our own humble way have been contributing to this madness for structured products by combining some simple debt instruments and exchange traded long term options.
However there are a lot of unanswered questions relating to some of the Structured Products being vended in the market place.
1. Where is the debt portion of the structured product being deployed? What is the credit risk associated with the same?
2. How is the option risk of the product managed?
3. Are private placement of debenture guidelines not being violated in spirit (if not in letter) by selling the same to the mass market in lots of Rs. 10 lacs?
4. Why are investors being fooled by giving simple interest or cumulative returns in product literature instead of annual compounded rate? Does “innovation” in financial markets mean a new way of fooling investors?
5. Why are investors being fooled by having a different participation period for equity linked returns and a different maturity period of the underlying debenture (much longer than the participation period)?
6. Do the rating agencies understand the risk of these instruments when they are giving AAA so or AAA r etc to these instruments?
7. Why are internationally discredited issuers being given AAAs freely? Why are investors falling over each other in the rush to invest in paper backed by these issuers?
8. Does RBI know that associate companies of foreing banks are dabbling in these derivatives? on the other hand do the investors know that these instruments are issued by small private limited companies and not the banks?
This frenzy for structured products coming so soon after being discredited internationally and in the foreign exchange markets in India is quite surprising. Calling out to regulators to bring some semblance of order to this wild wild market………….