Money Manager 6.0

8/3/2019 Money Manager 6.0

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MONEY MANAGER

As we sat down to decide on the theme for this edition

of the Money Manager, we saw, and more importantly

hoped, that the economy was on its path to recovery.

Exploring the myriad of topics that we wanted to

discuss and opine on, it dawned upon us that perhaps

the era of high risk and complex derivatives was over.

Or was it? And there began our discussion - were

derivatives really the cause? Was it the end of

derivatives or had they become so intrinsic a part of

our life that it was impossible for them to die - and ifthat were to be the case, then were there any

learnings which people would remember for the future

- or did their inherent risk always render them

unstable?. Thus emerged the topic, "Derivatives - the

good, the bad and the wobbly"

The students' articles competition saw some very

good entries - extremely theme relevant and yet wide

in their coverage - they ranged from Carbon

Derivatives to the Rupee Derivatives; from stress

testing to ADRs and many more. We also present to

you in this issue a short interview with former RBI

Governor, Dr. Y.V. Reddy who expresses his views onthe financial landscape in India, the tools at our

disposal and the norms and regulations. An article by

Mr. Saurav Arora, Senior Vice President, Jaypee

Capital which has a substantial stake in the latest

currency exchange in India provides interesting

insights on emerging competition amongst Indian

exchanges, its effects and implications.

On behalf of the Editorial Team I would like to express

my gratitude to our sponsor, Jaypee Capital and our

faculty advisor Prof. Sankarshan Basu. Prof. Basu

along with Prof. Anindya Sen and Prof. P.G. Apte also

kindly accepted to judge the entries for the students'articles competition.

Hope you enjoy this edition of the IIM-A, IIM-B and

IIM-C initiative. Do send us your feedback and/or

comments to [email protected] and/or

[email protected]

Happy Reading!

Neha Gupta (IIMB)

Editor - in - Chief

Editor-in-Chief

Neha Gupta (IIMB)

Managing Editor

Rahul Bajaj (IIMB)

Editorial Board

AV Naga Chaitanya (IIMB)

Priyank Patwari (IIMB)

Sunny Somani (IIMB)

Coordinating Committee

Samrat Ashok Lal (IIMA)

Mohit Gupta (IIMA)

Saurabh Aggarwala (IIMB)

Anand R (IIMC)

Shishir Kumar Agarwal (IIMC)

Feedback/ queries at

[email protected]

[email protected]

THE

MONEY

MANAGER

From the Editor's Desk


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MONEY MANAGER

Jaypee Capital is proud to be associated with Money Manager 6.0. As the worldrecovers from the jitters of the economic meltdown last year, the financial sector

too is slowly starting to make a turn around. At such a time, Money Manager

provides a wonderful platform for fresh, bright and young minds from across the

country to pitch their ideas and give new food for thought to the field of finance.

There are two aspects that define the value Money Manager offers. Firstly, we

strongly believe in the power of the new and young minds often provide the kind

of new thought that has the ability to change the way things work. Secondly,

Jaypee also considers finance to be a fundamental part of the career of every

individual and encourages learning in this field. Money Manager offers

opportunities to further both these ends. Moreover, it does so by putting together

material that is both practical and relevant to the finance of the day which makes

it a good read for students, researchers, faculty and the industry.

This edition of Money Manager is dedicated to derivatives - the instruments that

have been in the eye of the storm over the last few years. Opinion, as always, is

divided over the efficacy of derivatives and ways of using them. While they have

helped many a corporation hedge their risk, they've brought many down to their

knees as well. The issue takes a look at all these and is aptly titled: Derivatives -

the good, the bad and the wobbly. Money Manager 6.0 includes opinions across

the spectrum and addresses a broad range of issues.

Jaypee Capital proudly presents to you the Bangalore chapter of Money Manager

6.0.

Gaurav Arora

Managing Director

Jaypee Capital

Foreword


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Contents

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From the Faculty's Desk 06

Acknowledgement 06

Derivatives: The past, the present and the future (Editorial) 07

An Interview with Dr. Y. V. Reddy 12

Competitive Landscape in Indian Exchanges (Guest Article) 15

In Fed We Trust - Ben Bernanke's War on the Great Panic (Book Review) 22

Winning Entries 25

Student Articles 40


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From the Faculty's Desk

Acknowledgement

The Financial markets and systems around the

world have undergone a sea change since the

collapse of the venerable Lehman Brothers in

September 2008. The ostensible culprit is an

animal called "Derivatives". While the knives are out

to ensure that derivatives are blamed for all the

mess that has been created, it is also important to

note that for a number of years preceding the

collapse of Lehman Brothers, the same animal

called derivatives was the most revered of all

financial products - almost the holy grail of all

financial products. While it is indeed true that

derivatives did add on to the woes, it will not be fair

to say that derivatives were the root cause of the

problem - in a sense it will then be akin to blaming

fire as the root cause of all burn related incidents

completely overlooking the benefits that fire also

provides to mankind. The issue of derivatives, or

rather the adverse publicity that derivatives have

received over the last year or so has had students

in elite business schools very worried - particularly

those who contemplated making a career in

finance, especially in derivatives.

In the backdrop of this framework, the current issue

of The Money Manager with the theme "Derivatives:

the Good, the Bad and the Wobbly" assumes a very

high level of significance. The articles in this edition

go a long way in demystifying the issues related to

derivatives and their markets and, in a way, help

the reader in segregating the grain from the chaff.

With summer placements of most business schools

round the corner, I find this a very commendable

effort on the part of the students of IIMB, IIMA &

IIMC to apprise their peers about the latest

developments in the financial world; particularlywith respect to the issues surrounding derivatives

products and markets. This will help these students

and all readers of this issue of the Money Manager

significantly allay their fears and make informed

decisions on careers in the financial world, and, in

particular, the derivatives segment.

My heartiest congratulations to The Money

Manager. I wish the editorial team the very best in

all future initiatives and I wholeheartedly commend

this issue of The Money Manger to all the readers.

Sankarshan BasuAssociate Professor, Finance and Control Area

Indian Institute of Management Bangalore

We at Networth would like to sincerely thank all

those who have been instrumental in helping usrelease this edition of the Money Manager.

We are grateful to Jaypee Capital who have been

very supportive of us at every stage from

conceptualization to printing, to the esteemed

faculty of IIM Bangalore, especially Prof. Prakash

Apte, Prof Anindya Sen and Prof Sankarshan Basu

who took time out of their schedules to go through

the articles and select the winners, to Dr. Y. V.

Reddy for giving us a peek into his thoughts and

answering our questions, to all the students from allover India who sent in their articles that form the

DNA of this magazine. We would also like to thank

the finance clubs of IIMA and IIMC for their role in

working with us to make every issue of Money

Manager a good, informative read.

Last but not the least we would like to express our

gratitude to all the members of Networth for all the

inputs and feedback.


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Derivatives: The past, the present and

the future

Evolution - A Historical

Perspective

Contrary to what a trader might be persuaded to

think today, derivatives have had an extremely long

history. Probably then the only change that has

undergone down the ages is the evolution of theconcept and modification of the original form to

create more 'exotic' forms. As early as 1637,

derivatives are known to have been traded in the

Royal Exchange of London. However, the major

revolution in this area of finance took place with the

creation of the Chicago Board of Trade in 1848 in

the United States. With Chicago turning into a

growing hub for food grains, the traders came up

with a concept of 'to arrive' contracts. These

allowed the traders to hedge against the volatile

price changes. This was soon followed up by the

standardization of the same contracts. By 1925,

the first futures clearing house came up and there

was no looking back after that. There were indeed

times when a regulation would come up or trading

would be banned but the 'movement' had taken

off.

American entrepreneurship spirit in the financial

arena is perhaps epitomized with the genesis of

exchange traded financial derivatives. The age of

financial futures trading kicked off with the creation

of the International Money Market (IMM) in 1972,

as an offshoot of the Chicago Mercantile Exchange

(CME). In their drive to diversify, commodityexchanges in Chicago had developed an

intriguing penchant for new types of contracts.

This was coupled with the fact that the Bretton

Woods fixed exchange system had recently

collapsed and hence currency volatility was on the

rise. Therefore, it was quite natural to start flirting

with the concept of foreign exchange contracts. In

other words, with floating exchange rates coming

into play post Bretton Woods, there was an

increasing demand for hedging the currency price

volatility. Thus, IMM started high on volumes right

since its birth.

Soon it became evident that a similar logic could

be worked out in the bond markets also and in

1975, the Chicago Board of Trade (CBoT) came up

with the first interest rate futures contract in the

form of Government National Mortgage

Association (GNMA) futures, commonly known as

Ginnie Mae mortgages. However it failed to gain

much headway and was soon outdone by the

Treasury Bill futures launched by CME. This

contract has been widely dubbed as the first

successful futures contract. In 1977, the short term

T-bills evolved and led to the next step - the long

term Treasury Bonds. These have of course gone

on to become one of the leading contracts in terms

of volume. Shortly after, in 1982, CME came up

with the famous three month Eurodollar contract

which even managed to surpass T-bonds in terms

of volumes.

EDITORIAL


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In the midst of all these activities, the trading

activity started showing phenomenal growth.

Between 1972 and 1994, the volume of trading

increased almost fifty-fold. This however did not by

any means rule out the OTC trading which

continued to flourish. The IMM had developed its

comparative advantage in the handling of smaller

trades while the interbank market dealt with big

trades. Outside of the United States too there were

important developments in the world of derivatives.

The most important markets turned out to be the

England's LIFFE (London International Financial

Futures Exchange), Brazil's BM & F (Brazilian

Mercantile and Futures Exchange), France's MATIF

(Marche a Terme des Instruments Financiers) and

German DTB ( Deutsche Terminborse). Between

1986 and 1995, the annual turnover grew aboutfour times from 315 million contracts to 1210 million

contracts. In the same period, the share of trade in

US exchanges fell from 90% to 60% as the rest of

the world started catching up rapidly. Primarily

growth was taking place in the European

exchanges. In particular the interest rates futures

were most popular, growing seven fold since 1986.

Standardized options were also introduced in a

similar way by the Chicago Board Options

Exchange in 1973. The need for a liquid secondary

market was felt and as the erstwhile options could

not be traded, therefore this could be a potential

solution. Meanwhile, 1973 turned into a historic

year when Fischer Black and Myron Scholes came

out with their option pricing model which has

revolutionized the world of derivatives since then.

The Black-Scholes model is regarded as the most

well-known mathematical formula in the world of

finance.

A decade later, in 1983, another major event took

place which was basically the genesis of the now

popular, S & P 100. The CBOE created the index

which was then called the CBOE 100. This indexbecame the most actively traded and was later re-

christened the S & P 100. Important to note here is

the fact that at the time of introduction, exchange

traded options were simply derived on individual

stocks. However, post 1983, options on other

instruments were also introduced like the those on

Treasury Bonds, notes and bills. The entry of

currency options was also facilitated at the

Philadelphia Stock Exchange in the December of

1982. And by 1983, options on index became a

reality with the CBOE introducing an option on S &

P 100.

This, in short has been the foundation of arguably

the most famous financial instruments in the worldtoday. However, complexity being the name of the

game, the history continues.

Criticism - the black sheep

"The introduction of derivatives has totally made

any regulation of margin requirements a joke," said

Mr. Buffett, referring to the U.S. government's rules

limiting the amount of borrowed money an investor

can apply to each trade. "I believe we may not

know where exactly the danger begins and at what

point it becomes a super danger. We don't know

when it will end precisely, but at some point some

very unpleasant things will happen in markets."

EDITORIAL

The history of derivatives hasn't been all

smooth riding, though. They have not been

universally well-received and there exist

those who believe that their vices far

outweigh their virtues. The most prominent

amongst the naysayers is the man widely

acclaimed as the greatest investor of all time

- Warren Buffett.


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Most of the criticism of derivatives primarilyrevolves around the following issues:

Firstly - the use of the mark-to-market mechanism

(in some cases, since a marked is not well defined,a mark-to-model mechanism is used). Derivatives

contracts are often long term instruments whose

value depends on a variety of reference

parameters. Moreover, since these contracts do

not have complete collaterals and guarantees, one

of the parameters deciding their value is the credit

worthiness of the counterparties to the contract.

The mark-to-model allows these parties to book

large sums of profits and losses without the basic

transaction actually having been carried out. The

earnings thus reported can be extremely bloated

figures of the actual amount and such gross

inaccuracies are not brought to light until thematurity of the derivative contract. The

inaccuracies often arise because of over-optimistic

projections of derivatives' performances but then,

the reasons can be more ulterior than just hope.

Traders have incentives of earning enormous

bonuses while CEOs are under pressure to show

booming profits. Such incentives often compel

these parties to cheat in their accounting for

derivatives. Derivatives are essentially zero sum

games - the amount of money made by one party

stems from a transfer from the other party.

Outlandish assumptions, projections andaccounting for derivatives can result in both

parties showing substantial profits for long periods.

In Buffett's words, this leads to a system where the

'mark to market' degenerates into 'mark to myth'.

Secondly, derivatives can create a negative spiral

that can lead to what Buffett refers to as a

'corporate meltdown'. Many derivative contracts

require the counterparty to maintain a certain

credit rating or provide a certain amount of

collateral in the event of a ratings downgrade. A

company facing a downgrade because of general

economic downturn would need to furnishcollateral which could put them in a liquidity crisis

that might cause further downgrade.

Thirdly, derivatives are powerful instruments that

are good only if used in the right place. In most

cases, derivatives are meant to be used by

companies for hedging their non-core risks but

often end up being used for hedging non-core

risks as well. Core risks are what the companies'

shareholders buy its shares for and expect

rewards in proportion to. Non-core risks are the

subsidiary risks that a firm is subject to in the

course of conducting business. In the late 1990's,

Ashanti Goldfields fell in market value because its

hedging activities deprived its investors of profitsduring a bull run. The fact that the firm fell in

market value is testimony that its shareholders had

willingly bought into its core risks and were

unhappy at having been deprived of profits that

should have accrued to them. Similar was the case

with Barrick.

On the other hand, the Californian power crisis

arose because the power companies were barred

from using derivatives to hedge against large price

shifts while also being disallowed from passing

power purchase costs to their customers directly.

As a result, when demand and prices rosedramatically, the companies had to buy power at

exorbitant prices. If they had been allowed to

hedge any of their price shock risk, they would not

have had to undergo this experience.

Both the above examples demonstrate how the

use of derivatives in the wrong places can lead to

significant losses.

Fourth, derivatives have been accused of being

vulnerable to creating a domino effect during an

external crisis or event. While the Fed is there to

protect the banks from such an event, there is nosuch central bank that can control a domino effect

in derivatives. Many parties that deal with

derivatives are linked to each other. A trader

having derivative contracts with multi-parties may

consider himself well diversified and thus, less at

risk, but in truth, because of these linkages, all

these parties may suffer a fall in case of an

external crisis. As Buffett puts it, "firms that are

fundamentally solid can become troubled simply

because of the travails of other firms further down

the chain."

Moreover, most derivatives deals are concentratedin the hands of few dealers who engage in mutual

trade. Events of misfortune to one could easily

translate into a disaster for everyone else too.

Fifth, derivatives create a haze around a firm's

financials that make them difficult to analyze

financially and control the amount of leverage they

are engaged in.

EDITORIAL


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Warren Buffett and many others like him are

severely critical of derivatives and the way these

are being used in the financial markets today. While

derivatives took birth as means of hedging risks,

they have now become financial investments in

their own right. Traders and management derive

paychecks by using derivatives and showing

profits that do not exist. Its little surprise then, that

he describes them as "financial weapons of mass

destruction, carrying dangers that, while now

latent, are potentially lethal."

Reforms - the other side

Some of the deficiencies of derivative contracts

came to the fore in the recent financial meltdown.

In particular, the structure of over-the-counter

derivatives markets has acted as an obstacle to the

containment of the recent liquidity crisis. The

Lehman experience has prompted policy makers

around the world to reform these markets. From the

proposals and counter proposals emerging in this

direction, two prominent trends may be

deciphered.

Firstly, there is definite policy movement towards

more effective risk mitigation. Derivative contracts

bind counterparties for the duration of the contract

which could range from a few days to a fewdecades. Hence market participants may have a

build-up of considerable counterparty credit risk on

their books. This risk is seldom mitigated by

bilateral clearing which is most often used in the

OTC derivatives markets. Bilateral clearing suffers

from various drawbacks - the reliance on internal

'risk engines', weekly and sometimes even monthly

valuation and collateral exchange cycles, influence

of perceived credit quality of a counterparty on the

collateral it is required to provide and the need to

manage multiple clearing relationships are some of

them. Also, institutions tend to relax collateral

requirements to attract more business. All this has

translated in to a greater emphasis on Central

Clearing. The European Commission (EC) and the

US Department of Treasury have proposed moving

towards Central Clearing through the use of one or

several Central Counterparties (CCPs). However,

one must note that not all OTC derivatives can be

brought under CCPs.

Secondly, there is increasing interest in bringing

about more transparency to the OTC markets. The

immediate aftermath of the collapse Lehman saw

market participants and regulators desperately

trying to disentangle the web of counterparty risks

in the over-the-counter credit derivatives markets.

To avoid such situations, the EC suggests that

centralized data repositories be maintained to keep

track of trades, positions and other market data.

The US Department of Treasury has also made a

similar proposal to make timely data about each

and every market participant available to market

regulators. Regulated trade repositories by

publishing price, open positions and trading

volumes to the public could bring about greater

transparency to the financial markets.

Measures such as these are readily applicable toOTC derivatives which are standardized.

Standardization of derivative contracts can bring a

host of other advantages to the OTC markets. Most

important of them is to improve the operational

efficiency of the markets and reduce operational

risks. Automation of post trade affirmation and

confirmation, payments, collateral management etc

can be taken up if contracts are standardized. It is

no wonder; therefore that we find the EC stating

categorically that the standardization will form the

core building block of its reformative policy.

To be sure, not everyone is eager to see these

proposals put in place. End users of the OTC

derivatives markets are raising concerns over the

increased margin requirements that central

clearing would require. Some argue that as

businesses find more of their working capital

locked in as collateral, speed of recovery of the

economy as a whole will be adversely affected.

EDITORIAL


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Conclusion - the final take

Having looked at derivatives through the ages and analyzed the twists and turns that they

have had to undergo along the path, one can aptly define them as 'the good, the bad and

the wobbly'. These are the instruments that have revolutionized the markets and in turn

economies. At the same time they have drawn ire from every nook and corner of the same

markets and economies. More importantly they have found ways to modify according to felt

needs and come back stronger from setbacks. On that note one might compare it with a

'hungry tide' that is easily the strongest element at water's edge and even if it has to recede

occasionally, we must be certain that it shall rear its head once again. But given the fact that

the pace at which instruments undergo changes in the markets, we can only just wait and

watch what stories it has to tell in the future.

http://seekingalpha.com/article/34606-buffett-on-derivatives-a-fool-s-game

http://ec.europa.eu/internal_market/financial-markets/docs/derivatives/report_en.pdf

http://www.ustreas.gov/initiatives/regulatoryreform/

Authors:

A. V. Naga Chaitanya is a first year student at IIM Bangalore. He graduated with a B. Tech.in Electrical Engineering from IIT Delhi and worked as a Research Analyst with the

Algorithmic Trading and Technology Services division of Futures First. His interests include

reading, writing, music and trying his hand at graphics software.

Priyank Patwari is a first year student at IIM Bangalore. He graduated in Economics from St.Xavier's College, Kolkata. Apart from a core interest in finance, his other interests include

playing tennis and football and cheering for his favourite club, Real Madrid.

Sunny Somani is a first year student at IIM Bangalore. He graduated with an IntegratedM.Sc. in Mathematics & Computing from IIT Kharagpur and worked as an Associate at ZS

Associates and Symantec. His interests include creative writing and playing with numbers.

EDITORIAL


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Dr. Y.V. Reddy is an Indian Administrative Service (IAS) officer of the 1964 batch. He served as the

21st Governor of the Reserve Bank of India (RBI) from 2003 to 2008. He has held a plethora of other

positions both in India and internationally. He recently authored a book titled "India And The Global

Financial Crisis: Managing Money and Finance".

Money Manager: Having encountered a massive setback in the form of a financial crisis, what in youropinion is the future for derivatives? Do you not consider it to be a 'necessity' in the years to come despitebeing branded as 'evil', time and again?

Dr. Reddy:In regard to derivatives, the general view is that some derivatives are good and in any case too

much of derivatives may not add to efficiency or stability of the financial system. Further there is a clearcut preference to reduce the risk by enlarging scope of exchange traded derivatives. The policychallenge is to avoid excessive or undesirable derivatives and reduce settlement risk without seriouslyundermining financial innovation.

Money Manager: Currently the world seems to be stuck in a bottleneck. Most of the governments aretrying to push themselves out of it primarily through fiscal injections. Although most of their hands seem tobe tied due to a liquidity trap, can the monetary authorities not play a more active role with regards to this?

Dr. Reddy: In times of crisis the line between fiscal stimulus and monetary stimulus is blurred. Usuallymonetary policy is only the first line of defense.

Money Manager: Considering the present situation of the industry in general and the finance sector in

particular what challenges do you think could the current crop of business school graduates encounteronce they are out in the arena? What approach could they adopt to turn these challenges intoopportunities?

Dr. Reddy: The business school graduates are very bright people and they can adapt to emergingchallenges. However in view of the global crisis and India's strengths, there are more opportunities inIndia now relative to the rest of the world.

Money Manager: Almost all economists would tend to believe that the present situation is part of a cycle.But what repercussions, if any, could it have on the spread of globalization not just in the context of thefinancial sector but also in the larger sense?

Dr. Reddy: The global crisis indicates that while benefits of globalisation of trade are clear, there areserious risks in globalisation of finance due to immense externalities of the latter. Hence, there is a seriousreview of the benefits, risks, and appropriate policy as well as regulatory safe guards to maximise benefitsand minimise risks in financial sector liberalization.

Money Manager:Basel II has been perceived as a revolution in regulation and risk management. Do youthink the industry is adequately prepared vis--vis technology and operational costs before we endorsethe move towards Basel II. In your opinion what are the issues and challenges in its implementation?

Dr. Reddy: Basel II is under review and is likely to be improved upon. However in India we have a threetrack approach and Basel II compliance is only for one set. Hence the approach is pragmatic andfeasible.

Money Manager: Thank you Sir.

An Interview with Dr. Y. V. Reddy

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MONEY MANAGERGUEST ARTICLE

Competitive Landscape in Indian

Exchanges

Introduction

The past few years have seen an unprecedented

activity in the Indian Financial Exchange scenario.

While we already have 3 national level commodity

exchanges and 2 national exchanges trading in

stocks; we can soon see a new commodity

exchange; 2 more exchanges trading stocks; and

1 exchange exclusively for Small and Medium

Enterprises (SMEs).

Suddenly the whole impression of what exchanges

are has changed. Until only a couple of years ago,

it was difficult to think of exchanges as firms that

produce and sell goods to customers and competeamongst themselves. Traditionally, exchanges were

seen either as public entities, or as formally private

bodies, deeply regulated by public rules.

The article aims to discuss this new competitive

landscape in the country with a backdrop of what's

happening in the rest of the world. Also there is a

brief analysis of what an exchange is and what its

products are.

The economies of

agglomeration andfragmentation

Exchanges are a classic example of "network

economies" as the more the traded volumes on an

exchange; less will be the bid - ask spread and

better will be the price discovery. The firms listed

on an exchange also want more traders to trade

their stock; and thus would prefer an exchange

which provides more volume. Thus all in all a

"region" should be the happiest with a single

exchange. And with the advent of Electronictrading systems, local boundaries are fast

disappearing - firms in China, India, and other

countries are getting listed on exchanges in the

United States, Hong Kong, and other international

financial centres. The definition of "region" could

have encompassed the entire world; but for

regulations.


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The acquisition of CBOT and NYMEX by CME; the

merger of Euronext and NYSE; and the coming

together of derivative exchanges of Deutsche

Borse (Frankfurt) and the Swiss Exchange (Zurich)to form EUREX are a few examples of

agglomerating forces in practice in the exchange

market space. When CME acquired CBOT; the two

exchanges represented about 85% of the market in

US futures exchange trading . And with NYMEX;

the new CME group is second to none across all

major exchange-traded derivatives sectors .

But better service, transparency, efficiency,

resilience, and product innovation are a few of the

reasons why competition still exists amongst

exchanges. A case in point is the new BATS

Exchange which boasts of 10.9% market share

(October 2009) within a year of getting approval . It

has certainly shaken up NYSE Euronext and

NASDAQ OMX - the big boys of Exchange

marketplace - with its aggressive pricing and better

system performance. BATS boasts of latency as

low as 400 microseconds (average) while its

competitors are still struggling to achieve the 5

millisecond mark . Quite similarly, Chi-X Europe

has been eating into the market share of European

Exchanges by charging at times as low as 20% of

what LSE charges for the same volume of trades .

So, although while the global marketplace is seeing

consolidation; the new players can take the market

by surprise if they have something new and

innovative to offer. India, quite interestingly, is

seeing both of agglomerating and fragmenting

forces in action. On the one hand while we are

seeing new exchanges being set up driving

competition; we are also seeing old exchanges

taking stakes in the new ones - BSE taking 15%

stake in the new United Stock Exchange of India

Ltd. The next part of the article focuses on the India

side of the exchange marketplace.

The India Story

India is not new to the exchange business. Trading

on corporate stocks started on BSE in as early as

1875, making it the oldest stock exchange in Asia.

But other national exchanges got set up quite lately

- NSE in 1992, NMCE in 2002, MCX and NCDEX in

2003, and MCX-SX in 2008. By the end of this year

we could see one more stock exchange (United

Stock Exchange of India Ltd.). Within the next 2

years a new commodity exchange and one

exchange for small and medium enterprises mayalso come up in India.

Although the Indian Capital markets are seeing

reforms (introduction of Mini Index futures, allowing

small size currency and IRF contracts to be traded

on exchanges, etc), still they are way behind their

western counterparts both in terms of the variety of

products traded and the outreach of financial

services. While deregulation has seen introduction

of new products in the Indian marketplace (like

currency, Interest rate futures, derivatives, etc.) the

scope of more products is immense. When it

comes to financial outreach, less than 2 per cent of

India's population participates in the capital

markets compared with nearly 40 per cent in

developed countries. In addition more than 90 per

cent of exchange trade is confined to only 10 cities

in India . Moreover, only 5 percent of personal

savings in India are invested in the market, but

given the high savings rate in India; and the rapidly

growing GDP, this figure is expected to grow

exponentially. So, there is a huge potential; and the

market is big enough to absorb larger number of

players. The growing market is one of the reasons

why the turnover figures at both BSE and NSE havecontinued to grow over the years.

Competition in India

Although the government and SEBI have helped in

the development of the Indian capital markets; the

competition has also had a tremendous impact in

the radical transformation which Indian markets

have witnessed during the past 10 years. It was the

arrival of NSE which broke the monopoly of BSE in

the securities trading. It was this competition that

even the smallest grievances of investors were nowgiven heed to. It was the competition between

these two exchanges which led to the launch of

electronic trading in the country, dematerialization

of securities, reduction of the fortnightly settlement

period to a T+2 system, and introduction of new

traded products like Futures and Options. The

competition has contributed to the development of

Indian Capital markets in many ways:

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1) Efficiency: India has some of the highly

efficient and cost-effective computerized and

fully automated trading platforms, rapid real-

time gross settlements and delivery. Thepresence of strong exchange institutions has

helped play a key role in this. India is today the

largest market for individual stock futures

market

2) Robustness: There hasn't been any pay in

payout default at any of the national

exchanges in the country. The settlement

guarantee fund and the investor protection

fund have always grown for all exchanges.

3) Better Risk Management Systems:

Competition from rivals have forced theexchanges to set up excellent risk

management systems by prescription of

prudential norms for trading in terms of

exposure and volume related to the capital of

the members, collection of up-front and

market-to-market margins, and circuit filters.

4) Investor Education: Investor Education is

being given importance with exchanges

striving to educate the investors by organizing

seminars and making available necessary

informative inputs.

Hopefully, the new exchanges could do the same

to the Indian Capital Markets what NSE did in the

'90s. Unlike the west; product innovation is still at

its early stages in India. Competition could help

bring in more innovative products to the market.

Role of regulation

Government and regulators have played a crucial

role in transforming the Indian Capital markets to

what they are today. As far as the efficiency ofcapital market is considered; India is even

considered ahead of many developed markets.

The approval to new products like Currency

Derivatives and Interest Rate Futures in a difficult

year has already got the thumbs up from markets

with exchanges touching daily volumes of USD 4+

billion in the currency segment.

But still, the product approval process in India is

convoluted and time consuming. A case in point is

the approval for stock index futures. This process

took from 14th December 1995 to 9th June 2000, a

delay of 4.5 years. A further three years lapsed in

dealing with first order difficulties of regulation andtaxation. In this case, the innovator (NSE) could

have had a five-year head start. Instead, trading on

BSE actually started a few days before NSE and

trading on SGX started a few days later. NSE

captured no temporary advantage by investing in

innovation .

One of the reasons why there is a delay in product

approval process is the emphasis which Indian

regulators place on averting scams. India is better

than most of its western counterparts when it

comes to ensuring systemic stability, effecting

coping mechanisms in times of institutional and

market failures, risk management systems, and

consumer protection. We owe it to the regulator for

the minimum impact we have had during the Asian

Crisis of 1997; even the impact of the global

financial crisis (2008) on India has not been as

sharp as in some other Asian economies. But all

this has also resulted in protectionism and

micromanagement. Probably a little bit of loosening

up to allow innovation and financial flexibility can

help a long way in developing the Indian Capital

Markets.

The Road Ahead

Competition has played a vital role in improving the

exchange infrastructure in the country. With the

advent of electronic trading, Indian exchanges

face competition not just from within; but from the

global exchanges too. Indian exchanges have to

work hard to match the technology might of NYSEs

and LSEs. The multilateral trading facilities in the

Europe and United States have much lower latency

rates as compared to India. Network infrastructure

and system scalability are also other aspectswhere Indian exchanges are somewhat behind

their western peers. Competition from the

upcoming exchanges should be able to provide

better trading ideas, encourage newer products,

and improve the technology infrastructure in the

exchange marketplace; and thus help us match up

with the other exchanges of the world. Here's a

toast to the interesting times ahead!

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About the AuthorMr. Saurav Arora, Senior Vice President

Mr. Saurav Arora started his career with Jaypee Capital and over the years has become an

integral part of the management. As Senior Vice President, he is responsible for new business

initiatives of the company. These days he is busy with the United Stock Exchange project.

Mr. Arora also heads the overseas operations for Jaypee Capital. With offices in New York,

London, Singapore and membership of exchanges such has NASDAQ and NYSE; he is

successfully expanding Jaypee's operations across the globe. Under his able leadership,

Jaypee Capital is also about to become a member of EUREX.

Trading is a passion for Mr. Arora and his domain expertise is an asset to the organisation

References

http://www.finextra.com/fullstory.asp?id=16535

http://www.advancedtrading.com/exchanges/showArticle.jhtml?articleID=210101824

http://www.bloomberg.com/apps/news?pid=20601084&sid=aprNZpSajDl0

http://batstrading.com/resources/press_releases/BATS_Latency_Upgrade_FINAL.pdf

http://www.thetradenews.com/trading-venues/exchanges/3360

http://www.thetradenews.com/trading-venues/exchanges/3360

http://businesstoday.intoday.in/index.php?option=com_content&task=view&issueid=1166&id=11375&Item

id=99999999&sectionid=25

MIFC Report - Chapter 9: What are the limitations of financial regime governance

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In Fed We Trust - Ben Bernanke's Waron the Great PanicAuthor: David Wessel | Publisher: Crown Business (August 4, 2009) | Hardcover: 336 pages | Language: English

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MONEY MANAGER BOOK REVIEW

This is the story of how power players quickly used

trillions of public dollars to pay both winners and

losers of the Great Derivatives Game. Central

bankers are not typically associated with high

drama. But a year ago America's top economicpolicymakers faced a momentous decision:

whether or not to let Lehman Brothers fail. Ever

since, debate has raged about the effect of these

decisions. Could Ben Bernanke, chairman of the

Federal Reserve, and Hank Paulson, then treasury

secretary, have saved Lehman? Was their failure to

do so a colossal mistake, or would the financial

crisis have deteriorated anyway? Analysts will

debate these questions for years. As they do, this

book should be at their side. David Wessel has

written a gripping blow-by-blow account of how the

top brass at the Federal Reserve and Treasury

flailed against financial collapse.

He begins with a vivid description of the drama thatplayed out at the New York Fed on the weekend of

Lehman's collapse: the frantic search for a buyer

for the beleaguered bank; the efforts to convince

other Wall Street firms to chip in; the unwillingness

to engage in a wholesale public bail-out; the hopes

pinned on Barclays as a saviour, dashed, in his

view, by Britain's Financial Services Authority; and

the subsequent inevitability of bankruptcy. Mr.

Wessel lays out the chain of events that led both to

Lehman's demise and to the policymakers'

decision that they couldn't (or wouldn't) save it. He

then describes the same officials' extraordinary

efforts to combat the calamitous consequences.

Along the way, he takes a useful look at the 1907

financial panic (which eventually prompted the

creation of the Federal Reserve), and offers a quick

recap of the underlying origins of the crisis (much

blame is pinned on Alan Greenspan). But this book

is largely a tick-tock tale of a battle by technocrats

against an ever-changing crisis during 2007 and

2008.

The core cast is small. Along with Mr. Paulson at

the Treasury, four central bankers take centre

stage. These "Four Musketeers", as they becameknown at the Fed, include Mr. Bernanke at the

helm, determined to do "whatever it takes" to avoid

a repeat of the Depression; Don Kohn, the Fed's

vice-chairman and longtime insider; Tim Geithner,

then president of the New York Fed, now Barack

Obama's treasury secretary; and Kevin Warsh, a

whizz-kid former investment banker, who moved

from George Bush's White House to become the

youngest Fed governor in 2006.


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MONEY MANAGERBOOK REVIEW

The story of their financial firefighting is a thrilling

one, deftly told by a veteran journalist with access

to those involved. Mr. Wessel has an eye for

enlivening detail (a deal between the Feds andSubway restaurant, for instance, ensured a ready

supply of sandwiches); and he has a knack for

making finance accessible to the layman without

boring the specialist.

If there's a villain looming over the Wessel version

of why the government was so overwhelmed, it is

Greenspan. As Wessel explains, Greenspan's

strong libertarian leanings led him to scorn the

ability of government employees to keep track of

bonus-crazed bankers and traders. Greenspan

preached a free-market theory that the self-interest

of large financial players would cause them to drive

hard bargains with one another and prevent the

sort of mischief that could bring markets crashing

down. He encouraged the "financial engineering"

that created securities no one fully understood, and

he helped shield the mad scientists of Wall Street

from government restraints. Then, in October 2008,

Greenspan admitted to a House committee he had

been, well, totally wrong: "I made a mistake in

presuming that the self-interest of organizations,

specifically banks and others, were such that they

were best capable of protecting their own

shareholders." Now the pressing question iswhether Bernanke will learn from his predecessor's

mistakes. Wessel points out that while Bernanke

deserves credit for ultimately taking bold actions in

the breach, he "remains reluctant to criticize

Greenspan publicly."

Maybe he's just very polite. But the fact remains

that Bernanke and his colleagues didn't see thecrisis coming and for too long ignored those who

did. Wessel makes a persuasive case that if our

economic overseers do not renounce the

lackadaisical deference to Wall Street that

characterized the Greenspan era, they risk not

anticipating the next crisis and determining how to

avoid it.

This book is not a comprehensive account of the

crisis: that would have required more time, more

research and the inclusion of people other than the

officials involved. Nor is it wholly impartial. Mr.

Wessel's assessment of Mr. Geithner is a bit rose-

tinted, while he overdoes the criticism of Mr.

Paulson as bungling and erratic. Nor does the

book stand out analytically. Mr. Wessel is broadly

sympathetic to the officials' response. When he

faults them for being slow to realize the gravity of

the crisis, or for failing to prepare for the collapse of

another big financial institution after the Bear

Stearns bail-out, his criticisms are conventional and

underdeveloped.

Mr. Wessel spends little time teasing out lessons for

crisis-management or for the future of centralbanking. But he has written a cracking story, the

best chronicle so far of what officials were doing in

the great financial bust of 2007-08.

About the Author

Rahul Bajaj is a 2nd year student at IIM Bangalore. He graduated from IIT Kanpur with

a dual degree in Electrical Engineering. He has worked for Deutsche Bank and

Morgan Stanley prior to joining IIM B. He is also interested in mimicking, listening to

music, reading autobiographies of people from Wall-Street and writing poetry.


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Winning Entries


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Abstract

The last two years have seen unprecedented

financial turmoil and much of it has been blamed

on Mark to Market (MTM) accounting. Though,

rooted in transparency and prudence, its

methodology is debatable and it raises serious

questions about its adverse impact on the financial

system. It has been suspended for the time being

but a complete repeal is not desired. We need to

look at a middle path to safeguard investor's

interests while sustaining the financial system. It

calls for creating uniform guidelines across

borders and placing checks to prevent financial

creativity on the part of managers.

What is Mark to Market

Mark to market (MTM) is an accounting practice

which requires a company to report accounts on

balance sheet at their current fair market value

rather than the historical cost. MTM aims to provide

a realistic appraisal of an institution's or a

company's current financial situation. With the

growing number and complex nature of

instruments on the rise, this method gives a rather

transparent method of valuation to potential andexisting investors in tandem with the principal of

prudence which aims to provide for all losses,

anticipated or real.

MTM: Methodology andIssuesMTM can be done at three levels. Level One

system relies on the most recent trades of identical

assets. This is simple and uncontroversial when it

comes to things like publicly traded stocks.

If that data is not available, the next choice is Level

Two, which uses prices of similar or related

securities as a guide. This might be used for a

stock option -- the right to buy shares of a given

stock at a set price during a certain period. There

may be too little trading in identical options to use

Level One pricing, but the option's value can be

figured pretty closely by looking at prices of the

stock itself.

The Trouble with Mark to Market and

the way outMajid Asadullah, Smitalee Prusty (IIMC)

MONEY MANAGERWINNING ENTRIES

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MONEY MANAGER

When there is too little data for Level One or Twopricing, institutions can use Level Three. LevelThree is what analysts often call 'mark-to-make-believe' or 'mark-to-myth. Institutions use mark-to-

model method and value an asset using a financialmodel. For example valuing a mortgage basedsecurity at Level Three requires predicting defaultrate correlated to economic conditions.

The critics of MTM claim that it unnecessarily putsthe firm under duress due to temporary marketfluctuations. They claim that the assets are notimpaired, they are long term and the market valueoften reflects distressed sales into an illiquidmarket and not the actual inherent value. Firms thatare otherwise solvent must price assets to fire-salevalues. Not only does this make them ripe for

forced liquidation, but it chases away capital andleads to a further decline in asset values (Figure 1).This is further accentuated by short selling ofstocks triggered by a rating downgrade on thebank.

Another issue with MTM is the use of Level Two andThree methods of accounting where proxies areused for assets which don't have a liquid andtrading market. The use of proxies is flawed as itgives enough freedom for accountants to use their

creativity and more often they use proxies whichare illiquid and thinly traded.

MTM accounting values the sum of the parts. Itvalues each component part of a business or aportfolio on a standalone liquidation basis ratherthan as a whole. Sometimes the whole is worthmore than the sum of its parts and hence theassets could be undervalued. Further confusinginvestors, MTM accounting has inconsistentapplication across industries and companies. As

an example, insurers and banks account for similartransactions differently, as do banks and brokers.Different accounting for the same transactions andinvestments confuse investors and is inconsistent

with the objectives of GAAP.

Regulatory capital assessment should take a longterm view rather than short term and hence assetsshould not be written down unless impaired.Besides the tedious task of asset pricing in adisrupted or illiquid market, MTM does just theopposite. When times are good, it artificially boostsbanks' capital, thereby encouraging more investingand lending. In a downturn it sets off a devastatingdeflation. MTM accounting is thus a "double edgedsword" - it can and has been used to manufactureearnings. Even by accounting standards, it's hard

to ignore the cyclical nature of MTM. It inherentlyinflates assets in up markets, enabling companiesto manufacture earnings during bull runs anddepresses them in bear ones hitting the bottom-linehard. It is no coincidence that Lehman Brothersfailed after manufacturing $2.4 billion in pre-taxprofits by "marking to market" its liabilities. Itassumes that a borrower, like Lehman, can go intothe market and purchase its debt at the "marketprice" rather than repaying it in ordinary course.Enron too, back in 2000 used this to overinflate thevalue of its stock by MTM.

MTM and the CurrentFinancial Crisis

The last two years saw the housing bubble burst inUS and home pricing falling at unprecedentedrates. Coupled with recession and risingunemployment, it caused homeowners to defaulton their mortgage payments leading to foreclosure,more so in the case of Sub-Prime borrowers.

The biggest players on the Wall Street heldhundreds of billions of dollars worth of exotic

derivatives and securitized assets benchmarked tothe mortgage market which were marked down byMTM accounting. With the sub-prime mortgagebubble going bust, their value plummeted andMTM accounting forced to these firms to post hugelosses, some which, unable to manage the losses,spiraled into bankruptcy and restructuring.

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MTM has thus been blamed for much of the currentfinancial crisis which saw big banks like Lehmanbrothers filing for bankruptcy, Merrill Lynch beingsold to BOA at fire sale price and Morgan and

Stanley and Goldman being converted intocommercial banks with tighter government controland regulations. It forced many of these institutionsto huge unanticipated write-downs on securities.These write-downs were done at values that,arguably, were overly depressed because themarkets for them froze and companies were forcedto price them at their "exit value".

According to Federal Reserve estimates, as ofmarch 2009, MTM had wiped off close to $100billion of bank equity capital. These losses havealways been there, fluctuating between a positive

of $20 billion to a negative of $20 billion over thepast decade.

It has however swayed sharply on the negativeside over the past two years (Figure 2). Assuming aleverage ratio of 4%, it has destroyed $2.5 trillion ofbank lending. This has seriously jeopardizedlending capability leading to the present creditcrunch in the economy. This in turn is hurtinginvestments in legitimate industries in sectorswhich can play a crucial role in reviving theeconomy by creating jobs and putting money in thehands of consumers to drive demand.

Be MTM also made its way into litigations withSumitomo Mitsui attempting to seize Lehman'smarked to market assets to recover its $350 millionloan which Lehman contested, countering thevaluation as speculative rather than legitimate.Cause of such credit woes and politico-corporatepressures, as of April'09 FASB (FinancialAccounting Standards Board-US) has suspendedmark to market stipulation in the wake ofunprecedented financial crisis. This has created apotential conflict with the Treasury's plan for taking

the toxic assets away from the banks' balancesheets using the Public Private Investment Fund(PPIF). Since the assets will not face further writedown due to MTM, banks have incentive to keep

the assets on their books, rather than going fordistress sale. In the short term suspending MTMhas enabled firms to hide the potential losses onthe toxic assets. However this has also madevaluation of these assets very difficult and thismight drive away the investors from such firms inthe long run due to doubts about their financials.

The way out: The Middle

Path

In the wake of all the shortcomings of the MTM

policy, there is massive cry from financialinstitutions and bankers for permanent repeal ofthe policy. Suspension of the MTM rules all togetheris only hiding of economic realities rather than acure. The next best option of allowing banks tovalue these assets using mark to model accordingto their own financial models would allow banks torevert back to shady accounting practices and justhide their underlying liabilities. Continuing withMTM in such crisis times will further drive downasset prices and force more firms to bankruptcy orto seek long term government support. Hence weneed to tread along a middle path.

While the FASB is considering a reversal from itsApril stance which suspended MTM and bringingmore asset classes in the ambit of MTMaccounting, IASB (International AccountingStandards Board - most of Europe and Asia) hasindeed proposed the middle path. Applicable fromend of this year, it delivers accounting rules that thetwo sides- investors (actual value of assets) andmanagers (prevent economy going a downwardspiral) are satisfied. It proposes two asset-categorystructure - long-term plain vanilla debt securitieswhich will be valued at cost and more complex

debt securities like derivatives and equities whichwill be carried at market value on the balancesheet.

This however is fraught with a moral hazard asfirms will try to pass off more and more securitiesas cost-valued. In 2008 when IASB relaxed a fewrules European banks reclassified over half a trillionassets to post $29b profit.


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A pre-requisite of this system to succeed is that

investors should have a way to find out the market

value of even the cost-valued assets to check if the

managers' valuation is in consonance with the

markets. One way to do it, as proposed by Metron-Scholes, is to either use MTM or list the hard-to-

value securities on public exchanges whenever

possible to ascertain the actual market value.

Another key issue is that of regulatory arbitrage

across borders with disparate standards. This is

further exacerbated by the political view to look for

a quick fix solution as Tim Geithner, the US

Treasury secretary, tried to distinguish between

inherent value and artificially depressed market

values and sough to mark up the valuation. So

along with arriving at common standards,

regulators need to wade off such "politicallycorrect" solutions.

Conclusion

There is enough evidence to suggest that current

mark to market principles face serious limitations

when encountered with current financial crisis or

illiquid markets. However any change in the

accounting principles need to be viewed with

utmost caution as the opportunities of abuse are

plenty as has been seen in the past. Clear and

uniform guidelines need to be set for segregating

assets for valuation on cost basis or market value

basis and revaluing the toxic assets based on cash

flows rather than allowing institutions to use their

own models to furnish figures. The proposed IASB

model offers some hope but stipulates strict

regulation and global adherence. The ultimate

goal should be to restore investor confidence in the

markets while allowing firms to sustain heavy write

downs in assets in a global financial crisis in

coupled global markets.

References

Economist, T. (n.d.). Mark-to-market accounting- Divine Intervention. Retrieved from http://www.economist.com.

Floum, A. (n.d.). Mark-to-Market Accounting Essential. Retrieved from http://www.globalresearch.ca.

Frank_Holmes. (n.d.). How FAS 157 Mark-to-Market Helped Slow the Economy. Retrieved fromwww.marketoracle.co.uk.

Kwak, J. (n.d.). The Mark-to-Market Myth. Retrieved from http://baselinescenario.com.

Andy. (n.d.). Financial Crisis: Mark to Market Accounting Demystified. Retrieved from http://www.savingtoinvest.com.

Andy. (n.d.). Financial Crisis: Mark to Market Accounting Demystified. Retrieved from http://www.savingtoinvest.com.

Thompson. (n.d.). http://www3.gsionline.com. Retrieved from Mark-to-Market: SEC Keeps Status Quo. (Sunshine)

About the Authors

MAJID ASADULLAH: He is a 2nd year student atIIM Calcutta enrolled in the PGDM course. Heholds an engineering degree from IIT Kharagpurand has prior work experience with Citigroup and

Morgan Stanley Capital International (MSCI).Email: [email protected]

SMITALEE PRUSTY: She is a 1st year student at IIMCalcutta enrolled in the PGDM course. She holds amasters degree in Mathematics and Computingfrom IIT Kharagpur and has prior experience withFair Isaac and HSBC group.Email: [email protected]

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AbstractCarbon trading is not a new phenomenon, but

derivative products based on carbon make an

interesting proposition. CER and EAU are the most

traded carbon products over the exchanges and

OTCs across the world. The last bubble the world

saw was asset price inflation due to the use of

sophisticated derivatives.

With the use of derivative products based on Offset

carbon futures, and the loose regulation on carbon

as well as derivatives, the world can soon see

another bubble. We have tried to explore the idea

of a carbon bubble inflated by derivative trading ofcomplex Carbon Based Securities and what could

be done to avoid this.

Carbon Trading

When the world is taking its first steps towards

growth after one of the biggest depressions since

the late 1920s, little do we know about similar

derivative products hitting the markets. Sooner or

later these products will create yet another price

bubble. We are talking about carbon trading and

derivative products thereof, traded in the name of

saving the planet.

Increase in carbon emissions and rising

temperature on earth made the world come

together and develop a framework to

systematically reduce greenhouse gas emissions.

According to many environmentalists, the world

carbon emission will have to be reduced to near

zero levels and temperature rise to less than 2

degree Celsius in order to avoid the ultimate.

An organization gets an emission allowance based

on historical data analysis, and if it is able to save

by not emitting that much, the same allowance canbe traded on exchanges. These types of

allowances are generally known as carbon credits.

And there are other types of credits which are

generated by projects which emit less carbon than

usual by use of green energy or reforestation and

are outside the capped economy. These are known

as Carbon Offset credits. For example Shell can

invest in India in a project where it uses solar

energy and the emission thus saved can offset their

higher than allowed emissions in USA. These

offsets are also tradable products.

Financial Engineers and Carbon

Backed Securities: Deja vuAnkur Mathur, Nitin Batra, Parul Gupta (MDI)



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MONEY MANAGER

In order for these types of products to be traded,exchanges have been established and trading ofsophisticated spot, futures and options productson these credits has started. Trading in derivatives

of these products helps maintain a level of liquidityand price regulation.

Reduction of pollution, search of "GreenTechnologies" and protection of the world is themain theme behind enforcing stricter emissionnorms on the industrialized nations. But theloopholes in regulating carbon emission allowanceand the tradability of the carbon emission creditshas only given rise to a new class of asset fortraders to be interested in.

Derivatives in the Carbon

Market

The introduction of derivatives in the CO2 markethas opened up doors to numerous trading andinvestment strategies for investors. EUA (EUEmission Allowance) and CER (Certified EmissionReduction, a type of Offset credits) are two of the

most traded derivative products in the carbonmarkets today.

The idea behind creating such assets is that

markets will pass them on to the people who areequipped to handle these risks. But effectiveregulation is the most important thing that isrequired for such models to behave; and the samewas missing in 2008 when credit derivatives gaveup.

It is estimated that the Carbon Derivatives Marketwill be of a size more than $2 trillion within the nextfive years, which is a phenomenal growth story.According to Louis Redshaw of Barclays Capital,carbon derivatives market has the potential tobecome the largest commodity market of the

world.

There were 8 major exchanges for carbon productsat the end of the year 2008 namely ECX UK, NordPool Norway, EEX Germany, BlueNext France,CCFE US, Green Exchange US, NCDEX India andMCX India. The growth in the EUA and the CERcontracts traded on the exchanges worldwide was124% and 170% respectively.

Exchange Products Launch Date 2006 volume 2007 volume 2008 volume

ECX UK EUA Futures Apr-05 452,364 980,780 1,991,276

EUA Options Oct-06 560 57,541 243,166

CER Futures Mar-08 N/A N/A 507,779

CER Options May-08 N/A N/A 67,800

Nord Pool Norway EUA Forward Feb-05 59,618 70,641 69,624

CER Forward Jun-07 N/A 24,477 52,107

EEX Germany EUA Futures Dec-07 2,886 17,673 77,644


BlueNext France EUA Futures Apr-08 N/A N/A 1,580

CER Futures Jun-08 N/A N/A 12

CCFE US CFI Futures Sep-07 N/A 3,566 29,405

CFI Options Feb-08 N/A N/A 11,753

CER Futures Aug-07 N/A 128 166

CER Options Nov-07 N/A 1 1

Green Exchange US EUA Futures Mar-08 N/A N/A 5,066

EUA Options Mar-08 N/A N/A 2,000


CER Options Apr-08 N/A N/A 3,200

MCX India CER Futures Jun-08 N/A N/A 35,197

NCDEX India CER Futures Jun-08 N/A N/A 14,090

Total 515,428 1,154,807 3,139,389

Growth 124.0481697 171.8539981


The above table shows the size of the market growing 170% in 2008.


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American Clean Energyand Security Act of 2009

The Waxman-Markey bill approved by the USCongress in June 2009 is just another version of

Cap & Trade Carbon Emission Control mechanism.

Cap & Trade schemes enforce a cap on the

carbon emissions for organizations and then they

can trade and buy if they end up emitting more

carbon than allowed.

The bill states about reducing the emissions by

17% from the levels of 2005 by 2020, and by 80%

by 2050. The cap & trade program says that 85%

of the emission allowances will be allocated for

free and there will be an auction for the rest 15%.

The bill is under severe criticism for 85% freeemission allocation and also the use of Offset

credits to fulfil the emission needs. This provides

an incentive for organizations to pollute freely and

is said to be biased to help oil, coal and nuclear

power companies.

Creation of the BubbleThe polluting organizations now have a cap on the

emissions but they can still buy allowances or

offset credits if they need them. There is a grave

concern over a huge increase in the price ofcarbon assets. The emission offsets which are

openly traded OTC have a huge potential for

traders and speculators in the markets.

Offsets are generally emission savings by

investment in green projects but when we talk

about Futures and Options of these offsets we are

talking about offsets at a point in future. The sellers

can claim that they have a project lined up which

will emit X Billion tonnes of CO2 less than what it

could emit had it not used green technology.

Companies can have the prices of their stocks

influenced. There is also the scope ofsecuritization of offset carbon assets just like the

credit derivatives.

Supporters of the Cap & Trade scheme and

Carbon Derivatives products say that these

products will ultimately lead to an increase

in liquidity which will result in appropriate pricing of

such securities. But there is another set of

economists who believe with more and more fund

managers and banks getting involved and

increasingly using offset credit derivatives as

assets, the prices are bound to inflate and this will

lead to creation of yet another bubble; the "Carbon

Bubble".

According to rough estimates, more than 70% of

the trade by volume in Carbon derivatives are for

the purpose of capital gains. The carbon trading

market was introduced for the purpose of making

organizations more responsible towards usage of

resources. But the importance of Carbon trading

has hugely increased rather than the greener

technologies.

The level of allowed offset allowance is 30% of the

annual caps. This being for the period 2012-2020

could potentially lead to a significant increase indemand for offsets. While such a high level of

demand is not needed for the markets to balance

during this period, there does appear to be an

incentive on market participants to purchase

considerable volumes of offsets in a given year.

The risks involved in OffsetCarbon Derivatives

When the Offsets are traded as derivatives on the

exchanges, the promise is to deliver credits which

are generated by future projects. Even the

existence of such projects can be questioned. And

many large banks and financial institutions are

getting into these in just the same way as they did

with Credit derivatives. Institutions like Goldman

Sachs, many Hedge Funds and accounting firms

like Deloitte, E&Y and KPMG are already into it in

order to help companies use and account these

products.

These will behave in similar fashion, as the risk of

default here will be inability to deliver credits at the

stipulated time. The projected issuance of CO2

emission credits from international offset projectsare given below.



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Source: UNFCC

The challenges in regulating Carbon Derivatives

The world saw the bubble created by credit basedderivatives bursting and taking down a barrage of

banks with it in 2008 and 2009. The major reason

for the same was the lack of proper regulation on

the way these instruments were used. The way

these mortgage backed securities were modelled

and represented was very difficult to regulate. The

lesson on properly regulating derivatives was

learnt the cruel way.

With the Cap & Trade carbon emission regulation,

the financial engineers have given birth to a whole

new range of securities very similar to MBS in

nature called "Carbon Backed Securities".

Already, it is reported that Credit Suisse bundled

20 projects and created a set of Offset credits

backed securities. These were then divided into

three tranches of different risks and sold to

investors with different risk appetite in absolutely

the same way as the mortgage bonds of 2007-08.

Sound like Collateralized Carbon Obligations.

CFTC, the US Commodity Futures and Trading

Commission, is the regulator for such instruments.The biggest challenge for them is that the

complexity of these instruments is very high as

these are based on carbon offsets. Nobody is

certain about when these credits will actually be

generated and the claims made by the sellers are

highly questionable. There is no certain way to

ensure if these credits will even be generated. The

premise of the very assumption goes for a toss as

they are valued far in advance of any type of

regulatory proof of their existence. Given the high

probability of default, we have no doubt in our

minds that soon the "Carbon Default Swaps"

mirroring the much talked about CDS will see thelight of day.

Some of the basic steps which should be taken are

(1) regulating the exposure and (2) disclosure of

position. Another important step in this direction

must come from the UNFCC which should enforce

strict evaluation and regulation of Offset projects.

Organizations must disclose the position of their

investments and the progress of those projects

regularly to make the buyer aware of the

underlying asset quality. The need of the hour is to

regulate the OTC market as large investors who

burnt their fingers in 2008 may soon be ready toinvest yet again into similar securities which are

now based on carbon instead of other assets. The

American Clean Energy and Security Act fails to do

justice to the environment as it only encourages

trading of speculative instruments rather than

discouraging emissions.



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References

Carbon Emission Trading. (n.d.). Retrieved August 31, 2009, from Goodground:

http://www.goodground.com/page?rd=1&i=2698

Schwartz, M. (2007, December 12). The Future is Carbon Futures. Securities Industry News , p. 4.

American Energy and Security Act 2009. (2009). Retrieved September 4, 2009, from Wikipedia:http://en.wikipedia.org/wiki/American_Clean_Energy_and_Security_Act

Clean Development Mechanisms. (n.d.). Retrieved September 4, 2009, from unfcc.int:http://unfccc.int/kyoto_protocol/mechanisms/clean_development_mechanism/items/2718.php

Eurex. (2008, July). CO2 Emissions - A New Asset Class for Institutional Investors. Eurex .

Protecting Against Subprime Carbon: Proposed Framework for Regulation of Carbon Markets in American CleanEnergy and Security Act of 2009. (2009, August/September). Climate Change Law and Policy Reporter , pp. 112-114.

Carbon Finance comes of age. (n.d.). Retrieved September 4, 2009, from cnn money:http://money.cnn.com/2008/04/15/technology/Gunther_carbon_finance.fortune/index2.htm

Eurex. (2008, July). CO2 Emissions - A New Asset Class for Institutional Investors. Eurex .

Protecting Against Subprime Carbon: Proposed Framework for Regulation of Carbon Markets in American Clean

Energy and Security Act of 2009. (2009, August/September). Climate Change Law and Policy Reporter , pp. 112-114.

About the Authors:

Ankur Mathur is a Chemical Engineer from Instituteof Technology, BHU. He is a student of Finance,MDI Gurgaon. Prior to joining MDI he worked withGrail Research for 9 months in the capacity of aMarketing Research Analyst.

Nitin Batra completed his Bachelor of Business

Studies in Finance from College of BusinessStudies, Delhi in 2008. He is a student of Financeat MDI Gurgaon.

Parul Gupta is an Electronics Engineer from ITMGurgaon, MD University Rohtak. He worked withVerizon Data Services India in InformationTechnology for 2 years as an Analyst before joiningMDI in 2008.



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Abstract

The year 2008 witnessed the high risks associated

with derivatives and recently the U.S. Treasury

suggested increased regulations of these

products. Recently, in India, RBI was reported to

have asked the leading banks in the country for

their opinion on CDS introduction. This seems quite

ironic on a preliminary view. But when studied in

detail, we realize the importance of CDS as an

effective risk management mechanism, especially

to deepen the debt markets in the country. India

would also do well to learn from the lessons learnt

by the Western countries, while introducing CDS in

the country.

The U.S. Treasury, on June 18, 2009, unveiled a

series of new changes that it proposes to

implement in the aftermath of the ongoing global

financial crisis. Among several others, the Treasury

focused on creating comprehensive regulation of

all OTC Derivatives, including Credit Default Swaps

(CDS). It states:

"In the years prior to the crisis, many institutions

and investors had substantial positions in CDS -

particularly CDS that were tied to asset backedsecurities (ABS), complex instruments whose risk

characteristics proved to be poorly understood

even by the most sophisticated of market

participants. At the same time, excessive risk

taking by AIG and certain monoline insurance

companies that provided protection against

declines in the value of such ABS, as well as poor

counterparty credit risk management by many

banks, saddled our financial system with an

enormous - and largely unrecognized - level of

risk."

Almost all media reports, on the collapse ofLehman Brothers and the bailout of AIG last year,

mention CDS as one of the causes. Coincidentally,

around the same time (on 30th June, 2009) The

Economic Times published a news report that said

the Reserve Bank of India is taking the first steps to

introduce the CDS and has sent questionnaire to

the country's leading banks to gauge the

acceptability of the product in India's financial

markets.

Credit Default Swaps and their

Introduction in IndiaVineet Jhunjhunwala (ISB)



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The same news report quoted Mr. Ashish Vaidya,the Head of interest rate trading at HDFC Bank,saying that CDS is "absolutely needed" for theIndian markets and the country's regulators can

build a robust system for the product by learningfrom the experiences of the Western countries.

Therefore it is evident that CDS is a very importantproduct for the financial markets. The motivation ofthis article is to understand CDS as a product andif it should be introduced in the Indian financialmarkets, especially in these times.

What are Credit Default

Swaps?

A Credit Default Swap is a derivative financialcontract under which the seller agrees toreimburse the buyer, against a default on afinancial obligation by a third party, (called thereference entity), in exchange for a premium (alsocalled spread). (See Figure 1 below).

The buyer is usually a financial institution, like abank, that has bought bonds of the Company (thereference entity) and therefore has exposure to thisCompany. If the bank wants to diversify its risk, itmay choose to sell the bond or transfer the riskthrough a CDS contract.

The seller is a dealer of such contracts. Thesedealers are generally the leading banks of theworld and they transact over the counter (ratherthan on an exchange). The buyer will request thedealer to place collateral to ensure itsperformance. Therefore, this dealer, in order tomake an offsetting hedge, will then enter intoanother CDS with a second dealer and so on.Depending on the reference entity's creditworthiness, the spread would rise (or fall), thebuyer (or the seller) will be "in the money" andrequire additional collateral from the other party.

The Role of CDS in the

Financial Markets

The Credit Default Swap is one of the innovativefinancial instruments developed to provide betterrisk management capabilities to financialinstitutions. The sheer size of the outstandingamount of these contracts ($57 trillion as at June2009 end) makes them one of the most widelystudied instruments.

They are used to remove the inefficiencies in thecredit market due to which banks hold only loans(with higher returns) and other financial institutionslike mutual funds, insurance companies, etc. holdonly bonds (with comparatively lower returns).

CDS transactions lead to a diversification of thecredit risk among the various financial institutionsoperating in the markets, which would beotherwise concentrated among banks.

Moreover, the spread on the CDS is widely used asan indicator of risk in the markets. The spreads fora particular reference entity determines thecreditworthiness and can alert the markets aboutproblems at those individual entities, or banks orother financial institutions involved.

Benefits specific to Indianmarkets

The Reserve Bank of India released a report of theworking group on the introduction of creditderivatives in India. This report laid down thefollowing benefits of introducing the CDS to India'sfinancial markets:

CDS can prove to be an effective transmissionmechanism of risk, taking cue from thesuccess of Interest Rate Futures in India.

Investors (including banks, DevelopmentFinancial Institutions, mutual funds, etc.) canget additional avenue for higher yields bytaking on extra credit risk.

Banks can free up capital by transferringsome of the credit risk.

Existing clients can have higher exposure thanthe specified limits when banks havetransferred credit risk on these clients.

Figure 1



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A target credit risk portfolio can be managedby banks.

CDS are liquid instruments compared to other

mechanisms of the same category viz.insurance, guarantees and securitization.

From the above, it is clear that CDS can reallyaccelerate the much awaited development of thedebt markets in India, besides other benefits.

Lessons learnt from the

crisis

The ongoing global financial crisis has maderegulators all over the world sit up and learn fromthe past mistakes. Several lessons have beenlearnt and some related to CDS can be particularlyrelevant to India, while deciding on their launch inthe country.

CDS as OTC Derivatives are not executed onregulated exchanges. Therefore, India maylaunch only the exchange-traded format tobegin with. The finance ministry has beenquoted to believe that the best market designto mitigate risks posed by these derivatives isto have a standardized product on regulatedstock exchanges. We can have tradeexecution systems that are electronic andtherefore regulated as well as transparent.

At a later stage, if the need for CDS as OTCderivatives is felt, the necessary regulationsshould be imposed so as to require theirclearing through "regulated centralcounterparties (CCPs)".

Large sized dealers should be subject to anongoing system of supervision and regulation,primarily related to the capital requirements,business conduct standards, reporting

requirements, and margins on creditexposures.

Transparency of such contracts should beincreased by imposing necessaryrecordkeeping and reporting requirements onthe CCPs and regulated trade depositories.

Conclusion

The Wall Street Journal reported the FinanceSecretary, Mr. Ashok Chawla saying that India willcontinue with a financial-sector overhaul despitethe recent global financial crisis, which led

several major economies into recession. He said"[Financial reform] is a continuous process,incremental, not big bang."

Moreover, the Government has got enoughevidence that once launched, the CDS can besuccessful in India. The recent launch of theInterest Rate Futures on the National StockExchange saw a huge success. More than 10,000contracts were traded within less than two hours oftrading on the first day itself (September 1, 2009).As many as 14,559 contracts amounting to $55million exchanged hands on this very first day.Celente, a research firm, estimated that 100 millioncontracts will be traded in 2010 and more than 150million contracts in 2011.

The Indian Government seems committed todeepen the debt markets in India as a part of thebroader financial sector reforms required in thecountry. Although derivative products (includingCDS) have attracted a lot of flak from critics ontheir potential contribution to the financialupheaval, the Indian finance ministry is on the righttrack by acknowledging that there is no intrinsicproblem with the product but with the marketdesign and oversight required before they get outof hand. Once these are addressed, creditderivative product, especially the CDS, can becertainly beneficial for the Indian financial markets.



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Money Manager 6.0

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