Financial Derivatives have established themselves as a major driving force in the international monetary sphere in the recent past. While derivatives were originally used as an effective monetary instrument to multiply the wealth through ripple effect, of late these instruments are also used by banks and financial institutions to mitigate risk arising from the volatility of the underlying asset. This apart, derivatives along with the new generation monetary instruments such as Investment securities in bearer form have already become the back bone of International Economy.
Regulation of Financial Derivatives has a chequered history. There were periods in history when the trading in these instruments was banned. However like any prohibition, the prohibition of openly trading in financial derivatives only led to evolution of a clandestine market for these instruments, and innovative players in these markets created new types of instruments to bypass regulatory restraints.
Derivatives regulation in the United States as well as in India is essentially a hybrid of "institutional" and "functional" regulation. Some institutions that trade in derivatives are regulated by institutions like FSA, Securities and Exchange Commission, RBI, SEBI etc., and these institutions have come up with disclosure norms to ensure greater transparency in the trading of derivatives. On the other hand, the functional regulatory regime controls the instruments are "financial instruments" with a slew of measures to ensure transparency and accountability. On the whole it can be seen that the derivative regulation is more focused on self regulation with an underlying assumption that the trade houses that utilises derivatives does so prudently and with self regulation.
This paper tries to examine the various models of regulation of financial derivatives from a purposive perspective.
Regulation of Financial Derivatives: Some Policy Considerations
Introduction
History of Derivatives Markets and Regulatory Efforts:
Ever since money was invented, humans have devised ingenious ways to increase its worth. Financial sector has been dominating the political scenario of many countries in the world since very early days in varying degrees. Financial derivatives have been in existence from very early days. The history of institutionalized derivative trading began almost simultaneously with trading in securities. Siems quotes Aristotle's story about Greek philosopher Thales who indulged in perhaps the world's first futures contract. Even in India, forward contracts were engaged for the purpose of trade. Zohary and Hopf (2000, pp. 140-141) maintain that the sesame plant was cultivated in the Indus Valley between 2250 and 1750 BC. The following tablet, which is from 1809 BC, shows that a Mesopotamian merchant borrowed silver, promising to repay it with sesame seeds "according to the going rate" after six months. He may have used the silver to finance a trading mission to the Indus Valley to obtain sesame seeds. This contract combines a silver loan with a forward sale of sesame seeds.
"Six shekels silver as a Å¡u-lá loan, Abuwaqar, the son of Ibqu-Erra, received from Balnumamhe. In the sixth month he will repay it with sesame according to the going rate. Before seven witnesses (their names are listed). These are the witnesses to the seal. In month eleven of the year when king Rim-Sin defeated the armies of Uruk, Isin, Babylon, Rapiqum and Sutium, and Irdanene, king of Uruk."
In the modern history, medevial European merchants made extensive use of financial derivatives for trade. An important legal development in the history of financial derivatives was the Royal Decree in Antwerp made contracts for future delivery transferable to third parties. At about the same time, Merchants discovered that there is no need to settle forward contracts by delivering the underlying asset, as it is sufficient if the losing party compensates the winning party for the difference between the delivery price and the spot price at the time of settlement. Contracts for differences were written on bills of exchange, government bonds and commodities. Although it is likely that similar deals had been done in Bruges and with monti shares in Italy, contracts for differences were used on a large scale for the first time in Antwerp. The commodities exchanges whose history starts with the beginning of options and futures trading in Amsterdam Stock Exchange in 1611, gave further impetus to the growth of financial derivatives. By the end of 19th Century, there were well established Commodities Exchanges in different part of the world and India was a leader in commodities trading. During early 20th Century, there were a number of well established commodity markets in India, trading in futures and other similar derivatives.
They were regulated by social control of close-knit groups and whenever such control failed, there would be a crisis. Some analysts are of the view that by the beginning of 1900's India had one of the world's largest futures industry.
The history of regulation of Financial derivatives is also not recent. The first attempt to regulate the financial markets can be seen from the early 16th century ban on short selling in 1610. However in Antwerp contracts for differences were outlawed shortly after forward contracts had been made transferable, around 1541 (Swan 2000, p. 144). But it is unlikely that this restriction was effective because a forward contract does not show how it will be settled. Even if the contract requires the delivery of the underlying asset, the parties to the contract can informally agree on a cash payment at the delivery date. In Amsterdam contracts for differences were not made illegal, instead, in 1621, 1630 and 1636, three edicts were issued with the intention to undermine contracts for differences by making them unenforceable in the courts (Kellenbenz 1957, p. xiv). In 1734, the British Parliament passed the Sir John Barnard's Act, which declared contracts for the future delivery of securities to be "null and void". Fines amounted to £500 for "refusals" and "putts" and £100 for short-selling operations. The Act applied only to derivatives on securities because, as debated in Parliament, it was feared that commodity markets would move back to Amsterdam if contracts for the future delivery of commodities were outlawed in London. Hence for a long time, the trade in derivatives was based on reputation of traders rather than on the basis of legal backing. In France too the Commercial Code of 1807 outlawed the trading in securities otherwise than in authorized exchanges. A Police Order of January 24, 1823 again restricted the trading in securities and commodities to authorized dealers at stock exchanges. However Jureg notes that this did not prevent trading in such commodities or deriviative trading, but only took them out of the premises of stock exchange, based on reputation, with no recourse to court in case of breach of contract. In the 1820s, derivative trading with government bonds flourished in Paris. Contracts such as contracts for future delivery (négotiations à terme), forward contracts (marchés fermes) and options (marchés à primes, marchés libres), a call option called an "achat à prime" and a put option called "vente à prime" and repurchase agreements, which were called "reports" were greatly traded in Paris. By 1857 however, contracts of future delivery were made legal if the delivery date did not exceed 2 months(1 month for railway shares). In Germany contracts for future delivery were called "Zeitgeschäfte",which were subdivided into Contracts for future delivery were subdivided into forward contracts (fest abgeschlossene Geschäfte, feste Geschäfte, Fixgeschäfte) and options (Prämiengeschäfte, Dontgeschäfte).
In 1885, derivative contracts became legally enforceable in France, although it was still possible to raise the objection against gambling under some circumstances. In Germany the regulatory framework was similar to that in France for most of the nineteenth century, i.e. derivatives were traded in a legal limbo. In Prussia contracts for future delivery were outlawed for Spanish government bonds in 1836, for all foreign securities in 1840, and for securities of railways in 1844. After the unification of Germany in 1871, it was up to the courts to decide whether a contract for future delivery was legitimate or whether it was motivated by illegal gambling. The courts took into consideration the contract's terms, the profession and wealth of each party and anything else that might shed light on the contract's purpose, which all gave rise to considerable legal uncertainties. In 1896, Germany passed a law (Börsengesetz) that severely restricted derivative dealings. It became illegal to conclude contracts for the future delivery of wheat and milling products, and for shares of mines and factories. The government also could regulate and prohibit contracts for all other goods and financial assets. These severe restrictions disrupted commodity markets and financial markets in Germany, diverting trade in commodities and securities to foreign exchanges. The German law of 1896 also determined that contracts for future delivery were enforceable only if both parties had registered as dealers. However instead of facilitating any meaningful regulation, this clause took out derivatives trade largely into the unregulated zone, since many traders opted not to register themselves and instead opted to carry on trade in derivatives on reputation basis.
In India too trade in financial derivatives have been carried on for long on a reputation basis. Indian Contract Act, 1872, contained provisions modeled on Gaming Act, 1845(UK) which prohibited agreements by way of wager. For long this provisions were thought to be prohibiting derivative transactions, though the courts have, on many occasions clearly decided to the contrary. Soon after independence, Forward Contracts(Regulation) Act, 1952 and Securities Contract(Regulation) Act, 1956 were enacted in quick succession in India, and the objectives of these Acts, interestingly, were to prevent undesirable transactions in securities by regulating the business of dealing therein, "by prohibiting options and by providing for certain other matters connected therewith". There were specific provisions in these statutes, which prohibit the trading in certain financial derivative products. However the trading in such financial derivatives continued in the grey market throughout this period.
It was only in the wake of liberalisation of Indian Economy which started from 1991, the financial derivatives got some respectability. Currently there are three regulators in the regulatory space governing financial derivatives in India: The Reserve Bank of India(RBI), Forwards Market Commission(FMC), Securities and Exchange Board of India(SEBI). There is also a level of self regulation among the market players. However, each of these regulators play in a different turf, for example, Reserve Bank of India is concerned with only the activity of banks and NBFC's in dealing with derivative instruments, where as other companies dealing in derivatives are being controlled by SEBI. To understand the scope of regulation by these entities it is necessary to understand the basic theory of regulation.
Definition of Regulation:
Robert Baldwin tries to analyse the meaning of the word regulation as follows:
"At its simplest regulation refers to the promulgation of an authoritative set of rules, accompanied by some mechanism, typically a public agency, for monitoring and promoting compliance with these rules. Rule making and monitoring/enforcing mechanisms need not be located in a single institution. A second broader conception of regulation takes in all the efforts of state agencies to steer the economy. Such an approach has the merit that a variety of tools are considered as possible alternatives to possible command and control type regulation, so that where rule making seems to be inappropriate as a means for achieving policy objectives, other tools may be used. A third definition, broader still considers all mechanisms of social control-including unintentional and non state processes- to be forms of regulation. Thus…such a definition extends also to mechanisms which are not products of state activity, nor part of any institutional arrangement, such as development of social norms and the effects of markets in modifying behaviour."
Thus regulation has three different connotations, in an ascending order of broadness:
Regulation means administrative rule making power, which restricts administrative discretion and provides a framework for administrative action, such as any regulation by RBI for regulation of activities in derivatives market.
Regulation means all efforts taken by state agencies to steer the economy, including the efforts by state agencies to enforce compliance through agreements, guidelines which do not have any binding force but which sets best practices which cannot then be ignored by the market players
Regulation means all mechanisms of social control including self regulation.
In this paper, the word regulation is being used in the broadest sense of the word.
Regulatory Approaches:
There are three distinct approaches to regulation as follows:
1. Public Interest approach or functionalist analysis: According to this approach, the State is considered to act in public interest to tackle market imperfections.
2. Interest group approach: This approach sees regulation is the product of relationship between different groups and between such groups and the State.
3. Regulatory Capture approach: Under this approach regulation is driven by the pursuit of self interest by policy participants. Focus rests on individual actor rather than group or state activity." Regulation is seen as another commodity, "bought" by the economically powerful and used in a manner calculated to gain further wealth to the powerful."
In India, though in practice the interest group approach and the regulatory capture approach drives regulatory activities to a great extent, the public interest approach is the only publically taken approach to regulation. Generally, regulation of securities market like regulation of Capital market has often been divided into prudential regulation and conduct of business regulation. This division is arguably flawed in two respects: It inadequately reflects philosophical justification for regulation, and it focuses on type of rule imposed rather than the type of risk which is to be addressed.
The financial regulation in any country, should aim at the following:
Ensuring that the underlying instruments are transactionally, informationally and functionally efficient.
Regulation should not hinder or have negative impact on financial innovation.
Steps should be taken to avoid regulatory arbitrage.
Regulatory Styles:
Operating style of regulators differ with jurisdiction and regulatory styles are deeply rooted in a country's political, social and cultural past. Though there may be variations in the functioning of individual regulators, there are certain common traits that can be identified as the regulatory style of a particular jurisdiction. Generally critics have identified three major regulatory styles:
Formalised Regulation: United States of America follows this style which is largely dominated by formalized and legalistic style, administered by powerful regulators having rule making, enforcement and sanctioning powers, with formal and relatively transparent processes involving fairly lengthy decision making cycle.
Informal Regulation: UK follows this style characterized by less formal and less transparent regulators who wield substantial powers with little procedural check. Regulation has been considered a private affair between the regulator and the regulated in which third parties are deemed to have little interest or even right to information or consultation.
Advisory Regulation: This system, which was largely followed in countries like Japan, where while regulatory authorities exercise wide discretion in issuing guidance, compliance is largely voluntary. The Old boy network, with retired government officials commonly transferring to the management of businesses ensured low relational distance in regulation.
India generally follows the UK model of regulation, which is characterized by informal, less transparent and almost private regulation.
While we can broadly catagorise regulation as above, based on jurisdictional culture, it is to be understood that regulatory models within a single jurisdiction is also not homogenous. There will be a number of varied approaches following within a country itself depending on the sector being regulated. Some of the sub models of regulation are:
Command and Control theory: Classical model of regulation with the regulator making and enforcing the rules. In India, control of RBI is broadly falling within the category. RBI issues regulations, which generally the regulated entities have no option but to follow.
Partial Industry Intervention: The regulated businesses will have some obligations in their licenses which the agencies would enforce. A key aspect of such regulation is that though all players are obliged to have licenses, only those with a dominant market are exposed to all the regulatory requirements. SEBI in India generally operates in this mode.
Franchising: Firms wanting to carry the regulated activity bid for the right to do so. The franchise would be issued to the most favoured bidder, who will have to carryout regulated activity for a fixed period of years. The franchisee agreement would contain certain clauses as to quality and mode of carrying out the activity, which the regulator would then seek to enforce. Though such a model is largely not applicable in financial sector in India, telecom regulation in India is the best example for such a model of regulation.
Regulation by Contract:
Self Regulation:
Objectives of Derivative Regulation:
Financial Standard Foundation(FSF), after analyzing the reports of International Organization of Securities Commissions (IOSCO) and Committee on Financial Sector Assessment (CFSA) and various other international bodies has set certain guidelines for regulation of securities market which are internationally accepted and has been continuously monitoring the performance of various countries in meeting these objectives. The regulatory guidelines set by FSF are as follows:
The principles of the regulator should be clear and objectively stated.
The regulator should be operationally independent and accountable in the exercise of its functions and powers.
The regulator should have adequate powers, proper resources and the capacity to perform its functions and exercise its powers.
The regulator should adopt clear and consistent regulatory processes.
The staff of regulator should observe the highest professional standards, including appropriate standards of confidentiality.
The regulatory regime should make appropriate use of Self Regulatory Organisations (SRO's) that exercise some direct oversight responsibility for their respective areas of competence to the extent appropriate size and complexity of markets.
SRO's should be subject to the oversight of regulator and should observe standards of fairness and confidentiality when exercising powers and delegated responsibilities.
The regulator should have comprehensive inspection, investigation and surveillance powers.
The regulators should have comprehensive enforcement powers.
The regulatory system should ensure an effective and credible use of inspection, investigation, surveillance and enforcement powers and implementation of an effective compliance programme.
The regulator should have authority to share both public and non public information with domestic and foreign counterparts.
The regulators should establish information sharing mechanisms that set out when and how they will share both public and non public information with their domestic and foreign counterparts.
The regulatory system should allow for assistance to be provided to foreign regulators who need to make inquiries in the discharge of their functions and exercise of their powers.
There should be full, timely and accurate disclosure of financial results and other information that is material to investors' decisions.
Holders of securities in a company should be treated in a fair and equitable manner.
Accounting and auditing standards should be of a high and internationally acceptable quality.
The regulatory system should set standards for the eligibility and the regulation of those who wish to market or operate a collective investment scheme.
Regulation should require disclosure, as set forth under the principles for issuers, which is necessary to evaluate the suitability of a collective investment scheme for a particular investor and the value of the investor's interest in the scheme.
Regulation should ensure that there is a proper and disclosed basis for asset valuation and the pricing and the redemption of units in a collective investment scheme.
Regulation should provide for minimum entry standards for market intermediaries.
There should be initial and ongoing capital and other prudential requirements for market intermediaries that reflect the risks that the intermediaries undertake.
Market intermediaries should be required to comply with standards for internal organization and operational conduct that aim to protect the interests of clients, ensure proper management of risk, and under which management of the intermediary accepts primary responsibility for these matters.
There should be procedures for dealing with the failure of a market intermediary in order to minimize damage and loss to investors and to contain systemic risk.
The establishment of trading systems including securities exchanges should be subject to regulatory authorization and oversight.
There should be ongoing regulatory supervision of exchanges and trading systems which should aim to ensure that the integrity of trading is maintained through fair and equitable rules that strike an appropriate balance between the demands of different market participants.
Regulation should promote transparency of trading.
Regulation should be designed to detect and deter manipulation and other unfair trading practices.
Regulation should aim to ensure the proper management of large exposures, default risk and market disruption.
Systems for clearing and settlement of securities transactions should be subject to regulatory oversight, and designed to ensure that they are fair, effective and efficient and that they reduce systemic risk.
Regulatory objectives in India:
As early as in 1997, SEBI and PWC along with USAID had tried to outline the broad features of regulatory framework for derivatives market. As per the PWC report the following were the considerations that should be kept in mind while evolving an appropriate framework for exchange traded derivatives:
"…the regulatory framework must provide the necessary protections but not restrict market development. Such a framework should be based on:
The demand for such a market,
Potential market participants and how they believe they would use the market,
The existing financial and legal infrastructure and its integration into the regulatory structure, and
The existing market environment and culture.
The PWC report suggested that the principal function of the over sight government is to assure self regulation is in public interest. To accomplish this the oversight regulator reviews the exchange rules and procedures expressly for the purpose of determining whether they are:
consistent with minimum best practice derivatives market standards, and
designed to ensure a market that is open and competitive (free from manipulation and other forms of trade practice abuse).
The self-regulator has the front line responsibility to assure financial integrity, to protect the customer and to ensure open and competitive markets that treat outside capital and all participants fairly and equitably. In addition to performing at least periodic auditing of all SRO programs and activities, the oversight regulator steps in to investigate alleged market manipulation or other wrongdoing and takes appropriate enforcement action when the SRO does not adequately fulfill its responsibility. The report further points out the following minimum regulatory goals that are internationally accepted:
Financial safety, including integrity of clearing houses and market participants
Fairness, including fiduciary and related customer(investor) protection practices
Market efficiency and integrity.
Subsequently SEBI appointed Dr L C Gupta Committee to study the appropriate regulatory framework for financial derivatives, which came up with the following broad regulatory objectives:
Investor Protection: This includes rules relating to ensuring fairness and transparency in market dealings, guidelines for safeguarding client's money, ensuring competent and honest service and market integrity.
Quality of Markets: aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery.
Innovation: Should not stifle innovation which is the source of all economic progress.
While these objectives form the broad basis of the regulatory scheme floated by SEBI, the SEBI circular No FITTC / DC / CIR-1 / 98 dated June 16, 1998, has also laid down how the stock exchanges should be regulated as follows:
"The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the Governing Council. The exchange shall regulate the sales practices of its members and will obtain prior approval of SEBI before start of trading in any derivatives contract. "
However RBI which regulates empowered to regulate the interest rate derivatives, foreign currency derivatives and credit derivatives which are basically traded by financial institutions like banks and Non Banking Finance Companies have an entirely different set of regulatory goals. In its Guidelines on Derivatives Trading, RBI has outlined the following as the regulatory goal:
To ensure suitability and appropriateness of the derivative products being offered to customers.
Providing adequate information to the investors about the products.
Ensuring proper documentation of the derivatives product.
Identification of risk.
Risk measurement and setting proper risk coverage limits.
Ensuring independent risk control mechanism.
Segregating operational management control of the organisations dealing with derivatives.
Audit requirements.
RBI is enforcing these requirements through a command and control mechanism, and hence the regulatory spectrum of RBI is more wider than that of SEBI.
Derivatives Regulation in India:
In India derivatives trading is regulated by a mixture of command control, franchising, contractual and self regulatory mechanism. The Securities Contract (Regulation) Act 1956(SCRA), the Forward Contracts(Regulation) Act, 1952, Depositories Act, 1996 and certain provisions of Companies Act, 1956 provide the statutory back bone for derivatives regulation. However it is worth noting that apart from creating a regulator and entrusting the duty of regulating derivatives with the regulator, these statutes do not deal with regulation of derivatives in any great respect. While Section 17 of SCRA entrust the regulatory responsibility of certain types of derivatives to SEBI, Sections 20, 21 and 21A of Reserve Bank of India Act, 1934 empowers RBI as the regulator in respect of certain government securities market and also regulate the major players in the derivatives banks-the financial institutions. SEBI has created certain Self Regulatory Organisations(SRO's) which are non-governmental bodies with the responsibility to regulate their own members through a set of rules of conduct for fair, ethical and efficient practices. SEBI also exercises its regulatory oversight through Stock Exchanges. Stock Exchanges are bodies created by cooperation among market players and the SEBI generally maintains tight regulatory oversight over these market places. These bodies like the National Stock Exchange, Bombay Stock Exchange(BSE), Multi Commodities Stock Exchange(MCX) etc, acts as franchisees to SEBI to enforce regulation of players in derivatives market through a process of listing contracts, rules and guidelines. Commodities market is regulated by yet another regulator, Forwards Market Commission (FMC) which, unlike SEBI and RBI is not a statutory body but a department of Ministry of Consumer Affairs. FMC exercises considerable powers under Forwards Contract(Regulation) Act, 1952 regarding futures and options trading in commodities,(which is a variant of derivatives) and exercises its control both through command and control mechanism as well as through franchising regulatory duties to commodities exchanges like MCX etc. There are also a host of self regulatory organisations, at national {Foreign Exchange Dealers Association of India (FEDAI)} and at international level{International Swaps and Derivatives Association(ISDA) which set industry standards for derivatives trading and ensure compliance through a peer pressure mechanism.
Out of the regulatory objectives identified by FSF, except the requirement of internal control of market intermediaries all other regulatory requirements are either in progress for compliance or fully complied with in India. The latest available report of CFSA dated March 2009 concluded that India has fully implemented 20 IOSCO principles, broadly implemented 8 and partly implemented the remaining 2 principles. The gaps in compliance, as observed by the report, included those in the areas of supervisory autonomy, transparency and disclosure, regulation and inspection of market intermediaries, and oversight of the secondary markets. According to the report, there is a clear division of regulatory jurisdiction over Indian financial markets between the Securities and Exchange Board of India, the equities market regulator, and the RBI, which also oversees the government securities market. On the basis of this FSF has concluded that India has complied with only 58.33 % of the IOSCO guidelines, with a rank of 14 in Financial Standards Index, in which Netherlands ranks first with 73.33 % compliance. UK ranks 5 and USA ranks 7 in this index, as on March 2009, with 68.33% and 65% compliance respectively.
Lessons from 2008 Market Crash:
It would be worthwhile to note that most of the countries which are ranking above India in Financial Standards Index had been badly affected by the market crash of 2008 and have seen failure of institutions involved in derivatives trading, in India no institution of considerable repute failed on account of financial crisis.
Unregulated trading in derivatives have been cited by many experts as one of the crucial factors that led to the financial crisis of 2008. The main pitfalls, so long as derivatives regulation are concerned are as follows:
Deregulation of derivatives trading leading to lack of oversight over the practices of originator firms.
Watering down of the concept of risk during 1990's leading to further laxity in regulatory approach. As Lynn Turner, former chief accountant of Securities Exchange Commission(SEC) observes, what resulted in the effective collapse of major financial institutions such as AIG and Enron was the introduction of credit derivatives that the congress and administrations ensured would never be subject to regulation. He points out that the regulatory system in place for years leading up to the crisis was not out dated but was systematically dismantled by the administration.
Increased complexity of the derivatives product made them beyond the understanding of regulator and common investors giving leeway to the originator to stash high risk financial products and market them as no risk products to unknowing investors.
Uncontrolled operation of Statistical Rating Organisations which continued to rate bad derivative products as good deepened the impact.
Repeal of Glass-Steagall Act, 1933 which was designed to segregate banking and securities business with Gramm-Leach-Bliley Act, 1999 which effectively removed the segregation between investment and commercial banking lead to creation of a vicious circle of bankers who were more interested in satisfying their greed than in ensuring consumer protection.
Dr Syamala Gopinath, former Deputy Governor of RBI, in a paper entitled "Financial Crisis-Some Regulatory Issues and Recent Developments" records that one of the important lessons that India learned from the financial crisis is that financial sector development per se cannot be an objective in itself. It needs to be pursued in the broader context of financial stability and has to necessarily correspond to the level of maturity of the financial system and the needs of the real economy. Reforming financial markets involves improving access to simple, transparent, and easy-to-understand products. Increasing complexity does not facilitate the market mechanism. The purpose of financial instruments is to transfer risk to those that understand these risks, not to hide or camouflage them. Regulatory comfort and assessment should therefore be a critical determinant in pursuing financial reforms. In regard to derivatives, India has both OTC and exchange traded instruments for currency and interest rates. OTC markets in India are well regulated, unlike many other jurisdictions, to address issues of leverage and customer appropriateness and suitability. Only OTC contracts where one party to the transaction is a RBI regulated entity is considered legally valid. Suitable reporting and post trade clearing and settlement mechanisms are being further strengthened. In fact the realization that OTC derivatives require more regulation is deepening even in USA where the Obama Administrations Reform Plan announced in June 2009 called for all OTC derivatives to be traded to recognised clearing houses to eliminate lack of transparency and threat of widespread defaults. According to the plan, clearinghouses and exchanges would provide a needed guarantee to derivatives transactions by requiring dealers and corporations to post collateral on the deals and meet daily margin requirements.
Suggestions for improvement of regulatory framework:
As already noted India was less affected by financial crisis than USA and EU nations, and one of the important reasons for this was that the risk appetite of Indian Banks and other institutions were much less compared to US and EU banks due to cultural factors among other things. Moreover the Indian derivative markets being nascent, many of the high risk products including mortgage based derivatives were less prevalent in India than in other countries like USA, and EU Countries. Another important aspect was that the real estate sector, though unregulated had not entered the derivatives market in a large way, so as to have impact of the falling reality prices felt on the financial sector. Combined with this the tight regulatory control by RBI and SEBI over different derivative products and originators, had helped to prevent systemic risk to a great extent.
However, it would be foolish to believe that our regulatory system is superior to other systems or that enough has been done to prevent the derivative products from operating as weapons of mass destruction in India. On the contrary, the need for vigilant regulation suitable to the investment culture of the country and maturity of the markets, and ensuring transparency and appropriateness of the derivative products to ensure customer safety have been brought to the forefront by the experiences of countries that followed laisse faire policy in regulation of derivatives. Joseph Stiglitz, in his latest book, "Free Fall- America, Markets and the Sinking World Economy" has pointed out the need for a stricter regulatory regime for derivatives, in other words, re-regulation and more government involvement in the economy. In fact it should be kept in mind that financial products per se are not bad; it is the greed behind them that make them bad. In order to keep away greed from derivatives products, regulatory vigil should focus on the transparency of the products as well as the system, which will then make these products what they profess to be- money multipliers-not just for a few, but for all prudent investors.
