The RBI recently by its circular re-introduced the use of Derivatives as a financial instrument for hedging currency and interest rate risks after it was banned in 2013. Derivatives and structured products were in use, or rather liberally used till before that before the sub-prime crises triggered “events”, resulting is colossal negative MTMs for corporates in 2006. The use of derivatives by both banks and corporates without specific governing rules from the Central Bank which should have limited the kind of structures that can be executed, limits, bank balance sheets or Accounting Standard regulations brought about the collapse of many large companies and rendered many in complete financial dis-array.

Derivatives and structured products, unlike forwards and Options and linked to specific events like cross-rates, interest rates or even unrelated events like CMS which invites penalties and can drive the MTM values to stratospheric negative values. Companies doing such structures should understand the scenario analysis and be ready for such eventualities and they can happen as the sub-prime had taught us. Banks should thus be able to give a clear scenario analysis and qualified consultants should vet these before embarking on such structures, as the notional in them are normally higher.

In the event of a negative event, these derivatives have to be fully or partly re-structured, as it is almost impossible for corporates, especially in India to service such negative flows. The type of deals that can be done should be clearly specified by the RBI as back then we had seen deals like “ Ratchets” being executed which are even banned in the US. Most Indian banks do not have the bandwidth to execute these structures in the overseas markets and are thus executed by foreign banks who write the deals in the local banks lines. This is all good till the time things turn negative, as then the local banks are dependent of their foreign counterparts to restructure them and all these come with very heavy margins. The only way these deals can be restructured is either by extending time or notional and either of these are not given by the local bank to their clients as that would tantamount to exceeding limits and lines exponentially. These lead to legal disputes where the bank has to first provide for them and subsequently write them off with the corporate suffering on freezing of their existing lines.

The main issue back then that there were no re-structuring guidelines by the Central Bank and they simply resorted to a summary ban on all ongoing and new derivative deals, something which can only lead to chaos. Entering new deals is comparatively easier but restructuring requires either the negative MTM of the deal to be unwound and embedded in the new deal and the events to be altered by way of KI or KO, either of which increases the risk  or cash bleed many times over. The Accounting norms back then also did not warrant the company to provide or declare the negative MTM beyond the current year but the advent of AS-31 and Basil will mandate them to do so and thus companies need to be extremely careful before executing these structures.

As I had mentioned, change in governing regulations have to be clear from the beginning and should not introduced or banned midway as that creates a financial collapse. Banks and companies alike had done many of these deals by ignoring certain events as “improbable” but as we have learnt, however unrealistic the clause is, there is always a possibility and a certain probability needs to be attached to it. Zero or negative short term interest rates, dollar yen at 80s or inverted CMS are all probable and this compounded by collapse of large institutions like the Lehman Brothers only compounds the issue, as our local banks write these structures with these institutions on a back-to-back basis.

Qualified Treasury consultants in India are scarce given that many of them are from banks who have not seen these structures being done in the last decade or due to lack of courses like the Certified Treasury Professionals in India. Consulting is not about managing exchange rates or margins, which to me is rather superficial but rather the risk and structures which a company can or cannot execute. Our company was called upon by banks and corporates alike for we had qualified people who are well adept to handling these on a global basis and more often than not found lack of diligence or ignoring of scenario analysis which drove companies to bankruptcies and can only hope that re-introduction of  derivatives comes with clear guidelines and controls to avoid a repeat of history.

Soumya Dutta, CEO, Eforex India