My two previous columns on rediff.com on derivatives (and how these instruments are primarily speculative in nature) invited insightful comments from readers. Some suggested that a bit of speculation was necessary for the liquidity of the markets. Yet some others opined that these financial instruments are necessary for the purposes of price discovery.

Better still, some readers felt that, as a chartered accountant, I was not qualified enough to understand derivatives, leave alone write a critical column on the subject. The ostensible reason: these complex financial instruments are beyond the comprehension of CAs. If that were so, the logical question is: what about the common man?

No wonder, on the April 28, 2008, the Apex Chamber of Commerce & Industry (Punjab) inserted an advertisement in a leading national business daily seeking intervention of the finance minister and the Reserve Bank Governor in order to 'save SME/business from currency derivatives.'

The advertisement alleged that some private sector banks devised special currency derivative products which were then sold to their clients as hedging instruments. Further, the ad alleged that these transactions were speculative in nature and against the RBI guidelines and policy.

It did not stop there. It went on further to add that any dealing with a bank fundamentally rests on faith and trust. It alleged that some of these banks had sold these exotic derivative products to their clients, leveraging this relationship between bankers and their clients. Later on, businesses realised that these derivatives, instead of hedging the gyrations in the forex markets, actually enhanced their risks and increased their losses substantially.

In the process, this faith of Indian business on the Indian banking industry has been tremendously shaken. Trust, so very vital to the banking system and mechanism and assiduously built over decades by our bankers, seems to have evaporated within months because of the reckless actions of a few bankers. From now on not many relationships with bankers will be anchored on trust.

Indian exporters devastated by derivatives

But members of the Apex Chamber of Commerce & Industry (Punjab) are not the sole victims of these products across the country. In fact, Tiruppur and Karur are two prominent centres in Tamil Nadu that seem to have been hit by the derivative tsunami.

In fact, press reports suggest that such dubious transactions have been replicated in many other such export centres across the country. And in all these places, the estimated losses run into several hundred crores (billions). The original estimate of the loss on derivatives -- Rs 20,000 crore (Rs 200 billion) -- for India as a whole, does not seem to be too conservative.

Naturally, the business in all these places is devastated. Remember, as centre after centre falls to the devastation of these financial instruments, no one talks of price discovery or increased liquidity. Just as businesses are kicking themselves for falling victims to these instruments because of their own greed, the role of bankers in this saga too is increasingly coming under scrutiny.

Importantly, no one is able to explain as to how the mechanism of de-risking -- the end objective of the derivatives game -- can become a risk in itself.

Is managing risk a risky business? Or is it unmanageable? If that were so then why this pretence of managing risk? Surely, someone needs to answer these questions.

The genesis of the problem

Readers may recall that since 2006 the US dollar has been depreciating against most global currencies. In April 2007 the rupee, keeping in line with its global peers, too began to appreciate significantly against the dollar. And as the rupee appreciated, these exporters began to lose both their top-line and bottom-line.

It is in this situation, banks (mostly private and foreign, but also some nationalised ones) took advantage of the situation to sell both exotic derivative products as well as naked hedge products to exporters. Without understanding the law that regulates these products or without understanding the financial implications of the same, thousands of firms entered into these contracts. Desperate times calls for desperate measures, right?

This is where the entire issue of the role of banks needs to be examined in greater detail. According to experts, the Reserve Bank of India [Get Quote] does not allow naked hedge transactions as it does not have the necessary underlying requirement for the hedge. Put pithily, any hedge instrument, not based on any valid import or export transaction, is not allowed under the extant RBI guidelines as it is merely speculative.

What was observed (by me) in the case relating to one exporter in Tiruppur, was that he had hedged the purchase of approximately 5 million pounds (Rs 40 crore) against various currencies. What I understand from this particular exporter is that banks did not insist on any document that would suggest import of machinery to the equivalent value. Nor did this firm care to provide the bank with any detail.

Similarly, banks allowed bets to be placed by exporters without any underlying exposure on the dollar against the Euro, Euro against the Yen, Yen against the Canadian dollar, the Canadian dollar against the Australian dollar and Australian dollar against the US dollar. All these require detailed knowledge of global finance, economics and intricate knowledge of currency movements, which most exporters never had.

And in most cases, the rupee was never hedged! Now if this is not gambling, what is?

Apart from these naked hedges, exotic and complex options were sold by banks as customised products by staffs who were marketing motor finance till the other day. The net consequence is that bankers never explained the risks in totality to the exporters.

What is appalling to note here is that one of the fundamental requirements to contract under the Indian contract law is that the parties to the contract must be 'competent.' If chartered accountants are incompetent to understand these instruments, how does one expect exporters to understand them, especially when the persons explaining the risks too were no experts.

No wonder exporters are sitting on significant losses and run the risk of closure. And the banks are now after the exporter to recover an amount that can never be recovered, even if the firm or company -- as the case may be -- is liquidated and all its assets sold.

But what is lost in the entire debate is that banks have been acting as (sole) advisor to these transactions with their clients. Naturally, this raises serious questions over the role of banks, corporate governance, and ethical and conflict issues. How could banks advice clients and yet be counterparty to such transactions? Crucially, how could they expect their clients to bear the losses on such transactions without any demur, especially if the banks are the beneficiaries of such losses.

Decisive intervention required

Due to extreme competition in the banking sector, it is understood that that this idea of selling exotic derivative products emanated first with private sector banks and then flowed to foreign banks. Now even nationalised banks, always known for their ultra cautious approach, are neck deep into this. The only plausible explanation for this is Gresham's law: when good circulates with bad, bad drives out good.

Another pattern that emerges from this is that these banks have taken a position 'against' the dollar and thrust a 'for' dollar position to their clients. As already explained, the US dollar was facing a fall since 2006. As positions were squared, people realised that they were holding a currency that was falling and banks had currencies that were appreciating. That explains the loss to the business and industry.

Is this a simple case of bets going bad? Or did the banks take a wholesale position against the dollar in international currency markets? And when they found that the dollar position they held was fast turning negative due to the falling US currency, did they retail their own risk and bad dollar positions and pass it on to exporters?

Whatever be it, the situation at the ground level is alarming. It is not the quantum of losses that makes it one. Rather it is the conduct of banks that is creating enormous consternation amongst the business community.

As authorised dealers under the FEMA (Foreing Exchange Management Act), banks are virtually disregarding the RBI for the purposes of dealing with other currencies.

To me, these are all characteristics of a scam. It is time that the derivative issue is christened as one. Given this scenario, it is time the RBI interfered in this matter. In the alternative a Joint Parliamentary Committee probe into the entire issue may well be in order.

The author is a Chennai-based chartered accountant. He can be contacted at mrv1000@rediffmail.com

Other articles by the author:

• The real reason why oil prices are rising
• Is the US economy heading for a collapse?
• Derivatives: The time bomb in our financial system