Few readers, even of financial newspapers, may voluntarily delve into a book that features both the words ‘economics’ and ‘derivatives’ in its title, unless they’re cramming for an exam. But events in recent years, from the US sub-prime crisis to the six-year stretch of runaway food inflation, to the National Spot Exchange scam, have made it clear that even if you want to have nothing to do with the derivatives market, it can still exercise a significant influence.

The Economics of Derivatives is a surprisingly accessible book which steers clear of mathematical formulae, the Greek alphabet and investment lingo. It debates the contribution of the derivatives market to economic wellbeing. Touches of dry humour liven up a dry subject.

Why derivatives? Are derivatives the “financial weapons of mass destruction” of Warren Buffett’s description or “an important vehicle for unbundling risk” as Alan Greenspan charitably saw them? The first part of the book is mostly devoted to threshing out this issue.

Economic theory argues, and the authors agree, that derivatives serve a useful purpose in transferring price risk from producers or owners of an asset to the people who can take it. A cotton farmer can thus focus on growing cotton and stop worrying about prices for his produce, if he can lock into a price for his harvest through a futures contract. Derivatives contribute to an efficient market by impounding future events quickly. Specialist speculators who dabble in derivatives may bring new information to the market. Thus, the argument goes, a robust derivatives market should help stabilise prices of the underlying asset by smoothing out the impact of future events. But this nicely reasoned economic theory flounders in practice because market participants often don’t play by the book.

For starters, hedgers or actual users of a commodity (or asset) make up only a minuscule proportion of global derivative markets today, with speculators and investors dominating. Here the book offers the unusual insight that the advent of ‘long-term investors’ into commodities who treat it as an asset class, has actually harmed the market. While the typical speculator indulges only in short-term two-way trades, these investors fuel price bubbles by creating artificial demand in bull markets.

When this happens, derivative markets can expand unchecked and futures or options prices, far from being derived from the underlying, can begin to actively influence it. Momentum trading and dynamic hedging may also prompt speculators to follow the trend, instead of taking a contrarian view.

Regulators help such bubbles along by taking a benign view of asset price spirals, but panicking when corrections unfold. It is this fatal combination of factors, the authors reckon, that has resulted in many derivatives-fuelled crises in recent years, from the US housing and credit crisis, to the bursting of the commodity super-cycle.

The RBI receives many pats on the back in these chapters for steering India’s debt and forex markets smoothly through the global credit crisis. Mostly, it has viewed derivative market innovations with active suspicion.

No benefit of doubt Drawing from recent experience with derivative mishaps, the authors conclude there is no longer a good theoretical basis for maintaining that derivative markets must be left to their own devices.

They have concrete suggestions on how policymakers can go about regulating (but not stifling) them. One, it is best to route all standard derivative contracts through a transparent electronic exchange so that price manipulation is difficult. OTC derivatives (private contracts) if allowed, should be the exception. This will ensure that policymakers can keep an eye on the size and growth of such markets even where they don’t actively intervene.

Two, regulators should curb profit-linked compensation packages to the fat cats in financial firms as this provides incentives for market manipulation. Three, a ‘revolving door’ policy on regulatory appointments — where Wall Street (or Dalal Street) players become regulators and vice versa — is best avoided. Finally, rather than intervene in the pricing of assets when there is a bust, regulators should use selective margins or interest rate tweaks to curb speculative excesses.

This section bears reading by Indian policymakers who have peremptorily banned futures trading in agri-commodities on several occasions, as a cure for inflation.

Noting that it was the “excessive de-regulation” of the OTC derivatives market in the US in 1999 that led to dubious innovations such as collateralised debt obligations, the authors argue that if a new derivatives instrument is beneficial in the public interest, it may be allowed. But where there is even an iota of doubt, it is best not to allow the ‘innovation’ at all!

All these points offer valuable insights to anyone directly involved in regulating the Indian financial markets or framing policies for it.

The authors raise many contentious questions on derivatives market regulation across 15 chapters and answer all of them, without any academic waffling. One may disagree with some prescriptions, which tend towards ultra-conservatism, but the arguments seldom fail the test of logic.

The later chapters in the book dedicated to the design of the regulatory framework for derivatives may be somewhat tedious . But readers can certainly pick up the book for the clarity with which it imbues subjects such as global QE, the US sub-prime crisis, the working of credit default swaps and the Libor fixing scandal.

It is mercifully short on theoretical concepts and uses numerical examples, if not real-life anecdotes, to illustrate almost every point that it makes.

The recounting of how Indian textile exporters from Tirupur were inveigled into buying “Tokyo cut European style options” in Swiss francs to which they had no actual exposures, demonstrates how hedgers can end up on the wrong side of derivative trades even in a heavily regulated regime like India.

The two chapters on emerging markets provide a good account of how some emerging nations are using derivatives to good effect to protect the exchequer from the deleterious effects of financial market volatility. Mexico’s strategy of hedging its fisc against oil price declines and Uruguay’s successful use of derivatives to shield its economy from poor rainfall (80 per cent of its power needs are met by hydro-projects) make for fascinating reading. This begs the question why India, a much larger emerging economy, cannot hedge against oil price risks.

Indeed, the one real shortcoming of this book is that it dwells too little on the Indian market and domestic investors’ trysts with derivatives over the years. There is a fleeting mention of the futures market flourishing in the 1870s.

But an Indian reader would surely want to know more about how the BSE’s badla system worked, the regulatory lacunae leading up to NSEL’s spectacular collapse or even corporate India’s limited success with hedging out forex risks.

TV Somanathan is joint secretary at the PMO, former director at the World Bank, Washington, and has a doctorate in economics (derivatives). He has written a previous book on derivatives.

V Anantha Nageswaran has a doctorate in finance, over two decades of experience in global capital markets, and is adjunct faculty on international finance and economics at IIM-Bangalore.

Title: The Economics of Derivatives

Authors: TV Somanathan and V Anantha Nageswaran

Publisher: Cambridge University Press

Price: Not stated

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