Derivatives not the root of financial crisis: Satyajit Das

Last weekend the G20 among other things promised to rein in reckless banking. Reckless banking in the years before Lehman was largely made possible because of complex derivatives that allowed traders to hide risks, maximise their upfront profits and fool customers, shareholders and even regulators.

The question today is can derivatives traders be tamed and can derivatives be made serve their prime purpose of hedging? Answering these questions exclusively on CNBC-TV18, Satyajit Das, the famous author of the book Traders, Guns and Money—the knowns and unknowns of the dazzling world of derivatives, says derivatives did help the economy go into a financial crisis, but it is a little simplistic to say derivatives are the cause of it. “They definitely made it worse because they allowed risk to hide in places and risk became fragmented and also they assisted in creating leverage and complexity in the system and that complicated the crisis and it is also complicated how we are going to have to deal with it.”

Traders, Guns and Money—the knowns and unknowns of the dazzling world of derivatives is a minor classic. Former RBI Governor Dr YV Reddy had distributed this book to members of the RBI board in 2006, when he wanted to warn them of the emerging crisis in the financial world.

Here is a verbatim transcript of the exclusive interview with Satyajit Das who is currently a risk consultant and has spent nearly 25 years trading derivatives, on CNBC-TV18. Also watch the accompanying video.

Q: First let me begin with your book. In Traders, Guns and Money you begin with a derivative product sold to an Indonesian company, where the company has to pay more if rates rise and if interest rates fall, they don't get lower rates but they have to pay fixed rates and the principal doubles. It is a product which a fool will know is heads you lose and tails also you lose. How close is this example to reality? Are such products actually sold or were you caricaturing?

A: It is actually based on real transactions I saw but I cannot tell you the details because I would have to kill you because if the liable laws. But interestingly enough the transaction that is outlined actually has a parallel in real life at the moment because as you may be aware the municipalities in Italy have entered into some transactions which bear a striking a resemblance. So perhaps somebody copied them from the book.

Q: How much would you say that derivatives were the root of the financial crisis?

A: I think derivatives helped but it is a little simplistic to say derivatives are the cause of the problem. They definitely made it worse because they allowed risk to hide in places and risk became fragmented and also they assisted in creating leverage and complexity in the system and that complicated the crisis and it is also complicated how we are going to have to deal with it.

Q: The Financial Stability Board (FSB) and the BIS have put forth some plans to tame derivatives—like Central Counterparty Clearing (CCC). Will it work at all?

A: I think one has to come back a little bit from what the issues are to look at where the central counterparty fits in. What has actually happened is that after the AIG episode and the Lehman’s episode, the issue of counterparty risk—this is the risk that one bank has on another—became very central to the concerns of regulators because I always took about daisy chains of risks—somebody deals with somebody, somebody deals with somebody and if anybody in that chain breaks down then you have a systemic crisis and I think the central counterparty goes to the heart of the problem. Now the first comment I would make about that is it’s not new. It has been around for a quarter of century but it is not in my view the complete answer for a whole bunch of reasons. The first reason is the idea of putting these on an exchange takes the idea of two big to fail to an entirely new level because as I have said some divine power ought to be supporting this because fundamentally if this counterparty every has a problem then you have got a huge, huge issue. And there are also mechanics of how you do it which I don’t think the FSB and central banks under stand fully and haven’t thought through.