Financial Inclusion – include Derivatives?
Inclusion has been the most-talked-about term in the last few years. India is talking and RBI is walking the way for financial inclusion among the Indian masses. It has been pondered over by economists and financial experts as to why the Indian rural market should be brought under institutional financing and what the end state should look like. The ultimate aim is to bring everyone under the governance system to enable easy dispatch of welfare packages and bring them out of the unregulated financial system. But what about derivatives inclusion among the masses who are already within the system?
Statistics from RBI website shows that derivatives are increasingly traded and total value now reaches to lakhs of crores of rupees (F&O total value: 1,16,280 cr, as on 18th Sept 2012). But how many certainly know the real power of derivatives and the lethal nature of it? Some investigations after the Global Financial Crisis in 2008, shows that the top management of many of the ‘too big to fail’ institutions really didn’t understand the functioning and the math’s behind derivatives. If you take the case of many of Indian public sector banks, they don’t run large scale derivatives trading just because they don’t want to risk investing in something that they don’t know about. But then why are derivatives getting popular (especially in the OTC market) and being used across industries and sectors to make gain for the treasury?
Derivatives are instruments which allow the participants to bet on their ‘views’ about the movement of an asset. Whatever be the impact of the financial crises across the past decades, derivatives continues to be traded in high volumes and the open interest increases day by day – why? One reason could be ‘disaster myopia’ – the thought that makes you drive fast as you move away from your last accident and that disasters can only happen to your neighbors. Second reason could be the never ending greed of human beings to multiply their assets manifold.
Whatever be the reason – is derivatives inclusion important? To get more clarity on this, we need to understand the people who make the financial system. These people mainly come as a byproduct of professional or management courses in finance, making them experts in financial products and financial risk management. But once on the playfield, they forget the latter and apply their entire intellectual prowess in creating innovative financial products – which over the past few decades form part of the derivative suite. If you go back to the class of these financial geeks, they would have been the brilliant ones among the crowd. The fame and glamour that comes with their brilliance makes them think less of risk management and more of how to create more complex financial products such as derivatives. Newer and newer geeks get smarter learning from the mistakes of their predecessors and influence the process of augmenting complexity. The financial attraction of these products makes the crowd bet on that, even if they really don’t need it. This herd mentality results in bubbling and accumulation of risks, ultimately leading to financial crisis, either at a personal or systemic level.
So do we need to get the masses educated in derivatives? Derivatives inclusion has become a need of the hour. Retrospection of the last crisis and the blame game among bankers, intermediaries, regulators, and credit rating agencies reveal that many of the investors in the derivatives market really didn’t knew what they were doing. Jesus once told “forgive them for they don’t know what they are doing”; but markets don’t follow this, they severely and literally punish the ignorance, because the players on the other side are as greedy as the ones on this side. This ignorance plus high volatility makes the market more and more complex.
Does this mean that derivatives inclusion is important? Yes, the target audience for derivatives inclusion should cover everyone from regulators to rating agencies to bankers to investors. All of them need to know what they are doing; failure to achieve this will result in financial crises again and again, leading to job losses, austerity measures and decline in the quality of life. There are many advantages in getting all of the participants to understand derivatives and the benefits, potholes on their way. This will enable players to understand and validate the new products coming into the market and point out flaws and suggest improvement; similar to other consumer product reviews. All of this will ultimately improve the trust of common man in the financial system, getting him closer to the system and bringing real financial inclusion for those who are already inside the system.
Bringing people under the purview of regulated banking doesn’t necessarily mean financial inclusion, but it should bridge the gap between the system and its participants. Financial inclusion must be a continuous process, as the financial system moves forward – so should all the players, thus bringing true financial inclusion in place. This should be driven by a team comprising of all sections of the market and should really increase awareness of the derivatives market, helping more players to reap the fruits of derivatives trading while mitigating associated risks effectively because they know what they are doing. The best place to start this is from the class rooms and financial institutions. The day when players realize this and start the real financial inclusion, is the day when we can certainly say that “we have achieved financial inclusion”.