Tuesday, July 15, 2008

Financial Instruments of Mass Destruction ?

Derivatives - Warren Buffet called them "Financial Instruments of Mass Destruction" . These instruments are responsible for a lot of losses - Long term Capital Management, Amaranth, Barings, Society Generale...... It is a long list.
Derivatives in different shapes are responsible for the current finncial crisis in the USA which is now engulfing the entire world.
In India, the indiscriminate use of Derivatives has caused havoc and destruction. Here is how. First, The introduction of stock futures has turned the stock exchange into a gambler's den. Lakhs of middle class families have been destroyed by losses caused by trading in stock futures - an instrument with no productive purpose. While Index Futures & Equity Options provide hedging and risk management benefits, stock futures are simply an instrument for gambling. This is the reason why no other country in the world offers such extensive trading in stock futures.
We have created gambling dens in every nook and corner of the country. At this rate, an entire generation of the middle class will be addicted to gambling (in stock futures) ,destroying themselves. When this happens, we can say farewell to the India Story. Why are we doing this ? When the badla stystem was abolished, the regulators said that this was done to prevent unwamted speculation. We were told that the system will provide for Equity Options which will enable hedging and risk management. Fair enough. Instead, the country has been gifted with the 'Mother of all Gambling Instruments' - the stock future.
Now what purpose does the stock future serve ? Nothing. If you want to buy a share, you can buy it by paying the full amount or by buying it on margin. Thus, the stock future serves no puirpose when buying. If you want to sell a share, you can sell it outright, or borrow stocks to sell. For both buying and selling, you should be able to use Options. (Thanks to stock futures, the options market has languished, with no depth.)
When both buying and selling activities can be conducted without stock futures, what purpose do the futures serve ? Nothing. They are a pure and simple instrument for gambling.
Second, Proprietary trading in derivatives by some brokerages has caused an increase in risk in the financial system with an unfair influence on the market. The more respectable brokerages do not do such trading.
These are difficult times. In order to prevent a financial catastrophe, SEBI should withdraw the instrument of stock futures & ban Proprietary trading in derivatives by brokerages.