Saturday, July 12, 2008

Proprietary Trading in Derivatives: A Time Bomb ?

Lehman Brothers & Bears Stearns, two of the largest brokerages in the USA have fallen in deep trouble. While Bears has been sold, Lehman is on the verge of such a sell off. Both companies have large losses. What do these stories have in common ? Proprietary trading.

As the brokerage business moved up to become 'Investment Bank' some brokerages increased their profits by resorting to the highly risky business of derivatives trading on their own accounts.
Why should an institution (brokerage) which accepts public money do trading in derivatives on their own account ? By doing so, they put at risk the entire financial system of which they form a part. Of course, they also risk the money of their clients.
If the owners of a brokerage wish to trade, they should set up a seperate corporate entity, at arms length with the brokerage. This trading vehicle can be capitalized properly and then trade in the market by opening an account with a broker (any broker).
Fortunately, most Indian brokerage houses do not do any kind of derivatives trading for themselves. Just to be on the safe side, clients should ask their broker: Do you trade derivatives on your own account ? If the answer is : Yes, then quickly close your account with the broker, withdraw your money and go to another broker who does not do any proprietary trading in derivatives.
Why is this issue discussed today ?
The improper use of derivatives has caused large losses all around the world. Barings bank, Long Term Capital Management, Society Generale, are just a few of the big names. Currently, the entire financial world is reeling under the weight of losses in derivatives. In such circumstances, it is wise to be prudent and prevent such events from occuring in india.