DERIVATIVES AND PAKISTANI MARKET
AROOJ ASGHAR (email@example.com)
Sep 03 - 09, 2007
As with all other companies around the world, Pakistani companies are also facing various types of financial and operating risks. In response to these risks and in order to manage and reduce those risks, many new and complex financial instruments have been established by banks, ranging from traditional debt or equity securities to customized instruments that allow companies to address specific risks. Only few big forward contracts have been made since 2003, though entry of derivatives in Pakistan was made in early 1990s with currency swaps when foreign exchange reserves plummeted to low levels. State Bank of Pakistan (SBP) rightly says that Pakistani financial market has not yet fully developed to take large exposures therefore it is actively intervening in these riskier initiatives of the banks.
Few years back, SBP reviewed the Malaysian regulatory model for derivative market and made various changes in its regulations on that basis. In November 2004, SBP allowed banks and DFIs or development finance institutions to issue these instruments. Before that, it was supposed to secure prior permission of the SBP to transact derivatives business on case-by-case basis. According to the latest reports issued by SBP, taking advantage of this permission, only two foreign and one local bank, Citibank, Standard Chartered and United Bank got the status of authorized derivatives dealers (ADD) and conducted several transactions till the mid of 2006. The number of ADD has now increased to five from three during the last year. However, till now, no institution has obtained the status of non market maker financial institution. Nonetheless, the institutions, which are not ADD, can also undertake business transaction with prior approval from SBP. As for the development of Over the Counter (OTC) financial derivatives market, Financial Derivatives Business Regulations (FDBR) issued by SBP in November 2004 allows three types of transactions; IRSs, FX options and Forward Rate Agreements (FRAs). Of these three products allowed under FDBR, the first two appear to hold the major share of OTC market since FRAs are very few. The FRAs wiped out perhaps attributed to the perceptions of interest rates as well as the absence of a developed market, which is imperative to create demand for such products. During the last one year, transactions have grown substantially owing to the growing interest of the market players. Resultantly, players in OTC derivatives market reported outstanding derivatives contracts with a notional value of Rs 115.5 billion as of March FY06, a measure that has grown manifold compared to Rs14.5 billion in March FY05. Most of these transactions were under the IRS category. So far, foreign banks have been quite active in carrying out these transactions as the major chunk of these transactions lies with such banks. As for the FX options, around Rs 18 billion have been booked with major currency being the Euro against the US Dollar. Most of the IRS has been undertaken by the foreign banks with both their corporate and financial sector clients. Since FRAs are essentially short term in nature, outstanding FRAs stand as nil.
The use of financial derivatives is a recent phenomenon in Pakistan and first such real transaction took place in August 2003 which was a Rs. 100million FRA. During the four years, the market has grown considerably. Besides the plain vanilla products, market is slowly and gradually moving towards more complex and exotic structures. According to the Governor of State Bank of Pakistan, Dr. Shamshad Akhtar, in FX options the Pak rupee equivalent is merely 177million and FRAs 9.65million. Experts say that these numbers are very small despite having grown substantially and it is quite clear that a lot of work is required to be done in this area. Economists in Pakistan talk much about this, but that is not according to the expectations and potential of the market. Nothing concrete has been done on the economic reasons, costs, and impact of their use. There are many interesting and economically important issues of this instrument.
The State Bank says: "Although the derivatives market is growing in Pakistan, however, it is facing some teething problems, of which the major are; a less developed market for the derivatives business, less number of ADD and absence of non-market maker financial institution, unavailability of the market data and the absence of benchmarks for vanilla products." The central bank says that once these problems are addressed, this market is expected to grow at a higher pace and would largely serve to provide risk management solutions.
There is a tremendous growth in this market around the world despite reports of major losses like the bankruptcy of Orange County, California, and Barings Bank. A lot has been said on these scams but for a layman it happened due to wrong strategies even without enough financial internal controls. After many years, these incidences are still quoted as reference worldwide and haunt bankers.
Derivatives, as their name implies, are contracts that are based on or derived from some underlying asset, reference rate, or index. Most common instruments can be classified as one, or a combination of four types: swaps. forwards, futures, and options that are based on interest rates, currencies, commodities or any other assets.
Few banks in Pakistan mostly multinational and big local banks have developed financial risk management products specifically designed to control risk associated to any project effectively. One of the most popular derivatives in Pakistan is simple foreign exchange forward contract. During the 90s' rupee was not only depreciated massively but foreign currency reserves also went historic low level while in recent times it is considered stable (though some believe it is artificially stable). Dollar rupee parity was around 1 to 20 by the end of eighties whereas it crossed 60 in next ten years and went highest level of 1 to 64 in 2001. Due to continuous jolt in foreign exchange rates and reserves, banks had to introduce foreign currency hedging strategies for their customers. They successfully enable to convince their customers that by entering into a foreign exchange forward contract; they would be able to offset the risk of large movements in foreign exchange rates which eventually destroy the economic viability of their projects. It has evolved over the period of time and almost all the business houses dealing in foreign currency are using this quite effectively.
In recent times, another instrument which emerges aggressively in Pakistan's financial market is interest rate swaps. It is becoming one of the major swap activities of the banks these days. There are various forms of interest rate swaps including fixed-for-floating-rate swap which was not fully utilized by Pakistani companies when KIBOR was touching its lowest level i.e. less than 4%, and foreign currency interest rates swaps which is now becoming popular in Pakistan due to continuous increase in KIBOR.
Recent studies conducted by various international agencies and financial institutions have concluded that there is a growing need of corporate financial risk management system in Pakistan's corporate world. Those studies also give strong reasons for corporate hedging while they also found that a great proportion of firms throughout the economy still do not manage their financial risks. Therefore, it's logical to analyze why many companies in Pakistan are reluctant to hedge despite all the potential benefits of corporate hedging. Most of the companies in Pakistan don't have any risk management strategies through which they devise strategies to counter various risks associated to their business. It is important that it should be part of company's risk management strategy so as to protect their existing investment but also to enhance that as well.
MISCONCEPTION ABOUT DERIVATIVES
It should be understood that companies using these instruments have been able to create new ways to comprehend, measure, and manage their risks. There are few common misconceptions about this in Pakistan; here these are not as popular as these are else where in the World. There are various reasons for this and no single stakeholder is responsible for this. Those who oppose this in Pakistan fear a financial disaster of tremendous proportions can occur while dealing in it that would paralyze Pakistan's financial markets and economic growth. Critics believe that it creates risks that are uncontrollable and not well understood which is to a great extent correct. Few of the misconceptions are as follows, (not in order of importance);
* These instruments exist around the world for years but surely new in Pakistan. These are considered to be complex, high-tech financial products created by Harvard and Stanford professors. A vast majority of finance people in Pakistan think that this is another name of gambling, sounds strange but its bitter reality. Due to its complexity, it is also believed that these are purely based on speculation and are highly leveraged instruments. They believe that it is a way to speculative trading of interest rates or currency exchange rates.
* It is argued that a handful of banks including commercial and investment banks don't have enough interest controls. They are not only using unsafe and unsound banking practices but also lack world wide accepted best banking practices. Due to this, there is a fear that any one dealing in it might take entire banking sector in hot waters.
* It is said by few of the stakeholders that they might be worst off if they adopt financial derivatives where banks and their counterparties might be charging them heavily in response to the coverage of their risk. The viability of it rests on the principle of comparative advantage that is the relative cost of holding specific risks. Whenever comparative advantages exist, trade can benefit all parties involved. And it allows for the free trading of individual risk components.
* Local investor also believes that economic benefits of this are only dependent on the size of the company. It is for the multinationals and large local business groups only whereas medium or small sized companies can't benefit from this. This is one of the big reasons why most of the local companies don't take this seriously. Here they forget that it has nothing to do with the size and is mainly driven by the company's strategic objectives.
* A lot many Pakistani companies lack good financial governance. In this situation they miss to address which risk requires hedging and which not. They also fail to understand what kinds of instruments and trading strategies are most appropriate for them to adopt. As is the case with all tools, it is important that the user understand the tool's intended function and that the necessary safety precautions be taken before the tool is put to use. When used properly, it can help organizations to meet their risk-management objectives so that funds are available for making worthwhile investments. Again, a firm's decision to use it should be driven by a risk management strategy.
* Types of risks associated to any financial instrument hardly change; rather, with the passage of time, it gets more complex. Most of the Pakistan's local companies lack credibility whereas effective utilization of derivative market is not possible without good financial governance. It is indeed a fact that if businesses are run with integrity they can produce more opportunities than keeping things vague.
* During the last few years, Pakistan is going through its best economic times and most of the business houses have shown apprehensions in taking any risk. With this they have developed a mind set that only risk seeking organizations should use it which they believe are multinationals and large local business groups only. Keeping in view, only a handful of companies exit in Pakistan which has international projects; otherwise most of the companies are of medium or small size. As these companies don't have any international projects thus they are not willing to understand its benefits and feels that it takes money out of productive processes and never put anything back.
* There are instances where businesses are managed by young graduates themselves with the greed to become multi-millionaires overnight they took adventure by taking very risky measures without clear strategy thus suffered badly. It not only created hurdles in their future projects but also adversely affected their existing projects in financial terms. This happened due to their unclear understanding of the instrument and poor risk management philosophy. On top of that, a few people in banking sector in Pakistan who are competent enough to handle this easily. There are instances where they have ill advised their clients. Due to this, a lot of apprehensions exist in business community. It wouldn't be wrong to say that numerous people are not fully aware of the risks associated with these instruments as every transaction in derivative is considered new, has unknown factors and already established model can't be replicated for that. It is said by the conservatives that these are much more risky than other traditional instruments where they know the risk in traditional instruments but it is a territory of unknown.
* One of the areas, where Pakistan lacks most in this market is the development of their human resource. If banks utilize knowledge of global financial markets for their clients' then the story would be significantly different.
* One of the criticisms it is facing in Pakistan is that most of the business people think that adopting derivative strategy means elimination of business risk. Pakistani banking community faces this problem almost everyday from their clients while explaining them that risk management is not about the elimination of risk; it's all about the management of risk by choosing risks which are an organization is comfortable with and minimizing those that it does not want.
* Most of the finance people working in various local and even in multinational companies in Pakistan think that chance of default in it are much higher because of volatility and sensitivity. As a matter of fact, there is hardly any difference between defaulting derivative and any other loan. The reason for this is that every transaction is covered by back to back contract. It is important that market players must perform their due diligence of risk and rewards diligently and minutely.
As part of the liberalization process of the inter-bank market, derivative products have been introduced to allow financial institutions to hedge their balance sheet risks. Consequently, the Netting of Financial Contracts Act, 2006 has been introduced by SBP in order to provide a legal basis to parties of financial contracts of terminate such contracts and determine values with respect to their rights and obligations and thus arrive at a net payable amount. Pakistan has also set up its first National Commodity Exchange which plans to introduce trading in derivatives, mainly futures contracts in commodities starting with gold contracts and later to expand to agro-commodity contracts such as cotton, rice, and wheat.
With the passage of time and especially recent turnaround in the Pakistani economy, focus on exports has increased many folds thus it is vital for the Pakistani exporters to comprehend financial instruments. It wouldn't be wrong to say that it is in their own interest to reduce their risk and take productive activities that might not otherwise be pursued. Here it is not meant that non-exporters can't take benefits from this; any company which wants to do business overseas can get benefit from this. For example, a company gets contract to build a manufacturing facility in the UAE but is concerned about the project's overall cost because of exchange rate volatility between the rupee and the euro/dollar. To ensure that the company has necessary cash available, the constructer should devise a prudent risk management strategy. As part of that strategy, that company should use financial derivatives to hedge against foreign exchange risk. If these are used as a hedge then it can improve the management of cash flows at the individual firm level as well. It is vital for Pakistani business community to focus wisely on financial instruments which can increase their business valuation by providing a means to better control their risk exposures and cash flows. As every aspect has two dimensions, so as with this, sensible adoption can improve Pakistan's economy in general and banking sector in particular.
Pakistan's business and trading community is not fully aware of its benefits; it can be used for hedging against unwanted risks and also to speculate by taking a position in anticipation of a market movement. In one of the area where it can be used effectively is the agriculture sector, with the passage of development of commodity market one can see derivative trading in agriculture sector as well. However, it is important that all users, regardless of their size, understand how their contracts are structured, the unique price and risk characteristics of those instruments, and how they will perform under stressful and volatile economic conditions. This can only be possible if Pakistan's business community including banking sector develops their human resource as well.
There are few companies which disclose their financial affairs either correctly or according to the best practices of the world in Pakistan even though financials are being certified by the external auditors. It is essential that more emphases should be made on additional disclosure of financial instruments positions in financial statements. In addition to this, it would also be logical that institutions maintaining financial instruments should have sound risk management practices because it could have implications for the stability of the financial system as a whole.
Every issue can't be controlled through regulation; few matters need to be settled at management level. Best practices and guidelines should be regularly reviewed and can include; active board and senior management oversight of trading activities; establishment of an internal risk-management audit function that must be independent of the trading functions; thorough and timely audits to identify internal control weaknesses; and risk measurement and its management information systems, and contingency plans for adverse market movements. It should be the responsibility of a bank's senior management to ensure that risks are effectively controlled and limited to levels that do not pose a serious threat to their capital position.
Before dealing in it, one must remember that the kinds of risks associated with it are no different from those associated with traditional financial instruments, although they can be far more complex. There are credit risks, operating risks, market risks, and so on but these risks can be properly mitigated. As with any other traditional financial instruments, risks are always originated from the customer. Most of the times, these risks emerge due to lack of proper knowledge, impatience, and sometimes ill will thus all are man made. Here it is appropriate to quote example of home loan, though old concept in Pakistan but these days' banks are campaigning aggressively for this product. When a person negotiates with a lender to borrow house loan, the customer counter offers mortgage of his house. Here it allows banks to break up their risks and dispense them around the financial system via secondary markets. Thus, many risks associated with it are actually created by the customer himself. If these are used correctly then they can save costs and can increase returns.
There are no sure things in the global marketplace. Deals that looked good six months ago can quickly turn if unforeseen economic and political developments encourage fluctuations in exchange rates or commodity prices. In recent days, Pakistan is witnessing political instability which is gradually adversely converting that into numbers; its implications would be far reaching and may involve millions of dollars. Next few months are very crucial and can change economic front drastically. In this scenario, it becomes very essential that these instruments should be utilized at maximum. This continuous political uncertainty can hamper progress of last few years.
Summing up, Pakistan's economy has successfully turned around in recent years. We have been witnessing a boom in almost all the sectors especially in the banking sector. There should be no ambiguity among ourselves that derivatives are here to stay. Sooner or later we have to face this reality. Sooner we understand this better will be our position. If we really want to compete internationally and have ambitions to have a regional best banking sector then we have to adopt or develop new financial products in order to improve risk management practices. If we want to retain the current boom in place then we have to understand the importance of the derivatives and new technologies that are continuously being developed around the world. It is evident that use of financial instrument is of great importance to the economy and to the health of financial markets. Banks must have to educate their customers that it not only allows risk sharing but also provide sources for risk reduction. Last but not the least, it is not only going to help the banks and their clients in hedging their risks but are also going to make money market and foreign exchange market more mature in Pakistan. It can be said that with the increased knowledge, and realizing the importance of managing various risks, banks along with their clients will establish systems and models to better assess and manage those risks going forward.