William Gamble
Sukuk derivatives modified

In theory, derivatives are supposed to hedge risks in developed markets. Often, they have the reverse effect and they can create a disaster far larger than the problem that they were supposed to cure

Derivatives are all the rage these days. Presently, the US Senate is debating a Bill that would establish a better regulatory framework for derivatives. Meanwhile, the eurozone is struggling with the effects of skyrocketing derivatives for the sovereign debt of Greece and other members of the EU. A new derivatives market has just opened in China and both the trading and prices have been rising at a spectacular rate. Not to be outdone, the International Islamic Financial Market (IIFM), a Bahrain-based Islamic capital markets body, and the International Swaps and Derivatives Association (ISDA) have come up with standardised documentation for derivatives instruments that comply with Sharia, or Islamic law.

In theory, derivatives are supposed to hedge risks in developed markets. Often, they have the reverse effect and they can create a disaster far larger than the problem that they were supposed to cure. There are several reasons.

The first has to do with counter-parties. Derivatives on their simplest level are nothing more than contracts. A contract is simply an agreement between two parties to do something in the future. In the case of a derivative, that often requires the payment of money by one party to another upon the occurrence of a specific event—usually a loss or a default.

When the triggering event occurs, the party who experienced the loss asks the other party to the contract, the counter-party, to pay up. But what happens if they don’t? What happens if they can’t or won’t? In the United States, this is exactly what happened. Many of the big Wall Street banks like Goldman had AIG as a counter-party. When the collapse occurred it became clear that AIG couldn’t fulfil its side of the bargain. As a counter-party, it was a failure and the derivatives contract would have been worthless, except that the US government stepped in and guaranteed the deal.

This is still an especially difficult problem or for the eurozone and Islamic finance, because of the extra layer of cross-border guarantees and enforcement. The issue is having dramatic consequences in the EU, where European banks are so worried about counter-party risk that interbank lending is limited to overnight and spreads over three-month rates have soared. All of this is due to counter-party risk across borders.

The next question is how is the contract to be enforced? It may be possible to enforce these contracts in the US and EU. Emerging markets are a totally different story. The Chinese financial system is replete with massive toxic assets, because it is basically impossible to collect a debt. Any problems with their new derivatives markets will most likely not be resolved. Other emerging markets are hardly better.

The cross-border issue is also a problem for regulators. Which regulators are responsible for policing these transactions? We also have to assume that there are regulators, that they have jurisdiction and that they both will and can enforce the regulations on their respective country’s books. Legal disincentives without enforcement by regulators or courts are worthless. So would be the value of derivatives as insurance.

The real problem with counter-parties often is asymmetry of information. The contract or derivative—whether standardised or not—is a private transaction. These derivatives are not yet traded on any exchange. One of the main causes of the 2008 financial collapse and the present strains in Europe is the lack of information. No one knows the extent of the interconnections, so without information markets can collapse. Derivatives increase the interconnections and decrease the information. One of the main aspects of the new US reform would be to require derivatives to be traded through a clearing house. This would provide both transparency and the potential to both provide and monitor collateral.

The end result may not be hedging risk, but creating more. The illusion that a specific investment is protected from loss may result in investors taking risks that they would not otherwise have taken. If they feel protected by the derivatives contract, there is less of an incentive to do more due diligence. This was proved recently when the holders of unrated illiquid “asset-based” sukuks (Islamic bonds) realised that their investments were in fact not collateralised.

No doubt derivatives if properly regulated might actually do some good, but we have to wonder why they are so important. After all, this market is quite new both in terms of the scope and size. Markets did pretty well for most of their history without these new instruments. The answer came at the end Financial Times article about sukuk derivates. According to a banker at a Western bank, “In theory, the potential market size is several billion dollars per annum of structured investment products and hedging instruments, but we’re barely scratching the surface today.” So the real reason has nothing to do with risk management, but a lot to do with profit management for Western investment banks.

(The writer, William Gamble, is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected]).




7 years ago

I am afraid wrangling among scholars and wiggle room in interpretation of Shariah principles threaten to derail any attempt to arrive at global standards in Islamic finance

LMN: Desperate methods

There are just too many soft drink brands in the market and the window to build the brand AND rake in returns is quite short. While viewers may recall the ad, they could connect it with another brand

Don’t be surprised if you find too many cold drink ads being reviewed of late on this site. It’s that scalding time of the year when makers of chillers make serious hay while the sun shines. There’s near domination of the TV channels by cold drink ads this summer.
The latest to jump into the heated fray is a lemon drink called LMN (guess they are hoping consumers will connect that abbreviation with ‘lemon’). And they have flown as far away as the Kalahari Desert to make the point of acute dehydration and the torture thereof. Currently there are as many as five commercials on air featuring a couple of African lads (Bushmen). The idea is this: The commercials revolve around the trials and tribulations the boys go through in the hot, hot desert land to be able to get their hands on one drop of water. Of course, they’ve tried to be funny in the execution… they had to… acute water shortage and malnutrition in that part of the world is no laughing matter, so the creative had to be ‘cooled down’.
And so the dudes chase un-ending water hoses, mistake taps for digging tools in their desperation, try to kill each other for water. They even attempt to suckle a she-cheetah to quench their thirst! Yup, totally whacko stuff, but works on the principle that raising the temperature bar on thirst to phenomenal levels can help position LMN as the ultimate liquidifier. Also, using African kids helps them differentiate the brand from other Indian rivals, which is a sound idea. Of course, they run the risk of upsetting some sensitive folks for parasiting on the miseries of impoverished nations, but when you do mad things, you don’t ponder over such minor details.
And madness is the order of the day. The LMN ads must have cost them a bomb, but these are desperate times for soft drink makers. There are just too many brands in the market and the window to build the brand AND rake in returns is quite short. Come June, the monsoons will arrive in many parts of India and then consumer interest will begin to taper off. However, if there’s one issue I have with the campaign, it’s this—the branding is very poor. Somewhere along the way, the team went overboard trying to be whacky and lost sight of the fact that while viewers may recall the ad, they could connect it with another soft drink brand. They forgot the most important piece of advertising gyaan: The seed of the idea must always emanate from within the brand’s genetics, not out of it.




7 years ago

Dear Sir,
Though the comments about LMN marketing strategies has been described in detail by this piece but i think it lack in-depth knowledge as there was not a single time use of neither Parle Agro (the manufacturer) nor the marketing strategy being followed by Parle for branding of Hippo or as a matter of fact about Appy Fizz.
I think you would appreciate if this piece would have been a comparison of Appy Fizz and effort of Parle to establish LMN.


3% market jump: What follows?

The major market indices today have jumped by more than 3%. What happened in previous instances when the indices made such a giant leap?

It is not often that the stock index manages to vault over 3% in a single day. It did so today. The Sensex jumped 3.35% from 16,769 to close at 17,330 at the end of the day. When such a move occurs, one is bound to take notice.

Moneylife decided to take a look back to figure out how many times this has happened previously and, more importantly, what has been the reaction the very next day. Did the index put on more gains or did it slide? What we found was very interesting.

Our study covers the period 2001-2010. In this period of 10 years, there have been 83 instances (excluding today) of the markets crossing the 3% threshold in one trading day. Out of these, there have been 47 instances when the markets have remained positive for the next successive trading day. This translates into a 57% chance that the market will witness a spike in tomorrow’s trading. Not much of a heartening statistic, but an indicator nonetheless that is mildly encouraging for the bulls. On these occasions, markets have gained up an average 1.63% on the following day, with a maximum gain of 6.41% and a minimum gain of 0.06%.

On the 36 occasions that the markets have turned negative on the following trading day after a 3% gain, the index has shed 1.52% on an average. The maximum fall on such occasions has been 6.61% while the minimum fall was 0.03%.

Today’s surge was driven solely by the supposed happy end to the financial woes of several European countries, specifically Greece. The unprecedented $900-billion bailout organised by the European Central Bank (ECB) and the International Monetary Fund (IMF) to rid the
eurozone of its debt plague have brought joy on the faces of investors worldwide.

One single day of rally has wiped out almost the entire 4% decline that markets witnessed last week. There is every chance that today’s feel-good factor will roll on to the next trading session. Don’t expect the markets to do a high-jump again, but at the time of writing this piece, the European markets were up a huge 5%-9% while S&P500 futures were up a massive 4.7% in premarket trading.


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