21 - 27 December 2000
Issue No.513
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Al-Ahram Weekly On-line 21 - 27 December 2000 Issue No.513 |
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| Published in Cairo by AL-AHRAM established in 1875 | Current issue | Previous issue | Site map | ||
Risky business
By Aziza Sami
Can our banking sector sustain trading in derivatives-those instruments involving calculated risk? The question is important, because within quite recent memory backfiring derivatives have led to the collapse of financial institutions much stronger, and more streamlined than our banks are.
The new Capital Market Law due to be presented to parliament in its current session allows for trading in derivatives as a step towards developing the financial market further and soliciting much needed medium and long-term funding.
But while the initiation of trading in derivatives remains conditional on the Central Bank of Egypt's approval, which still has reservations against such a step, the question must be addressed in view of the general conditions of our national banking sector and the fact that voices are being raised advocating that it venture into the derivatives markets
Derivatives -- whether options, futures or swap contracts -- are a medium by which the investor may make contracts for future deliveries at specified prices, expanding the potentials for trading beyond the limitations of the physical market.
If they are well utilised, they facilitate the allocation of capital for investment, scout information on financial markets, and evenly distribute risk costs among trade partners. This is in theory.
The reality though, is that the widespread use of derivatives has in many instances reduced long-term investments, because it tends to concentrate capital in short-term, speculative transactions. It destablises cash markets and increases the volatility of interest rates and currency rates.
In recent memory is the collapse in 1998 of Long Term Capital Management -- the hedge fund which had to be bailed out at a cost of $3.5 billion. The incident was ironic and telling, since Nobel Prize Winners Merton and Scholes -- who had perfected the theory of calculated risk- were among its principal shareholders.
And, earlier, there was the scam involving Barings Bank, which showed how in an intricate trading system one man, (Nick Leeson) through willful abuse, could bring bankruptcy to a venerable bank and disaster to its investors by incurring a loss estimated at $1.4 billion .
Within memory as well is the Wall Street crash of 1987 -- where the sheer magnitude of losses incurred in the derivatives markets assessed at $16 trillion caused economists to dub derivatives a very risky business, potentially dysfunctional to the world's financial systems.
Since then, bankers and financiers have been concerned about the destabilising effects of the derivatives markets -- even as they concede their benefits.
Our government is still grappling with how to deal with the exchange rate, and has not come to grips with how it can reform the banking sector. In these circumstances, is it opportune to embark -- even in principle -- upon adopting sophisticated financial tools which the more advanced systems are still perfecting and reassessing, and which central banks the world over placing stringent controls upon?
If the banking sector is the mirror of economic administration, then how can our banks, which have fallen short of the standards requisite for the assessment and monitoring credit, and are suffering a lack of transparency over capitalisation, negotiate the serious risks involved in derivatives trading?
Only last week, the ratings agency Moody's announced that the seven Egyptian national banks are at risk of a downgrade on their outlook, citing liquidity problems which some of these banks have played no small role in compounding because of their faulty practices.
And while it is commendable that our economic authorities strive to keep up with the mechanisms of global finance and to develop the legal framework for its needed instruments, this must be coupled with more work on the ground, and more drastic reform. Otherwise, the disparity between aims and potentials will be too great to sustain.
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