Playing it safe

Though the decision of the State Bank to closely monitor the derivative transactions of the market players could be termed an extra-cautionary or a conservative approach by certain financial circles but it is wiser to play it safe beforehand than make a fool of itself later on. According to a circular issued on 6th April, 2015, the SBP had developed a Derivative Transaction Reporting System (DTRS) to capture all the derivative transactions executed in Pakistan. “All authorised derivative dealers (ADDs), non-market maker financial institutions (NMIs), and the banks (involved in financial derivative transactions) are advised to report all derivate transactions, including forward rate agreements (FRAs), cross-currency swaps (CCS), interest rate swaps (IRS) and foreign currency options (FXO) in DTRS on a weekly basis,” according to SBP. The derivative itself is merely a contract between two or more parties and most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. As per the new requirement, the data for all derivative transactions, including new deals and changes in existing deals, maturity structure, terms and conditions during a week will have to be reported on the first working day of the following week. It has also been clarified that “with the increase in volumes of derivative transactions, the SBP may increase the frequency of data reporting”. In addition to reporting on DTRs, reporting institutions were required to continue to submit data related to derivate transactions as per instructions prescribed earlier by the SBP.

The latest instructions of the State Bank on the reporting of derivative transactions have certain background and a convincing rationale. Derivative transactions, those were rather simple and less risky, had always been a part and parcel of the financial landscape but these (future contracts, forward contracts, options, swaps etc.) assumed a highly complicated shape in the beginning of the past decade, resulting in a financial crisis that erupted in 2007-08 and continues to haunt the economies of various countries until now. Luckily, however, Pakistan remained largely unaffected during and after the crisis of 2007-08 because derivatives found a very small space in its financial system. Since the volume of derivative transactions had increased since then, State Bank could no longer afford to take a risk of a banking crisis and hence the latest instructions on the subject were considered essential. With proper and timely reporting, the risk on derivative transactions could of course be mitigated to a large extent because early signals could then be detected on the radar. As a central bank of the country, SBP of course has to make every effort to protect the interest of depositors and ensure the solvency of the financial institutions. Clearly, a default by a single institution could spread quickly to other institutions and harm the whole system with a catastrophic impact on the entire economy of the country. The derivatives which were highly risky and had earlier shocked the global financial system are normally termed “weapons of mass destruction” and need to be closely monitored. However, it needs to be stressed that it is not possible to exclude the existence of derivative transactions from the financial industry altogether. As such, a distinction has to be made between less and highly leveraged derivatives for risk assessment. Moreover, a proper balance has to be maintained between risk management and stifling of competition and innovation in the financial industry. Too much control by the central bank on new products could undermine the growth potential of financial institutions and render them less competitive at the global level. We hope that the State Bank is fully aware of the issues involved and would continue to take timely actions to ensure that the financial system of the country is not only vibrant and efficient but continues to be in good health to meet its obligations towards its depositors and investors who are the backbone of country’s economy. The SBP, nonetheless, could consider augmenting the reporting period from a weekly basis to a monthly basis as there is no immediate threat of deterioration in the quality of derivatives or a sudden expansion in the percentage of their volume in the total portfolios of the concerned institutions.