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Mainstream, VOL LIII No 1, December 27, 2014 - Annual Number

Foreign Currency Derivatives — A Sophisticated Loot?

Saturday 27 December 2014


by Vahidha Nizam

A sophisticated loot of more than one lakh crores of rupees through ‘foreign currency derivatives’, is alleged to have been aided and abetted by the Indian banks. Under the garb of a benign taxonomy ‘foreign currency derivatives’ Indian corporate and SMEs have been subjected to phenomenal losses that would add upto more than one lakh crore rupees. SBI and 18 other Indian private and foreign banks in India have allegedly acted as the obsequious agents of the foreign entities whose exotic derivative contracts have eventually led to huge losses to the customers. The ingenium of this potentially lethal product, the genesis, its intriguing evolution in the background of extremely meticulous detail with which the global currency market was manipulated to engineer the loathly crime, all conjoined together, unravel a global financial conspiracy.

All these essentials perceived in the background of the global currency fluctuation and Libor (London Inter Banks Interest Rate) manipulation during this period in focus lead to shocking revelations that this highly structured product was conceived with wicked intent to fill the booty of the International banking bigwigs. It is all the more shocking that the Indian banks, including the state owned State Bank of India, have voluntarily played the facilitating role of active intermediaries simply for a hefty commission at zero cost. This raises the most pertinent questions: were the Indian banks more ‘committed’ to facilitate the dubious trade or were they decoyed into the hefty commission that was promised? What was the role of the RBI? Why is the CBI enquiry thwarted? Who is stalling a free and fair investigation?

The RBI has levied penalties on the 19 banks for gross violations of FEMA. The penalty is a peanut as against the pillage. That the Indian banks acted as intermediaries and conduits to the foreign enterprises to siphon off the profit outside the country can be postulated. But that which can be hypothesised should be established in the court of law. It was done in the Odisha High Court on the case filed by Pravanjan Patra. The Odisha High Court’s order for a CBI enquiry has been challenged in the Supreme Court. The RBI does not cooperate.

The case unfurls like this. The currency derivatives contracts entered into by the Indian companies, exporters and importers, with their banks—ostensibly for the purpose of ‘hedging’ currency exposures during the period from 2005, much of 2007 and 2008 to 2009—were exotic and glamorously marketed in the background of appreciation of the US dollar against all the international currencies. Hundreds of exporters and importers in India have been tricked and ensnared into the contrivance laid out so meticulously by the international banking behemoths. Disputes have been raised against the respective bankers for several thousands of crores and these remain unresolved as yet. But the banks in their attempts to cover up themselves have offered loans to the customers to ‘restructure’ the ‘outstandings’ caused as a result of these contracts. It is essential again to note that the loan amounts that go to cover up the ‘ill deeds’ of the banks are obviously from the savings of the people. Some bankers, it is reported, are even arm-twisting and intimi-dating the customers that their accounts would drift as NPAs and their credit limits would be blocked.

The RBI, in its response to the questionnaire of the CBI based on the orders of the Odisha High Court in the WP of Pravanjan Patra versus GOI and Others, attributes the subprime crisis in the US in the later part of 2007 as the reason for the loss of contracts during the period between 2007 and December 2008. In the same document the RBI also states that there are complaints and disputes but it is inappropriate for the RBI to intervene between the parties. It further states that after holding discussions with the Chief Executives of the 22 banks that were active in the business it came to a conclusion that this was not a systemic issue. That this is not a systemic occurrence, but exotic in content and character is the dispute all about.

I am a neophyte in the area of Forex dealings and derivatives. It indeed requires rare skills to comprehend the labyrinthine intricacy with which the whole process is suspected to have been manoeuvred. But a diligent reading of the works of A.V. Rajawade, Cash and Derivatives Markets in Foreign Exchange and Currency Exposures and Derivatives—Risk, Hedging, Speculation and Accounting gave me some insight into the whole range of issues. A critical discernment of the whole issue appropriately correlated with the international events confirms that here is a scam of currency derivatives, a scam larger than the largest, whose authors and executors could brazenly exploit the Indian banks to the best of their favour.

The RBI regulations in India allow use of derivatives primarily for hedging price risks. According to the dictionary of Banking and Finance, 10th edition, Hedging is “action taken to reduce risk or market exposure... a form of insurance... It is not speculation, but the avoidance of speculation.” It is therefore a transaction undertaken to reduce price or exchange risk, defined as the uncertainty of outcome; the risk of prices moving adversely. Hedging currency risks require use of derivatives.

Derivative is defined as under in the Accounting Standard (AS) 30 and quoted in the RBI’s Comprehensive Guidelines of Derivatives, April 2007: “A derivative is a financial instrument: (a) whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index or similar variable (sometimes called the underlying); (b) that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions and(c) that is settled at a future date.

This explains that the traditional forward exchange contract under which the parties agree to exchange two currencies at a specified future date, at the rate specified in the contract, is a derivative, a plain vanilla transaction. But these derivative contracts under the scanner, though clothed plainly as derivative contracts, are highly structured products, not in accordance with the model of RBI structures. They are structured to derive their value from the level of a benchmark interest rate, such as the London interbank offered rate (LIBOR)—which is used for various currencies. The contract is called a ‘swap’ or ‘options’ contract. There is no ‘underlying’. The currencies involved are not USD/INR, but a combination of USD/JPY, USD/CHF, USD/Euro and other various combinations. The currency specifications do not signify any geographical connotation or point to any particular trade relations. This is a typical ‘rat-trap’ to lure and loot! All the contracts are so ‘tailor made’ that the customer would end up ‘buying USD against another foreign currency. Concepts such as American Knock Out (AKO) and European Knock In (EKI) which represent an extremely skewed risk reward relationship are deliberately incorporated to carry out the loot. The language in the contracts is so wantonly imperceptive with a wicked intention to obscure the risk involved.

Taking advantage of the then prevalent exchange rate and based on the universal view during that period that the USD would appreciate against the rest of the currencies, the bankers set out for the sale of this structured product. High-terrain sales practices of the sophisticated marketing teams, the assurance of definite gains and promises of losses being extremely unlikely—all these, coupled with the traditional trust that the bankers had enjoyed in the society, led the customers easily into the carefully-laid-out trap. Of course, greed to make a fast buck and hope had overpowered any rational analysis. The old adage, ‘If it sounds too good to be true, it probably is’, takes the most of the customer and he enters into the ‘benign’ deal.

Subsequent to the contract the USD depreciated against all other foreign currencies in the year 2007-08 when the contracts were in vogue and as per the skewed terms of the contract, the banker exercised the EKI option and declared that the customer suffered loss of several crores.

To substantiate our contention that the global currency market was manoeuvred, let us follow the course of the currency rate prevalent in India during the period in question. The rupee was steadily depreciating for a decade after being floated in 1993. From 2003-04 to 2005-06, however, the rupee appreciated against the US dollar by three per cent per year on an average. Indian exports enjoyed the advantage of slow depreciation of the currency during the period of mid-2005 to mid-2006. The rupee got depreciated during July to October 2005 and then in February to August 2006. But the rate of appreciation of the Indian rupee has been unprecedentedly high from July 2006. The average rupee-US dollar rate in November 2007 was the lowest since 1999-2000.

This sudden upward rallying of the rupee evidently cannot be simply attributed to the natural outcome of India’s economic growth. That this was a wangle, engineered by the American and European banking cartels, was evident from the tumbling of the developed economies and the sequence of events that followed.

The possibility that the entire process has been engineered, the depreciation of the USD is manoeuvred to effect the EKI option certainly holds water. A.V. Rajawade makes some general comments in his work Currency Exposures and Derivatives where he says: “Most of these products have obviously been structured outside India—and sold by foreign bank branches in India either directly or quite often through Indian banks. It seems that Indian banks have been brought in as intermediaries in respect of the more risky structures where the suitability, regulatory and/or credit risks were particularly high. The process was, the foreign bank sells the product to a company; approaches an Indian bank to act as an intermediary, often on the plea that the foreign bank has no credit limit on the company and that it will take too long to establish a limit; the Indian bank earns what it considers a good margin for a zero (market) risk transaction on a back to back basis, often overlooking the reputation, legal, regulatory and credit risks it carries”.

This observation needs to be analysed together with the revelations of the international investigations on Libor manipulation which confirmed that between 2005-10 banks indulged in manipulating the world’s mostly used benchmark for short-term interest rates, the Libor. The Financial Conduct Authority of the UK has investigated to show that the cartel of international banks including Goldman Sachs, Barclays, Deutche, Citigroup, Standard Chartered, Royal Bank of Scotland, HSBC, JP Morgan and Morgan Stanley manipulated the Libor by setting it low against the USD in order to cover up their financial problems on the one side and manoeuvre the derivatives market and make huge profits on the other. This was done by distorting the normal course of pricing components.

Therefore, the events unfolded thus: this exotic derivatives product was designed in the year 2005, sold to the developing nations such as India, China, Brazil etc., in the year 2006 through the banks, the Indian Government was involved to create the legal framework to encourage OTC in the 2006 Budget, interest rate manoeuvring was done to peg down the dollar rate and reap huge profits. When the financial crisis hit the US economy in the end of 2007, the bubble burst and the investigations carried out by the USA, UK, Germany brought out these stunning details. It was not the Subprime lending crisis that was responsible for the losses, as held by the RBI. As has been manifested, it was the vicious interest rate manipulation that was the major reason for the crisis.

In India during this period a large number of contracts were signed by the exporters with the SBI, ICICI, Axis Bank, ABN Amro, etc,. It was true that the customers were lured and waylaid into this contract. This was done on the basis of research data provided by these banks to exporters showing how the rupee would continue to go down and probably touch Rs 32 and below. But contrary to the claims, the American dollar depreciated to as low as Rs 39 per dollar and the INR shot up to Rs 52 in a time-span of less than a year with approximate variation of about 33 per cent. According to a research, the participants in the derivatives got trapped based upon the historical movement of the dollar over a prolonged time-frame of seven years and this sudden movement from Rs 39 to Rs 52.

Even assuming that it was the greed of the customers that was responsible for their own debacle, the argument does not hold well in this context. Let us examine a plain hedge derivative contract in case of an exporter. If at the time of contract the rate of the USD is Rs 60 and subsequently the USD depreciates and on the date of settlement of the contract the USD is Rs 57, then the derivative contract has resulted in a hedge positive of Rs 3 per USD and it translates into a gain for the exporter. In the case of the importer it is the reverse. But in either case the loss or gain is only to the extent of the difference in the fluctuation rate which might be quantified to a few lakhs of rupees. This is in the case of plain vanilla contracts. The product in dispute is a structured product involving a deceptive deal, but the RBI tries to make it appear as simple as the plain derivative contract.

However, the banks’ fee income has shot up virtually from nowhere. It is pertinent, in this context, to engage a bit with the dramatic surge in the profit registered by the State Bank of India in the year 2008-09. From close to Rs 835 crores in 2006 the profit grew to Rs 3750 crores in 2008-09. There has been a spectacular transformation in the trading operations of the SBI since 2006. The bank is integrated with almost the entire global trade, the Forex market predominantly ranging from interbank currency trading to forward rates and cross rates. The USD is the most important currency of the SBI Forex trading.

The Reserve Bank of India has in April 2011 fined 19 banks—including the country’s top private banks such as the ICICI, HDFC and Axis; foreign banks such as the Citi, Stan Chart, HSBC, Deutsche—besides the State Bank of India, for violating its guidelines on derivatives. Six banks have been fined Rs 15 lakhs each; eight banks have been fined Rs 10 lakhs each. A penalty of Rs 5 lakhs each has been imposed on the remaining five banks. It is reported that the amount of fine is modest because this is the maximum that the RBI can levy under the provisions of the Banking Regulations Act. The RBI seems to remain content with what maximum it could do. Further, the RBI, through an internal circular, has asked all the banks to keep these transactions in a separate account. Only the fact that there are violations is established.

The RBI also shares a fact that the gains of the 22 banks that had actively participated in these transactions was Rs 31,719 crores. The gains that the banks had made were only through commission on the transaction. Even assuming that the commission was 10 per cent of the deal amount, then the amount involved would be Rs 31,71,900 crores!!

A data provides the catapulted quantum involved in India in this business of derivatives as an upshot of this product. There is a rapid growth in the Over The Counter (OTC) market in currency and interest rate derivatives during the year 2007-08. The aggregate notional principal of all outstanding derivative contracts on the books of banks in India, including foreign currency derivatives, has gone up from Rs 16 lakh crores at the end of March 2005 to Rs 85 lakh crores at the end of March 2008. This is again a cause of suspicion.

There have been hundreds of such illegal derivative contracts in India involving thousands of crores of rupees. The proceedings of the Public Interest Litigation filed by Pravanjan Patra, an eminent economist, in the Odisha High Court reveals certain shocking facts. “The scam is estimated to be valued at approximately Rs 25 lakh crore, much bigger than the 2G scam,” says Manoj Mishra, an advocate from the Odisha High Court. The Odisha High Court, in its Judgement dated Dec 24 2009 on the WP filed by Pravanjan Patra versus Republic of India and others claiming frittering of foreign exchange reserves declares: “the commission of offences of cheating, fraud and criminal conspiracy cannot be ruled out....... The instant matter is a matter of national interest. If the allegations are found to be true, then the CBI would be busting a large financial scam affecting the economy of the country....... We think it appropriate that the matter should be investigated by the CBI and action in accordance with the law should be taken.”

But FIMMDA (Fixed Income Money Market and Derivatives Association of India), an association of involved banks and enterprises, has gone on an appeal in the Supreme Court. The RBI, in the additional affidavit filed as per the order of the Supreme Court of India, rules out the possibility of frittering away of Forex reserves but admits to certain violations of FEMA. Until now, the RBI has not shared information on the overall issue. The RBI seems to be keen to defend the action of the bankers. In response to an RTI query seeking details of the total outflow of foreign exchange on account of derivatives during 2007-2010 and the country to which such payments were made, the RBI says that the Foreign Exchange Department, RBI does not have any information in this regard. This gives cause for a firm suspicion that there is much more than what meets the eye.

Derivatives, as Warren Buffer, the world’s most successful investor, says, are the financial weapons of mass destruction. The world has experienced the onset of this destruction. The notional value of the world’s derivatives actually is estimated at more than $ 600 trillion. The world’s gross domestic product (GDP) is only about $ 65 trillion, or roughly 10.83 per cent of the worldwide value of the global derivatives market.

But unlike India where there has been institutionalised resistance to fair investigations, many countries have not only fined the banks but also through the courts recovered the huge losses incurred to the customers. The European Commission has fined eight international financial institutions to the tune of € 1,712,468,000 for participating in illegal cartels in markets for financial derivatives covering the European Economic Area. The Federal Deposit Insurance Corporation of the USA has sued many of the world’s largest banks including the JP Morgan Chase and Barclays alleging their actions played a role in the failure of more than thirtysix US banks.

After the crisis in the USA, the Barrack Obama regime had initiated inquiry and made recoveries from all these banks. To quote one, in the final judgement of the case of Securities and Exchange Commission versus Goldman Sachs & Co, the US District Court of New York had held the defendant, Goldman Sachs, liable for disgorgement of USD 15,000,000 and a civil penalty of USD 535,000,000 payable to the Deutsche Industrial Bank.

The Australian Court in November 2012 has given a landmark judgement against the rating agency, Standard & Poor, who misled investors by giving its highest rating to derivatives that lost almost all their value in the run-up to the 2008 global economic crisis.

The Federal Supreme Court of Germany has given many judgements sentencing the defendant banks to compensate fully for losses suffered because of the fraudulent investments. The court has denied any further right of appeal also. The list that goes to provide data on the responses of other countries to the derivative fraud is quite reassuring as against the lackadaisical and non-committal apathy of the erstwhile
UPA Government to the woes of the Indian industries.

Comparison with China is as essential as it ever is. The Market Manipulation Monitoring Model in China was prompt to detect the criminality of the contracts and instructed all the public sector undertakings who had entered into these contracts not to honour them. The Chinese government categorically had proclaimed that it would meet the banks if they went to the International Court. But surprisingly none of the foreign banks went to the court.

Evidently in the end it is only India which remains casual to the drain-down of its economy. Though the issue has been in the public domain since 2007, it has not created the slightest ripple as the other comparatively smaller scams could do. There is a sure case for argument. There are evidences to substantiate the contest that there has been a financial scam involving more than one lakh crore of rupees.

The erstwhile UPA 2 Government maintained silence to all representations from the Left political leaders. D Raja, on July 30, 2014, had raised the issue in the Rajya Sabha and insisted that an investigation be ordered. The government should order for an investigation. There has to be a thorough probe by the CBI. A Special Investigation Team should also be constituted to call for the details from the banks and establish as to whose ‘profits’ were the ‘losses’ the exporters made. Efforts should be taken to recover the Indian money involved through an international arbitration for financial disputes. India lives in the hope that its democracy is still ‘alive and kicking’ and therefore somewhere, some mechanism will help to unearth the loot.

The author is a Secretary of the All-India Trade Union Congress (AITUC).

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