Derivatives are complex financial instruments deriving their value from an underlying. This underlying can be an asset, interest rate, or currency. Businesses and financial institutions use them to adjust the actual risk with the quantum of risk they wish to take.

Derivatives, therefore, primarily serve the purpose of risk management and hedging. However, some players also use it to exploit any arbitrage profit available due to price differential while others (usually day-traders) speculate changes in the market.

The global derivatives market is colossal in size. In accordance with the Bank of International Settlements’ insights, the total outstanding notional principal stood at a towering $640 trillion in the first half of 2019. Some analysts argue that such figures inaptly portray the picture, but they still consider the market sizeable.

The derivatives market has flourished in countries like India and China. At the start of this year, Bloomberg reported that the National Stock Exchange of India surpassed the USA’s Chicago Mercantile Exchange in terms of the volume traded. On the flip side, Pakistan has a rather uninspiring derivatives market that sees modest trading volumes due to a lack of financial knowledge, statutory restrictions, abysmally-low propensity to save, and an ailing economy.

The success of evolution will largely depend upon the risk appetite and economic and financial literacy of market participants along with liquidity and a formidable regulatory framework

It makes one wonder why on earth is Pakistan limping behind its counterparts in this regard. Are derivatives a viable solution to limited horizons available for the investors to hedge risk? Do we need to thumb the paddle for the development of a financial market little known to the masses?

An under-developed country like Pakistan is marred by economic uncertainty. Businesses face considerable risks in the wake of a volatile currency, elevated price levels, and a subsequently unstable discount rate. Amidst this market ambiguity, a financial innovation like derivative offers an opportunity for businesses to manage risk in an increasingly dynamic business environment.

For instance, a textile exporter can take a long position in the currency forward if he anticipates the exchange rate to improve. On the other hand, an oil importer can go long when the market predicts depreciation in the rupee. Similarly, local producers can take a long position (borrow) if the interest rate is expected to rise. In case of a plain vanilla swap, businesses can take pay fixed, receive float position if they anticipate the interest rate to head northwards, and vice-versa.

However, the room to hedge a plausible risk comes itself in jeopardy. Derivatives follow the theory of a zero-sum game where one party’s loss is the gain to the other. With a possibility that economic indicators respond oppositely to the forecasts, derivatives might result in financial loss, which otherwise would not have transpired. The problem aggravates when one realises that the global over-the-counter (OTC) market’s enormity, in parameters of outstanding notional value, outshines that of exchanges. The reason is simply the default and liquidity risk premiums these instruments offer compared to exchange. Because an OTC is laxly regulated, it runs a risk of engaging in malpractices.

Moreover, a derivative is a knotty concept to conceive for a common person. This makes them dependent on information like the ratings by the Pakistan Credit Rating Agency (Pacra). An unholy alliance of the two parties (the issuer and the rater) in the USA led to the subprime mortgage crisis from 2007 to 2010. The crisis had ramifications on most of the world. Such aspects are a potential lacuna for the regulators to monitor and stage a paradox for an upturn in developing the derivatives market in Pakistan.

However, the exposure to potential risks associated does not downplay the case of progression in Pakistan’s derivatives market. The success of evolution will largely depend upon the risk appetite and economic and financial literacy of market participants along with liquidity and a formidable regulatory framework. The regulator must ensure price transparency and predetermined classification as per the quality and quantity of the underlying commodity. In this way, the hedgers can yield gains or incur losses following the underlying’s performance. Moreover, the government can minimally impose taxes to promote this financial avenue in Pakistan.

Published in Dawn, The Business and Finance Weekly, November 2nd, 2020