Derivatives to breathe life into stagnant investments

An efficient capital market is a prerequisite at both the micro and macro levels of the economy. At the micro level, a well-organised capital market aids investors by providing a range of investment outlets for their savings. On the other hand, corporations may raise their capital whenever they face any financial necessity. At the macro level, the government is assisted by effective dissemination of national savings to both public and private enterprises.  Besides, by efficaciously mobilising finance from indigenous sources, the government can also cut its reliance on overseas funds to finance its progression.

The capital market of Bangladesh is still in a very embryonic stage of development. The volatility in share markets has become a matter of apprehension in recent months for investors, regulators and policy makers and the debacle of the capital market has viciously exposed the lack of vehicles for risk minimization and alternative investment in the capital market of Bangladesh. Here, alternative financial instruments are infrequent to find. There is no distinct bond market. Moreover, money market is also not well-engrained. Investors can not apply any hedging approaches through risk-shifting mechanisms like derivatives while they are buying risky assets. Suppose, at the time of buying a stock, if a purchaser simultaneously can buy futures or options from the similar marketplace to safeguard the investment, an impeccable implication of his portfolio (comprising risky assets and risk-free assets) then is possible. Unfortunately, in Bangladesh the market for derivatives is almost non-subsistent. With the expansion of Bangladesh's market economy, it has now become indispensable to have a vibrant financial derivatives market.

The market for derivatives is the largest single segment of the financial market and according to the data available through the Bank International Settlement (BIS) as of June 2019, the global derivatives market amounted to $640 trillion in terms of notional amount outstanding. It is also estimated from the data that the derivatives market is more than eight times larger than the combined global equity and bond markets measured by market capitalisation.

From the above table it is crystal clear that the number of futures and options that changed hands on exchanges around the world rose 20.2 per cent to an all-time high at 30.28 billion contracts. The Futures volume rose 15.6 per cent to 17.15 billion contracts, while the options volume went up by 26.8 per cent to 13.13 billion contracts. The rapid growth in trading in derivatives on exchanges around the world highlights its significance conspicuously.

Irrespective of access to a derivative market through a specific exchange or over-the-counter, the derivative markets add substantial value to institutional or retail investors or corporate stakeholders. Currently, most of the derivatives markets in the Asia Pacific region comprise numerous products based on the requirement of different users.

The above table summarises different derivative products and the turnover across the Asia Pacific region up to the year 2018. The derivative markets have provided strength, variety and, most importantly, better risk management tools in the afore-mentioned emerging economies. Since the major stakeholders in Bangladesh are presently looking for the first-hand and pragmatic means for strengthening and stimulating the capital market, the probability of fostering a structured as well as regulated derivatives market as in the flourishing emerging economies of India, China, Malaysia and so on, needs to be taken into consideration.

The importance of derivatives instruments is undisputable for a financial market. Derivatives securities are primarily used for hedging or handling risks such as exchange rate risk, interest rate risk, equity price risk, default risk, etc. For organisations and even households looking to manage currency risk, financing costs or credit exposures, these instruments are enormously valuable. For governments looking to issue debt, derivatives products will help limit the cost of borrowing.

However, derivatives instruments may pose some certain undesirable risks. The market participants encounter such as counter party, operational, legal and liquidity can eventually lead to a systemic risk  i.e. default of one counterparty may have detrimental effects on other market participants. A big headache of all stakeholders, including regulators and policy makers, is to limit the systemic risk to the utmost extent possible and a resilient set of administrative regulations can definitely lessen such types of unwanted risks. In a country like Bangladesh dominated by inexperienced investors along with inadequate knowledge of global investment products, there must be watchful regulatory oversight over derivatives to sustain financial steadiness.

The derivatives market is very dynamic and has promptly grown into the most significant portion of the financial market. For last two decades, emerging markets, namely Singapore, Korea, Malaysia, Japan and India have innovatively and thoughtfully used a vibrant derivative market for risk mitigation and the efforts also yielded substantial benefits in terms of market expansion and overall economic growth. In view of the overwhelmingly positive outcome in similar markets of the world, introduction of a derivatives market in Bangladesh would have a noticeable effect on the country's capital market and the overall economy. It is anticipated that adequate legal and regulatory reforms as well as governance infrastructure will pave the way for successful initiation of derivative securities in Bangladesh and provide the perfect stimulus to recuperate our economy.

The writer is Sagira Sultana Provaty, Lecturer at Bangladesh Institute of Capital Market (BICM).