Throwing the baby out with the bathwater

Policy on derivatives needs to be informed by the evolution of these markets in India and the benefits of risk management

- K P KRISHNAN

A sophisticated and efficient market economy is ruled by prices. Prices fluctuate and send signals that generate a demand and supply response. These fluctuations can be painful in the short run. The financial derivative markets create tools through which, in exchange for a payment, protection from price fluctuations can be obtained in the short and medium term.

The establishment of gross domestic product (GDP)-scale, deep and liquid markets for financial derivatives runs alongside the establishment of a market economy. Over a generation, progress has been made in India on these fronts, albeit at a great cost. There is undoubtedly room for doing better on the problem of mis-selling of some derivatives. For the rest, reversing the basic direction will be costly.

In socialist India, the government controlled many prices. Sometimes, the law defined a fixed price and inflicted punishments for violations. Other times, the law restricted who could transact (e.g. only banks and primary dealers permitted) or where transactions could take place (e.g. at Agricultural Produce Marketing Committees only), and punished transgressors. The state built up a large arsenal of controls upon the economy, which were used to influence prices, such as export and import bans, regulatory requirements, etc.