Derivatives: A long way to go

'Derivative' is the new buzz word in the financial sector of Bangladesh. Some local and international experts are continuously telling about the importance of introducing a derivatives market to mitigate investment risks in a developing country like Bangladesh. The Bangladesh Securities Exchange Commission (BSEC) also seems interested to introduce derivatives in the country's financial market soon. Wide acceptance among investors and its use as a tool for ensuring efficiency and depth of the capital market make the market for derivatives the largest single segment of the financial market in the world.
Derivative is actually a financial instrument which has no intrinsic value; its value is derived from some other underlying assets or products. The underlying asset includes stocks, currencies, interest rates, commodities, debt instruments, etc. For example, one farmer is assuming price of his product say mango would drop in coming days. If there is an efficient 'Derivative Exchange' in our country, he might go to an investor to buy a 'contract' that specifies that the investor would buy determined quantity of mango at a determined price in a certain day of future. The farmer has to be paid a pre-determined price by the exchange for getting this commitment to buy. This type of contract is called future contract which is actually a derivative. Derivatives also include other financial contracts like forward, option, swap etc.
Presence of the derivative would not only hedge the risk but also would provide an alternative investment opportunity for the market participants. To ensure a competitive capital market, there is no denying fact that derivatives must be introduced. But there is still a question mark regarding the readiness of Bangladesh's financial market to bring derivatives into play. Sophisticated instruments like derivatives need sound institutional set-up and efficient regulatory framework. Well-organised and full functioning market for securities and other commodities from which the value of derivatives is derived is the fundamental requirement for introducing derivative.
In Bangladesh, there is no commodity exchange so far though BSEC has taken a step forward to establish a commodity exchange by amending the Securities and Exchange Ordinance 1969 in November 2013. On the other hand, we have a volatile capital market which is still in a recovery phase after the 2010-11 stock market crash. Before the crash, the market experienced an astonishing growth which was not in line with the growth in real sector of the economy. As a result, the market went for a huge correction at that time and many small investors were affected badly. Even after years, investors still lack confidence in the market. It means the ghost of the market crash is still prevalent. There is also an allegation that the market is highly manipulated by a few players.
Former economist of the World Bank Oliver Fratzscher (2006) identified three critical issues that must be considered before introduction of derivatives in his paper titled 'Emerging Derivative Market in Asia'. These are: (i) a deep liquid cash market supported by market-determined prices, (ii) how much regulation is needed in derivative markets and (iii) what infrastructure is necessary. For a full functioning derivative market, an efficient and liquid cash market is very necessary. In Bangladesh, we do not have a liquid secondary market for government bonds. Though we have very few corporate bonds traded over stock exchanges, they are not popular among investors due to lack of liquidity. Corporate bonds are treated like any other stocks in the market. For example, transaction cost and maturity cycle are the same for bonds and general equities.
Close monitoring and strict regulations are required to ensure a credible and sound derivative market. A sound risk management tool has to be introduced to give security to the investors in financial distress. The capability of the BSEC to ensure such monitoring and regulations is still in a question due to its alleged failure to efficiently run the capital market. Infrastructure is another concern that cannot be overlooked if we really want to see derivatives in our market.
It has been heard in recent days that a derivative market is necessary in Bangladesh to ensure getting fair prices of agricultural products by producers. To do so, a commodity exchange for agricultural goods must be established and it will not be an easy task for the authority. A lot of things has to be considered in this regard such as product's quality, perishability etc.
However, basic knowledge of investors and participants about derivatives is a must for an effective derivative market. In a country like Bangladesh where investors cannot even understand the easy concept like mutual funds (mutual funds in Bangladesh were being traded at a very high discount or premium on the net asset values in last few years which was not ideal in any scenario), it can be said without any confusion that the investors will be surely in puzzle if complex financial instruments like derivatives are introduced now. Without ensuring proper training for potential investors and other parties including brokerage houses introducing derivatives will not be a wise decision.
Derivative is often termed as true capitalistic instrument as it offers a 'zero sum game' for the investors. If derivatives are introduced now in our market, speculators would be happy as they would get another gambling tool in their portfolio. But the true intention of introducing derivative should be the reducing the investment risk and to fulfill this, an efficient financial system and an adequate infrastructure are required.
Bangladesh has still a long way to go for ensuring a favourable condition for introduction of derivatives. Derivative market should be in our long-term plan and the short-term plan should include removal of existing problems of the capital market and the commencement of liquid bond market. Some experts said that without derivatives, investors walk in investment market barefooted. If the shoe is too big for their feet, general investors should not mind walking barefooted.
The writer is a student at IBA-JU.             [email protected]