Nothing is without risk

Everyone and his uncle wanted to speculate in the commodity markets. Brokerage houses like India Infoline, Anand Rathi, Motilal Oswal, etc. were aggressively pushing their clients to trade in the commodity bourses. The "exchange", in this case National Spot Exchange would ensure fair trade and also there were enough stocks in their godowns to ensure that the contracts were covered with physical stocks at the back end. There was also a settlement fund that was worth more than a thousand crores, or so we were told.

And then something happened. The exchange was forced to cancel contracts and get the parties to settle. It's a mess of counterparties on both sides, with some of them being merely shell companies with no assets on the balance sheet, owing crores to the exchange. The "settlement fund" suddenly shrank to less than a hundred crores. There are whispers that the stocks in the godown may not even exist, since they may have been created by fake purchase receipts. The brokers, the same people who encouraged their clients to trade in the exchange, in exchange for commissions, now want to file a case against Jignesh Shah and his family. They know very well that nothing will come out of it, but they have to show to their clients who have lost money that they are taking some action. When the whole thing unfolds there will be a few thousand crores still owing, a few thousand investors, or speculators in this case, crying foul since they have lost money, a few hundred articles decrying the whole shameful episode without really coming to grips with the problem, a few cursory enquiries to quiet the many strident voices demanding action, and a collective shrug of the shoulders. Some people will be left nursing their wounds, never to see their money again.

We are repeatedly told that the markets are safe since there are institutional structures to cover for counterparty risk. There will be no default because the exchange mechanism will ensure this, is what we keep hearing. Of course this cannot be true. The moment you give your money, or your commodity or whatever, to someone else to safeguard, there is always a risk. The moment you create instruments out of them, and complicated structures to administer them, there is further risk.  There is no such thing as zero risk.

What about lending to the government? May be as zero risk as you can get? The returns are barely enough to cover inflation, and we are funding the government to cover its deficits. No government has savings that it can dip into to pay you when the time comes. They just rely on the next person in line to lend them money which they can then pay to you. The city of Detroit has just declared bankruptcy, and many cities or municipalities in the US are set to follow. That means that the promised pensions of all those who worked for the city may never come, and all those who invested in supposedly safe municipal bonds may never see their money.  Federal governments don't like to declare bankruptcy, so they just print more notes to cover their debts. Which erodes the money that the rest of us hold.

Lending to the bank? Insured up to Rupees one lakh in India, only one lakh. A lot of banks are actually bleeding, and have highly suspect balance sheets. Politicians need to expand their patronage network, and banks are a good source. Which farmer in India really believes that he has to repay the bank when the time comes? He just waits for the next loan waiver scheme to happen. A lot of small businessmen in India pass a credit entry in the P&L (as revenue!) instead of a liability entry when they take a loan from a bank! Are you sure the NPA's of your bank are what they are stated to be? You can still consider it zero risk, since the banks will be bailed out, and someone else will pay. That someone is usually the taxpayer, which is you wearing a different hat. 

Investing in shares of a company? The risk is that the business may not do well, due to macroeconomic factors outside your control, or due to inefficiency of the management. Both of these you are willing to live with. But what about corrupt managements lining their own pockets? Corrupt promoters diverting money from the company to their own shell companies through various ingenious ways? What about boards who are actually dependent on the management and promoters to retain their board seats, hence are ineffective? In case there are huge losses, you can be sure you as a shareholder will share in it. In case there are very good profits, what are the odds that part of it is siphoned off and never reaches you?

And then of course there are institutional structures on top. You invest in the shares of a company through a mutual fund. The fund has its own fees which have to be recovered by the fund managers by generating an alpha over the benchmark returns. How many funds generate return over the benchmark consistently? And are the funds truly independent researchers and thinkers as they claim to be? Because of the way they are appraised, against a benchmark, and against each other, quarter on quarter, they tend to follow a herd mentality. Herd mentality implies investing in the Anil Ambani power venture's public issue - because everyone else is investing in it! Even a person without any knowledge of business would have found their business plan without any substance. Or it implies investing in the Facebook IPO. No one questioned the 100 billion dollar valuation at the time of the IPO, while any reasonably cautious retail investor would surely have stayed away.

And then there are the ETF's. Gold ETF's are safe we are told. We think it is because there is always physical gold of like amount to back up our units. While in reality, most ETF's say they invest in Gold or in assets (read paper securities) that move with the price of gold! Paper securities have a way of multiplying more than the underlying physical stock. During times of "national crisis" the gold that actually exists in the ETF's vaults is easy prey for any policy wonk who can commandeer it and give you "currency" in return. Just a few months back, Chidambaram permitted ETF's to lend twenty percent of their stock to jewellers, thus introducing counterparty risk to the ETF.  Just goes to show, that the moment something goes out of your hands and is replaced with a piece of paper, there is risk.

So what is the solution? Where do we get a real risk free asset to invest in? No such thing as risk free exists. Right from the time the caveman lent his tool to his neighbor on a promise that he would get it back, there was always risk that he would not. You can create instrument on instrument, structure on structure, on top of basic transactions like these, cloud them with jargon, insure them for all they are worth, and create complex derivatives out of them and claim they are risk free, but the risk always exists so long as the underlying risk exists. 

Someone finally has to pay.