IS: Securing India's Interests in Middle East

Adil Rasheed, Independent Security Analyst, New Delhi

Published on Indian Peace and Conflict Studies Website on June 16, 2014

The rabbit hole of Iraq springs up bizarre and devastatingly new challenges for the US even a decade after its invasion of the country. The embarrassment does not end there. The US is now forced to re-enter the quagmire and may fight alongside its arch-enemy Iran, much to the chagrin of its most ardent allies in the

region – the Arab Gulf states and Israel.

The Islamic State of Iraq and the Levant (ISIL), a new virulent strain of Wahhabi militancy, recently took control over the Iraqi cities of Mosul and Tikrit and according to some regional commentators threatens to rejig the region’s entire post-Ottoman shebang. Strangely, a large part of the ISIL’s forces comprises remnants of Saddam’s so-called secular regime – particularly the Naqshbandi Army operating under the command of the fugitive Ba’ath Party leader Izzat al-Douri. In response, Shiite militants have answered the call to arms by Grand Ayatollah Ali Al-Sistani in their thousands, raising fears that Iraq might soon disintegrate on sectarian lines.

These unforeseen events in Iraq follow other extraordinary developments that are fast transforming the geopolitical landscape of the region. Signs of a possible détente in relations between the US and Iran have taken the world by surprise. The six oil-rich Gulf monarchies that constitute the Gulf Cooperation Council (GCC) have been particularly outraged by the so-called US ‘double-cross’, with Saudi Arabia being so incensed that it refused to take the UN Security Council seat to which it was elected. The country has even warned of a major shift away from the US and is seeking to build an Asian pivot for a new security architecture.

The US-GCC relationship first came under strain in 2011, when Washington sided with democratic forces that deposed Hosni Mubarak in Egypt and then recognised the Muslim Brotherhood-backed president Mohamed Morsi. Fissures widened following the US’ inaction in Syria and its ‘neutrality’ during the Bahrain uprising, which confirmed GCC fears that Washington was no longer the guarantor of Gulf security. The last straw was the surreptitious nuclear deal with Iran last November, which apparently did not consider taking Gulf countries into confidence.

Thus, the trust is breached and the 40-year-long ‘oil-for-security’ pact seems past its sell-by date. The phenomenal increase in the US’ shale oil and gas production has helped the superpower outgrow its ‘addiction to Middle East oil’, allowing it to act more independently in the region. This has impaired confidence in regional security arrangements, which could have far-reaching implications for West Asia and the world.

For its part, India would have to continue walking a diplomatic tightrope between Iran and the GCC, building on the trust and goodwill it has earned among all sides in a volatile region. Interestingly, the early signs of thaw in the US-Iran relations augur well for New Delhi, as this had been a major point of contention in Washington-New Delhi relations. India has maintained diplomatic ties with Iran and both have shared geostrategic interests, particularly in Afghanistan and Central Asia. A breakthrough in the US-Iran negotiations could also allow India to increase its oil imports from the Gulf country – which are currently limited by the sanctions regime. There is also ample scope for trade and cultural exchanges. 

Still, a wide gulf exists between Washington and Tehran as the present thaw could dissipate any moment.

Moreover, any changes in regional relations should not come at the expense of India’s historic and strategically important ties with the GCC states. West Asia supplies over 62 per cent of India’s oil imports, most of which come from Arab Gulf countries. Moreover, the over 6 million-strong Indian Diaspora in the GCC states has created deep human links between the two societies. While 70 per cent of Indian expatriates in the GCC are blue collar workers, over 20 per cent are professionals. They remit about $30 billion to India every year.

Additionally, the GCC countries view the emergence of Indian economy with great interest. With the rise of major non-OPEC oil producers such as Russia and the US, the Gulf is looking toward the Indian and Chinese markets for sustainable demand. Again, following 9/11 and the 2008 global recession, Gulf capital is increasingly seeking investment out of the West. A significant degree of cultural comfort and confidence in India’s property rights protection and rule of law (unlike China’s) makes India an attractive investment destination. However, the policy paralysis that dogged India’s previous administration proved disappointing for some corporations. It is hoped that with the coming of a strong, new leadership in New Delhi, India may finally be able to meet expectations.

However, the security architecture of the Gulf remains a major concern for India. With the US influence in retreat, India needs to actively engage with the GCC, Iran and Iraq to secure its vital trade and energy interests. In cooperation with other Asian powers such as China, Japan, South Korea, Indonesia and Malaysia, it should initiate building a durable, non-hegemonic security architecture which ensures stability and peace in the region.

http://www.ipcs.org/article/suicide-terrorism/isil-iraq-and-securing-indias-interests-4517.html

MANIFESTING THE FUTURE

Indian parties use social media to draft poll manifestos

Khaleej Times (March 7, 2014)

It is often claimed that political parties in India never take their election manifestos seriously. Manifestos, it is said, make for dull reading as parties generally refrain from providing specific details or solutions on crucial issues out of fear that these might provide ammunition to the opposition or the press in targeting the stated policies.

Again, manifestos are generally published just a few weeks or days before the elections. The intent is to

avoid giving the detractors enough time to widely criticise the vision, goals and policies of a party. Therefore, manifestos are viewed by parties largely as a formal democratic custom and at best a public relations exercise to project political personalities at the expense of clear policies and programmes. Thus, it is not surprising that hardly any political party has so far released its manifesto for the Indian general elections of 2014.

However, political parties are viewing the drafting of their manifestos a little differently this time. Hiding their ineptitude in gauging a restive public sentiment, most parties are now soliciting the voters themselves (particularly the young) in writing the manifestos through social media websites. Perhaps, many parties have understood that in upcoming elections, manifestos would be read by a wider audience in the country — thanks to greater Internet accessibility — and would play a more important role in determining a party’s prospects than in earlier elections.

Thus, under the slogan ‘Your Voice Our Pledge’ the Indian National Congress is asking its supporters to “voice your ideas for the Congress Party’s 2014 Lok Sabha Election Manifesto” on a dedicated web site. Even more forthcoming is the Bhartiya Janta Party (BJP), which has a web site titled ‘BJP Manifesto 2014’ and a Facebook page named ‘BJP Election Manifesto’.  The description on the Facebook account reads: “Election manifesto is an important document that defines the policies of the nation for the next government. BJP has started the work on its manifesto for the next general elections. Being a party of grass roots, where anyone can voice his (sic) opinion, you have a once in a lifetime opportunity to get your viewpoint across… ”

The Aam Aadmi Party that claims it was more effective than any other party in its social media campaign during its successful bid in the New Delhi elections is gearing up for its social media campaign during the nation-wide elections and is setting up online pages in various regions of the country for this purpose. Again, it has sought the help of various economists, environmentalists, industry leaders and policymakers to prepare its national manifesto, which is scheduled to be published in late March.

This ‘online manifesto campaign’ by the major political parties cannot be dismissed as merely an election gimmick. The enormity of the crises facing the country and the growing public disaffection with the political system has underscored the need for a major systemic overhaul in various spheres of governance. This would entail a collective rethink and the formulation of new policies that would necessitate greater public support and acceptance. Most political parties are realising the magnitude of the challenges ahead and hence are reaching out to the public for solutions. The trendy information technology is also obviously helping them in their election campaigns all the same.

The problems facing India today are not limited to the supposed ‘endemic corruption’ or a faltering economy. In addition to the burgeoning fiscal and current account deficits, the country needs a fresh approach in centre-state relations, defence policy, foreign affairs, public administration, revenues and taxation, infrastructure development, energy and agriculture, education, law and order and so on. These problems can be resolved through greater public discourse and participation.  Perhaps the public formulation of manifestos by political parties could be taken to a higher level by developing a more broad-based national manifesto. This could be the first step toward transforming India from a representative democracy to a more participative democracy — a governance determined more by policy than personalities, by leadership than by crises.

http://www.khaleejtimes.com/kt-article-display-1.asp?xfile=data/opinion/2014/March/opinion_March10.xml&section=opinion

Drones: Terminators With Gaming Console Joysticks!

By Dr. Adil Rasheed

Article Published on Website of the ECSSR (3 June 2013)

In the wake of the 9/11 attacks, governments and militaries around the world faced a hideous enemy who could morph and blend into the landscape after carrying out asymmetric kamikaze and shoot-and-scoot attacks.

The difficulty in identifying, tracking down and taking out a terrorist required the development of a new and unconventional form of warfare, one which combined search and reconnaissance capabilities as well as the ability to shoot down and eliminate the threat with minimal risk of collateral damage and with few military casualties.

Inevitably, the solution came from cutting-edge technology, particularly the revolutionary innovations taking place in Unmanned Aerial Vehicles (UAVs), popularly known as drones.

This technology proved highly beneficial for militaries, as the large-scale, conventional wars in Afghanistan and Iraq proved inadequate and very costly (both in terms of lives and money) in eradicating the threat of terrorism.


In contrast, drone warfare provided a more effective, less violent and highly cost-efficient alternative to conventional warfare and so it became the preferred option for the Obama administration in conducting the ongoing war against terrorism.

In fact, the technology has now become so ‘convenient’ that it is being frequently used in missions that are considered “too dull, dirty or dangerous” for manned aircraft. In fact, the game consoles wizards are fast replacing fighter pilots of old aircraft as operators of lightweight UAVs. Thus, the tendency to overuse drones in military operations has in itself raised a new set of legal and ethical issues for the technology.

Over 70 Countries Have Drones!

But before addressing some of the legal aspects, it would be important to gain a better understanding of drone technology and its rapid advancement. A drone can be defined as an aircraft which has no human pilot on board. Its flight is controlled either autonomously by computers or through remote control by a pilot situated in a distant location on land or in another vehicle.

Drones have become so popular and pervasive today that according to the US Government Accountability Office (GAO) report, published in February 2012, at least 76 countries already have military unmanned aerial systems. The GAO report adds that the number of countries with drones has ‘nearly doubled’ in the span of seven years.

In fact some drones, particularly Unmanned Combat Air Vehicles (UCAVs), have now achieved worldwide fame that arguably matches the star status of some of the most advanced fighter jets and bombers of our times. The names of Predator (armed with Hellfire missiles), the Reaper and the surveillance aircraft, Global Hawk now bask in international limelight. However, militaries also use UAVs for a variety of other purposes and applications too such as reconnaissance, search and rescue, logistics, research and development applications, etc.

According to some military aviation experts, UAVs today even have the potential to eliminate the use of piloted aircraft in the not-so-distant future. More important, a new swarm of small and insect-like drones are joining the military fleet, adding a surprising twist to a rapidly unfolding hi-tech tale. For years, the US military (particularly its Defense Advanced Research Projects Agency or DARPA) has been working on developing ‘micro-air vehicles,’ i.e. ultra-small flying robots capable of performing surveillance in ‘dangerous’ territory.

The Drone Bugs

According to DARPA, these drone bugs have a wide variety of uses. For example, when fitted with chemical sensors, these insect drones can detect traces of explosives in suspected buildings and caves. Again, these insect-like drones can be equipped with small video cameras that could show whether a building is occupied and whether those inside are civilians or combatants. They could also be equipped with microphones to record sounds and conversations.

For example, the DelFly Micro, is “the smallest flying ornithopter carrying a camera in the world” and measures less than 10cms from one wingtip to another. Then there are the small kamikaze drones that can destroy enemy targets by crashing into them. The drone named ‘Switchblade’, developed by the US technology company AeroVironment, carries a video feed and can locate a hidden enemy like a sniper and kill him. A similar kamikaze drone, called the ‘Devil Killer,’ has been developed by South Korea. But the US military is taking a step further by using neuroscience technology to hack into insects’ bodies, whose movements are then controlled by micro-machines placed on them.

Another promising breakthrough is the control and coordination of a fleet of drones from one computer. It is claimed that a computer software called Ballista, built by the company DreamHammer’s, could enable a single operator to control many drones simultaneously by using an intuitive computer interface. Thus, the movement of several drones being controlled by this software and all of them do not have to be aerial vehicles, as some may be UAVs, while others could be unmanned wheeled rovers, watercraft or even submarines. Thus, one person at the controls could launch a full-scale offensive of drones through air, land and sea.

Drones in Commercial Airspace

Again, drones of all shapes and sizes are not only revolutionizing military technology, they are also about to change civilian lives. Their non-military applications are growing by the day, and they are already used in oil-gas-mineral exploration, search and rescue operations, detection and dousing of forest-fires, agricultural surveillance, commercial aerial surveillance, remote sensing, transportation of various kinds of payloads, etc. Even household drones will soon be available for cleaning and dusting the floor.

Last year, the US Congress passed a bill which requires the Federal Aviation Administration (FAA) to issue regulations on integrating drones into commercial airspace by September 2015. Thus, we are fast approaching the time when anyone, at least in the US, can buy a drone over the counter with a few hundred dollars. In the words of Peter W. Singer, senior fellow at the Brookings Institution, the opening up of the US national airspace to commercial drones would do “what the Internet did to desktop computers.”

However, the commercialization of drone technology is currently facing three important impediments: safety, privacy and insurance. There are concerns that despite legal provisions mid-air collisions between manned aviation (airplanes and helicopters) and unmanned vehicles or even among UAVs could occur frequently. In addition, increased use of private drones (particularly small drones) could intrude upon individual space and violate privacy as drones could pry into homes or offices and transmit images and sounds in real time to their operators stationed far away. Again, insurance companies are reluctant to provide coverage for aerial drone accidents as these unmanned flying objects could fall and cause incalculable damage to people or properties below them.

Convenience to Kill!

However, it is the military uses of drone technology which has really stirred a hornet’s nest for its advocates. One of the pet peeves of peace activists and human rights campaigners that oppose the use of drones by the military stems from the very benefits the technology provides. It is said that because drones are cheap, highly effective, seemingly risk-free for their operators and are adept at minimizing civilian casualties, it is tempting governments and militaries to employ them more often. Many human rights activists charge that it is this convenience that has allowed US military to carry out hundreds of drone strikes on hapless human targets in Afghanistan, Northwest Pakistan, Yemen and Somalia and other regions of the world.

According to estimates by the New America Foundation, there have been 355 drone strikes in Pakistan and 66 in Yemen till date. In February of this year, US Senator Lindsey Graham estimated that about 4,700 people have been killed in America’s drone war, many of whom were innocent civilians. Again in February of this year, The Bureau of Investigative Journalism published its estimates of deaths caused by drone strike in Pakistan, Yemen and Somalia, which, it said, ranged between 3,072 and 4,756.

Again, many legal experts around the world are alarmed by the impunity with which drones allegedly breach international law, violate the sovereignty of nations and carry out extrajudicial killings. Concerns have also been expressed over the lack of transparency, oversight and regulation in these campaigns. Many civil rights advocates were outraged when the Obama administration publicly acknowledged for the first time that four US citizens have been killed in drone strikes since 2009 in Pakistan and Yemen.

Breach of International Sovereignty and the Human Cost!

US President Barack Obama recently addressed most of these concerns by signing a new “presidential policy guidance” on when the US can use drone strikes. On May 23, 2013, he made a groundbreaking speech and declared that he is now going to restrict the use of drone strikes.

He proposed the institution of special courts to decide on targeted assassination of terrorism suspects under new legal regulations to prevent any possible violations. He also said that drone attacks will now be carried out primarily by the US military rather than the CIA, and only after a new test has been passed to ensure that all other alternatives to avoid such strikes have been exhausted.

Human rights campaigners greeted this announcement but continued to have reservations. Many called on the US President to publish the new legal tests that have to be cleared before a drone strike is carried out, as the details of these tests have only been read by the US Congress.

Despite the various legal and ethical challenges attached to the use of drones, it is clear that this technology has now become so popular and widespread around the world that it would be difficult to stop its spread and growth. Therefore, the big test ahead lies for governments, militaries, legal institutions and human rights organizations to properly regulate the uses of this technology for the good of mankind. Like it or not, drones are here to stay or as Peter Singer puts it: “This is a powerful technology. No amount of hand-wringing is going to stop it.”

http://www.ecssr.com/ECSSR/print/ft.jsp?lang=en&ftId=/FeatureTopic/Adil_Rasheed/FeatureTopic_1689.xml

Stock Market Flash Crashes and Risks of High Frequency Trading

By Adil Rasheed

Article for ECSSR Website published on April 29, 2013

After hacking into the twitter account of an international news agency (Associated Press), criminals send out a message that the White House is under attack and the US President has been injured. Immediately, stock markets press the panic button and high speed algorithmic trading plunges the Dow Jones Industrial Average into virtual free-fall (dropping sharply 143 points), as stocks are dumped in the milliseconds. However, sanity is soon restored as the news is found to be false. Stock markets rebound but only not after Standard and Poor’s has fallen one percent and $136 billion in stock value has been wiped out.

This narration is not a piece of fiction, but a report of the ‘flash crash’ that hit US stock markets on April, 23, 2013. Surprisingly, this event is also not a freak accident or an unfamiliar occurrence anymore. In today’s global financial markets, the trend of a sudden and precipitous drop, known as a ‘flash crash,’ is becoming increasingly frequent and alarmingly commonplace.

The above mentioned ‘flash crash’ was not just the first of its kind it was also not the biggest till date. The first ‘flash crash’ took place on May 6, 2010, in which the Dow Jones Industrial Average fell 1000 points (by 9 percent). There have also been other such crashes involving stocks of major companies, including Google, Apple and Bitcoin. It has also been suggested that commodities like agricultural products, oil and gold remain as vulnerable as the stocks of companies in today’s hi-tech stock exchanges.

Flash crashes have added a new element of uncertainty into today’s financial markets. Although still a matter of debate and speculation, the occurrence of flash crashes has been attributed to the rise of computers and their high-speed algorithmic trades that are fast replacing human traders on the floors of the world’s biggest bourses. Studies suggest that automated trading in major US and British stock exchanges already constitute over 50 percent of the total volume.

The use of sophisticated computer algorithms to trade stocks and securities in seconds, or the fraction of a second, is known as High-Frequency Trading (HFT). In fact, HFT involves trading in and out of investment positions tens of thousands of times a day.

With the introduction of this highly automated form of trading, the human element — particularly human assessment, judgment, initiative and enterprise — seems to be declining in global stock markets. In fact, HFT firms are not only conducting most of the trade in stock exchanges, they are doing so almost entirely with each other, as the human trader is unable to process vast amounts of information or trade as rapidly as them. Thus, even as the conventional human trader continues to look for opportunities on a weekly, monthly or longer-term basis, HFT firms take on short-term trades that involve high risks and rewards, which are often thousands of times higher in returns than those sought by their human counterparts.

The enthusiasts of this new technology contend that HFT improves market liquidity. They cite various studies that show that transaction costs for traders have substantially decreased with the growth of these systems. They also point out that computers make for better and honest traders, have enhanced attention spans, follow instructions properly, do not allow emotions to cloud their judgment, monitor and process information from many sources simultaneously and cost a lot less.

On the other hand, the detractors of HFT bewail a long litany of grievances. To begin with, they claim that HFT often causes instability in financial markets and drains out liquidity, especially when it is most needed. They point out that high-frequency liquidity providers had withdrawn from the market, when the May 6, 2010 flash crash was unfolding.

It has also been claimed that HFT is often used for ‘front-running’, an illegal practice wherein program traders learn about incoming orders before other traders and jump in front to make profits. A study conducted last year by Andrei Kirilenko, the chief economist at the US Commodity Futures Trading Commission, found that high frequency traders often make money at the expense of others as their algorithms are capable of gleaning investing patterns of other traders. Some traders also complain that HFT is even used to manipulate markets for economic and even political ends.

Some market experts have also raised the alarm over the ‘technological arms race’ initiated by the HFT. In order to beat competition, they aver, each HFT firm is increasingly spending large amounts of money on new and expensive technology to outpace rival automated competitors. Many economists suggest that if this ‘technological arms race’ does not stop, average investors will become disillusioned and drop out of the stock markets, which will reduce the real volume of trade and will adversely affect economic welfare.

But the biggest charge against HFT is that it remains vulnerable to several forms of systemic risks. For example, trading systems may at times demand too much liquidity too quickly and may cause prices to fall or rise to unreasonable levels. Again, it has been found that algorithms at times place large number of unanticipated orders or a trader misuses an algorithm by setting parameters that cause it to trade aggressively (as is alleged to have happened in the May 2010 crash). There is also the possibility of HFT trades getting trapped into a negative feedback loop in which they take turns into responding to each other. The other huge concern is that the system remains vulnerable to hacking or infiltration by terrorists or even a rogue trader betting on a meltdown. The April 23 incident offers a grim warning, as just a sentence-long tweet was picked up by the HFT computers to cause a major market sell-off. This also raises questions about the linking of HFT to social media network for information.

Current rules and procedures to prevent a ‘flash crash’ range from using circuit-breakers (or so-called ‘kill-switches’) or effecting a five minute pause if trading is unable to occur within the price band for more than 15 seconds. However, these are not viewed as effective solutions by market experts, as the nature of high-volume, high-speed algorithmic trading, is introducing new and unknown variables in stock market operations at a rapid pace. In addition, a flash crash in times of a negative market sentiment will always have the potential of triggering a major meltdown.

Although the impact of flash crashes has till date been manageable, there is always the possibility that a flash crash caused by automated trading systems might snowball into a major systemic crisis, particularly in times of high volatility and stressed market conditions. There is also the danger that terrorists or criminals design a computer virus that causes major structural damage to global financial markets. In the absence of any serious measure to forestall the problem, it seems an accident is just waiting to happen.

http://www.ecssr.ac.ae/ECSSR/appmanager/portal/ecssr?_nfls=false&_nfpb=true&lang=en&_pageLabel=featuredTopicsPage&_event=viewFeaturedTopic&ftId=/FeatureTopic/Adil_Rasheed/FeatureTopic_1677.xml

Anti-Defection Law and the Curse of Coalition Politics

By Adil Rasheed

April 4, 2014

For several years now, the incubus of ‘policy paralysis’ and ‘governance deficit’ has plagued the Indian body politic. 

In Pythagorean terms, the recurring non-terminating factors of irrational political numbers and their strangest of configurations have produced perpetually hung parliaments. It seems to be a Catch 22 situation that oscillates from one disjoint Lok Sabha to another fractured mandate and in the process drains the country of its democratic lifeblood.

Thus, coalition politics with its oversised governments and unaccountable excesses has become the norm ever since India enacted the unprecedented Anti-Defection law in 1985, which disqualifies individual members of parliament to defect from their political parties.  Ostensibly, the law was meant to prevent unseemly scenes of ‘floor-crossing’ and ‘horse-trading,’ but in the process has led to the ossification, if not the hegemony of minor political parties over important matters of governance.

Thus we find bloated coalitions (like the UPA or NDA) unable to pass crucial pieces of legislation or provide effective governance because smaller political parties often blackmail or put narrow, parochial aims ahead of the larger interest of the nation. Individual MPs are forced to adhere to the party whip and are denied the independence to act as responsible legislators. Horse-trading and ‘unparliamentary ‘ practices have all but increased and minor parties often get their pound of flesh in lieu of supporting the slender majority of a political bloc.

It is important to note that the constitution never used the word political party, until the time the Anti-Defection law was introduced as the 52nd Amendment of the 10th Schedule in the Indian Constitution. Not surprisingly, no party has ever complained against the law as it provides every one of them control over the elected legislators.

It would be very difficult for India to have a national party that is able to garner even a simple majority in parliament. Given the problems this situation entails, one should revert to the wisdom of the founders of the constitution and accord more respect to the independence of individual members of parliament.  The winner-takes-all formula may help the biggest party gain the majority, which the country desperately needs for good governance. Such a scenario would be less problematic than the queer combinations that political parties cobble up in the absence of a clear mandate.

http://www.khaleejtimes.com/kt-article-display-1.asp?xfile=/data/editorial/2014/April/editorial_April8.xml&section=editorial

The Threat of Derivatives to the Global Financial System

By Adil Rasheed

13 Jan 2010

In the last two decades, a new and innovative form of trading in complex financial instruments called ‘derivatives’ has caught the fancy of investors around the world. Considered by many economists as extraordinarily useful in providing excess liquidity and stability to the markets, these complex products of financial speculation have ballooned into a $700 trillion global market, which is at least ten times the size of the global GDP.

However, a growing number of economists and investors have started calling the trade in derivatives as the principal cause of the current global financial meltdown, and regard the US subprime mortgage crisis as merely the trigger for dangerous financial instruments—like Collaterized Debt Obligations (CDO) and Credit Default Swaps (CDS)—to unleash an incipient disaster. They aver that the unraveling of banks and financial institutions like Lehman Brothers, American International Group (AIG) and Citigroup that led to the current global financial crisis was a result of the enormous ‘toxic assets’ produced by the derivatives trade.

Even the supporters of these innovative financial instruments now concede that derivatives could work as a double-edged sword, which if unregulated and misused could cause major systemic flaws. Thus, many prominent global economists, investors and politicians have started expressing the fear that unregulated derivatives trade could still become the bane of the global financial system. Nobel economics laureates Joseph Stiglitz, George Akerlof and Myrol Scholes, and renowned investors like George Soros and Marc Faber have called for outlawing at least some of the most complex derivatives like Credit Default Swaps (CDS). Legendary entrepreneur and investor Warren Buffett has gone so far as to call derivatives “financial weapons of mass destruction.”

Despite the enormity of the problem, few understand the complexities involving derivatives or are able to wade through the soup of their abbreviated names like CDOs, CDSs etc. In plain terms, derivatives are financial instruments that do not hold any intrinsic worth but derive their value from an underlying asset, index, event, value or condition. These products are used to speculate or hedge individuals or businesses from perceived risks. Thus, instead of trading or exchanging the underlying asset itself, derivative traders enter into an agreement to exchange cash or other assets over time based on an underlying asset. In other words, derivatives are not assets in themselves, but financial deals made about assets, many of which are simply bets.

Derivatives are generally categorized by the relationship between the underlying and the derivative (for example forward, exchange or swap), the type of underlying asset like currencies, interest rates, shares, debt, property etc. and the market in which they trade (e.g. exchange-traded or over-the-counter derivatives).

These innovative products are so new and complex that their benefits and dangers have not yet been fully tested, explored or comprehended. Often, it takes advanced mathematics to clearly understand how they work. This complexity creates an aura of mystery about derivatives, and there is always an inherent danger of miscalculation. Any undetected error could potentially cause systemic risks. This flies in the face of the maxim circulated in the media today that one should not invest in what one does not understand.

There are also many other risks and dangers associated with derivatives trade. First, derivatives do not require the actual ownership of the underlying asset, and the level of bets often outstrips the level of underlying assets. Thus, even a small move in the value of the underlying asset causes a huge difference in the value of the financial instrument and causes huge anomalies for various financial institutions.

Second, derivatives are usually highly leveraged, as hedge funds and banks which trade in them make extensive use of borrowed money to increase their returns. Thus, investors who make huge amounts of money in the event of an upturn also sustain massive losses even in a marginal downtick, particularly on borrowed money which has a cumulative impact on the financial system in a variety of ways.

There have been many instances of massive losses in derivative markets, such as the crisis that hit AIG, which was overcome only after $85 billion of bailout money was provided by the US government, the loss of $7.2 billion by Societe Generale in January 2008 because of the futures contracts related crises, the $6.4 billion loss in the failed fund Amarnath Advisors in September 2006, the loss of $4.6 billion in the failed fund Long-Term Capital Management in 1998 etc.

Again, majority of derivatives trade is unregulated and takes place between two parties, without going through an exchange or other intermediary. These Over-the Counter (OTC) derivatives, which have an estimated outstanding notional amount of $684 trillion (according to Bank of International Settlements figure of June 2008), often involve high-risk products like swaps, forward rate agreements and exotic options and are free of any regulation as regards disclosure of information between parties. Estimates of OTC amounts of derivatives are difficult because these trades often occur in private. Moreover, the OTC market is made up of big banks and hedge funds, which are too vulnerable and too big to fail for the health of the financial system.

Many economists of the Austrian school deride the derivative market as a “casino” and call it a financial innovation of the Greenspan era that helped “hide the bankruptcy of the financial system following the 1987 stock market crash.” It is alleged that this virtual market was created to allow big banks and speculators to bet on movements of currencies, bonds, stocks and indices associated with them and thereby revive the economy. However, following the bust in the derivatives bubble in 2008, central banks have been allegedly printing money to pay for the “fictitious values and profits” of these derivatives, which in turn is building a hyper-inflationary bomb that has the potential of destabilizing the global financial system once more.

The above claims appear exaggerated, still the US Congress and the Obama administration has started introducing legislation and measures to regulate the unfettered excesses of derivatives trade. However, many in the US Congress are skeptical about the effectiveness of proposed regulations. The chairman of the newly formed Economic Recovery Advisory Board under President Obama and former Chairman of the US Federal Reserve, Paul Volcker is himself a major critic of these products of financial engineering. In a recent interview he said: “I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster.” With a tinge of sarcasm he later added that for him the best financial innovation in recent decades has been the ATM machine.

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