New Delhi: India will move a step closer to the possible introduction of credit default swaps (CDS), a debt derivative that has become controversial in the background of the global financial crisis, when the finance ministry discusses them in August at a meeting with finance sector regulators.
The possibility of introducing CDS on exchanges as a part of measures to reform the debt market in India would be placed on the agenda of the meeting of the high-level co-ordination committee on capital markets next month, said a senior finance ministry official who did not want to be identified.
The committee has representatives from the finance ministry and all financial sector regulators. It was created to resolve important regulatory and policy issues that require discussion among regulatory chiefs.
In November, Mint had reported the finance ministry hoped to see CDS introduced in India before the end of 2009. On 30 June, The Economic Times reported the Reserve Bank of India (RBI) had sent a questionnaire to some banks seeking their views on CDS. RBI has introduced guidelines for CDS sometime in 2007 and then withdrawn this during the financial crisis. The decision on whether or not to introduce CDS will eventually rest with RBI.
A CDS is a derivative used to offset risks in debt markets. It allows creditors to insure themselves against the possibility that a borrower might default. Derivatives are financial instruments that reflect the value of an underlying instrument. In the case of CDS, the underlying instrument is a bond or a loan.
If an investor in a company’s bond wants to buy some kind of insurance against the possibility that the company might default, the investor could buy CDS for a price (this is also referred to as CDS spread). The CDS seller, in turn, guarantees to pay the buyer a pre-determined amount if the company that has borrowed money defaults on repayment.
The instrument, first introduced nearly a decade ago, has recorded a sharp rise in trading over the past few years. According to data on the Bank for International Settlements website, the outstanding notional amount in the CDS market at the end of June was $57 trillion (nearly Rs2,760 trillion today). A paper on the website said CDS contracts had surged nearly five times the outstanding principal of corporate bonds worldwide by the end of 2007, compared with 85% of the size of the corporate bond market at the end of 2004.
In the second half of 2008, controversy swirled around CDS as firms with significant exposure to them such as US insurer American International Group Inc. (AIG) needed to be bailed out by the government after this exposure exceeded their ability to honour contracts.
Consequently, during the same period, the notional outstanding contracts of CDS in global over-the-counter (OTC) markets fell by 26.9% even as the total outstanding for all credit derivatives fell by 13.4% over a six-month period—to $592 trillion on 31 December.
The finance ministry does not believe there is an intrinsic problem with CDS. Problems such as the one AIG and its counterparties (or people with whom it had CDS contracts) experienced were on account of flaws in market design, goes the reasoning.
CDSs for most part are traded in OTC markets, where trades are done over phone. OTC markets tend to be opaque and it is relatively difficult for regulators to keep things under check. The finance ministry, for over a decade, has said the best market design to mitigate risks posed by derivatives is trading of standardized products on stock exchanges.
In an exchange-traded format, the clearing houses functions as the legal counterparty for all trades, which effectively neutralizes the possibility of markets freezing when one of the participants defaults.
Last year, India introduced standardized contracts on rupee-dollar futures on stock exchanges, which are seen as a successful template for the introduction of other derivatives such as CDS.
The idea of introducing derivatives in an exchange-traded format has support from independent experts as they say it mitigates risk to the system. The presence of the clearing house as a counterparty for all transactions serves to keep volume in sync with the risk the system can take.
“By not making it (CDS trading) OTC, in an exchange-traded volume you do not get such large transactions. You get unspoken stability because size is typically smaller,” Jahangir Aziz, chief economist (India) at JPMorgan Chase and Co., said.
The transparency in exchange-traded format also makes it difficult for a participant to quietly take large positions. “The automatic reduction in the size of the transaction is far more of a risk reducer. Large positions typically get priced in,” Aziz added.
A.V. Rajwade, an independent forex consultant, said typically a standardized contract traded on an exchange is a less risky proposition compared with OTC trading. However, the global backlash against credit derivatives such as CDS in the wake of last year’s turmoil made it unlikely CDS would be introduced in India in the near future, he said.