The Reserve Bank of India has put the introduction of credit derivatives on the back burner. It said in a statement: “In view of certain adverse developments witnessed in different international financial markets, particularly the credit markets...the time is not considered opportune to introduce the credit derivatives in India, for the present.”
Given the large size of the problem in Western financial markets, where central banks have even had to inject liquidity into the system, it’s difficult to disagree with RBI’s stance at this point. And considering that the central bank has traditionally been cautious about derivatives, the decision is hardly surprising.
Yet, those are no reasons to set aside the decision on introducing credit derivatives. J.R. Varma, a professor at the Indian Institute of Management, Ahmedabad, says that while the recent experience in the global credit derivatives market has proved that these markets can be vulnerable, it has also proved that the need for hedging credit risk is far higher than anyone had thought. Products such as credit default swaps help transfer credit risk from one party to another and since even large global financial institutions are on shaky ground, the need for such products has been immense.
Besides, the credit derivatives market gives good signals to regulators about weak links in the system — almost invariably, the credit default swaps of financial institutions that were in trouble have risen considerably before the news became public.
Of course, on the flip side, the opaqueness of the market and the fact that credit risk often ended up being concentrated in the hands of a few counter-parties, made the market rather risky and vulnerable. But as a result, a debate has started globally that some of these products can be standardized and traded on an exchange, where risk management is much more superior. Not only are mark-to-market margins collected regularly, but there are also position limits to ensure that the market is not concentrated in the hands of a few.
Writing for the Financial Times, Stephen Cecchetti of Brandeis International Business School contrasts the liquidation of Amaranth Advisors, which lost money on exchange-traded energy futures and the collapse of Long Term Capital Management (LTCM), which was exposed to thousands of interest rate swaps. Cecchetti noted that most people watched the Amaranth episode with detached amusement, while with LTCM the financial community sprang into action. The difference, of course, was that despite Amaranth’s liquidation, its counter-parties on the energy futures exchange were not at risk because all trades were guaranteed by a central clearing house. Not so in the case of LTCM, which, if not rescued, would have led to turmoil for all its counter-parties in the over-the-counter market. Of course, it’s not as simple to standardize a credit derivatives contract as it is in the case of, say, currency or interest rate derivatives.
Swaps often need to be customized, besides which contract sizes can be large and hence prohibitive for a typical exchange-traded platform.
Yet, as Varma points out, since India has never had credit derivatives (and it doesn’t look like they’ll be introduced anytime in the near future), there was a unique opportunity to start them on an exchange-traded format from day one. Clearly, that would be far better than having no market for credit derivatives at all. And as far as the concerns about the global credit market crisis go, all those issues are addressed by having the discipline of a central clearing house which collects daily mark-to-market margins and contains the risk in the system.
Commodity futures ban
So much for the ban on commodity futures trading to contain inflation. The price of refined soya oil has risen by 20% since the ban on 7 May. The price of rubber has also risen, but not as much and that of chana has remained flat. Only the price of potato, futures trading on which was also banned last month, has dropped, but that’s because of a bumper crop this year.
Hopefully, when the ban is reviewed about two months from now, better sense will prevail and it will be lifted. With the transparent price discovery mechanism of the futures market missing, large dealers could form a cartel in some of these commodities and extract higher prices from buyers. If that happens, the ban would only add to inflation.
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