The Reserve Bank of India (RBI) has recently released guidelines for trading in credit default swaps (CDS) on corporate bonds. Such “single-name” CDS contracts have become an important part of credit markets in developed capital markets, reflecting credit risk information ahead of bonds. The primary advantage is that unlike corporate bonds, which differ substantially in coupons and maturities, CDS is relatively standardized. On any given day, there is a one-year or five-year CDS traded with quotes for the fee that CDS buyer pays for it. This fee is a barometer for credit risk of the underlying name.
Through such standardization, a market for CDS has the potential to improve trading in corporate bonds. In practice, however, for CDS market to succeed, there should be sets of hedgers and speculators that naturally offset each other. Further, as the global financial crisis has shown, significant CDS players (such as Bear Stearns and AIG Financial Products, or AIG FP) could become too interconnected to fail. Since credit risk is cyclical, any default by a net CDS protection seller would likely be coincident with an economic downturn, making it tough for regulators not to bail out the seller or its counterparties. Adequate infrastructure and regulation are thus necessary to contain the excessive build-up of systemically important positions in the CDS market.
Do the RBI guidelines adequately meet the requirements to ensure a thriving but robust CDS market?
The guidelines create a separation of CDS players into two categories: “market-makers” and “users”. The market-makers would comprise commercial banks, primary dealers (PDs) and non-banking financial companies (NBFCs). These market-makers can buy or sell CDS, without any underlying position in the bonds. The users would comprise mutual funds (MFs), insurance companies, housing finance companies, provident funds, listed corporates and foreign institutional investors (FIIs). The users can only buy CDS as a hedge, to offset the risk of an underlying position, and are not allowed to sell CDS other than to exit existing long positions.
It is striking that these requirements seem to be exactly opposite of the flow of credit risk observed in CDS markets elsewhere. Banks and PDs are naturally exposed to the credit risk of corporations through their intermediation activities; hence, they are natural CDS buyers. Insurance companies, in contrast, are natural CDS sellers, as they want to obtain long-term spreads over risk-free rates. Surveys conducted by the British Bankers’ Association have shown repeatedly that banks buy net protection from non-banks, notably the insurance sector, even though banks are on both sides as market-makers. It might be reasonable to restrict non-financial companies to hedging transactions using CDS. However, limiting the use of CDS market by MFs, insurance companies and FIIs to hedging only will restrict market depth and go against the objective of enhancing bond-market liquidity.
By stipulating which forms of organizations can take on which economic positions in CDS, the guidelines are, perhaps, aimed at containing the risk of a build-up of large short CDS positions. The short leg will effectively be restricted to banks, PDs and NBFCs, which are RBI-regulated entities. Such regulation by form rather than function will, however, ensure that any speculative short CDS position will remain with banks and PDs, which are naturally long-credit risk in the first place and are systemically riskier due to the fragile structure of their liabilities.
A better approach would be to ensure that the risk management of financial firms is standardized across various regulators (RBI, the Securities and Exchange Board of India and Insurance Regulatory and Development Authority). Hedge positions could be subject to audit and freed of margin requirements, other than for basis risk due to maturity mismatch between the CDS and underlying bonds. Speculative positions could be subject to upfront and variation margins based on daily mark-to-market. Recognizing that default decision of a corporation is often a sudden surprise to markets (“jump to default”), concentration limits could be imposed on individual players relative to their capital and liquidity as well as the overall stock of CDS positions.
Indeed, if CDS were traded through a centralized counterparty (CCP), such as Clearing Corp. of India Ltd, or through an exchange, the CCP would be able to observe all positions and impose position limits accordingly. Further, under the current guidelines, margining of CDS positions is left to be set bilaterally by market participants. But the experience with AIG FP during 2003-07 has shown that bilateral margining does not adequately reflect systemic risk concerns. Since CDS positions will be disclosed to RBI, but not to market participants at large, how would a bank know the adequate margin it should charge a counterparty without knowledge of its overall CDS positions? Finally, the proposed disclosure requirements do not contain information on margins. Without knowledge of collateral being posted on positions, regulators would not be able to ascertain potential exposures of market-makers and the build-up of systemic risk.
In summary, RBI guidelines to kick-start a market for CDS on corporate bonds are a significant step forward. Revisions to the guidelines should aim at increasing the depth of participation in CDS markets by not requiring specific direction of positions for specific players. They should recognize the inadequacy of bilaterally set margins in a world of position opacity and aim to come up with a uniform transparency and risk management standard for all CDS players, possibly through a CCP arrangement.
Viral V Acharya is professor of finance at the Stern Business School, New York University, and co-author of Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance
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