The Reserve Bank of India (RBI) has put out a report on the proposed operational framework for single-name credit default swaps (CDS) for Indian corporate bonds. This is the third attempt at introducing credit derivatives in the country, after similar ones in 2003 and 2007, just before the global financial crisis.
The latest draft paper takes the process further, and it does look like market participants would finally be able to trade CDS in the country. The key questions are if the product design will draw liquidity to the new market and if it addresses some of the major concerns about the product that arose during the financial crisis.
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But first, why have CDS in the first place? A credit default swap is an important tool for hedging, as it transfers credit risk from one party to another. Besides, the credit derivatives market gives good signals even to regulators about weak links in the system—almost invariably, the CDS of financial institutions that were in trouble during the financial crisis had risen considerably before the news became public.
Through a credit default swap, a firm can buy protection against a default on a bond or loan obligation. It can do this by making a periodic payment (something akin to an insurance premium and referred to as spread) to the firm selling the credit protection. If there is a default on the underlying bond/loan obligation, the credit protection buyer will typically receive the face value of the underlying debt for which the protection was sought.
The key lessons from the financial crisis are that while some credit derivatives are useful products, some traditional features of these over-the-counter products such as the lack of transparency and counterparty risk should be dealt with. The RBI draft report makes the right noises about these issues, but stops short of prescribing concrete measures to deal with these issues. It has recommended that a centralized trade repository “may” be set up, giving the impression that the product could well be launched without having a repository.
Viral Acharya, professor of finance at New York University’s Stern School of Business, says that the trade repository must be mandatory. “If a large firm gets into trouble, the regulator needs to know quickly. This was precisely the problem when Lehman (Brothers Holdings Inc.) failed—regulators didn’t have a handle on the exposure of large firms to Lehman. Besides, it is also found that when there is no external requirement of trade reporting, a financial firm’s own risk management system is poor in capturing its true exposure.”
Acharya says that the issue of central clearing is a lot trickier. While there is a move towards central clearing of CDS trades in developed markets, in the Indian context, it seems perfectly all right to start with no such mandate. The reason being that in the initial phase, the number of trades in the market would be few and the central clearing house would not have enough collateral to guarantee trades. If it charges high margins to overcome this problem, it could drive away market participants owing to the high cost and the nascent market would never take off.
The key, according to Acharya, is to migrate to a central clearing mandate when the market grows in size and before risks related to the market are big enough to cause a firm’s failure.
The draft report says that in the initial phase, i.e. before trades move on to a central clearing mechanism, clearing houses such as Clearing Corp. of India (CCIL) “can” operationalize the settlement on a non-guaranteed basis. It would have helped if the report was more definitive about the proposals, since this is a good suggestion. Centralized settlement on a non-guaranteed basis can be achieved without imposing high margins on the system in the initial stages. This would also ensure that adequate trade reporting is happening and there is meaningful price discovery. Besides when it’s time to move on to centralized clearing, it’s not a huge shift for the market, as opposed to a shift from a totally bilateral structure. In this regard, RBI has done well to prescribe a standardized product in terms of coupon, coupon payment dates, etc., and the specification of credit events. Standardization of products is required for products to move to central clearing.
The central bank has also done well to leave out “restructuring of debt” from its list of credit events, especially keeping in mind the misuse of this clause by large financial firms in 2001-02 in developed markets.
Another problem that got highlighted in the financial crisis is that the outstanding positions in the CDS markets were way higher than the value of the underlying debt. It needs to be noted here that there is moral hazard related to CDS contracts—a credit protection buyer would have an incentive to influence the likelihood of a default to gain from the CDS position. This could happen when the buyer’s position in the CDS market is larger than the underlying position. Economist Willem Buiter has suggested that one way to tackle this problem is to mandate that a CDS owner should have an “insurable interest” or in other words an underlying position. RBI has mandated this for users, while another category of users i.e. “market makers” including banks and primary dealers are free to take naked positions. Some jurisdictions have provisions to deal with this and RBI should have laws to penalize such activity.
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