CDS entry, the wrong way

CDS entry, the wrong way

The Reserve Bank of India (RBI) recently put out a report on the proposed operational framework for credit-default swaps (CDS), which will be introduced as an over-the-counter (OTC) derivatives product. The central bank had come out with similar draft guidelines in 2007, but decided to wait and learn from the lessons of the financial crisis.

Even so, the central bank hasn’t fully embraced the key lessons that were learnt from the crisis—that the issues of opacity and counterparty risk associated with the OTC markets should be dealt with. Globally, this is being done by a move towards a centralized clearing system, which will not only capture critical trade data, but also act as a central counterparty, guaranteeing each trade.

In their statement after a meeting in September 2009, the leaders of the Group of Twenty nations decided: “All standardized over-the-counter derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest."

Since RBI is contemplating the introduction of plain vanilla single-entity CDS, which can be standardized, this would have been a good opportunity for starting off on an exchange-traded platform, especially since that is the direction developed markets seem to be headed in.

The ministry of finance has been pushing for exchange-traded CDS for some time now. But, of course, that would have meant that the market would be regulated by another regulator, the Securities and Exchange Board of India.

It’s not that RBI has completely overlooked the lessons from the crisis. Though it has ignored the role of exchanges in the CDS market, it has taken on board concerns about opacity and counterparty risk. It has recommended a centralized trade repository, and mandatory trade reporting within 30 minutes. It has also recognized the need for central clearing, though it has recommended a gradual approach to setting up a central counterparty (CCP) system, where trades are guaranteed. Already, CDS trades in North America and Europe are being cleared by clearing houses, and this experience could have been drawn from to introduce a CCP model. After all, it’s best to launch a new product with the best possible framework, rather than tweak it whenever there are glitches.

Some market participants feel that the proposed framework is restrictive in terms of what they can and cannot do, and as a result the CDS market may suffer just as the interest rate futures market. This is almost inevitable when a regulator designs a product. Globally, regulators aren’t involved in the nitty-gritty of each product introduction. Indian regulators would do well to provide a broad framework to ensure that systemic risk issues are addressed, and let the markets decide on product design.

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