Caution before CDS induction2 min read . Updated: 24 Feb 2011, 08:03 PM IST
Caution before CDS induction
Caution before CDS induction
Credit derivatives were made out to be one of the villains of the financial crisis. Keeping that in mind, it’s commendable that the Reserve Bank of India (RBI) will soon introduce credit default swaps (CDS) in the country. RBI has issued draft guidelines for the introduction of CDS on corporate bonds.
The draft guidelines aren’t very different from the proposed operational framework prescribed last August by a technical committee appointed by the central bank and made up of its employees.
Understandably, RBI is taking a cautious approach, with various restrictions on who can participate and under what conditions. The good news is that it has appreciated the fact that the problems in the CDS market during the financial crisis were because of the lack of transparency and counterparty risk associated with over-the-counter (OTC) markets in general, and not because of the product itself.
In this regard, it’s good to see the draft guidelines prescribe mandatory reporting of trades to a repository within 30 minutes of each trade. This would not only provide important information to market participants, but would also serve as an invaluable tool for the regulator and help in managing risk in the system. One of the major problems during the financial crisis was that there was inadequate information on the positions of large players in the market.
Globally, the problem of counterparty risk is being addressed by moving towards central clearing of CDS. The Dodd-Frank Act goes a step further and prescribes electronic trading of CDS, since they are standardized products. RBI’s guidelines, however, don’t mention the use of a central counterparty at all, even though the technical committee has recommended that eventually CDS should be centrally cleared. This is understandable. In the initial phase, when liquidity in the market is low, the central clearing house would not have enough collateral to guarantee trades. If it charges high margins to deal with this problem, it could deter market participants because of the high cost of transacting. Starting with a central clearing mandate from day 1, therefore, could mean that the market doesn’t take off. Even so, RBI should have pushed for a central settlement system, where a clearing house collects margins and settles trades without guaranteeing each transaction.
Needless to say, the product would have a slow start given the restrictions on participation. But RBI would need to be alert in making changes to the rules to ensure that the product gains acceptance. And like other segments of the corporate bond market, it is important that other regulators come on board soon, for volumes to pick up.
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