Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Mon, 09 Aug 2010

RBI proposes CDS market by dealers and for dealers

The Reserve Bank of India has released the report of the Internal Group on Introduction of Credit Default Swaps for Corporate Bonds in India.

What is proposed is a market by dealers and for dealers. Users can only buy CDS protection, and they have to buy them from dealers (banks and other regulated entities) who are the only people allowed to sell CDS. But the most diabolical recommendation is the following:

The users can, however, unwind their bought protection by terminating the position with the original counterparty. ... Users are not permitted to unwind the protection by entering into an offsetting contract. [Paragraph 2.7.6(ii) on page 19]

This leaves the unwinding users at the complete mercy of the original dealer from whom they bought CDS protection – that dealer can fleece the users knowing fully well that they cannot go elsewhere. Under these terms, it would be utterly imprudent for a company to use CDS at all. Well designed corporate risk management policies should demand the availability of competitive quotes both at inception and at unwind, and should therefore completely prohibit the use of the proposed CDS market. Of course, India has a number of imprudent companies with poor risk management policies; perhaps, the RBI proposed market is suitable only for them.

The other frightening part of the proposals is that at a time when the entire world is worried about the dangers of an opaque CDS market, the report envisages the creation of a CDS market without a trade repository let alone a clearing mandate. The report envisages a trade reporting platform at some unspecified future date, but the establishment of this platform is not a precondition for CDS trading to begin. As far as clearing is concerned, the report makes the right noises, but it is clear that the RBI is not very keen on this.

Even when the trade repository starts functioning, it is unclear what transparency it would bring. First of all, the recommendation uses the word “may” which deprives it of operational significance:

The reporting platform may collect and make available data to the regulators for surveillance and regulatory purposes and also publish, for market information, relevant price and volume data on CDS activities such as notional and gross market values for CDS reference entities broken down by maturity, ratings etc., gross and net market values of CDS contracts and concentration level for major counterparties. [Paragraph 4.2.1 page 40]

Second, the report provides a trade reporting format (Form I in Annex IV) and this format does not include any data on prices at all. This means that even when the reporting platform starts working, it would not provide price transparency even on a post trade basis. What more could the dealer wish for when it comes to fleecing the customer?

One relatively minor issue which I am not able to figure out is whether RBI intends CDS to be used to hedge loans and not only bonds. The report clearly states that only bonds can be reference obligations for CDS, but it is silent on whether loans can be deliverable obligations. Some parts of the report appeared to be deliberately written vaguely to allow loans to be hedged. For example, “The users can buy CDS for amounts not higher than the face value of credit risk held by them” (Paragraph 2.7.6(i) page 19). That would allow loans to be hedged, and what is deliverable would presumably be decided by the Determination Committee which can be counted on to go with the banks on this issue. Whether loans can be hedged is not terribly important, but if the intention is to permit it, why not say so explicitly?

Coming back to the important prudential issue, I believe that India needs a CDS market, but I am concerned that a CDS market as proposed by the RBI would create more systemic risks than it would eliminate. If these are the only terms on which a CDS market can be had, it would be better for the country that we do not create such a market at all.

Posted at 21:11 on Mon, 09 Aug 2010     View/Post Comments (2)     permanent link

Criticism of monetary policy

There has been a lively debate in India on senior central bank officials criticizing monetary policy decisions in which they may have participated. This debate has tended to focus on the harm that such alleged indiscreetness can do, while I think the important question is how to design the conduct of monetary policy in a manner where open debate does not cause harm.

Consider this passage in a paper last month by a member of the US FOMC that decides monetary policy in that country:

The U.S. is closer to a Japanese-style outcome today than at any time in recent history. In part, this uncomfortably close circumstance is due to the interest rate policy being pursued by the FOMC.

Or this from a UK MPC member who last month titled his speech provocatively as “How long should the song remain the same?”:

The normal monetary policy reaction to a sustained period of above target inflation would be to tighten policy, to create demand conditions which are more conducive to restraining price increases and bringing inflation back to target. But so far, the Committee has not supported that course of action – and is keeping monetary policy extremely loose. ...

Last month, however, I dissented from this approach and voted for a small rise in interest rates. And in today’s speech I want to set out the thinking behind my view of current economic prospects and the implications for UK monetary policy that led me to that decision. ...

The MPC has a clear remit, which is to keep inflation on target at 2% over the medium term. ... we need to adjust the policy settings we put in place to head off the downside risks to inflation identified in the immediate aftermath of the big financial shocks in late 2008 and early 2009.

I think such open debate and criticism strengthens the conduct of monetary policy by allowing divergent points of view to be heard and considered. Alternative analytical frameworks can thus be developed and are available to the policy makers if and when they choose to change their mind. My knowledge of either the theory or practice of monetary policy is very limited, but I like to believe that monetary policy is closer to a science that progresses through informed debate, rather than a dark art that derives its mystique and efficacy from a veil of secrecy.

Unfortunately, criticism of monetary policy decision by senior officials themselves can be prevented from doing harm only in a culture of transparency where minutes of monetary policy deliberations are published openly so that dissenting voices are not misinterpreted by the markets.

Posted at 07:29 on Mon, 09 Aug 2010     View/Post Comments (0)     permanent link