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

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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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     2 comments     permanent link

Comments...

ks1729 wrote on Wed, 18 Aug 2010 21:34

Re: RBI proposes CDS market by dealers and for dealers

Very useful, and alarming, post. Some thoughts:

1. Even if unwinding were allowed, as long as unwinding can only happen with the original counterparty - the whole arrangement is silly. In essence, two issues at stake on that level. (a) "approved" set of counterparties is an open invitation to the creation of an oligopolistic sellers market (b) no-unwinding clause, i think, is motivated by seeing CDS strictly as static insurance program. (however, CDSs are used to hedge credit risk DYNAMICALLY - over the term-structure of credit spreads on the same underlying entity.)

(2) The absence of a clearing house, I think, for the time being (say over the first 2-3 years) is understandable - since who knows what kind of demand exists, what infrastructure has to be set up, what documentation, how are recovery auctions to be conducted in case of credit events etc., i.e., the RBI is fumbling along (just like the rest of us). Ideally, they should just copy existing infrastructure for creation of CDS markets as done in the rest of world - and then worry about tweaking it as time goes by in accordance with Indian conditions. The present strategy is upside down: more, like - first cater to Indian banks, and then best practises later if time permits. That is silly at best, and stupid at worst.

3. If the concern is how to gradually get the Indian clientele accustomed to CDSs on bonds etc., -- perhaps, instead of single name, they ought to begin with CDS on indices. That is easier to understand, provides greater information on the quality of debt issuers, given multiple names on the index it also infuses greater transparency by construction to due to the competitive presence of various names.

Anyhow, quite a fascinating subject.

rk wrote on Wed, 01 Sep 2010 18:13

Re: RBI proposes CDS market by dealers and for dealers

My reading of the report is RBI is restricting the CDS to hedge bonds only. The credit risk mentioned arises on investing in bonds.

RBI has always been wary of opening up and probably is concerened with constraints rather than the principles of markes and market economics. Take the case of government securities market. The market access is restricted to exclusive players who are SGL account holders with RBI.It is presumed that the SGL account holders will play the role of dealers. So you have a sham of a market with a few players moving the security from one warehouse to another. Households and firms cannot access the markets as they have to approach the dealers for the securities who will fleece them.Try buying a government security as an individual and you will never think of a risk free security.

RBI policy is fearful of failures and hence the design is very restrictive. As you have rightly pointed out this leads to an opaque system and it is better not to have them at all. The half baked measures would be too dangerous and frustrating the purpose. Instead there is a need for a strong and robust cash market for bonds and similar instruments overseen by a market regulator.