The decision to allow a product or not, should depend on its economic value addition and not on its mere availability and wide usage in the “sophisticated” markets. This is true even for Credit Default Swaps (CDS), whose introduction in India appears imminent.
Earlier, RBI explored introducing CDS in 2003 and in 2007, but deferred the matter. Given the role played by complex financial instruments, including CDS, in the financial crisis, the current proposal by RBI to introduce CDS may appear inexplicable. CDS is akin to insurance or guarantee against default of a bond/loan. As much as an insurance cover or guarantee on debt serves genuine economic purpose, CDS also provides genuine benefit of protecting the buyer against default of the underlying debt. Hence, its introduction in India is appropriate.
However, the challenge is to design an appropriate regulatory framework to safeguard systemic stability, incorporating the lessons learnt from international practices (IP), two of which are traversed here.
First, volume. Logically, for CDS to perform its purported function (hedge), it is sufficient that its total outstanding volume be equal to the value of the underlying. However, in IP the volume of CDS outstanding is several times the value of the underlying. Illustratively, when Delphi, US, defaulted in 2005, the volume of CDS outstanding was estimated at $28 billion, against $5.2 billion of its bonds and loans (Satyajit Das, Eurointelligence.com).
Secondly, settlement in case of default. Given the mismatch in volumes, majority of CDS are cash-settled; CDS buyer receives the face value of the underlying, less its residual value, from the CDS seller. In the case of physical settlement, the CDS buyer receives the face value of the underlying from the seller upon physical delivery; importantly the buyer can choose to deliver from a range of instruments having comparable characteristics as the underlying. This creates uncertainty for the CDS seller, who would receive the “cheapest-to-deliver” bond.
As much as it is inappropriate (and illegal?) to have insurance cover or guarantee on an asset that is not owned, CDS unhinged from the “real” credit market is also inappropriate. Naked CDS leads to perverse incentive as the buyer is better off if the reference entity were to default. Instances of engineered default of the reference entities by CDS buyers, through massive speculative positions and coordinated manipulation, are well recognised and documented (Henry Hu and Bernard Black, 2008).
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Credit default events, unlike say the fall of an equity price, are large-scale irreversible events which impose significant disruption costs on the real economy (Turner Review, 2009). Further, in the event of default, the losses get exaggerated to the level of CDS volume, instead of being restricted to the value of the underlying, with serious consequences for systemic stability. Surprisingly, even after the crisis, there is no concerted effort in the “sophisticated” markets to rectify these anomalies. Illustratively, the initial proposal to ban naked CDS in the US was drowned by the “invisible hand of the market”.
Perhaps the real lesson learnt from the financial crisis is that no lesson has been learnt! Therefore, in designing the regulatory framework for CDS in India, it would be wise to ignore IP and use common sense instead.
How has the recent proposed framework of RBI fared?
RBI has allowed single name CDS on rated corporate debt and has clearly delineated market makers (sellers) and users (buyers).
As an OTC derivative, one side of the CDS transaction is required to be a RBI-regulated entity. It is suggested that entities regulated by other regulators, like insurance companies and mutual funds, may also be allowed to sell CDS to users not regulated by RBI, like provident funds and listed companies. RBI has allowed only holders of underlying to buy CDS. This would restrict the total volume of the CDS outstanding to the value of the underlying. Thankfully, RBI has ignored IP!
However, RBI mandates the CDS seller to ensure that the buyer holds the underlying while contracting/unwinding. Further, the onus of maintaining margin and collateral is vested with the participants till moving to central counter-party (CCP) framework.
This is impractical and inappropriate; as much as CDS substitutes the risk of protecting the seller for the risk of the underlying, it is imperative to commence CDS in India only through CCP. Besides risk management, CCP can be the trade reporting platform and be made responsible for freezing (in demat form) the underlying debt instrument of the CDS buyer, till the expiry/unwinding of the CDS. Such facility of “freezing” is already available and is well functioning in pledge of demat securities.
RBI has mandated physical mode of settlement for users. It is suggested that delivery may be restricted to the very same reference obligation alone. Restriction on deliverables will eliminate uncertainty of outcome and curb speculation as prevalent in IP. Further, the flexibility provided to market makers to have settlement also in cash and auction modes may be restricted to only physical mode.
The definition of “credit event” has enormous implications for triggering CDS obligations. Although RBI has conservatively disallowed “restructuring” as a “credit event”, a thorough and comprehensive definition of “credit event” is a prerequisite to eliminate uncertainties in outcome. The proposed capital adequacy norms for CDS participants are conservative and adequate. At a larger level, RBI’s policy inconsistency in disallowing bank guarantees for corporate bonds on the one hand and permitting CDS on the other needs to be addressed.
To conclude, RBI’s decision to introduce CDS and its conservatism are valid. RBI’s unambiguous divergence from IP is welcome. Should there be genuine need for CDS in India, a robust market could emerge under the proposed framework, subject to the suggestions delineated above.