The move to create a market for CDS in India has been delayed for the last few years due to a lack of adequate risk management systems and lessons learned from the financial crisis (where CDS is alleged to have contributed to the downfall of large U.S. financial corporations). Added to this is India’s specific experience, with several OTC derivatives transactions having been mired in litigation throughout the country.
Due to this background, RBI has adopted a cautious approach to introduce CDS. Several checks and balances have been embedded in the instrument. For example:
- The bonds which constitute reference obligations are required to be issued by corporate entities that are rated (although no minimum rating has been stipulated);Such an approach would provide a useful tool for bondholders to hedge their underlying risk, while at the same time controlling speculation. In his column in the Financial Express, K. Vaidya Nathan highlights the risk of improper regulation of such instruments, but commends RBI’s measures:
- Market makers (or those who write CDS) must be regulated entities, while users (counterparties) are permitted to hedge only their underlying exposures, or bonds held by them;
- Users without underlying exposure cannot purchase CDS, and any purchases must correspond to the extent (both in terms of quantum and tenor) of such underlying risk. In other words, there is no room for naked CDS.
It is not difficult to appreciate that CDS is a useful hedging tool. However, if not properly regulated, it can become an instrument for unbridled speculation. According to the International Swaps and Derivatives Association, the amount of CDS outstanding as of the beginning of this year was $30.4 trillion. Compared to this, the US Treasuries market is $4.4 trillion and its corporate bond market is $3.6 trillion. The world’s richest person has a personal net worth of $53 billion and one of the most cash rich corporations in the world, Apple Inc, has a cash pile of $46 billion. For sure, there isn’t $30,400 billion of money out there that needs to be hedged, which is what the current size of CDS market is. Quite evidently, a loosely regulated credit derivatives market has allowed market participants to indulge in rampant speculation.Returning to the RBI draft report, it contains a fairly detailed analysis of regulating CDS, both from an Indian perspective and also more generally.
RBI needs to be commended for taking this bold step to introduce the product, because post-crisis the popular sentiment is that all derivatives are weapons of mass destruction. An easy approach would have been to defer the introduction of credit derivatives indefinitely. RBI is steering a difficult course in that it cannot afford to run the risk of being too lenient, which could result in a purely speculative market, while ensuring that it is not too strict either. If RBI is able to regulate in such as way so as to facilitate a deep and liquid credit market, it would set a good example for other central banks in the region. Regulators indeed walk a fine line and this is a confident step in the right direction.