Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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