Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Indian uncollateralised derivative markets

An article by Christopher Whittall in the International Financing Review (IFR) about the difficulties in valuing uncollateralised derivatives is of great relevance to Indian OTC swap markets. Christopher Whittall explains in his article that “Unsecured trades now present a serious valuation headache”. FT Alphaville follows up on this story and highlights the problem: “… pricing even the most basic (uncollateralised) swaps is now very complex. … traders just flat refuse to enter into any detail about how they price uncollateralised derivatives nowadays — hardly a positive thing for a market that is regularly accused of being like a black box. ”.

Over the last few years, the two curve discounting model which discounts cash flows using the OIS curve (see my blog post of last year) has emerged as the market standard for valuing collateralised swaps. This technique is not applicable for uncollateralised swaps, and in fact there is no “market” valuation for these swaps because the value depends on the cost of funds of the two parties via the Credit Value Adjustment (CVA) and Debt Value Adjustment (DVA).

Deus ex Machiatto puts the matter succinctly:

A vanilla derivative is a collateralized one under the standard CSA these days (cash collateral in the same currency, daily MTM, daily margin). Anything else is exotic, because it involves an exotic collateral option.

All this is important for Indian OTC swap markets because the market runs largely without collateralisation. While these swap deals are governed by the standard ISDA (International Swaps and Derivatives Association) documentation, most Indian banks do not sign the Credit Support Annex (CSA) that deals with collateralisation. We have tended not to worry too much about the Indian OTC swap market because it is dominated by plain vanilla interest rate swaps. What Whittal and Deus ex Machiatto are saying is that this view is incorrect. Effectively, these are all exotic derivatives because of the lack of collateralisation. I believe that this is correct and the matter needs urgent regulatory attention.

There are three main ways to set things right:

  • Indian OTC markets can move towards collateralised swaps. This is simple as it only requires Indian banks to sign the CSA under standard ISDA documentation.
  • We can move one step further towards the post crisis global regulatory consensus and adopt central clearing of the OTC swaps. The Clearing Corporation of India (CCIL) already has the ability to clear OTC derivatives. Of course, moving more risks into CCIL would make it even more systemically important than it already is, and regulators would need to be extra vigilant about this concentrated risk.
  • The most radical solution is to move more of the markets towards exchange trading and clearing. There is a great deal of experience with this both in the equity markets and in currency futures and there is the added benefit of price and trade transparency.

I believe that it is necessary to move quickly along one or more of
these alternative paths to mitigate the risks in this market.


2 responses to “Indian uncollateralised derivative markets

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