Column: A bit too little, a bit too late

Written by K Vaidya Nathan | Updated: Jan 15 2013, 08:32am hrs
RBI is to be blamed for infant mortality of CDS market. Unless CDS on loans are allowed, the market will remain non-starter

In a bid to restart the credit default swap (CDS) market, RBI last week allowed CDS on unlisted rated corporate bonds in addition to the listed ones. A CDS is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a bond default. The buyer of the CDS makes a series of payments called the CDS fee or spread to the seller and, in exchange, receives a payoff if the bond defaults. The initial guidelines issued by RBI allowed CDS on only listed corporate bonds and did not allow for unwinding of CDS bought positions. It also did not permit CDS on securities with original maturity up to one year like commercial papers, certificates of deposit and non-convertible debentures. All those restrictions have now been relaxed.

However, the change of regulation is a bit too little and a bit too late. It is like trying to press the ignition button of a vehicle that does not have any fuel in the first place. RBI was ultra-conservative when it kick-started the CDS market in India and now it has realised its mistake. RBI brought out the CDS guidelines after a long wait of four years on May 23, 2011. The operational guidelines were announced on November 30, 2011. Post this, in the nine-month period till August 2012, there had been only three CDS transactions for a total transaction volume of just R15 crore. A lot of the blame for the infant mortality of the CDS market should lie on the doorsteps of RBI. They stifled the growth of the market, even before it could start to develop.

The 2011 guidelines proved to be a non-starter for several reasons. First, RBI started with the premise that a self-sufficient market can exist with predominantly hedgers. Any market participant worth his experience will tell you that it takes both hedgers and speculators to make a market. Even for hedgers, RBI limited CDS only for bonds. Most international CDS contracts are referenced to loans or bonds, not merely to bonds. Even then, one can understand the rationale for the guidelines if the bond markets were highly developed. In India, we have a corporate bond market that is largely limited to AAA and AA ratings. Most hedgers dont have an economic need to hedge highly rated bonds, such as with ratings of AAA and AA.

Even within bonds, RBI limited it to listed bonds. Arguably, if one of the primary purposes of a CDS trade apart from hedging is to take advantage of pricing inefficiencies in corporate bonds, this is not possible in case of listed bonds, where pricing is likely to be efficient and transparent.

Therefore, it is little wonder that there was hardly any CDS activity in the country. RBI has now relaxed the guidelines, but not as much as is required to make this asset class functional. The changes are too minor to jump-start the market. The worth mentioning changes are that the CDS is now permitted on unlisted but rated corporate bonds. It is difficult to understand why would the CDS market be kept limited to rated bonds, particularly when there is no rating minima specified in the initial guidelines. Rating itself assists in price discovery, which, to a certain extent, even a CDS contract does. So, there isnt much of an economic rationale for having a mandatory rating requirement for reference obligations of CDS.

RBI has allowed unwinding of CDS bought position with original protection seller at mutually agreeable or FIMMDA (Fixed Income Money Market and Derivatives Association of India) price. The revised guidelines do not permit offsetting of the contract with another counterparty, however novation is permissible.

CDS is now permitted in case of short-term instruments such as commercial papers, certificates of deposit and non-convertible debentures. In case of short-term instruments, including short-term bonds, the requirement of rating is not applicable. Once again, linking CDS contract for short-term instruments does not gel well with the nature of CDS instrument. Globally, most CDS trades are for a tenure of two years and above. If one has a short-term instrument, the risk of default, which is what a CDS instrument tries to mitigate, is itself low for most entities. Hence, an issuer or a holder may not even need a CDS protection.

In my view, the linkage with the bond market will still continue to keep the CDS market in shackles. It is a chicken-and-egg situation. We do not have an active bond market due to several inhibiting factors. And, we will not have a CDS market because we do not have an active bond market and RBI refuses to be pragmatic in its regulations. In a nutshell, the revised guidelines still retain several inefficiencies, and may not lead to the CDS market picking up any substantially. Unless RBI is bold enough to allow for CDS on loans as in other countries, this market will remain a non-starter.

The author, formerly with JP Morgan Chase, is CEO, Quantum Phinance