The Reserve Bank of India, on August 4, placed on its Web site the draft report on introduction of Credit Default Swap (CDS) for corporate bonds for public comments. RBI has been considering introducing credit derivatives since 2003 so as to provide market participants with an effective tool to manage credit risk. It issued the first draft guideline in 2003. However, considering the risk management practices in domestic banks way back in 2003, it decided to defer the issuance of the final guidelines to a later date.

Then, while it was deliberating on launching credit derivatives again in 2007, the subprime crisis had set in. The subprime crisis was, in part, attributed to this asset class because lenders and credit risk takers could be segregated using credit derivatives, which caused lending to get lax and reckless. RBI had to place the introduction of credit derivatives on the back burner, till such time it wasn?t clear if, and in what measure, credit derivatives contributed to the crisis. There is a developing consensus currently that credit derivative per se wasn?t at fault, but the lack of regulation around credit derivatives was the real culprit. It seems RBI is confident that it would be able to get the regulation right unlike other central banks, and is therefore initiating the process of introducing the most basic credit derivative instrument called the CDS.

CDS serves a similar purpose like that of insurance. One of the reasons why insurance is useful is it helps an individual or an organisation hedge against extensive loss. For instance, I don?t mind spending on home insurance because if my house gets damaged, it would have a substantial impact on my financial well-being. Moreover, buying insurance gives me peace of mind for a certain cost, which I am happy to pay even though I wish that the eventuality when I receive anything back from the insurance company does not arise in the first place. CDS works similarly. Consider a mutual fund that has a sizeable amount of corporate bonds in its portfolio. CDS allows the mutual fund to insure against possible default of corporate bonds. Consequently, investors in mutual funds would not lose money if those corporate bonds default. Thus, a CDS could help in hedging credit risk.

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.

If inadequately regulated, CDS may not be as benign as insurance. For instance, insurance is regulated in such a way that I can insure for my own house, but I cannot buy insurance on my neighbour?s house, because I don?t own that asset. Moreover, I cannot sell insurance unless I satisfy a specified set of stringent criteria. However, the way CDS market is currently regulated makes it possible for a large number of market participants to speculate by being able to buy or sell CDS contracts. For instance, a hedge fund can agree to provide protection against credit risk by posting a small collateral. If it indeed had to pay up on the CDS in case of a default, there is a pretty high chance that it won?t be able to make good the payment. AIG, when it was bailed out in September 2008, was holding CDS position worth $441 billion, which is quite high compared to the kind that cash corporations normally hold. If AIG had not been bailed out, all the entities which bought protection on the CDS from AIG would have been left high and dry. Loosely regulated credit derivatives market can allow market participants to become overly levered. To get the valuable benefits from this asset class, it needs to be regulated effectively.

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.

The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance