Vinod Kothari: Missed opportunity

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Vinod Kothari: Missed opportunity

Vinod Kothari / New Delhi June 02, 2007

By limiting credit derivatives to just single name credit default swaps, the RBI has ensured India will miss the huge potential in this market.

The RBI came up with a draft of guidelines on credit derivatives in March 2003. The Governor’s credit policy in April this year stated that the RBI will introduce credit derivatives in India in a calibrated manner and that it will come with guidelines by May 15, 2007. On May 16, 2007, the RBI posted yet another draft of the guidelines for public comments.

Between March 2003 and May 2007, more than four years have elapsed and there are several developments that speak aloud of the opportunities that we have missed. One, during this time, the global credit derivatives volume zoomed from $2.2 trillion (end 2002) to $34 trillion (end 2006) — a growth of nearly 1,600 per cent. Credit derivatives are today the fastest growing segment of the OTC derivatives market. Two, almost every country that one can compare India with has had full-fledged regulatory rules on credit derivatives for quite some time now. Three, several Indian names are traded on a regular basis in global credit derivatives markets and two Indian names are part of a popularly traded credit derivatives index called iTraxx Asia ex-Japan. In the absence of the regulations locally, several banks have been forced to export out their credit derivatives business through their overseas subsidiaries. There have, in fact, been some synthetic CDOs with all Indian names. Fourth, the global market has come a long way from bilateral credit default swaps — today, the market is abuzz with hundreds of thousands of trades in index tranches, which are pools of synthetic exposures on selected names in different countries and geographies.

Regrettably, after all these years, the RBI has come up with guidelines which are limited to single name credit default swaps, and that too, strictly on a hedging basis. It is an undeniable fact that banks and dealers do not use credit derivatives merely for hedging — it is more often than not a device for creating exposures. If this is just the beginning, one would understand it, albeit with the comment that the beginning is quite late, and quite diffident.

A quick understanding of the credit derivatives market:
The ISDA’s estimate of credit derivatives volume end-2006 was $34.5 trillion, growing roughly at the rate of over 100 per cent per annum. Credit derivatives emerged practically around 1993-4, but were hardly known until 1995-6. They really shot into fame when some smart banks demonstrated an ability to shed risk during the 1997 Asian crisis, the Russian crisis and so on. The shot in the arm was the bankruptcy of Enron.

Contrary to popular perception, credit derivatives are not typically linked to the default of a particular loan, but a credit event referenced to a particular entity. Take the case of the most common product — a credit default swap (CDS). For instance, if a protection buyer (PB) and protection seller (PS) trade on a reference entity X, X need not be on the books of the PB. In addition, the trade is mostly referenced to a generic credit risk or the risk of default of entity X, and a generically defined “loan or bond” is made the reference obligation for this purpose. In other words, the derivative is a stand-alone independent transaction between the PB and PS and it is not necessary for the PB to link it with an actual exposure in X. The PB uses the CDS as a device for shorting a credit asset, and the PS uses the contract as a device for going long on a credit asset. In other words, the credit risk itself becomes a commodity — similar to equities, bonds or other securities of the reference entity.

From the plain-vanilla single name credit default, the market saw a gradual progression to basket default swaps and portfolio default swaps. If the portfolio swap is linked with a diversified portfolio, it becomes possible to create multiple tranches, say 0-3 per cent trance, 3-7 per cent tranche and so on. The tranches take different layers of risk in the pool of credit exposures. These are known as synthetic CDOs.

A synthetic CDO is a self-made pool of credits, but the market was looking for more standardised pools of credit which would allow the players to take a view on the corporate sector as a whole. Hence came the index trades — the indices currently traded are sets of North American names called CDX.NA and European and Asian names called iTraxx. It was after the introduction of the index trades that the market took a real leap, since the indices allow dealers to trade in the direction of credit risk, correlation, delta, recovery rates, and so on.

The RBI guidelines — statutory basis:
These are proposed to be issued as mandatory guidelines to regulated institutions under the Banking Regulation Act. The question is: would these guidelines limit the credit derivatives market to banks only? Is there something that makes credit derivatives illegal, except where they are in accordance with the guidelines? While derivative transactions by banks will surely have to abide by the guidelines, it is the opinion of the author that derivative trades by others are not proscribed and do not have to be in accordance with the guidelines.

Only for hedging, or for trading too?
As the RBI proposes to permit credit derivatives trades on a calibrated basis, it has, for the time being, made a very narrow niche for credit derivatives to start in India. As stated before, the market is essentially motivated by arbitrage and trading motive, so limiting it to hedging neither makes enough of a motivation to initiate the trades, nor would it be practical to limit it to hedging.

Para 1.6.1 says that the PB must have a credit exposure in order for it to buy protection. Assume the PB has bought protection from the PS – so the PS now synthetically has acquired a credit exposure. Needless to say, the PS may now enter into an offsetting credit default with PS2, and may be motivated to do so if the CDS spreads have widened. The second CDS may be viewed as either a hedge or a trading deal. If the second type of CDS is permitted, there is no reason why the PS may buy protection from the PS2 first, and then sell protection to the PB, as the economic impact of the changed sequence is really no different. In addition, the guidelines have elaborate rules about the trading book treatment for credit derivatives — the trading book treatment by definition means the transaction was not meant to be a hedge.

Synthetic securitisation: a missed opportunity:
It has been the consistent view of this author that with the stamp duty and mortgage registration difficulties affecting securitisation transactions in India, synthetic securitisation provides a much more convenient alternative. Synthetic securitisations use credit derivatives to synthetically transfer assets, instead of using the true sale route.

With credit derivatives guidelines being put in place, it was hoped that it would be possible to use the synthetic securitisation mode in India. That would have also opened up the tremendous potential for synthetic CDOs referenced to Indian entities, which are currently forcefully being exported out of India. However, as the guidelines have remained limited to single name credit default swaps, they have completely missed the potential for synthetic securitisation.

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