FE Editorial : Liquid without froth

Wed, Oct 28 02:39 PM

RBI had issued draft guidelines for introducing credit default swaps (CDSs) in 2007. Then, the global financial crisis hit, and CDSs were accused of being a primary cause. With many economists and financial experts celebrating RBI's wisdom in having maintained a distance from these instruments—nicknamed weapons of mass destruction—one feared CDSs would be buried along with other financial reforms in India. But our central bank has sprung a pleasant surprise—it has proposed the introduction of CDSs, albeit with caveats. The proposed instruments will be 'plain vanilla', involving single-name CDSs for corporate bonds for resident entities, subject to appropriate safeguards. This is a not a bad thing. For it's a fact that derivatives formed the heart of the crisis maelstrom—think AIG, where each default threatened a chain of international corporate and economic failures. But it's also a fact that, as our columnists have argued, the problem was not with credit derivatives per se, but with lack of appropriate regulation and oversight.

The 2007 draft guidelines stated that credit derivatives can be used to reduce capital required to support credit risk exposures, release credit exposure limits to a counterparty, reduce concentrations by shedding exposures to a counterparty or to a sector, and assume exposures to a counterparty or to a sector to diversify risks or to fill gaps in the credit quality spectrum. In short, CDSs can help facilitate deeper and more liquid markets. But at its peak, the credit derivatives market was $62 trillion, more than the US federal debt, GDP, stock market, mortgage market and Treasuries market put together. Obviously, speculators were ruling the roost. Over-the-counter CDS trade was building up systemic risk. Chants in favour of banning it have, however, subsided into a whimper now. Dominant opinion has turned to demanding that all derivatives be traded on exchanges, just like stocks. And overturning the Clinton-era law that exempted them from oversight. Also, a year after the Lehman bankruptcy, one must note that CDSs seem to be losing their stigma. The Credit Derivatives Research's Counterparty Risk Index, which measures default swaps on 14 firms and which peaked on March 9 at a record 305.6 basis points, has now dropped to hang at around the 80-90 range. Clearly, the CDS market is once again making a functional contribution to the extension of credit, giving investors and lenders confidence. As the internal group that RBI is setting up to finalise the CDS operational framework in consultation with market participants goes to work, we welcome the fact of its introduction and RBI's initial caution.

Inside News

Editor's picks