लगे रहो सुब्बारावभाई (Keep going Subbarao): Rupee Credit Default Swaps (Part 3)

CreditLime Special Report
July 21, 2010

लगे रहो सुब्बारावभाई (Lage Raho Subbaraobhai, Keep going Subbarao): Rupee Credit Default Swaps (Part 3)

Continued from Part 2…

Lage Raho Subbaraobhai

If there is anyone that is able to get the job done (to introduce CDS to India), Dr. Subbarao is widely believed to be the man. Outlook Business magazine compared Dr. Subbarao with former Governor Dr. Y.V.Reddy around the time when the transition occurred saying “while both Reddy and Subbarao have a commonality—they worked in the Finance Ministry in their previous stints—they are also very different. Subbarao is looked upon as a close confidant of the Finance Minister [at the time headed by P. Chidambaram], and is expected to have a less conservative stance in pushing reforms.”

A CNBC-TV18 interview quoted reported Latha Venkatesh as saying “The expectation of the market is that Dr Subbarao coming from where he does and coming without any of those encumbrances of Dr Reddy who probably saw the excesses of the market in the past twenty four months, will probably come with a more market friendly mind and introduce some of these products whose time has come – credit default swaps; the time has come for these products and that is definitely an expectation from Dr Subbarao – that he will carry forward a market development agenda.”

In an October 2009 Bloomberg UTV interview, when asked what’s the basic thinking behind introducing credit default swaps was and what gains he expected from introducing them to India, Subbarao replied ” Yes, it is true that credit default swaps were scapegoats at the heart of the crisis. But that does not mean that we keep away from products forever. We have talked through this and we believe that there is a benefit in introducing credit derivatives because it provides a mechanism for the development of the corporate bond market. So, what we are introducing is a plain vanilla CD and I hope that this will be one of the several inputs that are going to develop our corporate bond market.”

If statements made by the RBI and Subbarao are any indication, onshore CDS is going to be a continued focus of Subbarao’s agenda while heading up the RBI and, if successful, it will likely be part of his legacy as Governor.

CDS Antagonists are still concerned

Like any issue, there are those on both sides of the fence and introducing CDS to India is no exception. There are skeptics who are more cool, if not outright opposed, to the idea of Indian CDS given the believed role of derivatives in the financial problems of other countries and this group may have even included former Governor Y.V. Reddy.

As reported by Ramesh Lakshman in Daily News & Analysis recently,

“If a market maker sells too many credit default swaps against the same reference entity, it could result in problems for them when that reference entity defaults. How this issue is proposed to be addressed by RBI will be known only when we see the draft guidelines as and when they are issued.

As a derivative, CDS can be used for speculation, arbitrage, trading and hedging.

A lot would depend on the guidelines. If the guidelines prescribe that only those with an exposure to the underlying credit can buy a CDS, then speculation and trading would be ruled out. The users would also depend on the regulations and participation by insurance companies and mutual funds would depend on the respective regulator’s permission.

It is unique to India that committees appointed by the regulator mandate the product structure, whereas in other countries the market players or exchanges come up with the product. Regulatory intervention is only in approving the product.

It can only be hoped that the committee does not come up with a scheme that destroys the demand for the product, making it a non-starter as in the case of interest rate futures. A more appropriate method would have been to let FIMMDA come up with the product design.”

Aside from the CDS-specific worries, other naysayers also point out to the questionable track record of derivatives generally in the Indian corporate sector and point to companies like Bharti Airtel, ICICI Bank, Infosys Technologies, KPIT, Satyam Computers, Wockhardt and Varun Shipping which have all had to suffer losses on derivatives (mostly on foreign exchange contracts related to unanticipated rupee exchange-rate movements). In the case of smaller companies like Rajshree Sugars, Himatsingka Seide and Sundaram Multi Pap, without the wherewithal to handle derivative losses, they have had report significant losses and take their banks to court.

The Hindu Business Line reported in 2008 that “the mark-to-market provisioning by some of the top Indian banks such as ICICI Bank, SBI, Axis Bank and Kotak Mahindra Bank against their clients’ exposure to various derivative transactions has been pegged at over $175 million (about Rs 700 crore)… Telecom major Bharti Airtel recorded a MTM loss of Rs 204 crore, which also includes provisioning towards other derivative transactions…[and] State Bank of India provided for Rs 40 crore in 2007-08 against such [subprime-related] losses, while ICICI Bank had in the previous quarter provided for $100 million towards MTM [mark-to-market] provisioning for credit derivatives [related to the subprime crisis].” The absolute level of those losses may seem relatively small and perhaps even “normal” now by global standards when compared to the losses reported by AIG, Lehman, UBS, Deutsche Bank, RBS, Citigroup, Bank of America Merrill Lynch, Morgan Stanley and other western institutions but for the Indian domestic market, such losses are unprecedented and extremely worrisome in what has otherwise been a conservative market.

Finally, concerns about how best to implement an onshore product in India according to the needs and concerns of the Indian market – without the influence of competing outside and external interests is another issue. This is a concern in other countries as well like China as they try to craft their own domestic regulation.

The importance of these issues were highlighted last year in Japan when debates about the credibility of Yen-denominated CDS contracts were questioned after the long-held bankruptcy process in Japan was thrust into the spotlight for not being in tune with the times (or rest of the world) in terms of facilitating hedging and CDS activity. Aiful, a consumer lender in Japan, was the first (and then Japan Airlines followed) to test the Japanese bankruptcy process known as Alternative Dispute Resolution (ADR) which doesn’t require the company to notify the public. This lack of (legal) public information prevented CDS from officially being triggered for settlement and auction. This was despite the fact that both companies had missed their regularly scheduled bond interest payments. In time, ISDA, the governing body for CDS, worked out the issues in both Aiful and Japan Airlines to hold successful CDS auctions and settle the issue for the time being but there is still the possibility that future issues in Japan could arise.

In India’s case, bankruptcy is already a public process so the Japan-style concern may not be there but instead, differences have tended to revolve around RBI’s desire to have CDS trade only on companies with public credit ratings (which ISDA doesn’t agree with) and whether loans will also be considered deliverable obligations in the rupee contracts. Secondly, the important information that RBI deems necessary to share and report may not necessarily fit the norms or wishes of foreign banks and jurisdictions. Thirdly, there is a little uncertainty regarding how to manage counterparty risk and what types of banks/trading entities will be allowed to trade rupee CDS (i.e. whether major foreign banks can trade through their existing capitalized foreign entities or whether they will need to setup separately capitalized Indian-based entities). India does not really have a major global bank and as such Indian-regulated banks will be at a disadvantage when it comes to competing in the CDS market with long-established western incumbents. As quoted by S. Ananthanarayan, chief bond trader at Kotak Mahindra Bank in Mumbai, “their basic fear is that once you allow complete freedom in CDS and the trades gather momentum, and they are not in a position to control it, they may land in a real mess.”

As optimists cheer the recent introduction of a new rupee symbol and continue to hope for an eventual Indian Rupee CDS introduction by the end of this year, one certainty that moviegoers can expect is that Munnabhai will probably end up delivering more shocks and thrills than laughs in this series (unless the prospect of losing millions of dollars from derivatives and increased market volatility is also found to be funny). If that is the case then perhaps this story would be more appropriate for the next sequel to Dhoom.

CreditLime Financial News Bureau

For Part 1 of this CreditLime report, click here

For Part 2 of this CreditLime report, click here

For CreditLime’s report about the introduction of onshore CDS to China, click here