Getting Credit Default Swap Market In India Up and Running
I propose to discuss in my column today the long overdue imperative of developing a vibrant Credit Default Swap market in India .
In the inflating of the credit bubble in the run up to the Global Financial Crisis , and its inevitable concomitant, the Great Recession from which the global economy is yet to recover , inflated ratings to sub-prime mortgage backed Collateralised Debt Obligations by global rating agencies played a significant role. Given,therefore, the question mark over the infallibility of rating agencies, the Basel Committee needs to revisit the primacy of role assigned to ratings of such agencies for assigning capital charge for credit risk by banks . In fact, credit appraisal and measurement are the most basic functions of intermediation performed by banks traditionally. In the light of this, ratings may be meant for, and be relied upon by, the unsophisticated and uninitiated retail and small investors, but certainly not banks. Besides, given the fact that pre-crisis rating agencies generated almost 40 per cent of their revenues from assigning the so-called inflated ratings to CDOs (Collateralised Debt Obligations) tranches, backed by sub-prime mortgages and the obvious inherent conflict of interest involved, the US Congress and regulators investigated the role and function of rating agencies in the aftermath of the Global Financial Crisis. In view of this, Basel Committee needs to de-emphasise ratings assigned by Rating Agencies for assigning capital charge for credit risk by banks. Indeed, if anything, given the tremendous volumes and liquidity of Credit Default Swaps (CDSs), both single-names and indices-based, it would be far more market-price discovery-driven for banks and regulators alike to rely on prices backed out from these credit derivatives . Indeed, CDSs price credit risks almost on real-time basis as much as Government bonds , foreign exchange, stock and commodities, markets do. Credit rating agencies, in comparison, are inertial and lagged. In the way of example, in the USA, the traditionally very healthy AAA rated mono-line municipal bond insurers MBIA and Ambac changed their business model from insuring only their staple municipal bonds to insuring CDOs and ABS (Asset Backed Securities) . While this went unnoticed by insurance regulators, Pershing Square, a hedge fund, spotted trouble and started shorting both equity and credit risk of these two companies by buying their CDSs. But even after sharp increase in real time CDS spreads of these two insurers , regulators failed to take notice of these early warning signals and any timely preemptive corrective action with the two companies being eventually downgraded several notches by Credit Rating Agencies but only much afterwards ! Significantly, as if to redeem their lost infallibility and reputation, these Rating Agencies , almost immediately after the financial crisis, started a new service which provided implied credit ratings backed out/derived from CDS spreads ! There is thus a very strong case for kick-starting a full-fledged CDS market in India.
The popular refrain that the last global financial crisis was caused, or exacerbated, by CDSs is again a myth in that CDSs which are simple plain-vanilla off-balance-sheet/non-fund based credit derivatives, were confused with the CDOs (collateralised debt obligations) which are on-balance-sheet and funded securitised structured credit products. It was securitisation/re-senuritization, involving CDOs that played a seminal role in the crisis and no way the CDSs ! In fact, it is also a myth that securitisation through CDOs was an originate-to-distribute model; rather, really speaking, it was an originate-to-distribute-back-to-originators model! This is because almost all CDOs originated came back to sit on the SIVs (Structured Investment Vehicles)/ conduits sponsored by originating banks themselves. Besides, for all the overdone and totally uninformed fears about systemic risks from the so-called unregulated Over the Counter (OTC) CDS markets, remarkably orderly and non-disruptive auction-based settlement of CDS claims in respect of CDSs written on Lehman Bros., Icelandic Banks, Fannie Mae, and Freddie Mac, incontrovertibly attested to the resilience of CDS markets. Indeed, if anything, CDSs can be an effective and neat answer ,and substitute,for lagged and inertial ratings of credit rating agencies ! And indeed precisely for this reason , RBI should not insist on CDSs being allowed only on listed and rated corporate bonds as what listing and rating purport to deliver is actually delivered far more efficiently on real time basis by CDSs , as typically, CDS markets sniff out financial mess much faster than even equity markets !
Interestingly, the New York Fed-led initiative to improve the OTC CDS markets sought to replicate India's CCIL ( Clearing Corporation of India Ltd) -model, where although OTC foreign exchange transactions are bilaterally negotiated, they are cleared and settled through RBI -sponsored Clearing Corporation of India Ltd. (CCIL). Today CDS prices/spreads are by far the most closely tracked early warning signals for real time changes in credit risk profile of an entity, whether private or sovereign. This is because CDSs make it possible to back out an implied credit price even when one is not being discovered in the underlying cash market instruments like bonds or loans as indeed in the latest instance of Deutsche Bank where its CDS spread widened real time from 100 basis points to 245 basis points in a matter of a week ! Thus, CDS market has tremendous practical application as a reliable diagnostic tool in stress-testing for supervisors and regulators. Besides, a CDS market will also enable efficient trading and hedging of credit risk and synergise development of active and liquid corporate bond and Repo markets. Like equity, credit risk subsumes all other risks as it is a function of forex risk, interest rate risk, leverage risk, liquidity risk, human resources and governance risks and that is why CDSs and equity prices have been , in equilibrium, almost perfectly negatively correlated, that is, as CDSs spreads widen, equity prices fall almost one for one !
Credit Default Swap, like Interest Rate Swap (IRS), or for that matter any other derivative, is no exception to the so-called law-of-one-price/ no-arbitrage-argument based cash market replication principle of derivatives pricing. Without going into mathematical gymnastic proper, price of a CDS, in spread terms, is reasonably approximated by the difference between the spread of a reference bond/loan to corresponding maturity G-Sec ( Government Security) yield and the spread of IRS to the same maturity G-Sec yield. Thus, if Sc be corporate bond spread and Ss be IRS spread to risk-free G-Sec yield of corresponding maturity, then the fair/theoretical/model value/price of a CDS is approximately equal to Sc minus Ss. Tautologically, since G-Sec yield is common to both spreads, another way to approximate CDS price is simply to take the difference between the yield of the reference bond/loan and the same maturity IRS yield. As is well known , finally when the product was launched in India on 7th December, 2011, it was a stillborn and remains so even after RBI’s revised Guidelines issued on 7 January 2013 . In fact, its epitaph was written in the warped, anomalous, quirky and preposterous feature of hugely negative IRS yield spreads to corresponding maturity G-Sec yields and which,alas, exist even today ! For, as one will readily see from the above formula, because of the hugely negative IRS spreads, fair price of a CDS would be so high as to make it both pointless, and useless, to buy a reference bond and also hedge it with a CDS! In other words, one is much better off straightaway buying a corresponding maturity risk-free G-Sec itself because hedged reference bond would have CDS-cost adjusted yield of G-Sec yield minus the IRS spread rather than the normal G-Sec yield plus the IRS spread ! Significantly, if actual CDS premium/price/spread is higher than the above theoretical/model price, then an arbitrageur will sell a CDS (which is equivalent to going long the reference corporate bond) and receive this actual spread and short the reference bond and invest the proceeds of short sale at the going corporate bond repo rate and receive fixed, and pay overnight, in an IRS, and do the opposite arbitrage if the actual CDS spread is lower than the theoretical/model spread/price until the arbitrage opportunity disappears and theoretical/model and actual market prices align again. But sadly, like in a classical catch-22, this arbitrage is just not possible simply because of its complete absence in the IRS market and, therefore, alas, much as we would all wish, a happening corporate bond market cannot happen, inter alia, to supplement huge infrastructure financing needs of the Indian economy!
I propose to discuss in my column today the long overdue imperative of developing a vibrant Credit Default Swap market in India .
In the inflating of the credit bubble in the run up to the Global Financial Crisis , and its inevitable concomitant, the Great Recession from which the global economy is yet to recover , inflated ratings to sub-prime mortgage backed Collateralised Debt Obligations by global rating agencies played a significant role. Given,therefore, the question mark over the infallibility of rating agencies, the Basel Committee needs to revisit the primacy of role assigned to ratings of such agencies for assigning capital charge for credit risk by banks . In fact, credit appraisal and measurement are the most basic functions of intermediation performed by banks traditionally. In the light of this, ratings may be meant for, and be relied upon by, the unsophisticated and uninitiated retail and small investors, but certainly not banks. Besides, given the fact that pre-crisis rating agencies generated almost 40 per cent of their revenues from assigning the so-called inflated ratings to CDOs (Collateralised Debt Obligations) tranches, backed by sub-prime mortgages and the obvious inherent conflict of interest involved, the US Congress and regulators investigated the role and function of rating agencies in the aftermath of the Global Financial Crisis. In view of this, Basel Committee needs to de-emphasise ratings assigned by Rating Agencies for assigning capital charge for credit risk by banks. Indeed, if anything, given the tremendous volumes and liquidity of Credit Default Swaps (CDSs), both single-names and indices-based, it would be far more market-price discovery-driven for banks and regulators alike to rely on prices backed out from these credit derivatives . Indeed, CDSs price credit risks almost on real-time basis as much as Government bonds , foreign exchange, stock and commodities, markets do. Credit rating agencies, in comparison, are inertial and lagged. In the way of example, in the USA, the traditionally very healthy AAA rated mono-line municipal bond insurers MBIA and Ambac changed their business model from insuring only their staple municipal bonds to insuring CDOs and ABS (Asset Backed Securities) . While this went unnoticed by insurance regulators, Pershing Square, a hedge fund, spotted trouble and started shorting both equity and credit risk of these two companies by buying their CDSs. But even after sharp increase in real time CDS spreads of these two insurers , regulators failed to take notice of these early warning signals and any timely preemptive corrective action with the two companies being eventually downgraded several notches by Credit Rating Agencies but only much afterwards ! Significantly, as if to redeem their lost infallibility and reputation, these Rating Agencies , almost immediately after the financial crisis, started a new service which provided implied credit ratings backed out/derived from CDS spreads ! There is thus a very strong case for kick-starting a full-fledged CDS market in India.
The popular refrain that the last global financial crisis was caused, or exacerbated, by CDSs is again a myth in that CDSs which are simple plain-vanilla off-balance-sheet/non-fund based credit derivatives, were confused with the CDOs (collateralised debt obligations) which are on-balance-sheet and funded securitised structured credit products. It was securitisation/re-senuritization, involving CDOs that played a seminal role in the crisis and no way the CDSs ! In fact, it is also a myth that securitisation through CDOs was an originate-to-distribute model; rather, really speaking, it was an originate-to-distribute-back-to-originators model! This is because almost all CDOs originated came back to sit on the SIVs (Structured Investment Vehicles)/ conduits sponsored by originating banks themselves. Besides, for all the overdone and totally uninformed fears about systemic risks from the so-called unregulated Over the Counter (OTC) CDS markets, remarkably orderly and non-disruptive auction-based settlement of CDS claims in respect of CDSs written on Lehman Bros., Icelandic Banks, Fannie Mae, and Freddie Mac, incontrovertibly attested to the resilience of CDS markets. Indeed, if anything, CDSs can be an effective and neat answer ,and substitute,for lagged and inertial ratings of credit rating agencies ! And indeed precisely for this reason , RBI should not insist on CDSs being allowed only on listed and rated corporate bonds as what listing and rating purport to deliver is actually delivered far more efficiently on real time basis by CDSs , as typically, CDS markets sniff out financial mess much faster than even equity markets !
Interestingly, the New York Fed-led initiative to improve the OTC CDS markets sought to replicate India's CCIL ( Clearing Corporation of India Ltd) -model, where although OTC foreign exchange transactions are bilaterally negotiated, they are cleared and settled through RBI -sponsored Clearing Corporation of India Ltd. (CCIL). Today CDS prices/spreads are by far the most closely tracked early warning signals for real time changes in credit risk profile of an entity, whether private or sovereign. This is because CDSs make it possible to back out an implied credit price even when one is not being discovered in the underlying cash market instruments like bonds or loans as indeed in the latest instance of Deutsche Bank where its CDS spread widened real time from 100 basis points to 245 basis points in a matter of a week ! Thus, CDS market has tremendous practical application as a reliable diagnostic tool in stress-testing for supervisors and regulators. Besides, a CDS market will also enable efficient trading and hedging of credit risk and synergise development of active and liquid corporate bond and Repo markets. Like equity, credit risk subsumes all other risks as it is a function of forex risk, interest rate risk, leverage risk, liquidity risk, human resources and governance risks and that is why CDSs and equity prices have been , in equilibrium, almost perfectly negatively correlated, that is, as CDSs spreads widen, equity prices fall almost one for one !
Credit Default Swap, like Interest Rate Swap (IRS), or for that matter any other derivative, is no exception to the so-called law-of-one-price/ no-arbitrage-argument based cash market replication principle of derivatives pricing. Without going into mathematical gymnastic proper, price of a CDS, in spread terms, is reasonably approximated by the difference between the spread of a reference bond/loan to corresponding maturity G-Sec ( Government Security) yield and the spread of IRS to the same maturity G-Sec yield. Thus, if Sc be corporate bond spread and Ss be IRS spread to risk-free G-Sec yield of corresponding maturity, then the fair/theoretical/model value/price of a CDS is approximately equal to Sc minus Ss. Tautologically, since G-Sec yield is common to both spreads, another way to approximate CDS price is simply to take the difference between the yield of the reference bond/loan and the same maturity IRS yield. As is well known , finally when the product was launched in India on 7th December, 2011, it was a stillborn and remains so even after RBI’s revised Guidelines issued on 7 January 2013 . In fact, its epitaph was written in the warped, anomalous, quirky and preposterous feature of hugely negative IRS yield spreads to corresponding maturity G-Sec yields and which,alas, exist even today ! For, as one will readily see from the above formula, because of the hugely negative IRS spreads, fair price of a CDS would be so high as to make it both pointless, and useless, to buy a reference bond and also hedge it with a CDS! In other words, one is much better off straightaway buying a corresponding maturity risk-free G-Sec itself because hedged reference bond would have CDS-cost adjusted yield of G-Sec yield minus the IRS spread rather than the normal G-Sec yield plus the IRS spread ! Significantly, if actual CDS premium/price/spread is higher than the above theoretical/model price, then an arbitrageur will sell a CDS (which is equivalent to going long the reference corporate bond) and receive this actual spread and short the reference bond and invest the proceeds of short sale at the going corporate bond repo rate and receive fixed, and pay overnight, in an IRS, and do the opposite arbitrage if the actual CDS spread is lower than the theoretical/model spread/price until the arbitrage opportunity disappears and theoretical/model and actual market prices align again. But sadly, like in a classical catch-22, this arbitrage is just not possible simply because of its complete absence in the IRS market and, therefore, alas, much as we would all wish, a happening corporate bond market cannot happen, inter alia, to supplement huge infrastructure financing needs of the Indian economy!
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