Thursday, 19 July 2018

India 2007: Credit where it's due

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India’s derivatives market grows from strength to strength each year, but its rate of expansion and maturation is a measured one due to the regulatory hand of the Reserve Bank of India. Excitement is building, however, about the introduction of credit derivatives, the trading of which should begin before 2007 comes to a close.

In keeping with its traditional approach to regulation, the Reserve Bank of India (RBI) has ensured that developments in the Indian derivatives market during 2007 held few surprises for market players.

Yet the appearance of draft guidelines on credit default swaps in May created a bit more of a buzz than normal. The bank issued the draft guidelines requesting feedback from the market, feedback that was received by June.

“There were some gaps in the draft [guidelines], but following feedback from the market and from the likes of ISDA, many of the gaps should have been filled,” said a banker in India.

Bankers’ best estimates of when the final guidelines will be released are September or October, but they confidently predict an appearance of the final document before the end of the year.

News of the impending arrival of credit derivatives into the Indian financial markets was generally warmly welcomed by bankers, who see it as a significant step in the development of a full range of credit hedging products.

“The introduction of credit derivatives is important as it provides a means of more-widely distributing credit risk and should also improve the efficiency of pricing credit,” said Manish Bhai, co-head of corporate sales and structuring in Citi’s fixed income, currencies and commodities team in India.

Through the use of this instrument the country’s financial sector will be able to more effectively manage credit risk, reduce concentration risk, and increase domestic lending capacity.

The creation of a credit hedge that enables financial institutions to pass on credit risk from their balance sheets should ensure that capital remains widely available to support the country’s growing economy. Dispersing risk away from the banking sector should also play a significant part in the success or otherwise of India funding its huge infrastructure building plans.

While the draft guidelines outline a market constructed along the same lines as that of the UK’s Financial Services Authority – thereby giving it a firm foundation from which to grow – there were some issues within it that bankers needed to question and clarify.

The main point of contention for most participants surrounded the limitation restricting the market to using single-name credit default swaps (CDS) only. The RBI will initially allow only plain vanilla CDS swaps referenced to a single entity to be traded, which severely impedes the impact of the changes on the market.

“The RBI likes to do things one step at a time,” said one banker. “This is good enough as a starting point, so we’re not too disappointed.”

Another banker agreed: “It [the RBI] takes small steps progressively, before eventually introducing more products.”

There will also be restrictions on those firms able to use CDS. Commercial banks and primary dealers represent the first wave of players in the market, but the RBI plans to allow insurance companies and mutual funds to participate as and when their respective regulators permit them to transact the new instrument. Corporates are, likewise, not involved in the first iteration of the guidelines.

As is often the case, the draft documents left some issues open to interpretation and bankers hope that the final circular will have nailed down some of the ambiguities.

“It is not clear whether CDS can be traded for profit or just used for hedging purposes,” said one banker. “We also need more clarity on the issues of prepayment or sale of the underlying in the contract.”

So, while the RBI is addressing the first stages in the development of a fully-fledged credit derivatives market, bankers are already looking forward to the regulator moving on to tackle the next major hurdle in India’s derivatives world – that of interest rate optionality.

Currently, the trading of interest rate swaps, forwards and futures fall within the interest rate derivatives regulatory purview of the RBI, but the question of optionality is also being considered. Some of the most optimistic bankers had even hoped that trading in interest rate options would, like CDS, begin before the start of 2008. Most, however, think it unlikely to take place that quickly although demand for interest rate options is undoubtedly growing.

“Interest rate swaps and options are the glue that bind investors and borrowers together, said Vipul Chandra, co-head of corporate sales and structuring in Citi’s fixed income, currencies and commodities team in India. “It allows both sides of the equation to more accurately express their views on interest rates.”

The benefits derived from using a full range of instruments that allow users to lock in their views of future interest rates may have to wait a little longer to be enjoyed.

Nick Herbert

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