Since AIG was bailed out just over a year ago, counterparty risk has been a burning issue. Without US$180bn in US government support, many of the insurer’s credit derivative counterparties would each have been left with losses that they could ill afford – potentially triggering further collapses. Markets are now trying to prevent a repeat by embracing central counterparties (CCP), which will sit in the middle of previously bilateral over-the-counter derivatives trades, to provide clearing and settlement services, while also guaranteeing that customers will be paid in full if their counterparty falls over.
It is a good idea, but not a new one and although much of the current focus is on Europe and the US, Indian regulators have long been pushing the country’s markets to move in the same direction, the CCIL’s Shahabuddin said. “It’s not a new topic for us – the Reserve Bank of India decided eight years ago that they wanted a CCP for the nation’s securities markets – and other regulators are now coming to the same conclusion. They want a CCP to sit between these transactions, so that individual institutions don’t have to worry about counterparty risk, and the system as a whole is safer and stronger,” he said.
CCIL was created in 2001 – a year after an influential report on payment and settlement systems recommended the move. The clearer’s non-executive chairman, R H Patil, was a member of the working group that produced that report. The clearer’s business to date has been mostly focused on cash bonds and currency clearing and settlement (it set a new daily record by clearing Rs330bn in government bonds on July 2), but in September it is ready to break new ground in Asia by becoming the first CCP to clear OTC derivatives transactions.
“We know that Japan and Singapore have well-developed exchanges, but in terms of OTC settlement through a CCP, we are well ahead,” said Shahabuddin.
The first product to be settled by CCIL will be the US dollar/rupee currency forward – a market with roughly US$900bn in outstanding trades. Shahabuddin estimated that around 30% of the market would switch to CCIL almost immediately, but that some lingering legal issues around customer defaults needed to be resolved before the business could really take off.
Despite that, he said 80% of the market should be settled through CCIL in about six months. CCIL also expects to capture the same proportion of the market for rupee interest rate swaps – where there is around US$700bn outstanding among the bigger market participants. It is already mandatory for the big swaps dealers to use CCIL as a trade information repository, and full clearing and settlement services should be rolled out by the end of this year, said Shahabuddin.
The choice of products says something about the nature of the CCP business – in order to offset the counterparty risk, CCPs charge initial and ongoing margin payments to their customers, and those payments are expected to provide the first line of defence should a default occur. As such, it is easier to take the risk in deep, liquid markets, which are well-understood and where margins can be calculated with more certainty.
Shahabuddin said that with the exception of the dollar-rupee forward and the rupee interest rate swap, India’s OTC markets were too thin for a CCP to step in. But could this dynamic encourage CCIL to try to hoover up business elsewhere in the region’s fragmented markets, now that it has stolen a march on potential competitors? Some observers have speculated that the clearing business will evolve so that many products are cleared via regional hubs rather than by domestic players serving their domestic markets. Shahabuddin, however, played the possibility down: “Presently we’re only focusing on India and I think we’d have to examine the issue very carefully before venturing into any regional hub business. Personally, I don’t think we’ll get into that in the near future.”
CCIL certainly has plenty to be focusing on for now, but Shahabuddin believes the clearer is doing the job envisaged nine years ago by its current chairman and the other members of the payment and settlement systems report – it is making India’s securities and derivatives markets more efficient and less risky places to trade: “We’re very stringently regulated, and market participants have confidence in us. I’m proud of what we’ve achieved so far and think we’ll become even more important to the market in the years ahead,” he said.