RBI new CDS guidelines: Feeble effort to a start a non-starting product

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9th January, 2013:

It is like trying to press the ignition button of a vehicle that does not have fuel!  The RBI has done some bit of widening of the CDS market, hoping that this time the ignition will work.

The RBI brought out the CDS guidelines, after a long wait of 4 years, in 23^rd May, 2011[1]. The operational guidelines were announced in 30^th November, 2011[2]. Post this, till August, 2012 there have only been 3 CDS transactions, adding upto a total transaction volume of only Rs 15 crores (less than USD 3 million). Compare this to the whopping USD 30 trillion international volume – the data speaks for itself.

The 2011 guidelines proved to be a non-starter for several reasons:

• First, the RBI has started with a notion that users in India can enter into CDS contracts only for the purpose of hedging. Most of the international trades are for trading motive, not for hedging motive. However, one may regard this as the usual feature of all OTS derivatives in India – most derivatives are allowed only for hedging.

• Even within the hedging motive, the RBI limited CDS only for bonds. Most international CDS contracts are referenced to loans or bonds, not merely to bonds. In fact, one may understand international CDS contracts being linked with bonds, as there is a huge bond market internationally. However, in India, the bond market itself is toddling. 

• Even within bonds, the RBI limited it to listed bonds. Arguably, if one of the primary purposes of a CDS trade is to take advantage of pricing inefficiencies in corporate bonds, this is not possible in case of listed bonds, where pricing is presumably transparent.

Therefore, little wonder that there was hardly any CDS activity in the country.

The RBI has now relaxed the Guidelines a bit. A comparative of the existing guidelines and the revised guidelines is provided for in annexure below. Among the major changes are:

1. CDS permitted on unlisted but rated corporate bonds for issues other than infrastructure companies also — It is difficult to understand why would the CDS market be kept limited to rated bonds, particularly when there is no rating minima specified. Rating itself assists in price discovery. To an extent, even a CDS contract leads to price discovery.

2. Unwinding CDS bought position with original protection seller at mutually agreeable or FIMMDA price – The revised guidelines do not permit offsetting of the contract however novation is permissible.

3. CDS permitted in case of short term instruments such as Commercial Papers, Certificates of Deposit and Non Convertible Debentures — In case of short term instruments, including short term bonds, it seems that the requirement of rating is not applicable. Once again, linking CDS contract for short-term instruments does not jell will the nature of CDS instruments. Globally, most CDS trades are for 3 years and above tenure. If one has a short term instrument, the probability of default, which is what a CDS instrument tries to mitigate, is itself low for most entities. Hence, an issuer or a holder may not even need a CDS protection.

In our view, the linkage with the bond market will still continue to keep the CDS market in shackles. It is a chicken-egg story – we do not have an active bond market, due to several inhibiting factors. And we will not have a CDS market because we do not have an active bond market.

In short, the new CDS guidelines still retain several inefficiencies, and may not lead to the market picking up any substantially.

Annexure: A Comparative on the CDS Guidelines issued and revised by RBI