RBI says Credit derivatives will have to wait

On 19 June 2008, RBI issued a press release saying credit derivatives will have to wait: (This was covered widely in media as well)

in view of certain adverse developments witnessed in different international financial markets, particularly the credit markets, resulting in considerable volatility in the recent past, such as mounting losses suffered by banks on account of sub-prime crisis, need for the central banks of those countries to inject liquidity into the system, as also the level of risk management systems and possible non-adherence to the regulatory guidelines on complex products such as credit derivatives, time is not considered opportune to introduce the credit derivatives in India, for the present.

I have been hinting all along the problems wth credit derivatives market (see few possts here). I also did some research on the most popular Credit derivative- Credit default swaps. The CDS market has expanded substantially with most trades in – multi-name , non-rated and longer term swaps. All these indicate increasing complexity. A simple CDS is difficult to price as it is based on probability of default (probability is not certainty) and with more complexity we never know what is going on. Just throw the model in the system and it gives you a price. And we know how these models are. The summary – increasing complexity.

The developed economies’ Central banks just saved another crisis. By intervening they didn’t let the financial firms collapse and no calls for honoring the CDS were made. If they were made, we would have seen another crisis.

I am sure this would have not made the “modern finance people” one bit happy.  No one doubts the usefulness, but we should realise all is not well with these derivative markets. Hardly anybody uses them for hedging and mostly it is used to earn premiums. And moreover, top financial firms have been seen to trade them with each other leading to large concentration risks. So, if one defaults, we really do not know how it will be settled.

This Mint article (from Mobis Philipose) suggests why not have exchange traded credit derivatives instead?  In my report I also mention that credit derivatives are an OTC product and not exchange traded. This is a good idea but somehow exchange traded derivatives have not picked up except for equities. Most of the other derivatives like interest rate, currency etc continues to flourish as OTC markets.

Hopefully, after this crisis we would see development of more exchange traded markets in these financial products as well.

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One Response to “RBI says Credit derivatives will have to wait”

  1. » RBI says Credit derivatives will have to wait Says:

    […] [Technorati] Tag results for finance wrote an interesting post today onHere’s a quick excerpt On 19 June 2008, RBI issued a press release saying credit derivatives will have to wait: (This was covered widely in media as well) in view of certain adverse developments witnessed in different international financial markets, particularly the credit markets, resulting in considerable volatility in the recent past, such as mounting losses suffered by banks on account of sub-prime crisis, need for the central banks of those countries to inject liquidity into the system, as also the level of r […]

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