RBI in talks with banks to cut derivative risks

Trades May Be Settled Fortnightly/Monthly

AMID greater uncertainties, frozen credit lines and choppy markets, policy-makers and market participants are in talks which could result in changes in the rules of the game in the world of derivatives. The aim is to lower the risk and smoothen trades at a time when markets as well as fate of institutions can change dramatically.
    Derivative deals between two banks or a bank and a corporate have a long life — two years or even five years when the derivative contract finally expires. By then, the market may have undergone a sea change or one of the parties may have collapsed. So, instead of keeping alive such risks for years, it would make sense for the two parties in a derivatives contract to take a look at the deal every fortnight or month, and then pay or collect cash, depending on which way the market has moved.
    This can be done on the basis of a credit support annex (CSA) agreement between institutions entering into a derivative deal. "There have been some discussions between the Reserve Bank of India (RBI) and some large banks to introduce this in the Indian derivative market. It will lower the credit risk, a factor which is pertinent in today's market," said a senior banker familiar with the matter.
    Who-pays-whom every fortnight and the amount of cash that changes hands depends on where the market is and who is in a winning (or losing)position at that point.
    It is possible to figure out at any stage what the derivative contract means for the two entities which have entered into it.
    This is captured by the markto-market position (MTM) at any point. It is similar to a bank holding a stock or a bond — if the market price of the security is below the price at which it had been bought, the bank is sitting on an MTM loss on the investment. Even for derivative position, such MTM losses for a party (which is a gain for the counterparty) can be calculated based on the market rates (say, exchange rates if it's a cross-currency derivative), volatility and interest rates.
    The party with an MTM loss — the position that is described as 'out of money' in market parlance — pays the other party who is 'in the money'.
RBI is trying hard to ensure that the fallout of the global crisis is confined to Dalal Street and does not boil over to Main Street. Thanks to its measures on Saturday—reduced standard provisioning and risk weightage for real estate companies and NBFCs—banks are likely to be less apprehensive in lending to real estate companies and NBFCs. The following are further steps the central bank can take to give the weakened system a leg up — Page 7 What else can RBI DO
For the squeezed credit market?
RBI can have a dollar swap line with Fed—something which other central banks have done. This will restore confidence in the market and improve dollar liquidity. The central bank can also activate the dollar swap it already has with Bank of Japan.
Make more oil bonds 'repoable'.
This will give greater trading flexibility to players in the local bond market. Recently, Rs 20,000-cr oil bonds were allowed under repo facility
Cut repo rate: This can be followed by a cut in reverse repo rate (the rate banks get for parking surplus cash with RBI)
Free rates on NRI deposits if dollar inflow still not adequate. This may be required as $89 billion dollar debt is coming up for repayment within next one year CSA norm may help free up inter-bank exposures
    HOWEVER, depending on market movements, this can change next fortnight when MTM is again estimated as per the CSA pact. If the market has moved wildly enough, the party which paid the cash last fortnight could end up receiving this time, and the cash that changes hands could be more or less. Such periodic cash payments are like margin money that an investor in stock futures is required to give. For example, an investor pays additional margin on a long futures position if the stock has slipped, or has to pay more margin if he/she has a short position and the market has gone up. Under CSA, such margins can also be in the form of liquid securities instead of cash.
    "In inter-bank deals, this is like a protection against risks such as the counterparty turning insolvent. If RBI goes ahead with it, it will be in the long interest of the market. Internationally, this has evolved as a market practice," said the treasurer of a private bank. According to him, it would be a mistake to argue that global markets went into turmoil despite CSA. "The current problem owes its origin to the mortgage crisis which was because of reckless lending... there are no defaults on derivative. In fact, a CSA helps to ensure that a derivative position does not spin out of control," said the banker.
    Some in the market said that while the central bank is keen to encourage it so that it becomes a market practice, there may not be a regulation. However, there is a feeling that the norm would help to free up some of the inter-bank exposures. For instance, if a foreign bank has an internal exposure limit of $300 million with an Indian public sector bank, then a large part of this exposure may be blocked by the existing derivative positions it has with the local bank. However, if the two parties settle the MTM losses as per the terms defined under the CSA pact they sign, then the credit limit will not be choked. This may be important in a market where several MNC banks have lowered exposures or pulled out credit lines with Indian banks. Such CSA deals are possible in derivative deals between a bank and a corporate. Most derivative positions with corporates are unsecured and banks often don't insist on margins.
    Over-the-counter derivative are deals, which banks and corporates do to lower costs, manage foreign currency exposures, speculate and trade on the spreads, can take the shape of interest-rate swaps, cross-currency swaps and options. It could be done by an exporter/importer trying to protect itself from currency volatility, or a corporate or bank, which chooses to convert a part of its expensive rupee borrowings into cheaper dollar or low-interest yen loans. These are synthetic deals cut between two institutions, and the transactions are outside the public domain or regulatory radar. Even the senior management of a bank may not be aware of the positions that have been built by derivative dealers in the trading rooms. Under the circumstances, taking account of the MTM losses every fortnight or a month would be good risk management practice.
    sugata.ghosh@timesgroup.com