RBI in talks with banks to cut derivative risks

[Sukumar.N]

RBI in talks with banks to cut derivative risks
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MUMBAI: 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.

Derivatives deals between two banks or a bank and a corporate have a
long life — two years or even five years when the derivatives 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 the derivatives deal.
“There have been some discussions between the Reserve Bank of India
(RBI) and some large banks to introduce this in the Indian derivatives
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 derivatives
contract means for the two entities which have entered into it.

This is captured by the mark-to-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 derivatives
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’.

Derivatives

However, depending on market movements, this can change next fortnight
when the 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 for 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 counter-party 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 derivatives. In fact, a CSA helps to ensure that a
derivatives 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 derivatives 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 derivatives deals between a bank and a corporate. Most
derivatives positions with corporates are unsecured and banks often
don’t insist on margins.

Over-the-counter derivatives 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 derivatives 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.


Soource : Economic Times