Financial Derivatives - Devil in disguise?

Recently RBI decided to develop a market for CDSs (Credit Default Swaps) in India. The underlying thought being the importance of Credit Derivatives for the growth of Financial Markets. Well, good thoughts on the regulator's mind to encourage growth of financial markets, But were CDSs not the force (or non force) behind the financial debacle which we witnessed in recent times in Developed markets? We did hear and read about how CDSs and CDOs brought the market down and that these instruments were the real culprits?

No argument can be farther from the truth. First and foremost, any instrument designed by a system and used extensively cannot by itself be an evil or faulty. If it was, then how come it had such a huge market for itself? Second, all of that market was legal and complaint. Then why does many in India have such aversion to these derivatives?

Contrary to what many believe, India was spared the horrors of Financial meltdown not because we forbade certain type of transactions but mostly because one, as a financial market we are not so well developed and second, we are slow to understand and adopt these new age products. And our inability to quickly get on top of these instruments kept us insulated and nothing else. However, even the regulator is smart enough to understand the importance of these instruments in building a robust financial structure of the country.

Let me try to bring more clarity here. CDSs (Credit Default Swaps) are nothing but insurance provided by a party to insulate a buyer of bonds from default of the issuers. The price of the Insurance depends on the Risk profile of the bonds. It is a simple risk reward structure, which we are aware of, even before commerce came about in this world any any avatar. Then how can they create havoc? Like any financial product worth its salt, CDSs can be traded. And the trade price is again a clear manifestation of weighted risk. A buyer needs to be sure of the intrinsic value of the underlying bond and the risk weighted price. This can only be done through extensive research on each and every trade which can turn out to be humongous due to the sheer volume (trade could be in Billions of dollars). So the trader/risk manager would depend on another "dependable" source in the financial services industry, Credit Rating Agencies. It is the job of these agencies to rate the underlying bond and the price of the instruments is basis the ratings. Now imagine a situation where the CDSs have changed multiple hands and is lying with Bank X. The trader who bought this at the Bank X has allocated a price to it based on his assessment, which is predominantly the Credit Rating Agencies' ratings. She is depending on someone to tell her that the underlying bonds of the CDSs she has bought is of quality for which the price equation was right. What if the underwriter who rated these bonds at rating agency did not do the job well and in a rush or due to the sheer volume adopted a shortcut and rated the instruments wrongly? Or maybe the understanding of the risk reward model was not up to mark? The entire basis of the risk reward equation is wronged. And here we are developing a classic situation of not enough forensic done before rating an instrument. This is further fuelled by the fact that the trader is also looking to trade the CDSs further at the opportune time, in the process putting the risk on someone else' balance sheet.

What happened during the recent meltdown was shortchanging of process in each and every step. The ratings agencies shortchanged and the fundamentals of underlying bonds did not support the ratings. The Insurance increased with every default instance on the bonds and hence the price of CDSs fell drastically. With falling prices the insurance amount increases further and on continued the death spiral. And the one left holding the CDSs in the end bore the brunt of the default as happened with Merril Lynch.

Similarly, CDOs (Collateral Debt Obligations) are also trade able instruments where the underlying instrument was the Mortgage payments. So the price of the derivatives was based on the streams of monthly payments. Rating agencies failed here again. This behaviour of rating agencies led to low quality acquisition as the acquirer of the loan was confident of passing on the risk in the form of CDOs. As a professional employed with an organisation which can provide you all the tools, why would someone not do the required research to ensure the trade price reflects the true risk of the underlying instrument? In a world where the big fat earnings are in the form of Bonus, the endeavor to deliver results in the short terms takes control. ( I have written about the short term Vs Long term decisions in my blog earlier). Hence acquisition/trade in low quality mortgage backed CDOs backed by higher ratings by the rating agencies. Show numbers and earn ever higher bonuses. 

So what have we now? Rating agencies with low credibility and traders with short term view being pushed to change the approach. This is the combination which pushed the markets to the brink and not the instruments themselves. Given to proper administration, the instruments do provide for enhancing the financial markets as it provides for better access to the scarce resource called Capital. What is required is spending enough time and effort to analyse each instrument to provide the right kind of risk weighted price. Rating agencies like many of the accounting firms are in a fix. They rate the same companies which provide them work. With rating agencies also taking up other lines of work, So it sometimes become difficult to maintain neutrality. So as has been said time and again, the rating agencies need to be regulated separately and the ratings business has to be stand alone. The agencies themselves need to be rated by the regulator basis their performance on ratings. And of course, the impact of long term solutions, needless to add.

So regulator surely needs to ensure our markets are exposed more and more to these instruments. Just the right kind of environment, both regulatory and monetarily to be provided to ensure the learnings of the financial debacle provide us with some much needed inputs.