Corporations and OTC derivatives

Central counterparty for OTC derivatives

Jayanth Varma is astounded that some corporate treasurers think that their derivatives positions should not be backed by collateral. I am too. On a related track, there is news today that RBI is pushing banks to report interest rate swap transactions through CCIL. This is in the right direction.

The futures clearing corporation as the role model

The role model here is the futures clearing corporation, e.g. NSCC. Futures clearing corporations are designed to enable safe trading between strangers, which makes possible the nice efficiencies of the anonymous electronic market. In doing this, futures clearing corporations demand the identical collateral from all customers. There is no question of NSCC exempting SBI from collateral requirements because SBI is para-statal. It is through such toughness on collateral requirements that NSCC has built up a 13-year track record, of surviving quite some market turbulence, as central counterparty.

More generally, the `recipe' of how clearing corporations work has fared well in the last 100 years, barring a few failures which are really about operational risk, corporate governance, malpractice etc. If someone is serious about running a clearing corporation properly, it can be made to work. All that one has to do is to ensure sound ownership and governance in the exchange business.

Rule of law

I have a disagreement with the mechanism adopted by RBI, on the issue of rule of law. If the newspaper story mentioned above is accurate, RBI officials met a few banks and asked them to do something different. If we respect the concept of rule of law, then it is better to run through the full set of steps:

1. Put out a draft rule change for comments.
2. Genuinely, substantively, listen to the comments. Consider it possible you may be mistaken.
3. Put out a modified rule on the website, after which everyone should be obeying it regardless of whether there has been a meeting with RBI officials or not.
4. Rule changes should be appealable at an SAT.

This is a better process flow, one that expresses the goal of having rule of law. SEBI is the most advanced financial regulator in India today, in having developed the closest approximation to this process.

A real problem with corporations and OTC derivatives in India

I am not a legal expert, but in my understanding, at present, if two corporations enter into an OTC derivative against each other, this is not enforceable. Enforceability is limited to the class of transactions where one of the two counterparties is a bank.

This is reminiscent of 1970s vintage rules of the game in exchanges. Here, exchanges forced the public order flow to only go to market makers. Public orders could not match against each other. Or to say it differently, public orders could not compete with the quotes posted by the market maker. This was a way to rig the rules of the game so as to favour the market makers.

In similar fashion, the existing rules with banks and OTC derivatives in India (if I have understood them correctly) are a way to prop up the profitability of banks at the expense of customers of banks. This is anti-competitive. It helps ensure that the inter-bank OTC market is a rigged game, one that favours banks at the expense of corporate customers. It is one more reason why exchange-traded derivatives are so important in India. It is only on the NSE screen that, for the first time in India's history, we are getting a genuine, competitive, transparent market for the currency or interest rate futures.

These kinds of efforts at rigging the game, in the context of corporations and OTC derivatives, help increase the chances that India will be a pioneer by world standards on the shift of the currency and bond markets to the exchange platform. In terms of the ratio of the size of the OTC currency forward to the size of the exchange-traded currency futures, India is already one of the remarkable places in the globe.

Where corporations are different

While futures clearing corporations should give no quarter to corporate customers as far as collateral requirements are concerned, I think there is a case for having bigger position limits for corporate hedgers.

There is a genuine tension here. If small position limits are used, this reduces the usefulness of the derivatives market for society, because the most important customers of hedging (corporations) are blocked from using it. If special rules are applied for corporate hedgers, there will inevitably be certain shades of gray on what gets done. Yet, when regulators swing over to the other direction and blindly force tiny position limits, it imposes a cost on society. There is a bias towards such over-reaction given that regulators have a different personal perspective on the risk and return from a rational rule set, when compared with the welfare gains to society.

I think the real answer lies in more principles based regulation. For physically settled contracts, there should be no dislocation in the delivery process and for cash settled contracts there should be no artificial distortion of the market price. An excessive attempt at writing down rules does not get the job done.