Many believe that over-the-counter (OTC) derivatives exacerbated the global crisis. As a result, a lot of regulatory attention is being focused on how to deal with OTC markets. The financial crisis has also intensified the debate over the limited development of post-trading infrastructure for OTC derivatives. The ECB argues – among others – that the lack of a good post-trading infrastructure not only leads to operational inefficiencies and risks but also hampers effective counter-party risk management and market transparency (ECB 2009).
Adding to this is a new wave of opinion promoting the introduction of a “centralised counter party” to improve transparency by allowing for easy collection of high frequency, market-wide information on market activity, transaction prices, and counterparty exposures for market participants (Cecchetti et al. 2009).
New evidence from India
In a recent ICRIER working paper (Arora and Rathinam 2010) we analyse the regulatory framework of the OTC derivatives market in India and propose new measures for market stability. The OTC derivatives markets in India are well regulated by the central bank. The Reserve Bank of India allows OTC derivatives trading so long as at least one of the parties in the transaction is regulated by the bank. Financial institutions in India use derivatives for their own balance sheet management whereas non-financial firms use derivatives only for hedging their exposures.
The flow chart below depicts the functioning of OTC regulation in India. A centralised counter party, called CCIL, is entrusted with the job of engaging in the OTC derivatives market as a reporting platform and a clearing agency for post-trading settlements. The banks and the primary dealers are required to report all their trades on the reporting platform within 30 minutes of the deal. Since one of the counterparty in an OTC transaction has to be regulated by the Reserve Bank of India regulated entity and has to report to it on a regular basis, the Indian model therefore offers a unique model for automatic surveillance of the OTC exposure of all banks in India. Additionally, the use of the centralised counter party as a reporting platform on a real-time basis helps the Reserve Bank keep a real-time watch on systemic risk.
Figure 1. Centralised counter party approach – Regulatory framework for Indian OTC derivatives
For all those OTC products, which are guaranteed by CCIL, the guarantee from the centralised counter party reduces the capital requirements for banks up to 80% by eliminating the counterparty risk. At present, CCIL collects initial margin (including spread margin), mark to market margin and other margins like volatility margin (whenever imposed). Such margins are collected in the form of eligible Government-of-India securities or cash or both. A minimum cash margin requirement is generally stipulated to address immediate liquidity needs. CCIL also takes contribution from members to the default fund in specific segments in the form of eligible Government-of-India securities to meet any residual loss.
Since CCIL is the only centralised clearing party for trade processing and settlement services in India, any potential mismanagement in CCIL could have system-wide implications. Concentration can lead to a “moral hazard” problem if the centralised counter party is considered “too big to fail”. The Reserve Bank of India, recognising the systemic nature of a centralised counter party, ensures that CCIL is closely monitored. Further, to eliminate the possibility of CCIL not being able to honour a contract, it maintains a guarantee fund and has adequate lines of credit arrangements with various banks to ensure funds settlement on guaranteed basis for trades in Collaterised Borrowing and Lending Obligations, government securities and forex markets. To ensure good corporate governance, CCIL follows International Organisation of Securities Commission best practices1.
We argue that, given the systemic significance of centralised counter parties and the existing concentration of activities in CCIL, the time has come to allow competition in post-trade clearing and settlement of OTC derivatives. Very much like in the market for foreign currency futures, where National Stock Exchange (NSE) and MCX compete as organised exchange-based centralised counter parties, we should start thinking about new infrastructure in OTC derivatives. The entry of one or two more CCPs in the business of post-trade clearing and settlement may bring with it the advantages of operational efficiency and, at the same time, reduce the concentration of risk.
Another measure that could contribute to the strengthening of centralised counter parties relates to increasing liquidity requirements of CCIL. As part of its operations, CCIL sometimes experiences intra-day liquidity shortfalls. To tide over the intra-day liquidity requirements, CCIL has made use of a dedicated line of credit from a few commercial banks. We are endorsing the demand of the Committee for Financial System Assessment (2009) for the grant of a limited purpose banking license, which will enable CCIL to take advantage of a repo window with another bank (or from the Reserve Bank of India) to meet the need for additional liquidity.
The policy implication of our research is that, knowing the functional value of OTC derivatives markets in the Indian financial system, there is no need for new moves to tighten the regulatory rope. Also, a shift of business from OTC-traded to exchange-traded derivative markets may not bring the desired results. Instead, what we propose is a concerted effort towards increased disclosure, more transparency, and more standardisation. In addition to that, towards a better understanding of OTC derivative markets, we suggest that notional outstanding value of contracts is not a correct indicator of the payment risk inherent in this market. It is only the uncollateralised part of the gross credit exposure which the supervisory bodies need to focus on.
Arora, Dayanand and Rathinam, Francis Xavier (2010) “OTC Derivatives Market in India: Recent Regulatory Initiatives and Open Issues for Market Stability and Development” ICRIER Working Paper 248.
Cecchetti, SG, Gynthelberg, J & Hollanders, M (2009), ‘Central Counterparties for Over-the-Counter Derivatives’, BIS Quarterly Review, September, BIS , pp. 45-58.
European Central Bank 2009, OTC Derivatives and Post-trading Infrastructure, ECB
1 The Reserve Bank of India (RBI 2007) reports that "CCIL's risk management practices are periodically evaluated against recommendations for CCP [by IOSCO]“ page 24 of "Report on Oversight of Payment Systems in India".