It is hardly surprising that the Reserve Bank of India's decision to revive a plan, first mooted in 2007, to introduce credit default swaps (CDSs) in India has met with considerable apprehension.
CDSs along with another set of financial instruments described by a similar acronym,credit default obligations (CDOs), earned a fair share of notoriety during the global financial meltdown of 2008.
In fact, the collapse in the markets for these instruments was one of the key factors that brought the western banking to its knees.
The Indian central bank's critics would argue that in introducing this instrument, it has chosen to ignore the lessons of the financial crisis, a decision that it is likely to rue later.
The counter-argument is that instead of somewhat naively withdrawing into a shell of anti-market dogma, RBI has taken a far more nuanced view of the financial crisis and the lessons it has to offer.
This is incidentally not the first financial instrument that RBI will promote since the advent of the financial meltdown. It introduced both currency and interest rate futures in 2009.
The RBI's decision to go down the path of financial market development suggests that, in its assessment, it was not the existence of these instruments per se that precipitated the financial collapse in the western markets.
Instead, it was the over-sophistication of the markets (manifested in the creation of bewilderingly complex instruments and equally complex transactions) coupled with leveraged speculative positions that proved to be their undoing. This was abetted by a lax regulatory regime.
Credit default swaps are akin to insurance and offer protection against default by bond-issuers. The problem in the western markets was that CDSs were offered for all sorts of exotic, "structured" products like CDOs and mortgage-backed securities, not just for plain vanilla bonds.
This along with liberal guidelines for reporting these transactions severely compromised transparency.
Loose regulations meant that CDS purchases were not confined to actual holders of the underlying bonds or financial assets but were actually exploited by hordes of speculators to bet on the markets.
Of the notional value of outstanding CDSs of $45 trillion in 2007, $20 trillion was estimated to be "speculative".
RBI guidelines for CDSs in India guard against both these problems. CDSs can be offered only for simple corporate bonds and can be bought only by actual holders of the underlying assets.
Besides, the central bank has insisted on a standardised instrument and has laid down strict guidelines for reporting transactions to ensure transparency.
The payoff from a thriving CDS market can be significant.
Most importantly, by offering bond-holders a way to hedge risks, it can breathe life into the moribund corporate bond market.
The danger, ironically enough, is that in order to reduce systemic risk, RBI could "over-regulate" these new markets and effectively smother them.
This has happened with the interest rate futures market. RBI has taken a correct step in promoting new instruments.
It now has to strike a balance between regulatory vigilance and creating the right set of incentives to attract participants into these nascent markets.
