CDS Derivatives Cannot Mitigate Financial Risks

Systematic risks are associated with every financial transaction, whether it is debt based credits or equity based finances. The practice of covering such risks through Credit Default Swaps (CDS) derivatives failed to mitigate risks at a time when the market collapsed due to large scale default swaps; rather it intensified the financial crisis.

After the global financial crisis the $55,000 billon CDS market has been found to be completely unregulated and lacking in transparency. AIG the world’s biggest underwriter of credit protection failed to deliver protection in time. The settlement auction on Lehman CDS contracts was a bombshell. Creditors got just nine cents on the dollar from the Lehman wreckage. Perversely the insured volume is greater than the $150 billion total of Lehman debt.

Risks cannot be covered by additional risks. If the bank needs protection to mitigate credit risk, it cannot be protected through CDS derivatives because there is a risk that the insurance company may also fail to protect the risks in case of large scale defaults. It should be noted that there are even times when the credit rating agencies could also be interested in taking undue advantages of such default swaps. In fact the risks for defaults of credits are shifted to insurance companies who also need protection through CDS derivatives and; when Swap starts from one point, it starts shifting to other points causing failure of all interlinked end points due to the process of shifting the risks instead of sharing them.

The better way to mitigate financial risks is to share it instead of shifting it on others. Islamic banking and financial instruments tend to share risks instead of shifting them, thus the inter-connected chain reaction in cases of huge defaults does not occur. Under Islamic banking and finance, the risks associated with products are shared by the investors and need not be shifted upon others. In case of any loss, that loss is meant for the investors and not for institutions or manager. It thus insulates the financial sector from multiplier effects of any financial loss if the systematic risks under equity finance were managed properly.

The working group’s report on ‘Introduction of Credit Derivatives in India’ was submitted to RBI by Shri B. Mahapatra in March 2003. By that time hardly anyone could have visualized that companies like AIG would ever fail. So, that report has not answered the question of what will happen if the Association of the Default Protection Sellers fails to stand as guarantor. Who can guarantee that the International Swaps and Derivatives Association, Inc. (ISDA) will never fail in providing security against any huge defaults by leading default protection sellers? If a company like AIG could fail, who will provide security if the Default Protection Sellers in India fail to perform? RBI should think thrice before allowing CDS derivative business in India, because if the US economy with a much larger market of CDS derivatives fell into one of its toughest financial crisis and is witnessing a negative growth rate, then how can we feel that India would be safer after the growth of a sophisticated CDS market?

After the global financial crisis, the need of mitigating credit risks by the Indian banks and insurance companies has intensified. But since the system of shifting risks through CDS derivatives has failed, it’s time to adopt instruments for sharing financial risks instead of shifting the risks through CDS derivatives. Our banks have been thus far safer from the global financial crisis, not only due to nationalization, but also for avoiding CDS derivatives. In fact CDS derivatives are like a paper umbrella that let the banks feel paper security, but fails when swaps start raining heavily.