Credit Derivatives - Techshristi · Credit Derivatives The development of credit derivatives is a...

11EX-013 Bishnu Kumar 11EX-015 Davinder Singh 11EX-040 Prateek Wadhwa 11EX-041 Priyanka Tyagi

Institute of Management Technology Ghaziabad

Credit Derivatives

Credit Derivatives

Institute of Management Technology, Ghaziabad 1

Table of Contents

Credit Derivatives .............................................................................................................................................. 2

A definition of Credit Derivative .................................................................................................................... 2

Types of Credit Derivatives ............................................................................................................................ 2

Risks of Credit Derivatives ............................................................................................................................. 3

Growth of Credit Derivatives ......................................................................................................................... 4

Credit Default Swaps ......................................................................................................................................... 5

Types of Credit Default Swaps ....................................................................................................................... 8

Settlement methods for CDS ......................................................................................................................... 9

Uses of Credit Default Swaps ........................................................................................................................ 9

CDS Pricing ................................................................................................................................................... 12

Credit Derivatives Market in India ................................................................................................................... 12

Benefits from Credit Derivatives ................................................................................................................. 13

Participants in the Indian Market ................................................................................................................ 13

Minimum Conditions ................................................................................................................................... 13

Draft CDS Guidelines ................................................................................................................................... 14

Participants allowed .................................................................................................................................... 14

CDS & its settlement in India ........................................................................................................................... 16

Role of CCIL ...................................................................................................................................................... 17

First Credit Default Swap in India .................................................................................................................... 18

References………………………………………………………………………………………………………………………………………………….19

Credit Derivatives


Credit Derivatives

The development of credit derivatives is a logical extension of the ever-growing

array of derivatives trading in the market. The concept of a derivative is to create a contract that transfers some risk or some volatility. Credit derivatives apply the same notion to a credit asset. Credit asset is the asset that a provider of credit creates, such

as a loan given by a bank, or a bond held by a capital market participant. A credit derivative enables the stripping of the loan or the bond, from the risk of default, such

that the loan or the bond can continue to be held by the originator or holder thereof, but the risk gets transferred to the counterparty. The counterparty buys the risk obviously for a premium, and the premium represents the rewards of the

counterparty. Thus, credit derivatives essentially use the derivatives format to acquire or shift risks and rewards in credit assets, viz., loans or bonds, to other financial

market participants.

A definition of Credit Derivative

Credit derivatives can be defined as arrangements that allow one party (protection

buyer or originator) to transfer, for a premium, the defined credit risk, or all the credit risk, computed with reference to a notional value, of a reference asset or assets, which it may or may not own, to one or more other parties (the protection sellers).

So here the protection buyer continues to hold the reference asset (loan or bond) and protection seller holds the risk associated with the asset (loan or bond) also called

as holding synthetic asset. The protection seller holds the risk of default, losses, foreclosure, delinquency, prepayment, etc. and the reward of premium. There could be two possible ways of settlement in case of credit event. In first case, physical

settlement, protection seller gives the par value of asset to the protection buyer and protection buyer hands over the asset to the protection seller. Whereas in second

case, cash settlement the difference between the par value of the asset and the market value of the asset is given by protection seller to the protection buyer.

Types of Credit Derivatives

Some of the fundamental types of credit derivatives are credit default swap, total

return swap, credit linked notes, and credit spread options. Credit Default Swaps: A credit default swap (CDS) is a credit derivative contract

between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults. Credit default

swaps are the most important type of credit derivatives in use in the market. Total Return Swaps: As the name implies, a total return swap is a swap of the

total return out of a credit asset swapped against a contracted prefixed return. The total return out of a credit asset is reflected by the actual stream of cash-flows from

the reference asset as also the actual appreciation/depreciation in its price over time, and can be affected by various factors, some of which may be quite extraneous to the asset in question, such as interest rate movements. Nevertheless, the protection

seller here guarantees a prefixed spread to the protection buyer, who in turn, agrees to pass on the actual collections and actual variations in prices on the credit asset to

Credit Derivatives


the protection seller. Total Return Swap is also known as Total Rate of Return Swap (TRORS).

Credit Linked Notes: It is a security with an embedded credit default swap

allowing the issuer (protection buyer) to transfer a specific credit risk to credit investors. CLNs are created through a Special Purpose Vehicle (SPV), or trust, which is collateralized with securities. Investors buy securities from a trust that pays a fixed or

floating coupon during the life of the note. At maturity, the investors receive par unless the referenced credit defaults or declares bankruptcy, in which case they

receive an amount equal to the recovery rate. The trust enters into a default swap with a deal arranger. In case of default, the trust pays the dealer par minus the recovery rate in exchange for an annual fee which is passed on to the investors in the

form of a higher yield on the notes.

Credit Spread Options: A financial derivative contract that transfers credit risk from one party to another. A premium is paid by the buyer in exchange for potential cash flows if a given credit spread changes from its current level. The buyer of credit

spread put option hopes that credit spread will widen and credit spread call buyer hopes for narrowing of credit spread. It can be viewed as similar to that of credit

default swaps but it hedges also against credit deterioration along with default. Consider the buyer of credit spread put: he/she pays a premium for the put. If the

bond (the reference entity) deteriorates, the spread on the bond will increase and the buyer will profit. But if the bond quality increases, the credit spread will narrow, bond price will decrease, and the put will be worthless (i.e., put buyer has lost the

premium). In summary, the credit spread put buyer wants to hedge against price deterioration and/or default risk of the obligation.

The payoff is -

Duration (D) x Notional (N) x [credit spread (-) strike spread; CS - K].

Risks of Credit Derivatives Various risks associated with credit derivatives are credit risk, market risk, and

legal risk.

Credit Risk: The protection seller is having a credit risk related to underlying reference asset because protection seller synthetically holds the asset and needs to do due diligence to counter this risk. Another risk is associated is counterparty risk

against protection seller if he fails to make good of his obligations. Market Risk: Market risk is associated with credit derivatives traders as the prices

of the instruments are a function of interest rates, the shape of the yield curve, and

Credit Derivatives


credit spread. Other types of risks involved are marking to market risk, margin call risks, etc.

Legal Risk: Lack of standard documentation and agreement as to the definitions of

credit event leads to legal risks. Usage of master agreements though has simplified and homogenized the trading of credit derivatives. More efforts are being taken recently to counter this risk with International Swaps and Derivatives Association

(ISDA) taking active role in it. The most important legal issues still revolves around the nature of credit event and the nature of obligations.

Growth of Credit Derivatives

Within no time credit derivatives have grown to a great extent to be a big part of derivatives segment after interest rate contracts (82% Q4‟08) and foreign exchange

contracts (8.4% Q4‟08) as per notional amounts outstanding (Credit derivatives – 7.9% Q4‟08.

Much of the significance credit derivatives enjoy today is because of the

marketability imparted by securitization. A securitized credit derivative, or synthetic securitization, is a device of embedding a credit derivative feature into a capital

market security so as to transfer the credit risk into the capital markets. The synthesis of credit derivatives with securitization methodology has complimented each other. This had allowed keeping the portfolio of assets on the books but transferring the

credit risk associated with it. The index products have also contributed to the increasing popularity of credit derivatives. It provides a means to buy or sell exposure

to a broad-based indices, or sub-indices diversifying the risks instead to buying or selling exposure to the credit risk of a single entity.

The third important factor contributing to the growth of credit derivatives is structured credit trading or tranching. Here the portfolio of assets is divided into various subclasses known as tranches (means slice in French) to fulfill the risk

appetite of various investors. The tranches are divided into various levels like senior tranche, mezzanine tranche, subordinate tranche, and equity tranche with the risk of

default rising in a sequence for these tranches. Talking about the growth of credit derivatives from year-end 2003 to 2008, credit derivative contracts grew at a

100% compounded annual growth rate. But due to the global turmoil the growth

has been curtailed from the end of 2007.

The composition of credit derivatives

is shown in the figure. As can be seen credit default swaps dominates the

composition of credit derivatives followed by total return swaps. The composition of credit default swaps

sometimes makes people believe that credit derivatives are nothing but credit

default swaps.

Credit Derivatives


Credit Default Swaps

Origin of CDS

By the mid-'90s, JPMorgan's books were loaded with billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. But what if JPMorgan

could create a device that would protect it if those loans defaulted, and free up that capital? And the solution they come up with is nothing but the origin of “Credit Default

Swap”. Credit Default Swap (CDS) is some sort of insurance policy where the third party

assumes the risk of debt going sour and in exchange will receive regular payments

from the bank who issues debt, similar to insurance premiums. Although the idea was floating for a while JP Morgan was the first bank to make a bet on CDS. They opened

up a Swap desk in mid-„90s and formally brought the idea of CDS into reality.

Definition

A credit default swap (CDS) is a credit derivative contract between two

counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.

There are three parties involved in a typical CDS contract – 1. Protection Buyer (Risk Hedger)

2. Protection Seller 3. Reference Entity

Protection buyer is the one who pays a premium (CDS spread, generally a quarterly premium) to the protection seller for taking credit risk to a reference entity and if the

credit event happens then protection seller will have to pay off. Typical credit events include – material default, bankruptcy, and debt restructuring. The size of the payment is usually linked to the decline in the reference asset‟s market value

following the credit event. The concept of CDS is explained pictorially in Figure 1.

The interesting thing about CDS market is you don‟t need to own the underlying reference entity to get into the contract. Such contract is known as naked CDS. Just like any derivatives market CDS can be used for speculation, hedging and arbitrage

purpose.

Significance of Credit Default Swaps

CDS creates Liquidity: The CDS adds depth to the secondary market of underlying credit instruments which may not be liquid for many reasons.

Risk Management: Credit derivatives makes risk management more efficient and flexible by allocation of credit risk to most efficient manager of that risk.

Risk Separation: Credit derivatives allows for separation of credit risk from other risks of the asset.

Reliable funding source: Credit derivatives help exploit a funding advantage or

avoiding a funding disadvantage. Since there is no up-front principal outlay required for most Protection Sellers when assuming a Credit Swap position, these provide an

Credit Derivatives


opportunity to take on credit exposure in off balance-sheet positions that do not need to be funded. On the other hand, institutions with low funding costs may capitalize on

this advantage by funding assets on the balance sheet and purchasing default protection on those assets. The premium for buying default protection on such assets

may be less than the net spread such a bank would earn over its funding costs.

Figure 1

CDS Premium

Premium prices – also known as fees or credit default spreads – are quoted in basis

point per annum of the contract‟s notional value. In case of highly distressed credits in

which CDS market remains open upfront premium payment is a common thing. The CDS spread is inversely related to the credit worthiness of the underlying reference

entity.

CDS Size & Price There are no predetermined limits on the size or maturity of CDS contracts, which

have ranged in size from a few million to several billions of dollars. In general the contracts are concentrated in the $10 million to $20 million range with maturities of

between one and 10 years, although 5 years maturities are the most common.

Credit Derivatives


Inevitably, the maturity of a CDS will depend on the credit quality of the reference entity, with longer-dated contracts of five years and more only written on the best-

rated names. Although there are differences in the quotes given by banks on CDS prices due to some technical reasons rather than financial reasons, but the CDS

premium price more or less remains the same. Over and above a valuation of credit risk, probability of default, actual loss incurred, and recovery rate, the various factors in determination of CDS premium are – liquidity, regulatory capital requirements,

market sentiments and perceived volatility, etc.

Trigger Events

The market participants view the following three to be the most important trigger

events:

Bankruptcy

Failure to Pay Restructuring

Bankruptcy, the clearest concept of all, is the reference entity‟s insolvency or inability to repay its debt. Failure-to-Pay occurs when the reference entity, after a

certain grace period, fails to make payment of principal or interest. Restructuring refers to a change in the terms of debt obligations that are adverse to the creditors.

Growth of CDS Market

Since the inception of the CDS market its growth has been astounding. The growth of CDS market over the period has been shown in the figure. As the market matured, CDSs came to be used less by banks seeking to hedge against default and more by

investors wishing to bet for or against the likelihood that particular companies or portfolios would suffer financial difficulties as well as those seeking to profit from

perceived mispricing; the rapid growth of index compared with single name CDS after 2003 reflected this change.

The market size

for Credit Default Swaps began to grow

rapidly from 2003; by the end of 2007, the CDS market had

a notional value of $62 trillion (as seen

in the above figure). But notional amount began to fall during

2008 as a result of dealer "portfolio

compression" efforts, and by the end of 2008 notional

amount outstanding had fallen 38 percent

to $38.6 trillion.

Credit Derivatives


It is important to note that since default is a relatively rare occurrence (historically around 0.2% of investment grade companies would default in any one year) in most

CDS contracts the only payments are the spread payments from buyer to seller. Thus, although the above figures for outstanding notional amount sound very large, the net

cash flows will generally only be a small fraction of this total. Currently CDS dominates the credit derivatives market with its unprecedented

growth. Although after the subprime crisis (which will be discussed later) the credit

derivatives market, in the 4th quarter of 2008, reported credit derivatives notionals declined 2%, or $252 billion, to $15.9 trillion, reflecting the industry‟s efforts to

eliminate many offsetting trades (Reference: OCC‟s Quarterly Report).

As shown in the chart above CDS represent the dominant product at 98% of all

credit derivatives notionals. As we can see from the other chart although majority of the CDSs composition is dominated by the investment grade CDSs sub-investment

grade CDSs also forms a significant part of CDSs (34%) which is considered to be one of prime cause for subprime crisis. Considering the global OTC market, the CDS accounts for about 8%.

Types of Credit Default Swaps

The CDSs can be classified as Single-name CDSs or Multi-name CDSs.

Single-name CDS: These are credit derivatives where the reference entity is a single name.

Multi-name CDS: CDS contracts where the reference entity is more than

one name as in portfolio or basket credit default swaps or credit default swap

indices. A basket credit default swap is a CDS where the credit event is the default of some combination of the credits in a specified basket of credits. In

the particular case of an nth-to-default basket it is the nth credit in the basket of reference credits whose default triggers payments.

Another common form of multi-name CDS is that of the “tranched” credit default swap. Variations operate under specifically tailored loss limits – these may include a

Credit Derivatives


“first loss” tranched CDS, a “mezzanine” tranched CDS, and a senior (also known as a “super-senior”) tranched CDS.

Settlement methods for CDS

The settlement for CDSs can be done in either of two ways: Physical Settlement or

Cash Settlement.

Physical Settlement: The seller of the protection will buy back the distressed

reference entity at par. Clearly given that the credit event will have reduced the secondary market value of the underlying reference entity, this will result in protection seller (CDS seller) incurring a loss. This was the most common means

for the settlement in CDSs and will generally take place no later than 30 days after the credit event. Till 2006 ISDA2 allowed settlement only in the form of

physical settlement. But due to increased amount of naked CDSs in the credit market ISDA has now allowed the choice between cash and physical settlement.

Cash Settlement: The seller of the protection will pay the buyer the difference between the notional of the default swap and a final value for the same notional

of the reference obligation. Cash settlement is less prevalent because obtaining precise quotes can be difficult when the reference credit is distressed. After the Auction process being started for the settlement of CDSs as per ISDA, this

problem has been resolved.

The example for the Physical and Cash settlement shown below will explain the process.

Uses of Credit Default Swaps

As mentioned already CDSs can be used for speculation, hedging or arbitrage. Out of which we will be considering

hedging and speculation in detail.

CDS for Hedging

When JP Morgan invented the credit instrument named CDS they meant it to be for

hedging their credit risk. Although market has changed a

lot since then but still the use of CDSs for hedging purpose remains to be a primary

reason. Credit default swaps are

often used to manage the credit risk (i.e. the risk of default) which arises from

holding debt. Typically, the

Credit Derivatives


holder of, for example, a corporate bond may hedge their exposure by entering into a CDS contract as the buyer of protection. If the bond goes into default, the proceeds

from the CDS contract will cancel out the losses on the underlying bond. For example, if you own a bond of Apple worth $10 million maturing after 5 years

and you are worried about its future then you can create a CDS contract with an insurance company like AIG which will charge a premium of say 200bps annually for insuring your bond. In this way you are hedging the risk of losing $10 million in case

Apple goes bankrupt. Here you will be paying $200000 to AIG for insuring your bond. If Apple goes bankrupt you will receive the par value of bond from AIG and even if

does not, you will lose premium value at the most which is worth transferring the risk to AIG.

Counterparty Risks

When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk. Examples of counter party risks:

The buyer takes the risk that the seller will default. If reference entity and seller default simultaneously ("double default"), the buyer loses its protection against

default by the reference entity. If seller defaults but reference entity does not, the buyer might need to replace the defaulted CDS at a higher cost.

The seller takes the risk that the buyer will default on the contract, depriving the seller of the expected revenue stream. More important, a seller normally limits its risk by buying offsetting protection from another party - that is, it hedges its

exposure. If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party.

Depending on market conditions, that may be at a lower price than the original CDS and may therefore involve a loss to the seller.

As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk. If one or both parties to a CDS contract must post collateral (which is

common), there can be margin calls requiring the posting of additional collateral. The required collateral is agreed on by the parties when the CDS is first issued. This margin amount may vary over the life of the CDS contract, if the market price of the

CDS contracts changes, or the credit rating of one of the party‟s changes.

CDSs for Speculation

Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market indexes such as the North American CDX index3 or the

European iTraxx index4. An investor might speculate on an entity's credit quality, since generally CDS spreads will increase as credit-worthiness declines and decline as

credit-worthiness increases. The investor might therefore buy CDS protection on a company in order to speculate that the company is about to default. Alternatively, the investor might sell protection if they think that the company's creditworthiness might

improve. As there is no need to own an underlying entity to enter into a CDS contract it can be viewed as a betting or gambling tool.

For example if you feel that Microsoft is not performing well and may go bankrupt in near future then you might enter into a CDS contract with AIG for a notional value of $10 million for 5 years even if you don‟t own a single share of Microsoft. This kind

of CDS is known as Naked CDS.

Credit Derivatives


Changing Nature of CDS Market towards Speculation

CDS was originally meant for hedging but as market matured the market has moved more towards using it for speculation purpose. Speculation entered the CDS

market in three forms: 1) using structured investment vehicles such as MBS, ABS, CDO and SIV securities as the underlying asset, 2) creating CDS between parties without any connection to the underlying asset, and 3) development of a secondary

market for CDS. Much has been written about the structured investment vehicle market and the lack

of understanding of what was included in the various products. Sellers of protection in the CDS market more than likely did not have sufficient understating of the underlying asset to determine an appropriate risk profile (plus there was no history of these

products to assist in determining a risk profile). As it has become clear, the structured investment vehicle market was a speculative market which was not really understood

which led to speculative CDS related to these products. A larger problem is the pure speculation in the CDS market. Many hedge funds and

investment companies started to write CDS contracts without owning the underlying

security, but were just a "bet" on whether a "credit event" would occur. These CDS contracts created a way to "short" sell the bond market, or to make money on the

decline in the value of bonds. Many hedge funds and other investment companies often place "bets" on the price movement of commodities, interest rates, and many

other items, and now had a vehicle to "short" the credit markets. [Actually CDS can be viewed as short in bond and buying a put option. Because in

the case of default protection buyer will have to give the underlying reference entity (bond) to the protection seller (in case of physical settlement) so shorting the bond.

While protection seller will have to pay the par amount to protection buyer in case of default hence can be viewed to be a put option. The payout to credit protection buyer can be described as –

Asset value at the time of swap – Asset market value; Payout to investor = if default

0; if no default So above expression can be viewed as binary put option based on two states of the

world: default and no default.] A still larger problem was the development of a secondary market for both legs of

the CDS product, particularly the seller of protection. The problem may be that a "weak link" would occur in the chain of sales even if the CDS terms are the same. The "weak link" is often a speculative buyer that offers to sell protection, but, in fact, is

just looking to quickly turn the product to another investor. This problem becomes particularly acute when the CDS is based on structured investment vehicles and firms

looking for a quick profit. An insurance company may unknowingly be pulled into one of these speculative

aspects of the CDS market. The insurance company would be viewed as "the deep

pocket" and may be asked (or sued) to recover losses by the buyer of protection.

Credit Derivatives


CDS is not insurance

In many terms CDS is like an insurance policy where there is a regular premium to be paid, there is a reference entity and in case of default a pay-off will be paid. But

CDS differs in many aspects from insurance like – The seller need not be a regulated entity The seller is not required to maintain any reserves to pay off buyers, although

major CDS dealers are subject to bank capital requirements (because CDS dealers are generally banks).

Insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond

markets. In the United States CDS contracts are generally subject to mark to market

accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract.

The buyer of a CDS does not need to own the underlying security or other form

of credit exposure; in fact the buyer does not even have to suffer a loss from the default event. By contrast, to purchase insurance the insured is generally

expected to have an insurable interest such as owning a debt.

CDS Pricing

The main aim of CDS pricing is to calculate the amount of premium to be paid by

protection buyer to the protection seller. For calculating the CDS premium we need to know the Recovery Rate and Probability of Default. Simple explanation of calculating

CDS premium (spread) for a 1-year CDS contract (with yearly premium) is shown below.

Let S = CDS premium (spread), p = probability of default, R = recovery rate.

The protection buyer expects to pay S. And his expected payoff is (1-R) p. When the two parties enter a CDS contract, S is set so that the value of swap

transaction is zero. That is, S = (1-R) p

Credit Derivatives Market in India Banks are major players in the credit market and are, therefore, exposed to credit

risk. Credit market is considered to be an inefficient market with market players like

banks and financial institutions mostly have loans and little of bonds in their portfolios while mutual funds, insurance companies, pension funds and hedge funds have mostly

bonds in their portfolios, with little access to loans, depriving them of high returns of loans portfolios. The market in the past did not provide the necessary credit risk protection to banks and financial institutions. Neither did it provide any mechanism to

the mutual funds, insurance companies, pension funds and hedge funds to have an access to loan market to diversify their risks and earn better return. Credit derivatives

were, therefore, developed to provide a solution to the inefficiencies in the credit market. Internationally, banks are able to protect themselves from the credit risk

through the mechanism of credit derivatives. However, credit derivative has not yet been used by banks and financial institutions in India in a formal way.

Credit Derivatives


Benefits from Credit Derivatives

Banks and Financial Institutions currently require a mechanism that would allow them to provide long term financing without taking the credit risk if they so desire.

Currently banks and financial institutions need to hold their portfolios on books depriving them of diversifying the portfolio as well as making them forgo some of the opportunities. Also non-banking institutions loses on some of the opportunities of

holding high yielding portfolios like loans. Credit derivatives would help resolve these issues. Banks and the financial

institutions derive four main benefits from credit derivatives, namely: Credit derivatives allow banks to transfer credit risk and hence free up capital,

which can be used in productive opportunities.

Banks can conduct business on existing client relationships in excess of exposure norms and transfer away the risks.

Banks can construct and manage a credit risk portfolio of their own choice and risk appetite unconstrained by funds, distribution and sales effort. Banks can acquire exposure to, and returns on, an asset or a portfolio of assets by simply

writing a credit protection. Credit risk would be diversified – from banks/FIs alone to other players in the

financial markets and lead to financial stability. Apart from above mentioned benefits credit derivatives also provides better liquidity

than the existing mechanisms of managing the risks like insurance, guarantee, securitization, etc. It also allows financial intermediaries to gain access to high gain

portfolios.

Participants in the Indian Market In order to ensure that the credit market functions efficiently, it is important to

maximize the number of participants in the market to encompass banks, financial

institutions, NBFCs (all regulated by RBI), mutual funds, insurance companies and corporates.

Minimum Conditions As per Report of the Working Group on Introduction of Credit Derivatives in India

by Department of Banking Operations and Development the bank should fulfill minimum conditions relating to risk management processes and that the credit

derivative should be direct, explicit, irrevocable and unconditional. These conditions are explained below.

Direct: The credit protection must represent a direct claim on the protection

provider. Explicit: The credit protection must be linked to specific exposures, so that the

extent of the cover is clearly defined and incontrovertible. Irrevocable: Other than a protection purchaser‟s non-payment of money due in

respect of the credit protection contract, there must be no clause in the contract

that would allow the protection provider unilaterally to cancel the credit cover. Unconditional: There should be no clause in the protection contract that could

prevent the protection provider from being obliged to pay out in a timely manner in the event that the original obligor fails to make the payment(s) due.

Credit Derivatives


Draft CDS Guidelines Reserve Bank of India (RBI) has come out with draft guidelines on Credit Default

Swap (CDS) per notification dated May 2007. The details of which are as follows:

Participants allowed

Protection Buyers:

Commercial banks and Primary dealers A protection buyer shall have an underlying credit risk exposure in the form of

permissible underlying asset / obligation

Protection Sellers: Commercial banks and Primary dealers RBI will consider allowing insurance companies and mutual funds as protection

buyer or protection seller as and when their respective regulators permit them to transact in credit default swaps.

Product Requirements:

Structure: A CDS may be used – By the eligible protection buyers, for buying protection on specified loans and

advances, or investments where the protection buyer has a credit risk exposure. By the eligible protection sellers, for selling protection on specified loans and

advances, or investments on which the protection buyer has a credit risk

exposure.

Settlement Methods: Physical Settlement

Cash Settlement Fixed Amount Settlement (binary CDS)

Documentation:

1992 or 2002 ISDA Master Agreement compliance. 2003 ISDA Credit Derivatives Definitions and subsequent supplements to

definitions compliance.

Documenting the establishment of the legal enforceability of the contracts in all relevant jurisdictions before undertaking CDS transactions.

Credit Events: Bankruptcy

Obligation Acceleration Obligation Default

Failure to pay Repudiation/ Moratorium Restructuring

Credit Derivatives


Minimum Requirements: A CDS contract must represent a direct claim on the protection seller and must

be explicitly referenced to specific exposures of the protection buyer, so that the extent of the cover is clearly defined and indisputable. It must be

irrevocable. The CDS contract shall not have any clause that could prevent the protection

seller from making the credit event payment in a timely manner after

occurrence of the credit event and completion of necessary formalities in terms of the contract.

The protection seller shall have no recourse to the protection buyer for losses. The credit events specified in the CDS contract shall contain as wide a range of

triggers as possible with a view to adequately cover the credit risk in the

underlying / reference asset and, at a minimum, cover – o Failure to pay

o Bankruptcy, insolvency or inability of the obligor to pay its debts o Restructuring of the underlying obligation involving forgiveness or

postponement of principal, interest or fees that results in a credit loss

event CDS contracts must have a clearly specified period for obtaining post-credit-

event valuations of the reference asset, typically no more than 30 days The credit protection must be legally enforceable in all relevant jurisdictions

The underlying asset/ obligation shall have equal seniority with, or greater seniority than, the reference asset/ obligation.

The protection buyer must have the right/ability to transfer the reference/

deliverable asset/ obligation to the protection seller, if required for settlement (in case of physical settlement).

The credit risk transfer should not contravene any terms and conditions relating to the reference / deliverable / underlying asset / obligation and where necessary all consents should have been obtained.

The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a

failure to pay. The grace period in the credit derivative contract must not be longer than the grace period agreed upon under the loan agreement.

The identity of the parties responsible for determining whether a credit event

has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the

right/ability to inform the protection seller of the occurrence of a credit event. Where there is an asset mismatch between the underlying asset/ obligation and

the reference asset/ obligation then:

o The reference and underlying assets/ obligations must be issued by the same obligor (i.e. the same legal entity)

o The reference asset must rank pari passu or more junior than the underlying asset/ obligation; and

o There are legally effective cross-reference clauses between the reference

asset and the underlying asset.

Credit Derivatives


Risk Management:

Banks should consider carefully all related risks and rewards before entering the

credit derivatives market. They should not enter into such transaction unless their management has the ability to understand and manage properly the credit and other risks associated with these instruments. They should establish sound

risk management policy and procedures integrated into their overall risk management.

Banks which are protection buyers should periodically assess the ability of the protection sellers to make the credit event payment as and when they may fall due. The results of such assessments should be used to review the counterparty

limits. Banks should be aware of the potential legal risk arising from an unenforceable

contract, e.g. due to inadequate documentation, lack of authority for a counterparty to enter into the contract, etc.

The credit derivatives activity to be undertaken by bank should be under the

adequate oversight of its Board of Directors and senior management (via a copy of a resolution passed by their Board of Directors or via adequate MIS).

Procedures: The bank should have adequate procedures for:

Measuring, monitoring, reviewing, reporting and managing the associated risks. Full analysis of all credit risks to which the banks will be exposed, the

minimization and management of such risks.

Ensuring that the credit risk of a reference asset is captured in the bank‟s normal credit approval and monitoring regime.

Management of market risk associated with credit derivatives held by banks in their trading books by measuring portfolio exposures at least daily using robust market accepted methodology.

Management of the potential legal risk arising from unenforceable contracts and uncertain payment procedures.

Determination of an appropriate liquidity reserve to be held against uncertainty in valuation.

Now after understanding the need for credit derivatives and the draft guidelines provided by RBI we will now understand the possible settlement procedures to be

adopted for CDS contracts.

CDS & its settlement in India

The Reserve Bank of India (RBI) has taken the first step towards introducing credit default swaps (CDS) to India‟s financial markets by sending out feelers to a number of

banks with a view to gauging the acceptability of CDS contracts. The questionnaire sent by RBI to the banks enquires about bankers‟ expectations from the derivative instrument. Although CDSs for the Indian companies like ICICI Bank, Tata Motors, SBI

etc. are already traded in US and some Asian market it is yet to be traded in Indian market. And RBI is looking at CDS for debt issued in the domestic market. The move

by RBI to launch CDS in India is considered significant considering its cautious nature and the role CDS played in subprime crisis. The move is welcomed by some of the banks. “There is surely a need for such a product (CDS)” said Ashish Vaidya, head of

Credit Derivatives


interest rate trading at HDFC Bank. “Indian regulators have the benefit of learning from the difficult experience (in derivatives) in the West and can build in a robust

system that effectively curtails the concentration of risks in a few hands”. RBI expects to develop the corporate bond market through the introduction of CDS contracts.

CDS Settlement in India:

The CDS market will be an OTC market in India which means the deals between

the protection buyer and the protection seller will be bilateral deals making them do the negotiation and pricing for the CDS contracts.

In the infancy stage of CDS market in India one can have a trade reporting platform which will be gathering all the information about the trades happening. This will provide the required transparency and help in gaining the confidence in

the product. Once the market matures one can think of having an electronic order matching

platform with central counterparty settlement (like CCIL).

Role of CCIL

The Clearing Corporation of India (CCIL) was set up with the prime objective to improve efficiency in the transaction settlement process, insulate the financial system

from shocks emanating from operations related issues, and to undertake other related activities that would help to broaden and deepen the Money, Gilts and Forex markets in India. The role of CCIL is unique as it provides settlement of three different

products under one umbrella. It has been instrumental in setting up and running electronic trading platforms like NDS-OM, NDS-Call and NDS-Auction system for the

central bank that had helped the Indian market to evolve and grow immensely. It had also immensely bolstered CCIL's image in terms of ability to provide transparent, efficient, robust and cost effective end to end solutions to market participants in

various markets. The introduction of ClearCorp14 Repo Order Matching System (CROMS), an anonymous Repo trading platform, has also changed the trading pattern

in Repo market i.e. shifting of interest from specific security to basket of securities. The success of its money market product 'CBLO' has helped the market participants as well as RBI to find a solution to unusual dependence on uncollateralized call market.

The total settlement volume during 2009-10 in government securities, forex market and CBLO stood at Rs.14934 billion, Rs.25424 billion, and Rs.20433 billion

respectively. The CCIL already has the necessary infrastructure for the settlement of OTC

products like interest rate swaps and forward rate agreement. CCIL already has a

trade reporting platform for IRS which provides non-guaranteed settlement for the reported trades. Now CCIL is moving towards the guaranteed settlement of IRS which

will involve trade matching, initial and MTM margining, exposure check, novation, multilateral netting, default handling etc. On this backdrop one can say CCIL is well

equipped with all its experience to act as central counterparty for the settlement of CDS contracts.

But before the introduction of CDS contracts in India, there are some issues that

need to be handled for the effective CDS market. Those are – Although RBI has allowed insurance companies and mutual funds as protection

buyer or protection seller, the permission of respective regulators needs to be addressed quickly before making CDS market open. Otherwise it may obstruct the stipulated expeditious growth of the CDS in India and will also defeat the

Credit Derivatives


purpose of CDS, i.e., to maximize the number of participants in the market and transmit the credit risk from the banking system to other risk seeking financial

entities. As per the draft guidelines provided by RBI restructuring is considered as a credit

event which has created many legal disputes in the global CDS market. Considering the complexities associated with the restructuring, restructuring as a credit event has been removed from North American CDS contracts. So more

clear information on restructuring as credit event is required. As CDS contract in India is only allowed if the protection buyer bears the loss

making it similar to insurance. Considering this close proximity of CDS contract with that of insurance contract, CDS contract should be made to be out of the purview of regulations of insurance contract making it incontrovertible.

Although CDS has helped in perforation of subprime crisis which has created

negative vibes about CDS but CDS as in instrument is very effective means of hedging your risk. And in India it is expected to provide the needed push to the corporate bond market. So it won‟t be long for the CDS market to pick up in India.

First Credit Default Swap in India

The first credit-default-swap trades offering protection on Indian corporate bonds were completed on Dec 7, 2011, according to separate statements from India's IDBI Bank and ICICI Bank.

IDBI said it underwrote one CDS transaction and ICICI said it was responsible for another. The combined trade sizes totalled $1.9 million, according to the Clearing

Corporation of India, Ltd., and comprised a pair of trades each worth 50 million rupees.

The protection was sold on bonds issued by India's Rural Electrification Corp. Ltd., a

lender to the power sector, and Indian Railway Finance Corp. Ltd. The buyers of protection paid 90 basis points. One basis point translates to $1,000

a year on a derivatives contract used to protect $10 million of debt against default for five years.

Credit Derivatives


References -Investopedia.com

-Introduction to Credit Derivative Article by Vinod Kothari -hereisthecity.com

-Futures and Options by J.C. Hull -RBI warms up to credit default swaps”, The Economic Times, dated 30 June 2009 -OCC‟s Quarterly Report

-ISDA -Call Reports

-CCIL

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