Introduction of Credit Default swaps for Corporate Bonds in India By Gagan Pareek Sameer Sanghavi
Credit default swap
A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of payments (often referred to as the CDS "fee" or "spread") to the protection seller, in exchange, receives a payoff if a credit instrument (typically a bond or loan) experiences a credit event.
Description Power Grid Bond = 10 Cr Purchaser = Mr. X Premium = 50 K Contract for 2 Years Bank = SBI Case 1: After paying both Year 1 and Year 2 premium nothing happens to Power Grid and so the contract expires. SBI gains 1 Lac. Case 2: After paying Yr 1 premium of 50K risk increases and company defaults. SBI gives Mr. X 10 Cr and takes bond.
No need to own the asset
Seller need not be a regulated entity
CDS contracts are generally subject to mark-to- market accounting, introducing income statement and balance sheet volatility
Insurance contracts require the disclosure of all known risks involved. CDSs have no such requirement. Most significantly, unlike insurance companies, sellers of CDSs are not required to maintain any capital reserves to guarantee payment of claim
Is CDS like Insurance ?
Used as a tool for hedging
If not controlled properly may cause unbridled speculation
2009 CDS Outstanding = $ 30.4 trillion
US Treasuries market = $ 4.4 trillion
Corporate bond market = $3.6 trillion
World's Richest person net worth = $53 billion
Apple Inc, cash pile = $46 billion
For sure, there isn't $30,400 billion of money out there that needs to be hedged, which is what the current size of CDS market is.
A loosely regulated credit derivatives market has allowed market participants to indulge in rampant speculation
CDS In India
Was tried by Govt. in Yr 2003 (lack of Credit regulation) and 2007 (Sub Prime Crisis)
On Aug 4 th 2010 RBI came up with final draft
Sold by banks and finance companies with a net worth of over Rs 500 Cr and bad loans of less than 3%.
Banks that intend to sell these swaps will need to have a capital adequacy ratio of at least 12% while for non-banks, the bar has been set higher at 15 %, according to the draft norms.
There are a number of ways because of which Indian CDS differ from CDS which bought down AIG in US
The protection can be sold against risks of a single issue. In the case of AIG, the protection was provided for a mortgage-backed security representing thousands of unknown home loans.
The protection can be bought by only those who actually hold the bonds. The global financial crisis was accentuated by the fact that many investors, who were not holding any bonds, bought protection betting on the default of a particular corporate.
RBI has severely restricted the number of parties that can offer or sell this product.
How is Indian CDS different from Foreign CDS ?
CDS shall be permitted only on corporate bonds as reference obligations and the reference entities shall be single legal resident entities.
Foreign banks and other lenders, which have the appraisal skills but not the resources to lend, can also gain by taking a credit exposure through CDS. The actual funding can come from some other bank which has the resources but does not want to take any credit risk.
CDS shall be permitted to be written on corporate bonds issued by Special Purpose Vehicle (SPV) of rated infrastructure companies
Users shall not, at any point of time, maintain naked CDS protection
Physical delivery is mandated in case of credit events, , adding users are prohibited from selling CDS
Proposes “rigorous audit” to ensure that buyers of CDS have underlying exposure, and to make “physical settlement” mandatory for CDS buyers.
“ All CDS trades shall have a RBI-regulated entity at least on one side,”
Market-makers cannot enter into CDS transactions without obtaining from the counterparty a copy of a resolution passed by their boards authorising it to transact in CDS
A Separate trading platform needs to be developed.
Related parties or banks and their subsidiaries cannot enter into CDS transactions between themselves
Protection sellers in the CDS market shall have in place internal limits on the gross amount of protection sold by them on a single entity as well as the aggregate of such individual gross positions.