This document discusses whether credit default swaps (CDS) should be introduced in India. It begins by explaining what CDS are and how they work. It then discusses the growth of the global CDS market and how CDS are used for hedging credit risk and speculation. It notes that India's corporate debt market is much smaller than other countries. The document evaluates the current state of CDS regulation in India and concludes that CDS should be introduced in India to help develop its debt markets, allow for more efficient pricing of credit risk, and enable broader participation in the markets. It recommends starting with exchange-traded single-name CDS of 5-year maturity that are cash settled.

1. Should Credit Default Swaps be Introduced in India
Shuvabrata Nandi, IIM Ahmedabad
A. Introduction
Simply put, a credit default swap (CDS) is a kind of insurance against credit risk. Credit
default swaps (CDS) are the most widely used type of credit derivative and are a powerful
force in the world financial markets. The first CDS contract was introduced by JP Morgan in
1997 and by middle of 2007 the value of the market (in terms of the total notional of CDS
outstanding) had ballooned to an estimated $45 trillion, according to the International Swaps
and Derivatives Association (ISDA), which interestingly is more than twice the size of the
U.S. equity market. The current notional of the all CDS contracts is assumed to be around $
62 trillion by the ISDA.
CDS contracts are in the centre of a major controversy after the recent financial crisis
unravelled itself (especially with the bailout of AIG due to huge CDS exposure), receiving a
lot of flak from regulators and common investors alike. Before we get into the details of the
reasons for the existence of a huge CDS market and the purpose it serves, we would have a
look at the basics of a credit default swap and its features and nuances. We would then look
at the ways at which CDS can be used to speculate, and how these simple looking credit
insurance can potentially destabilise the financial system itself. A brief look at the state of
Indian corporate debt market is also required to understand the whether there exists a need for
credit default swaps in India. Finally, we have a look at the current regulatory stance on CDS
in India and how has it evolved in the past, and we conclude on the decision to introduce
CDS in India.
B. Credit Default Swap Basics
A credit default swap is a privately negotiated bilateral contract. The buyer of protection pays
a fixed fee or premium to the seller of protection for a period of time (most liquid contracts
are for 5 years) and if certain pre-specified “credit events” occur the protection seller pays
compensation to the protection buyer. The premium paid by the protection buyer to the seller,
often called “spread,” is quoted in basis points per annum of the contract’s notional value and
is usually paid quarterly. Periodic premium payments allow the protection buyer to deliver
the defaulted bond at par or to receive the difference of par and the bond’s recovery value.
Therefore, a CDS is like a put option written on a corporate bond. Like a put option, the
protection buyer is protected from losses incurred by a decline in the value of the bond as a
result of a credit event. Accordingly, the CDS spread can be viewed as a premium on the put
option, where payment of the premium is spread over the term of the contract. It is important
to note that the CDS contract is not actually tied to a bond, but instead references it. For this
reason, the bond involved in the transaction is called the "reference entity." A contract can
reference a single credit, or multiple credits. (Nomura CDS Primer)
The 2003 ISDA Credit Derivatives Definition provide for six kinds of “credit events” -
Bankruptcy, Failure to pay, Repudiation / Moratorium, Obligation Acceleration, Obligation
Default, and Restructuring.
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2. However, for market participants, bankruptcy, failure to pay and restructuring are the most
significant credit events. It is also important to note that a written admission of a company’s
inability to pay its debt must be made in a judicial, regulatory or administrative filing. ISDA
master agreement for CDS includes four different ways to treat restructuring as well – No
Restructuring (NR), Full Restructuring, Modified Restructuring and Modified Modified
Restructuring. (ISDA Credit Derivative Definitions, 2003)
So, once a credit event happens, the buyer or the seller delivers a “Credit Event Notice”.
Then, compensation is to be paid by the protection seller to the buyer via either
1. Physical settlement - the protection seller buys the distressed loan or bond from the
protection buyer at par. Here the bond is called the “deliverable obligation”,
Or
2. Cash settlement - the payment is determined as the difference between the notional of
the CDS and the final value of the reference obligation for the same notional.
C. Evolution of Global CDS Market
The CDS market is an important market that has grown dramatically over a short period of
time. The market originally started as an inter-bank market to exchange credit risk without
selling the underlying loans but now involves financial institutions from insurance companies
to hedge funds. The British Bankers Association (BBA) and the International Swaps and
Derivatives Association (ISDA) estimate that the market has grown from $180 billion in
notional amount in 1997 to $5 trillion by 2004 and an astronomical $62 trillion by end of
2007. This rapid growth was spurred by the ISDA creating a set of standardized
documentation. This standardized industry standards and benchmarks which greatly lowered
the transactions costs to trading CDS.
This rapid growth got halted for the first time in 2008 at the wake of the global financial
crisis. The notional amount outstanding of credit default swaps (CDS) was $38.6 trillion at
year-end, down 29 percent from $54.6 trillion at mid-year 2008. Notional outstanding, for the
whole of 2008, was down 38 percent from $62.2 trillion at year-end of 2007. The $38.6
trillion notional amount was approximately evenly divided between bought and sold
protection: bought protection notional amount was $19.5 trillion and sold protection was
$19.1 trillion, with a net bought notional amount of $400 billion.
D. Why CDS is Used
Now, let us look at the reasons as to why credit default swaps, touted as “Satan’s financial
tool of choice” by the popular press, exist.
A. Hedging (Bi-directional Trading in Credit):
A CDS contract is used as a hedge or insurance policy against the default of a bond or
loan. An individual or company that is exposed to a lot of credit risk can shift some
of that risk by buying protection in a CDS contract. This may be preferable to selling
the security outright if the investor wants to reduce exposure and not eliminate it,
avoid taking a tax hit, or just eliminate exposure for a certain period of time. Please
note that, such contracts don't eliminate risk, and they don't increase it. They just
transfer the risk from one party to the other. But this enables those who bear a risk to
protect themselves against it, and considering the huge volume of risk-taking that
occurs daily in financial markets, the ability to redistribute risk has to be seen as very
useful.
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3. A competitive market in credit default swaps contributes to the transparency of price-
setting and thus to the efficiency of the whole process. This lowers the cost of
financial risk management in general.
B. Speculation:
Credit default swaps allow speculators to "place their bets" about the credit quality of
a particular reference entity. With the value of the CDS market larger than the bonds
and loans that the contracts reference, it is obvious that speculation has grown to be
the most common function for a CDS contract. CDS provide a very efficient way to
take a view on the credit of a reference entity. An investor with a positive view on the
credit quality of a company can sell protection and collect the payments that go along
with it rather than spend a lot of money to load up on the company's bonds. An
investor with a negative view of the company's credit can buy protection for a
relatively small periodic fee and receive a big payoff if the company defaults on its
bonds or has some other credit event. Hence CDS solves the following issues faced by
an active cash credit portfolio manager:
- A manager who wants to take a long position cannot find enough of the bond
to buy in the secondary market, receives insufficient allocations in the primary
market, or else finds himself constrained by his own risk limits.
- CDS allows an active manager to invest in foreign credits without currency
risk
At the same time there are some unique advantages of credit default swaps, which are briefly
discussed below:
a. Unfunded Instruments: As a general matter, credit default swaps are un-funded.
That is, the protection seller does not post the notional amount of the contract into an
account for the benefit of the protection buyer. This allows the protection seller to
invest that amount elsewhere, earning a return. Thus, credit default swaps allow for
unfunded exposure to credit risk, which facilitates a return that is higher than the
underlying bond.
b. Simplified Documentation: Credit default swaps also offer the advantage of
simplified and standardized documentation, which allows market participants to
precisely tailor the credit risks to which they are exposed. ISDA does a great job in
providing templates of master agreements to the market participants.
c. Advantage of a Contract: Credit default swaps are contracts, and so the rights and
obligations of each party can be whatever the parties agree to. This allows for the
creation of essentially infinite variations on the basic credit default swap theme –
from sovereign, to single name to basket products. (Derivative Dribble Blog on CDS)
E. Corporate Debt Market in India
At this juncture, it is imperative to look at the corporate debt market in India, which is
essentially closely linked to the introduction of CDS in the country. Compared to very well
developed equity and equity derivatives markets, corporate debt market in India is primitive
at best, with daily turnover of around Rs. 1,000 Crores compared to a turnover of Rs. 100,000
Crores in equity markets.
In comparison, in most matured economies debt market is three times the size of the equity
market. Investment in equity being riskier, certain class of investors choose to invest in debt,
based on their risk appetite and liquidity requirements. In fact, most investors like to spread
their investments into equity, debt and other classes of assets for reasons of optimal
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4. combination of return, liquidity and safety. A vibrant debt market therefore enables investors
to shuffle, reshuffle their portfolio depending upon the expected changes. Debt market, in
particular, provides financial resources for the development of infrastructure. Due to this lack
of depth in the domestic debt market, many large Indian corporate prefer FCCBs and Yankee
Bond route for debt placement.
Looking forward, Prime Minister Manmohan Singh says the country will need as much as
$475 billion over the next five years to upgrade the country's crumbling infrastructure and
Indian companies may need to raise as much as $200 billion, according to estimates by
Moody's Investors Service. (Bloomberg.com)
Hence, the question of credit risk becomes even bigger. Effective management of credit risk
is, therefore, a critical factor in banks’ risk management processes and is essential for the
long-term financial health of banks. Credit risk management encompasses identification,
measurement, monitoring and control of the credit risk exposures. Although Indian banks are
in a position to identify measure and monitor credit risk, they have no instrument to control
or hedge their credit risk exposure. In the process of financial sector deregulation, interest
rate risks and foreign currency risks are now effectively managed by derivatives, and the lack
of credit derivatives is a spot of concern for the banking community as well as the corporate
in the country.
F. Current State of Regulation in India
Currently, CDS contracts are available on debt raised by Indian companies overseas. ICICI
Bank Ltd., Reliance Industries Ltd., Tata Motors Ltd. and State Bank of India are among the
50 most-active USD-denominated credit default swaps contracts in Asia, excluding Japan,
according to a dealer survey conducted by the International Index Co. in Frankfurt. Bank of
India, ICICI Bank, IDBI Bank, Reliance Industries and State Bank of India each have a 2%
weight in the 50 member Markit iTraxx Asia ex-Japan Investment Grade 5-Year CDS Index
(quoting at 125 basis points as on July 31st 2009), whereas Reliance Communications, Tata
Motors and Vedanta Resources each have a 5% weight in the 20 member Markit iTraxx Asia
ex-Japan High Yield 5-Year CDS Index (quoting at 600 basis points as on July 31st 2009).
So, there exists a vibrant CDS market for Indian entities already.
In response to this as well as the Percy Mistry Committee report on “Making Mumbai an
International Financial Centre”, Reserve Bank of India (RBI) has come out with draft
guidelines on Credit Default Swap (CDS) per notification dated May 2007. In the wake of the
financial crisis, there has been no further progress on the same, but according to recent news
(July 24th 2009) the possibility of introducing CDS on exchanges as a part of measures to
reform the debt market in India would be placed on the agenda of the meeting of the high-
level co-ordination committee on capital markets next month as reported by business daily
The Mint.
According to ISDA, guidelines proposed by RBI for trading credit-default swaps exclude a
significant part of the domestic debt market and may limit growth in bank lending. Indian
lenders have to own the underlying notes in order to buy default protection and the securities
must carry a public credit rating, according to the guidelines. (RBI Draft Guidelines on CDS)
India's loan market is as much as six times larger than the amount of Indian corporate bonds
in existence, according to Bloomberg calculations based on central bank data, and most loans
don’t have a published rating. That significantly reduces the effectiveness of such a CDS
contract to be traded on exchanges and denominated in INR.
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5. G. Conclusion
Based on the discussion above and the pros and cons of CDS as an instrument to hedge credit
exposure or to take a view on credit exposure, I think it’s time that INR denominated CDS be
introduced in Indian Markets. For emerging markets like India the following points need to
be stressed upon:
- Being an efficient tool of pricing the risk of credit default by the reference entity, the
CDS market provides the most objective tool for pricing of credit risk. This synthetic
market is not affected by any of the inflexibilities and limitations of the cash bond
market – lack of availability, regulatory restrictions, etc and hence CDS market can
potentially become more liquid than the cash bond market in time to come, which is
already the case globally.
- Over time both single name and portfolio default swaps are going to get developed in
the country. Portfolio default swaps are particularly important from the viewpoint of a
bank transferring the risks of a portfolio – such as the SME loans portfolio, through
credit linked notes, which will allow much needed capital flow in the SME sector of
India.
Hence, keeping in mind all the benefits and potential troubles, here are the recommendations:
- Exchange traded CDS contracts of 5 year maturity should be allowed in India with
single name reference entity (only of Indian origin) as well as baskets formed through
a CDS index. Cash settlement is preferred rather than delivery based settlement. This
will be more transparent than traditional OTC CDS contracts.
- Market participants should be allowed to trade in instruments tied to reference entities
where they don’t have a credit exposure. This will potentially increase the depth of
the market and thereby allow a more efficient price discovery.
- Considering that the loan portfolio is much as six times bigger than cash bond
portfolio, loans should be allowed to be referenced as well, which again allows for
broader participation
Thus an efficient market of credit pricing and exposure can be started in India.
References
Derivative Dribble Blog, “Why Credit Default Swaps” retrieved on 1st August 2009 from
http://derivativedribble.wordpress.com/2009/01/14/why-credit-default-swaps/
International Swaps and Derivatives Association (ISDA), February 2003, “2003 ISDA Credit
Derivatives Definitions,” retrieved on 31st July 2009 from http://www.isda.org/cgi-
bin/_isdadocsdownload/download.asp?DownloadID=84
International Swaps and Derivatives Association (ISDA), “Summaries of Recent Market
Survey Results” retrieved on 1st August 2009 from http://www.isda.org/statistics/recent.html
Nomura Fixed Income Research, May 2004, “Credit Default Swap (CDS) Primer” retrieved
on 31st July 2009 from
http://www.securitization.net/pdf/content/Nomura_CDS_Primer_12May04.pdf
Reserve Bank of India, May 2007, “Draft Guidelines on Credit Default Swaps” retrieved on
1st August 2009 from http://rbidocs.rbi.org.in/rdocs/content/PDFs/77380.pdf
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