Fim project credit derivatives in india

Credit Derivatives

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

Institute of Management Technology
Ghaziabad

Credit Derivatives

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

Institute of Management Technology, Ghaziabad 1

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


Fim project credit derivatives in india

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