Credit Default Swaps in India

With all the credit risk that exists in the market, it is remarkable that anybody still wants to lend
money. Credit enhancements techniques, which help reduce the credit risk of an obligation, play
a key role in encouraging loans and investments in debt. Some credit enhancements
methodologies have existed for centuries, from plain out refusing to make a loan to asking for
guarantees, letters of credit, or other insurance products. However, such mechanisms let’s call
them commercial or business oriented – work best during economic upturns. When the economy
turns bad, risk normally accumulate and instead of off-setting each other, they start to default at
the same time, bringing substantial loan losses to lenders.

An alternative to commercial risk mechanics, various financial mechanisms have been developed
over the past few decades. Such credit risk instruments are normally referred as Credit
Derivatives. Credit Derivatives derive gain or derive their value from an underlying credit
instrument, such as a bond or loan). Instead of looking for guarantees from the obligor to the
lender, credit derivatives help to transfer credit risk away from the lender to some other party.
The risk is simply passed on to someone else – who of course is paid a fee for the trouble.

Credit Derivatives started to become a necessity in the 1980s and 1990s as individual and
corporate bankruptcies began to increase worldwide, starting in the US Credit Derivatives were
originally used by banks that were involved in the interest rate swaps markets and that wanted to
hedge against counterparty credit exposures.

Credit Derivatives help investors isolate credit risk, price it, and transfer it to other investors who
are better suited to managing it, or who find investment opportunities more interesting. As a
result of their versatility, credit derivatives can efficiently transfer tailor fit credit risk from one
party to another. While transferring a specific type of risk, they leave the other types of risk with
the individual investor. For instance an investor might want to keep the company specific risk of
an investment in her portfolio, while transferring the market risk of that same investment. Credit
derivatives help the investor split out, price and transfer this particular risk.

In legal terms, credit derivatives are privately negotiated bilateral contracts to transfer credit risk
from one party to another. The party that transfers the risk to another party is looking for
protection against the risk and is willing to pay a fee and is called a protection buyer. The party
that takes the risk, the so called protection seller, is willing to bear the other party’s credit risk
in exchange for a fee. The contract that the two parties enter into defines the credit risk in terms
of credit events that will cause the risk exposed party to experience an economic loss. As we
know, credit events include occurrences such as bankruptcy, failure to pay interest or principal or
interest when due, etc. If credit event occurs, the credit derivative contract provides for the
settlement of any payment obligation.

Total Return Swap

In a total return swap, an asset owner transfers the total return of a specific asset, such as a bond
or trade receivable, to a counterpart in exchange for a fee.

Let’s see this concept in detail. On one hand we have a seller, who holds assets with some credit
exposure. These assets are receivable such as loans, lease payments or trade receivables. On the
other hand we have they buyer, who wants the economic returns on these assets such as interest
due on loans or fees from the lease payments. In principle the buyer could purchase these assets
but the buyer does not want to acquire the assets. Here Total Return Swaps comes into the
picture.

Total return in asset (fixed coupon or interest payments)

Total Return Total Return

Swap Seller Swap Buyer
(Protection (Protection Seller)
Buyer)

LIBOR + Risk Spread

Underlying Asset
with credit
exposure

As we see in the above figure, the total return swap seller can also be seen as a buyer – buyer of
credit protection. The opposite then is true for the total return swap buyer.
 Because the buyer does not actually want to own the assets perhaps because of lack of
purchasing power or large payment account, the seller uses this tool to pass the expected return
on the assets. In exchange the buyer pays the seller a fee which is LIBOR + Risk Spread.

The swap benefits both parties. It offers the seller a way to keep a portfolio of assets, while
limiting the economic exposure of those assets. If the assets lose value and their returns diminish,
the buyer will have to compensate the seller. This is the credit risk mitigation part of the total
return swap agreement.

In total return swap, the buyer enjoys the economic benefits of the asset ownership without
actually having to hold the assets on the Balance Sheet or fund the investment upfront. Total
Return Swap can be categorized as a type of credit derivative, although it should be noted that
the product combines both market risk and credit risk, and so is not a pure credit derivative.
Standard Credit Default Swaps or Plain Vanilla Credit Default Swap

In a Credit Default Swaps (CDS), two parties enter into an agreement whereby one party pays
the other a periodic fee in exchange for a much larger, but floating, payment should a predefined
credit event occur. If the credit event never occurs, the other party does not have to make any
payment. The first party like the seller (protection buyer) is looking for protection against
default. The other party or the protection seller is available to offer that cover.

The fee that the protection buyer pays to the protection seller is calculated as a fraction of the
notional amount of the reference asset. The fee is often referred to as the credit default swap
spread and is paid periodically. For E.g. Suppose the notional contract is 10 million the fee
probably will be 2.5% of 10 million.

If the credit event takes place, the CDS contract is terminated and the termination payment takes
place. The CDS Contract defines one of two payment scenarios. The first option is to use
physical settlement, through which the protection buyer has to present the defaulted asset to the
protection seller to obtain the termination payment. If the physical settlement is required, the
termination payment becomes the full face value of the asset. The second option is the cash
settlement where by the protection buyer keeps the asset. In this case the payment becomes the
difference between the face value of the reference asset and its market recovery value. The
market recovery value and the value of the asset after default are then normally assessed by an
independent assessor.
Fee (monthly, yearly or quarterly)

Protection Buyer Protection Seller

(A) (B)

Payment contingent on credit event

Reference Asset
(bond or swap)

The credit event payment is made by the protection seller if there is any default on any bond or
swap where the protection buyer has insured himself. E.g. If Party A has a bond from any
financial institution and thinks that bond might default, so he ensures against the risk by paying a
monthly or yearly fee to party B. Suppose there is a credit event (default), Party B will make the
payment of the loss as mentioned in the contract to the Party A.
Basket Credit Default Swap

The plain vanilla CDS is written on just one single asset. However, the reference asset can also
be written on a portfolio or a group of assets. We can call this Basket CDS where the protection
buyer is looking for protection against default on any one of the securities in the basket. A
basket swap in which the protection seller has to pay the protection buyer as soon as any one of
the securities default is known as first to default basket CDS. The CDS contract can also define a
different default security in the basket such as second to default or third to default.

Premium

Protection Buyer Protection Seller

Payment Contingent on first default

Reference Assets 1, 2, 3, 4

Assume a Protection Buyer who seeks protection against default on any one of the four different
assets. Taking into account these assets he can go for a 3 year protection scheme. This being a
first to default CDS and thus covers only the first credit event. After the default is occurred, the
basket contract is terminated and the protection buyer stops paying the fee. Just like the plain
CDS settlement can be specified as physical or cash.

Two years into the 3 year contract, one of the reference assets default. As specified in the
contract, the Basket CDS expires and the protection seller makes the termination payment only
for the defaulted asset as the other reference assets have still not defaulted and still generate
income.

The advantage for the protection buyers in basket CDS is that it shields more than one reference
asset from default. As it turns out the fee on the basket CDS is less than the sum of individual
CDSs on the same reference assets. The advantage for a protection seller is that the basket CDS
is also an attractive instrument given the limited exposure to only one of several default
probabilities.
Digital Credit Default Swaps

Digital CDSs are almost identical to normal CDSs. The exception is that the recovery rate is
fixed beforehand, regardless of the real value of the underlying asset at the time of default.
Digital CDS are also known as Fixed Recovery CDS. In other words, the payoff in the case of
default is independent of the market value of the reference asset at default. Through its
construction, digital CDS eliminate any uncertainty about the recovery rate and payoff.

Digital CDS

Protection Buyer Protection

Seller

Payment = Principal – Fixed Recovery Rate

Plain Vanilla CDS

Protection Buyer Protection

Seller

Payment = Principal – Market Recovery Rate

E.g. suppose we have bought protection from a five year CDS for a $1000 notional. The
difference from the normal CDS is that the contract specifies the recovery rate to be $350. After
the 3 years suppose the bond goes into default the CDS comes into effect. The protection sellers
pay the difference between principal value and predetermined recovery value (1000-350 = 650).
Portfolio Credit Default Swap

A portfolio CDS is similar to a basket default swap in that it also references as group of assets.
However, a portfolio CDS is different from a basket default swap in that it covers a prespecified
amount rather than a prespecified sequential default number (first, second, third and so on).

For e.g., in a portfolio CDS where the prespecified amount is 10 million and first default loss is 5
million, the protection seller pays 5 million to the protection buyer and the contract is still active.
Just one default does not terminate the contract, unless the default happens to match the
predefined amount. A second default with a value of 5 million brings the total default to 10
million and the contract terminates as soon as the protection seller has paid the additional 5
million.
What role can credit derivatives play in developing markets?

Depending upon how do you use it, credit derivatives may either be hedging tools (to protect
against credit risks inherent in exposures held by banks) or trading tools (as a proxy tool to allow
trading in the general credit of a reference entity, and thereby replicating a cash bond). In
practice, credit derivatives trades today are more trading tools than hedging tools – there is no
data to confirm this, but that is a view generally shared by credit derivatives dealers. However, at
the end of a chain of trades, there might be somebody using it for hedging as well.

The trading intent is at least as much, if not more, significant as the hedging motive. The CDS
trade is an easy and global market that replicates the cash bonds market. A cash bond arises only
when the reference entity actually issues the same: CDS trades may take place without any actual
funding. The synthetic market is not affected by any of the inflexibilities and limitations of the
cash market – lack of availability, regulatory restrictions, etc.

But the trading intent is at least as much, if not more, significant as the hedging motive. The
CDS trade is an easy and global market that replicates the cash bonds market. A cash bond arises
only when the reference entity actually issues the same: CDS trades may take place without any
actual funding. The synthetic market is not affected by any of the inflexibilities and limitations of
the cash market – lack of availability, regulatory restrictions, etc.

The CDS market may not immediately lead to funds flowing into the corporates in question, but
then, by allowing the traders an alternative and unfunded platform to trade in Asian credits, it is
symbolic of the interest international investors have in the reference credits. The interest in the
CDS market may well be converted into actual cash, and lead to development.

There is yet another significant use we will like to stress upon. That is the synthetic securitisation
device whereby funding of SMEs may be supported by credit derivatives. A German company
called KfW has very successfully done it primarily in Germany and lately in Austria as well.
This is an area where Asian banks can do a lot.

The structure runs as under: banks that originate loans to SMEs sell the credit risk in their loans
(without selling the loans) to an intermediary, such as KfW. The intermediary pools the credit
risk of various originating banks, and packages the same into credit linked notes and sells them
to the capital market. In the process, the capital market investors have bought the risk of the
SME loans. Free of the risks, the originating banks will happily originate more such loans,
leading to easier access to SME credit.

The credit derivatives market is a very fast growing market, and nothing that moves very fast can
escape the attention of the regulators. While there are regulatory concerns, the market remains
largely unregulated. There are reporting requirements in different markets whereby regulators
collect data about credit default swaps, but it is still largely unregulated.

However, banks’ capital norms need to be spelt out in relation to credit derivatives trades. That is
a minimal requirement for credit derivatives trades to come up. The rules are clear from the
recent Basle II statement – central banks do not have to invent the rules. But they need to
implement them

The market today is mostly a credit default swap market – this is true for the global market. For
the Asian market, it is almost entirely a credit default swap market. Credit default swaps are
quite handy as proxies for the general credit of the reference party. Of late, another variant of
credit default swaps has come up – equity default swaps. Here, the swap is referenced to a
substantial and permanent fall in equity prices of the reference party. This is arguably more
transparent trigger mechanism than credit default swaps which are based on traditional, often not
public, measures of credit default such as failure to pay and bankruptcy.

We would expect both single name and portfolio default swaps to develop in the region.
Portfolio default swaps are particularly important from the viewpoint of a bank transferring the
risks of a portfolio – such as the SME loans portfolio.

Inexperience may be painful anywhere, particularly for a high leverage activity such as
derivatives. Derivatives themselves have a potential for very leverage – you are acquiring risks
but you may not be investing capital at all. The fact that you are inputting capital in a business is
a great restraint itself, but getting into a derivatives trades is like betting or bidding – you might
be bidding far more than what you have.
Capital regulations, which require banks to hold capital equal to the first loss portion of tranched
credit derivatives, is an important protection against the temptation to bid too much into credit
derivatives. India needs to put these regulations into place soonest.