Course: Treasury Management, Module III: Financial Derivatives NIBM, Pune

Module III: Derivatives

Chapter 7: Credit Derivatives
Dr. Kedar nath Mukherjee

Objectives:

Even if the fixed income securities are largely exposed to fluctuation of rate of interest
rates, there are some instruments, especially issued by Non-Govt. entities, which are also
exposed to different degrees of counterparty risk, and therefore need to be hedged
through credit derivatives product like Credit Default Swap (CDS). The objective of this
chapter is to make the readers well versed with the meaning and structure of such
product, its history and worldwide growth, its important features, current challenges and
future prospect in developing market like in India. At the end of this chapter, the readers
are expected to be familiar with:
i. Meaning and History of Credit Default Swaps, especially in light of 2008 US
Subprime Crisis;
ii. Different Types of Credit Default Swaps, with special reference to Indian Market;
iii. Important Features of Credit Default Swaps, in line with RBI Guideline on CDS;
iv. Current Scope of CDS in India and its Future Challenges

Structure
1. Meaning and Definition of Credit Derivatives
2. History and Growth of CDS
3. Different types of CDS
4. Important Features of CDS
4.1. Protection Buyer & Protection Seller;
4.2. Reference Asset & Reference Entity;
4.3. Asset and Maturity Mismatches;
4.4. Default Swap Premium;
4.5. Unwinding CDS Position;
4.6. Credit Events;
4.7. Compensation Settlement
5. Current Scope and Future Challenges for CDS in India

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1. Meaning and Definition of Credit Derivatives

Credit Derivatives are financial instruments designed to transfer the credit risk from
one counterparty to another. In other words, Credit derivative is a Privately Negotiated
contract the value of which is derived from the credit risk of a bond, a bank loan, or any
other instrument with an exposure to credit risk. Credit derivatives can have the form of
forwards, swaps and options, which may be embedded in financial assets like bonds or
loans, or other investments with a credit risk exposure. Therefore, credit derivatives, in
one hand, allow investors or creditors to eliminate or reduce credit risk involved in their
investment, and allow the counterparty to make some profit and leveraged their position
by assuming the credit risk in their own books of accounts. Alternatively, credit
derivatives can be defined as arrangements that allow one counterparty ( Protection
Buyer) to transfer, in exchange of certain price called Premium, the defined credit risk
(full or in part), computed with reference to a notional value, of a reference asset (s), with
or without its actual ownership, to another counterparty or counterparties (Protection
Seller).

There are different basic and complex or synthetic derivatives products or

instruments used to mitigate the credit risk that a person or entity carries in their books
of accounts. Broadly, credit derivatives instruments are classified into four categories:
Credit Default Swaps (CDS), Total Rate of Return Swaps (TRORS), Credit Spread Products
and different Synthetic Structures. Again, credit spread products include Credit Spread
Forward / Futures, Credit Spread Options, Credit Spread Swaps etc. Similarly, Credit Link
Notes (CLN), Collateralized Debt Obligations (CDOs) etc. are some of the examples of
synthetic credit derivatives instruments. All the above products may be of simple in
nature, or they may have a complex structure based on the type of the products. Apart
from having a common purpose of hedging against credit risk exposure, different credit
derivatives products have some identical features that can differentiate one product from
the other.

1.1 Credit Default Swaps (CDS):

Credit Default Swap is a Bi-lateral financial contract in which the Protection Buyer
pays a Periodic or Upfront Fee in return for a Contingent payment by the Protection Seller
following a Credit Event with respect to a Reference Entity. In other words, a CDS can be
viewed as a put option on the reference obligation, the owner of which, i.e. the default
swap buyer or the protection buyer has the right so sell the reference obligation to the
default swap seller or the protection seller in the event of default in any future period of
time. The pay-off structure of a simple CDS contract would be

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CDS is essentially similar to any credit insurance product, except the fact that unlike in
case of an insurance product, the CDS buyer need not to compulsorily hold the underlying
asset and the buyer can trade on the CDS contract, i.e. the CDS contract can be sold before
its maturity.

2. History and Growth of Credit Default Swaps

It is very difficult to define a specific time period when credit derivatives emerged.
International Swaps and Derivatives Association (ISDA), in the year 1992, first uses the
term “Credit Derivatives” to describe a new, exotic type of over-the-counter contract.
Credit derivatives market begins to evolve in the year 1994. In 1997, JPMorgan developed
a proprietary product called BISTRO (Broad Index Securitized Trust Offering) that used
CDS to clean up a bank’s balance sheet. By March 1998, the global market for CDS was
estimated at about $300 billion, with JP Morgan alone accounting for about $50 billion of
this. In 2000, credit default swaps became largely exempted from regulation by both
the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading
Commission (CFTC). At the same time, there was a tremendous growth in the subprime
mortgage market, leading to an exceptional growth in the market for Mortgage Backed
Securities (MBS). As a result, after 2000-01, there has been also a tremendous growth in
the world wide volume of different credit derivatives products, especially for CDS. The
market size for Credit Default Swaps started growing more than double in size each year
from $3.7 trillion in 2003. As a result, by the end of 2007, the CDS market had experienced
a notional volume of $62.2 trillion. But following the breakdown in the market for
subprime mortgages and therefore the market for MBS, known as 2007-08 US Subprime
Crisis, the CDS market started experiencing a drastic slowdown, and the notional amount
outstanding had fallen by 38 per cent to $38.6 trillion by the end of 2008, again fallen to

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$25.9 trillion in Dec., 2011, and to USD 24.3 trillion by the end of June 2013 (as per BIS
Report).

2.1 Reasons for High Growth in CDS Market

When we are talking about a faster growth of several credit derivatives products,
especially of CDS, all over the world, it is quite natural for us to explore the reasons or
motivation towards this tremendous growth, especially comparative to other existing
derivative products. In other words, why credit derivatives in general and credit default
swaps in particular have become more popular as far as credit risk mitigation is
concerned? Some of the possible answers can be derived from the following points:

Increasing Bankruptcies

If we look into the history of last few decades, it would be clear that there were a
large number of corporate and sovereign bankruptcies happened all over the world.
Some of the important crises include Latin American debt crisis in early 1980s, Asian
financial crisis in 1997-98, Russian debt crisis in 1998, Argentina crisis in 2001, Enron
bankruptcy in 2001, 2008 US Subprime crisis, 2010 Greece Debt crisis, etc. These
bankruptcies not only eaten up the capital of several banks and other financial
intermediaries, but also, caused for major financial crisis of a larger part of the economy.
Credit derivatives instruments, if used properly, can be used as a cushion for large credit
exposures that leads to its faster growth all over the world.

Improvement in Technical and Managerial Ability

Any derivative contract, in one side, can be used to hedge against any risk
exposure, and on the other side, can act as a boomerang if failed to value and manage in
a proper way. In other words, derivatives can be used to unbundled and remove the risk
component from the return of an asset, provided the derivatives instruments are truly
valued and properly managed. If it fails to do so, it invites different types of risk, even
more than the risk that the investors are trying to hedge. Sufficient technical, managerial
and quantitative skills are required for a proper utilization of several derivative
instruments. If we look into the last few decades, it would be clear that there was a lack
of sufficient technical and managerial ability in banks and other financial organizations,
which de-motivate them to use any sophisticated risk mitigation tools and techniques.
But as far as the present scenario is concerned, people have become highly technical and
they have the ability to properly value and manage the complicated risk management
tools. This improvement in the quality of manpower in banking and finance industry may
also be attributed for the worldwide rapid growth of more advanced derivative products
including credit derivatives.

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Yield Enhancement Possibility

The purpose of entering into a credit derivative market, for a protection buyer,
may be to hedge against the risk of credit exposure. But why the counterparty is selling
the protection by assuming the same risk in its own books of accounts? What is the reason
for being exposed to the credit risk transferred by the counterparty? The main reason
behind selling protection and buying risk is to get some non-funded return, i.e. return
without any investment. This may enhance the yield of the protection seller. By selling
protection on low rated credits, insurance companies, asset managers, hedge funds etc.
can earn a higher return that boosts up their yield. Therefore, not only on the buyer side,
but there is also a tremendous growth in selling protection against different risk
exposure, that significantly leads to faster development of different credit derivatives
products including CDS.

Exposure without Actual Lending

Though the basic purpose of credit derivatives is to hedge against the credit risk
raised due to some real credit exposure, it can be used even without any actual exposure,
i.e. buying credit protection without giving any credit. In other words, credit derivatives
allow investors to take exposure without actual lending. This may allow an investor
(protection buyer) to protect against some of his parallel exposure, or the purpose of
buying such protection might be simply to get the benefit of speculation and / or
arbitrage.

Regulatory & Economic Capital Relief

One of the important objectives for a protection buyer to buy protection against
his credit exposure is to remove the credit risk from his own books of accounts. Since,
banks and other financial intermediaries need to keep aside a certain amount of
regulatory capital based on the risk category of their assets of different credit quality, if
the risk of a specific asset comes down, it will directly affect the total amount of regulatory
capital need to be maintained by them. Therefore, bank and other financial
intermediaries can reduce their regulatory capital; alternatively, can get some relief in
regulatory capital, if they protect themselves from different credit exposure (s). This will
ultimately help the protection buyer to increase the volume of its business by utilizing
the excess capital relieved by the regulator.

Regulatory capital is the part of capital need to be maintained as per the requirement
of the regulator and the relief is related to the relief from the concerned regulator. At the
same time, amount of economic capital is based on the internal assessment of inherent
risk of an individual bank which that it should maintain to cover its unexpected loss at
any point of time. Therefore, if CDS leads to a significant reduction in the credit risk of

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banks and other financial intermediaries, it would ultimately help in reducing their
economic capital as well.

3. Different Types of Credit Default Swaps

3.1 Binary or Digital Swaps:

In case of binary or digital swaps, the amount of protection expected to be paid in

the event of a credit event is fixed in advance while entering into the contract. In such
cases, the protection seller neither goes for physical settlement nor for cash settlement.
Therefore, it is irrelevant to calculate the market value of the defaulted obligation. Binary
default swap is normally related to those standardized exposures where the losses arise
due to any credit event can easily be estimated in advance based on the past experience
of the counterparties. Therefore, any costs involved in deriving the market value of a
defaulted obligation can be ignored by entering into this type of swap contract.

3.2 Basket CDS:

A standard CDS, alternatively a single-name CDS deals with only one reference
obligation, whereas in a basket CDS or multi-name CDS, the reference obligation consists
of a basket of individual obligations. In this type of CDS contract, the protection buyer
looks for the protection against the default of any one of the obligations of equal quality
and of equal notional value in the whole basket. There are several types of basket CDS. In
case of a first-to-default basket CDS, the protection buyer is compensated after the first
default of any obligation in the basket and thereafter the contract gets closed. In other
words, this type of CDS protects only against the first default. Similarly, the basket CDS is
known as second-to-default if the loss for the first default would be borne by the
protection buyer himself and the protection will be given for any loss related to the
second default. Likewise, nth-to-default basket CDS gives protection for the default of nth
obligation in the whole basket. Basket CDS are useful for those protection buyers who can
bear the loss of one or few defaults, but only up to a certain level. The premium of a basket
CDS is lower than the sum of the CDS premium on individual obligations and therefore
the protection buyer is hedged against the risk of more obligations at a comparatively
lower cost. At the same time, the protection seller is also exposed to meet the
compensation of only one obligation, but receives a higher premium comparative to that
of a single-name CDS.

3.3 Portfolio CDS:

A portfolio CDS is similar to a basket CDS in the sense that it also refers a group of
reference obligations. But unlike basket CDS, the focus of a portfolio CDS is on covering a
pre-specified loss amount, rather than protecting against a pre-specified number of
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default. In case of a basket CDS, the contract gets closed after the nth default. But a
portfolio CDS contract works until the total amount of credit loss comes to the pre-
specified amount of loss or compensation as per the contract. Here, the focus is on the
amount, rather than the number of default. In case of portfolio CDS, it is not necessary for
all the obligations to possess same quality and notional value as like a basket CDS.

3.4 Index based CDS:

A simple CDS can be referenced to an individual asset or to a portfolio of assets.

Similarly, a CDS can also be related to an index of some representative obligations or
obligors, e.g. an index of high yielding bonds or an index of highly rated obligors. This type
of swap contract allows a protection seller to synthetically invest in a broad index of
obligations, which is otherwise impossible to generate in the form of cash.

3.5 Cancelable Default Swap:

A cancelable default swap is a default swap with the option to cancel the contract
at certain situation. The buyer, or the seller, or both the parties entertain the right to
terminate the default swap. The default swap, in the hands of the buyer, is known as
callable default swap; whereas the same in the hands of the seller is termed as putable
default swap. The first type, i.e. callable default swap is quite common in trading practices.
Suppose, an investor owns a credit asset, e.g. a bond, and has bought the credit protection
by entering into a cancelable CDS contract on that asset. Now, in the case of termination
or closure of that asset by its issuer, the investor need not to get any protection anymore
and is eligible to terminate the swap contract. Therefore a person needs not to continue
with a contract which has no worth to him.

3.6 Contingent Default Swap:

In case of contingent default swap, the compensation payment is usually triggered

by a simultaneous occurrence of the standard credit event and an additional credit event.
In other words, settlement takes place not after the occurrence of a credit event related
to an obligation, but after another credit event such as the default of another obligation.
Therefore the cost or the premium of such CDS is comparatively less, unless the two credit
events are perfectly positively correlated. The buyer of such CDS may be motivated for
the requirement of casual or weak protection on their credit exposure and / or for a lower
premium.

3.7 Leveraged Default Swap:

In case of leverage or geared default swap, the amount of compensation gets

leveraged or geared after the occurrence of a credit event. In other word, the amount of
compensation is multiple of the amount of the actual loss. Whatever would be the payoff
in case of a standard default swap, a certain percentage of the notional amount is added
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to derive the final payoff of a leveraged default swap. Because of this added benefit, this
type of swap is comparatively costlier than a standard default swap. In other word, the
premium of a leveraged default swap is comparatively higher. Now, the question is who
will opt for this type of swap at a higher cost. Obviously, the answer is the speculators. A
speculator, without a real credit exposure, can enter into a leveraged CDS and earn not
only the amount equal to the notional value of the exposure, but can enjoy a profit equal
to the multiple of the notional amount and can easily leverage its earnings.

4. Features of Credit Default Swaps

4.1 Protection Buyer & Protection Seller:

A party, with or without its actual ownership on the reference asset, who does not
want to carry the risk of its credit exposure and wants to transfer the credit risk to
another counterparty is known as protection buyer. On the other hand, a party, who
wants to carry the risk in exchange of some rewards and is ready to give protection
against the credit risk exposure, is called as protection seller. Protection buyer and
protection seller are alternatively termed as risk seller and risk buyer respectively.
Commercial banks or other financial intermediary, having exposure in credit asset,
funded or unfunded, can buy protection to hedge against the credit risks inherent in the
credit assets. At the same time, the role of protection seller can be played by commercial
banks, insurance companies, hedge funds, equity funds, investment companies, etc.
Before getting into this business of buying and selling of protection, it is mandatory to
take the permission of the concerned regulators, e.g. in case of Indian banks, insurance
companies, pension funds / hedge funds, the permission has to be taken respectively
from RBI, IRDA, and SEBI.

As per RBI Guideline on CDS, the concerned market players are broadly divided
into two groups: Users and Market Makers. Users can only buy protection, while markets
makers are free to buy or sell protection. But there are clear cut norms specified for both
these groups, such that:

 Users permitted to buy credit protection only to hedge their underlying credit risk
 Users are also not permitted to sell credit protection
 Users can unwind their bought CDS positions with the original counterparty
 Users can sell the underlying bonds only by assigning the CDS in favor of buyer of
the underlying bond
 Market Makers are allowed to buy or sell credit protection
 Market Makers can buy credit protection even without any underlying exposure

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 Market Makers (Banks) have to fulfill the Eligibility Criterion as set by the RBI:
CRAR ≥ 11% (or 15% for NBFC & PD), Tier I Cap ≥ 7% (Net Owned Fund ≥ 500
Cr.); Net NPA < 3%

4.2 Reference Asset & Reference Entity:

A CDS deal is made with reference to either a single credit asset or a portfolio of
credit asset. These are known as reference asset or reference portfolio. It is not necessary
for a protection buyer to actually own the reference asset, i.e. funded credit asset. Perhaps
the protection buyer may use the CDS contract as a proxy to transfer some other risks, or
may be interested to get the benefits of arbitrage or speculation. Irrespective of the
motive to enter into a credit derivative contract, such a deal does not necessitate the
holding of the reference asset by either of the counterparties. Bond can be considered as
the most common type of reference asset because of its tradability in the secondary
market. Apart from this, a bond price available in the market can be used as a basis to
calculate the default swap premium. On the other hand, since loans are not usually traded
in a secondary market, their prices are not directly observable, and are derived from
some financial and other factors of the company. Since it is difficult to price a loan, the
pricing of the CDS is also become difficult, especially with reference to loans.

CDS in India can be issued only on Single and Listed corporate bonds. Even if short
term instruments, with original maturity of less than one year (i.e. CPs, CDs, NCDs) were
originally excluded, the same are now eligible as reference asset in CDS. CDS can also be
written on Unlisted but Rated bonds, issued by Infrastructure companies. Such Infra
bonds, eligible for CDS, may also be unrated if issued by the SPVs set up by infra
companies. Other than only on bonds issued by infrastructure companies, CDS is India
can also be issued on any other unlisted but rated corporate bonds. Asset Backed
Securities (ABS), Mortgage Backed Securities (MBS), Convertible bonds, any other
Structured Products shall not be permitted as underlying in India.

4.3 Asset and Maturity Mismatches

There may be some dissimilarity or mismatches as far as the value and residual
maturity of underlying and reference assets in a CDS are concerned. Suppose a credit
protection is bought for an amount of 100 Crore on a reference asset with a residual value
of 200 crore. In such case, there is an asset mismatch in the CDS contract and the capital
relief supposed to be availed by the protection buyer will be adjusted accordingly based
on the part of the asset duly protected by the CDS. Investor will not get any relief for the
unprotected portion of the asset. At the same time, an investor may have a credit asset,
e.g. a bond, for 5 years, but a protection can be bought on that asset for a period equal to
or less than the said period. Therefore, if the tenure of the CDS is less than the residual
maturity of the underlying asset, or if the CDS is junior than the underlying, then it will
be treated as a maturity mismatch. Like the case of asset mismatch, maturity mismatch is
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also considered and accordingly adjusted to derive the amount of capital relief given by
the regulator. These mismatches do not affect the amount and time of protection given
by the protection seller of a CDS. In case of asset mismatch, the following points needs to
be considered:

 Reference & Underlying asset must be issued by Same Obligor;

 Reference asset must be junior than Underlying asset; and
 Cross-default & Cross-acceleration clause between assets should be
properly specified in the contract documents.

4.4 Default Swap Premium

The premium for a CDS contract is nothing but the reward paid for assuming the
unwanted risk of the reference asset lies in protection buyer’s books of accounts. This
premium is normally represented in annualized basis points and can be paid up front, i.e.
while entering into the contract, or periodically such as quarterly. The payment of
periodic premium terminates in the event of a credit event or the completion of the
tenure, whichever is earlier. Suppose credit event takes place before a due date of
quarterly paid premium. In such cases, the protection buyer has to pay the premium due
for the period from the last premium paid date to the date of credit event. The amount of
premium or the price of a CDS depends mainly on the quality or risk of the reference asset
or reference obligation. Apart from this, there are some other factors such as: Tenure of
the CDS, Terms of settlement; Risk of the protection seller; Joint probability of default of
the protection seller and the reference obligor or entity; Number of credit events included
in the CDS contract; Exchange rate risk (if any) involved in the contract, etc. which are
considered while pricing a CDS.

As far as pricing of CDS or CDS premium in India is concerned, the guideline

suggest that there will be a daily CDS pricing curve published by FIMMDA is association
with ISDA, subject to sufficient trading. Broadly, what observed in international market
suggest that there may not be any consistent and robust method to price a CDS contract,
and the same may be subjective up to a certain extent.

4.5 Unwinding CDS Position

A CDS buyer can unwind his position before the credit event or maturity. The unwinding
can be possible either by taking an offsetting position, or settling with the original
counterparty or anybody else in the market. This exit route plays a very important role
for the market player to get into any such contract. If the exit route, i.e. unwinding of a
position, is easy, the market for that position is expected to experience a good volume and
liquidity. Users in India, who at any point of time are not allowed to maintain naked CDS
position, are not permitted to unwind any CDS contract by entering into any offsetting
contract. Any open contract can be unwind only with Original Counterparty. Users are

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allowed to unwind their CDS bought position either with original protection seller at
mutually agreeable price or at the price as arrived at by FIMMDA.

4.6 Credit Events

Credit events, in the context of a credit default swap, are the collection of different
events or situations that define the type of risk against which the protection buyer has
bought a protection from its counterparty, i.e. from protection seller. Unlike some other
credit derivative products, the settlement of a CDS contract is totally restricted to the
occurrence of any one or more of the specific credit events. The type of credit events may
be standardized, or it may be non-standard. Any credit event set out by some parent
organization, such as ISDA in case of derivatives, and is common for all can be termed as
standard event. On the other hand, apart from the standard credit events, the
counterparties are free to define their own credit events based on their own requirement.
The scope of these events may depend upon the type of reference asset to capture the
risks inherent in a specific reference asset.

List of Credit Event, as suggested by Reserve Bank of India in their final CDS
Guideline released in May 2011, include: Bankruptcy, Insolvency; Failure or Inability of
the obligor to pay its debts within the Grace Period; Obligation acceleration, Obligation
default; Restructuring approved under BIFR and CDR Mechanism. The contracting
parties to a CDS may include all or any of the approved credit events. Any issue related to
Credit Event will be addressed by the Determination Committee (DC). DC, formed by the
market participants and FIMMDA, shall deliberate and resolve all CDS related issues.
Decisions of the Committee would be binding on CDS market participants. At least 25%
of the DC members should be drawn from the Users

4.7 Compensation Settlement

A CDS contract, in occurrence of a credit event, can be settled in any of the three
ways. These are: Physical Settlement, Cash Settlement, and Auction based Settlement.

There may be different situation when physical settlement is preferable

comparative to the cash settlement. Suppose, the reference obligation or asset cannot be
properly valued after the credit event, or the protection seller is in a financial business
and can easily manage to hold and recover the value of reference obligation. In such cases,
physical settlement is preferable. If a CDS is expected to be physically settled, the
protection buyer, after a credit event being taken place, has to deliver the reference
obligation or a deliverable obligation to the protection seller in exchange of which the
protection seller is obliged to settle the per value of the reference obligation.

In case of cash settlement, all the losses or compensation are settled in cash.
Normally, if the reference obligation, after the occurrence of a credit event, can be
properly valued and if the protection seller, such as an SPV, is not in a financial business
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so as to recover the true value of the reference asset, it is preferable to go for cash
settlement. In case of cash settlement, the protection buyer does not have to transfer any
asset to the protection seller. Therefore, in case of buying a protection on an artificial
exposure, i.e. buying a CDS other than for hedging, the preferable settlement mechanism
is cash settlement. On the other hand, cash settlement also prevents the protection buyer
from the difficulty of delivering a pari passu asset, if it is difficult to transfer the reference
asset, of a contracted notional amount. Therefore, if a CDS is cash settled, the protection
seller, after the occurrence of a credit event, is obliged to pay compensation equal to the
difference between the notional value of the reference obligation and its market value.

CDS can also be settled through an auction process where the same can be
conducted by some specified committee, as decided by the domestic regulator, and also
within the terms as set by the committee. The settlement amount is decided through the
auction.

CDS in India can be settled depending on the nature of the counterparty, Users or
Market Makers. Users always need to settle the CDS contract physically, while Market
Makers can opt for any of the three settlement mode. Participants need to be adhered to
the provisions given in the Master Agreement for CDS prepared by FIMMDA. Any
settlement related issue need to be resolved by the concerned committee, called the
Determination Committee (DC).

5. Current Scope and Futures Challenges for CDS in India

Economic Growth of a country highly depends upon the credit flow that leads to
increase the productivity in several sectors, leading to a higher GDP. Two very important
routes to channelize the credit flow in an economy are Bank Loans and Corporate Bonds.
There is no doubt that being a bank dominated economy, Indian banks plays a major role
to channelize credit to the economy to ensure a reasonable and sustainable growth in
India. This is evident from the fact that the gross outstanding credits from scheduled
commercial banks in India to its GDP is more than 50 percent during almost a decade,
which is much higher in comparison to the size of the total outstanding in corporate bond
market to GDP in India. This very high level of dependency on the banking sector for the
required credit is really a matter of concern for Indian economy. Banks are not only
exposed to the high level of credit concentration risk, they also face a huge problem in
managing their assets and liabilities, leading to the problem of ALM Mismatches,
especially for their long term priority sector exposure commitment for infrastructural
growth in India. An important solution for this high credit concentration risk and ALM
mismatches for Indian banks is to ensure a sufficient growth of corporate bond market,
so that the required credit can be channelize through the corporate bond rout. But at the
same time, Indian corporates are also finding real difficulties to raise the required capital
by issuing bonds in India, especially because of lack of sufficient demand from the
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investors, especially for the low rated bonds. Here as major financial institutions in India,
Indian banks have a very significant role to be played for the growth of any segment of
the financial market, and therefore for the corporate bond market as well. Since corporate
bonds, depending on their credit rating, carry a significant credit risk, and the market is
extremely illiquid for almost all securities, most of the Indian banks are very much
reluctant to invest in this market other than in very few securities issued by some specific
entities like PSUs and some very good corporate bodies having a rating of AA and above.
This lack of sufficient demand for the alternative channel for flowing credit to the
economy has led to increased credit risk concentration within the banking sector and
poses a serious systemic risk for the economy. Therefore, it is very important to provide
a market that enables lower rated companies to raise the capital required to finance their
project without depending heavily on bank loan and advances. The success of this
alternative credit channel largely depend upon the availability of an efficient mechanism
by which credit risk can be managed and distributed among a larger number of
stakeholders. Credit Default Swaps, even if after its so called role as “Weapon of Mass
Destruction” in the 2008 US subprime crisis, can be an important support to ensure a
proper mitigation of the credit risk, leading to a significant growth in the corporate bond
market in India. But the success of CDS market in India again depends on the interest of
major stakeholders and flexibility given to the market players to deal with the product.

Credit Default Swaps, even if is very well known and a controversial financial
product worldwide, is a new development in Indian financial market. After the release of
final guideline by RBI in May 2011, even if the first trading happened on December 07
2011, between two Indian banks: IDBI Bank and ICICI Bank, followed by very few deals
in first few months, the same market could not experience any further volume till date,
even after several discussion among the market players and several amendments in the
RBI Guidelines addressing the objection and further requirements from the market.

Besides the fact that India truly require product like CDS to ensure an overall
growth of Indian Financial Market, Indian market players are equally concerned about
some of the important issues that may affect the growth of this market, as evidenced from
the insufficient deals after its opening ceremony during December 2011. Some of the
future challenges towards the growth of CDS market in India, especially in line with the
RBI Guidelines, are highlighted in the following section:

o There is a lack of sufficient Market Makers to sell CDS contract not only on low
rated bonds, but also on unrated infrastructure bonds, especially due to the
possibility of improper pricing mechanism available in India that can capture both
the credit and liquidity risk of low rated and illiquid corporate bonds.

o Even if market players appreciate the stringent RBI regulations to control the
systemic risk that can arise due to excessive speculation, the incentive given to the

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Course: Treasury Management, Module III: Financial Derivatives NIBM, Pune

speculators in market making plays a very important role to ensure sufficient

liquidity in the CDS market.

o RBI concern on the possibility of offsetting an open CDS position only with the
original counterparty, even if at a minimum price set by FIMMDA, is really a matter
of concern to the market players.

o Lack of sufficient clarity in terms of credit event, triggering the settlement of

compensation may also pose an important challenge for the growth of CDS market
in India. Inclusion of cross default as a credit event, and presence of information
asymmetry between the loan and bond market may cause some ambiguity to
trigger a CDS settlement in the event of any cross default. Exclusion of Loan
Restructuring from the credit event list may also cause some problem.

o Stringent capital requirement, especially for trading positions, may also posse an
important challenge for the market makers to actively participate in the CDS
market in India.

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