Credit Derivatives in India

• What are Credit Derivatives?

    “Credit derivatives can be defined as arrangement that allow one party to transfer credit risk to one or more other parties”

• Terms associated with credit derivatives
• Protection  Buyer : Party that contract to transfer credit risk
• Protection Seller: Party that contracts to receive premium in return for assuming risk
• Credit event: Scenario agreed between the contracting parties that will trigger credit event
• Settlement : The amount that is paid following a credit event
• Reference Entity : Entity upon whose credit the contract is based
• Credit Derivative Products
• Credit default Swap
• Credit default option
• Total return swap
• Credit linked note
• Repackaged notes
• Collateralized debt obligation
• 
  Credit default swap
• Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit
• The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."
• 
     Credit default swap

• Credit default option
• An option to buy protection (payer option) or sell protection (receiver option) as a credit default swap on a specific reference credit with a specific maturity. The option is usually European, exercisable only at one date in the future at a specific strike price defined as a coupon on the credit default swap
• The option holder will have to pay a premium rate called the strike, made in a single upfront payment. In case the underlying credit does default, the option knocks out and becomes nullified or worthless
• Total Return Swap
• A Total Rate of Return Swap (Total Return Swap or TR Swap) is a bilateral financial contract designed to transfer risk between parties, but a TR Swap is importantly distinct from a Credit Swap in that it exchanges the total economic performance of a specified asset for another cash flow
• Payments between the parties to a TR Swap are based upon changes in the market valuation of a specific credit instrument, irrespective of whether a Credit Event has occurred
• Credit linked notes
• A credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from the note issuer to the investor.  
• The issuer receives the  issue price for each CLN from the investor and invests this in low-risk collateral.
• If a credit event is declared, the issuer sells the collateral and keeps the difference between the face value and market value of the reference entity’s debt.
• Credit linked notes
• Repackaged Notes
• A repackaged note means the note newly repacked using derivatives such as currency and interest rate swaps to make cash flows of secondary market notes more appealing to investors. Underlying notes (collateral notes) are transferred to an overseas SPC and new notes are issued backed by them
• Collateralized Debt Obligations
• A CDO is an ABS that is collateralized by a pool of debt obligations
• Examples include:

• Corporate Bonds with ratings below investment grade
• MBS and ABS (called structured financial products)
• Bond issues in emerging markets
• Corporate Loans commercial banks
• Special situation loans and distressed debt

• A CDO has the following structure:

• One or more senior tranches
• Several levels of mezzanine tranches
• A subordinate tranche known as the equity tranche, to provide prepayment and credit protection to other tranches

• Has preference/subordination structure (senior note/junior note, senior note/mezzanine note/junior note) as there are plural numbers of cash flows of numerous issues of collateral notes backing up CDO
• The target rating is once set forth based on the results of issue structure analysis, and then the actual rating is determined after establishing excess collaterals and assessing credit enhancing measures consistent with such target rating
• RBI’s stance on CDS
• RBI has taken a cautious stance on CDS guidelines so that the product that brought down AIG does not repeat itself in India. Therefore there are stricter norms in place

• The protection can be sold against risks of a single issue. In the case of AIG, the protection was provided for an MBS representing thousands of unknown home loans
• The protection can be bought by only those who hold the bonds unlike during the financial crisis when many investors bought protection betting on the default of a particular corporate
• RBI has severely restricted the number of parties that can offer or sell this product
• RBI Guidelines for CDS

• Eligibility for Market Makers
• Reference Entity and Obligations
• Pricing and Settlement Methodology
• Other Requirements
• The reference asset/obligation and the deliverable asset/obligation shall be to a resident and denominated in Indian Rupees;
• Obligations such as asset-backed securities/mortgage-backed securities, convertible bonds and bonds with call/put options shall not be permitted as reference and deliverable obligations
• CDS cannot be written on interest receivables
•  CDS shall not be written on securities with original maturity up to one year e.g., Commercial Papers (CPs), Certificate of Deposits (CDs) and Non-Convertible Debentures (NCDs) with original maturity up to one year
• the CDS contract must represent a direct claim on the  protection seller.
• Dealing in any structured financial product with CDS as one of the components shall not be permitted
• Dealing in any derivative product where the CDS itself is an underlying shall not be permissible
• It needs to be ensured that CDS are not used to build up excessive leveraged exposures
• CDS in India – Journey so far
• Global Experience
• RBI introduced CDS in the Indian market at the right time. It could draw upon the experience of the western world during the Financial Crisis of 2008 and incorporate important safeguards since the inception:

• Avoid complexity: Products like CDOs, ABS, MBS not allowed
• Curb Speculative activity: Users allowed to only hedge long positing in cash bonds
• Regulatory limits: Avoid excessive risk taking by putting limits like single name exposure, gross PV01 limits
• Standardized contracts: Enable trade reporting; enable trde compression thereby reducing systemic risks on account of large number of open contracts
• Regulatory oversight: Mandatory reporting of trades on central platform; Regulator can monitor activity of participants and avoid any misuse/ large concentration of risk 
• Central Clearing Counterparty: Important to avoid counterparty risk; Will be introduced when volumes pick up and viable to implement 

• Applications of CDS in the Global Market

1. Trading/ Market making
2. Product Structuring
3. Hedging trading instruments
4. Active portfolio/ asset management
5. Management of economic capital
6. Management of regulatory capital
7. Management of individual credit lines

• 1st CDS in India (Case study)
• Completed on Dec 7, 2011 Between IDBI and ICICI bank
• Protection was sold on bonds issued by REC ltd. and India Railway Finance Corp. ltd.
• Combined total size INR 10 crores, according to CCI
• Premium paid was 90 basis point