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Chapter 1 : Introduction
A Swap is a derivative in which two counterparties agree to exchange one stream of cash flow against another stream. Swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral. It can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.
The main objective of the project is to understand about Credit Default Swaps (CDS), its global footprint, its role in subprime crisis, its settlement in global arena and to check the feasible settlement of CDS in India, after its introduction in India, by understanding about Indian Credit Derivatives market. Research is concerned with the systematic and objective collection, analysis and evaluation of information about specific aspects to check the feasible settlement of CDSs in India.
The development of financial derivatives in recent past is astounding when we consider its volume globally. But at the same time the product once created for hedging the risk currently allows you to bear more risk sometimes making the whole financial system to tremble. May be that's why Warren Buffet called it a financial weapon of mass destruction. Whatever it may be but derivatives have grown exponentially and are necessary for the market to flourish.
The credit derivatives are nothing but the logical extension to the family of derivatives and have already made its presence felt globally. The credit derivatives have played a significant role in the development of debt market but also share a blame for the proliferation of subprime crisis.
A credit default swap which constitutes the major portion of credit derivatives is similar to an insurance contract which allows you to transfer your risk to third party in exchange of a premium. Right from its origin as plain vanilla product for hedging purpose it has grown to very complex products and now has posed a question mark on its credibility.
The subprime crisis started in what were regarded as the world's safest and most sophisticated markets and spread globally, carried by securities and derivatives that were thought to make the financial system safer. The subprime crisis brings the complexity of securitized products and derivatives products, the human greedy nature, inability of rating agencies to gauge the risk, inefficiency of regulatory bodies, etc. to the fore. Although CDS was not the cause of the subprime crisis but it had cascading effect on the market and was considered as the reason for the collapse of American International Group (AIG).
The lessons from the consequences of subprime crisis have helped in creating awareness about the regulatory frameworks to be in place which has increased the transparency, standardization, and soundness in the market. The various measures include formation of central counterparty for CDS, hardwiring of auction protocol and ISDA determination committee. On the backdrop of global crisis the movement of CDS is being watched carefully. The various data sources now provide data even on weekly basis. The efforts are being paid off and the market size of CDS has reduced considerably. And now with the central counterparties in place the CDS market will have more transparency and better control.
After opening up of the economy the equity market of India have grown significantly bringing in more transparency. But the corporate bond market is still in undeveloped mode and the efforts being taken on developing it have not provided expected returns. Under this light, India is now all set to launch Credit Default Swaps which are expected to ignite the spark which will flourish the corporate bond market. Considering the cautious nature of RBI and the havoc created by CDS in global market the move by RBI is significant. From the move of RBI one can say as the knife itself is not harmful but it depends whether it's in doctor's hand or a robber's hand. Similarly CDS as a product is certainly not harmful but its utility will depend on the judicious use of the same.
Chapter 2: Literature Review
The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates.
The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions.
Price fluctuations made it hard for businesses to estimate their future production costs and revenues. Derivative securities provide them with a valuable set of tools for managing this risk.
Financial markets are, by nature, extremely volatile and hence, the risk factor is an Important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates.
It is afinancial instrument(or more simply, an agreement between two people/two parties) that has a value determined by the future price of something else. Derivatives can be thought of as bets on the price of something.Itis the collective name used for a broad class offinancial instrumentsthatderivetheir value from other financial instruments (known as the underlying), events or conditions. Essentially, a derivative is a contract between two parties where the value of the contract is linked to the price of another financial instrument or by a specified event or condition.
Asecurity whose price is dependent upon or derived fromone or more underlying assets.The derivative itself is merely a contract between two or more parties. Itsvalue is determinedby fluctuationsin the underlying asset.The most common underlying assets includestocks, bonds,commodities,currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.Derivatives are generally used as an instrument to hedgerisk, but can also be used forspeculative purposes.
For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset.
Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.
The need for a derivatives market
The derivatives market performs a number of economic functions:
- They help in transferring risks from risk averse people to risk oriented people
- They help in the discovery of future as well as current prices
- They catalyze entrepreneurial activity
- They increase the volume traded in markets because of participation of risk averse people in greater numbers
- They increase savings and investment in the long run
The participants in a derivatives market
- Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset.
- Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.
- Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.
Types of Derivatives
Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts
Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are :
- Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
- Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an options to pay fixed and receive floating.
Uses of Derivatives
Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some pre-existing risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers (Fitch Ratings, 2004) and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators.
A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient. Jogani and Fernandes (2003) describe India's long history in arbitrage trading, with line operators and traders arbitraging prices between exchanges located in different cities, and between two exchanges in the same city. Their study of Indian equity derivatives markets in 2002 indicates that markets were inefficient at that time. They argue that lack of knowledge; market frictions and regulatory impediments have led to low levels of capital employed in arbitrage trading in India. However, more recent evidence suggests that the efficiency of Indian equity derivatives markets may have improved (ISMR, 2004).Development of derivatives market in India
Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the world's largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created.
In the equity markets, a system of trading called "badla" involving some elements of forwards trading had been in existence for decades.6 However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems.
The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre-conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as 'securities' so that regulatory framework applicable to trading of 'securities' could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk control in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of 'securities' and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three- decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): • Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system.
- On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips.
- Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.
- Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent.
- Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.
In finance, a SWAP is a derivative in which two counterparties agree to exchange one stream of cash flow against another stream. These streams are called the legs of the swap. Conventionally they are the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed.
A swap is an agreement to exchange one stream of cash flows for another. Swaps are most usually used to:-
- Switch financing in one country for financing in another
- To replace a floating interest rate swap with a fixed interest rate (or vice versa)
(Litzenberger, R.H)In August 1981 the World Bank issued $290 million in euro-bonds and swapped the interest and principal on these bonds with IBM for Swiss francs and German marks. The rapid growth in the use of interest rate swaps, currency swaps, and swaptions (options on swaps) has been phenomenal. Currently, the amount of outstanding interest rate and currency swaps is almost $3 trillion.
Recently, swaps have grown to include currency swaps and interest rate swaps. It can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.
If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.
Different types of swaps:-
Cross currency swaps are agreements between counterparties to exchange interest and principal payments in different currencies. Like a forward, a cross currency swap consists of the exchange of principal amounts (based on today's spot rate) and interest payments between counterparties. It is considered to be a foreign exchange transaction and is not required by law to be shown on the balance sheet.
In a currency swap, these streams of cash flows consist of a stream of interest and principal payments in one currency exchanged for a stream, of interest and principal payments of the same maturity in another currency. Because of the exchange and re-exchange of notional principal amounts, the currency swap generates a larger credit exposure than the interest rate swap.
Cross-currency swaps can be used to transform the currency denomination of assets and liabilities. They are effective tools for managing foreign currency risk. They can create currency match within its portfolio and minimize exposures. Firms can use them to hedge foreign currency debts and foreign net investments.
Currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets. Currency swaps allow companies to exploit advantages across a matrix of currencies and maturities.
Currency swaps were originally done to get around exchange controls and hedge the risk on currency rate movements. It also helps in Reducing costs and risks associated with currency exchange.
They are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies shop for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency.Credit Default Swap
Credit Default Swap is a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond.
- The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted.
- The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.
The first credit default swap was introduced in 1995 by JP Morgan. By 2007, their total value has increased to an estimated $45 trillion to $62 trillion. Although since only 0.2% of Investment Company's default, the cash flow is much lower than this actual amount. Therefore, this shows that credit default swaps are being used for speculation and not insuring against actual bonds.
As Warren Buffett calls them "financial weapons of mass destruction". The credit default swaps are being blamed for much of the current market meltdown.Example of Credit Default Swap
- An investment trust owns £1 million corporation bond issued by a private housing firm.
- If there is a risk the private housing firm may default on repayments, the investment trust may buy a CDS from a hedge fund. The CDS is worth £1 million.
- The investment trust will pay an interest on this credit default swap of say 3%. This could involve payments of £30,000 a year for the duration of the contract.
- If the private housing firm doesn't default. The hedge fund gains the interest from the investment bank and pays nothing out. It is simple profit.
- If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of £1 million - the value of the credit default swap.
- Therefore the hedge fund takes on a larger risk and could end up paying £1million
The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.
Credit default swaps are used not only by investment banks, but also by other financial institutions. Corporate entities use credit default swaps either for protection purposes, to hedge or to sell. Investment banks are primarily affected by the buyers. If a number of major corporate entities have bought protection from the same investment bank, and all of them fail simultaneously, this will put pressure on the investment bank to pay out. Moreover, the credit risk caused by the above failure may lead to other risks, such as liquidity risk, market risk and operational risk. Therefore, most of the investment banks re-sell the sold protection on the market to other market participants. Edwards (2004) argues that derivatives do not reduce credit risk, but rather transfer it from banks to other banks or entities. Therefore, most of the investment banks re-sell the sold protection on the market to other market participants. Edwards (2004) argues that derivatives do not reduce credit risk, but rather transfer it from banks to other banks or entities. Some of the top banks in America are carrying unknown gambling risks that no one has warned about, and they are all tied up in U.S. bank derivative portfolios (Edwards M, 2004).Commodity Swap
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve oil. A swap where exchanged cash flows are dependent on the price of an underlying commodity. This swap is usually used to hedge against the price of a commodity. Commodities are physical assets such as precious metals, base metals, energy stores (such as natural gas or crude oil) and food (including wheat, pork bellies, cattle, etc.).
In this swap, the user of a commodity would secure a maximum price and agree to pay a financial institution this fixed price. Then in return, the user would get payments based on the market price for the commodity involved.
They are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices.
A company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. There are two kinds of agents participating in the commodity markets: end-users (hedgers) and investors (speculators).
Commodity swaps are becoming increasingly common in the energy and agricultural industries, where demand and supply are both subject to considerable uncertainty. For example, heavy users of oil, such as airlines, will often enter into contracts in which they agree to make a series of fixed payments, say every six months for two years, and receive payments on those same dates as determined by an oil price index. Computations are often based on a specific number of tons of oil in order to lock in the price the airline pays for a specific quantity of oil, purchased at regular intervals over the two-year period. However, the airline will typically buy the actual oil it needs from the spot market.Equity Swap
The outstanding performance of equity markets in the 1980s and the 1990s, have brought in some technological innovations that have made widespread participation in the equity market more feasible and more marketable and the demographic imperative of baby-boomer saving has generated significant interest in equity derivatives. In addition to the listed equity options on individual stocks and individual indices, a burgeoning over-the-counter (OTC) market has evolved in the distribution and utilization of equity swaps.
An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. An exchange of the potential appreciation of equity's value and dividends for a guaranteed return plus any decrease in the value of the equity. An equity swap permits an equity holder a guaranteed return but demands the holder give up all rights to appreciation and dividend income. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do have.
Equity swaps make the index trading strategy even easier. Besides diversification and tax benefits, equity swaps also allow large institutions to hedge specific assets or positions in their portfolios
The equity swap is the best swap amongst all the other swaps as it being an over-the-counter derivatives transaction; they have the attractive feature of being customizable for a particular user's situation. Investors may have specific time horizons, portfolio compositions, or other terms and conditions that are not matched by exchange-listed derivatives. They are private transactions that are not directly reportable to any regulatory authority.
A derivatives dealer can, through a foreign subsidiary in the particular country, invest in the foreign securities without the withholding tax and enter into a swap with the parent dealer company, which can then enter a swap with the American investor, effectively passing on the dividends without the withholding taxInterest Rate Swap
An interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a sequence of interest payments without exchanging the underlying debt. In a typical fixed/floating rate swap, the first party promises to pay to the second at designated intervals a stipulated amount of interest calculated at a fixed rate on the "notional principal"; the second party promises to pay to the first at the same intervals a floating amount of interest on the notional principle calculated according to a floating-rate index.
The interest rate swap is essentially a strip of forward contracts exchanging interest payments. Thus, interest rate swaps, like interest rate futures or interest rate forward contracts, offer a mechanism for restructuring cash flows and, if properly used, provide a financial instrument for hedging against interest rate risk
The reason for the exchange of the interest obligation is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. In an interest rate swap they consist of streams of interest payments of one type (fixed or floating) exchanged for streams of interest payments of the other-type in the same currency
Interest rate swaps are voluntary market transactions by two parties. In an interest swap, as in all economic transactions, it is presumed that both parties obtain economic benefits. The economic benefits in an interest rate swap are a result of the principle of comparative advantage. Further, in the absence of national and international money and capital market imperfections and in the absence of comparative advantages among different borrowers in these markets, there would be no economic incentive for any firm to engage in an interest rate swap.
Differential information and institutional restrictions are the major factors that contribute to the differences in transactions costs in both the fixed-rate and the floating-rate markets across national boundaries which, in turn, provide economic incentive to engage in an interest rate swap.
Interest rate swaps have become one of the most popular vehicles utilized by many companies and financial institutions to hedge against interest rate risk. The growing popularity of interest rate swaps is due, in part, to the fact that the technique is simple and easy to execute. The most widely used swap is a fixed/floating interest rate swap.Credit Derivatives
Infinance, acredit derivativeis asecuritizedderivativewhose value is derived from thecredit riskon an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself.This entity is known as thereference entityand may be a corporate, a sovereign or any other form of legal entity which has incurred debt.Credit derivatives arebilateral contractsbetween a buyer and seller under which the seller sells protection against the credit risk of the reference entity.
Similar to placing a bet at the racetrack, where the person placing the bet does not own the horse or the track or have anything else to do with the race, the person buying the credit derivative doesn't necessarily own the bond (the reference entity) that is the object of the wager. He or she simply believes that there is a good chance that the bond or CDO in question will default (go to zero value). Originally conceived as a kind of insurance policy for owners of bonds orCDO's, it evolved into a freestanding investment strategy. The cost might be as low as 1% per year. If the buyer of the derivative believes the underlying bond will go bust within a year (usually an extremely unlikely event) the buyer stands to reap a 100 fold profit. A small handful of investors anticipated the credit crunch of 2007/8 and made billions placing "bets" via this method.
Where credit protection is bought and sold between bilateral counterparties, this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle(SPV) and payments under the credit derivative are funded usingsecuritizationtechniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative. For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.
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. Credit default swaps are explained in detail in next chapter.
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 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.Subprime Crisis
Background of Subprime Crisis:
The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005-2006. High default rates on "subprime" and adjustable rate mortgages (ARM) began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favourable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008.
In the years leading up to the crisis, high consumption and low savings rates in the U.S. contributed to significant amounts of foreign money flowing into the U.S. from fast-growing economies in Asia and oil-producing countries. This inflow of funds combined with low U.S. interest rates from 2002-2004 resulted in easy credit conditions, which fuelled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. As part of the housing and credit booms, the amount of financial agreements called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally.
While the housing and credit bubbles built, a series of factors caused the financial system to become increasingly fragile. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy, but they were not subject to the same regulations. These institutions as well as certain regulated banks had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses. These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to take action to provide funds to encourage lending and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments.
The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. Effects on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%. Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine. Leaders of the larger developed and emerging nations met in November 2008 and March 2009 to formulate strategies for addressing the crisis. As of April 2009, many of the root causes of the crisis had yet to be addressed. A variety of solutions have been proposed by government officials, central bankers, economists, and business executives.
Now after a brief idea about subprime crisis let's understand in detail about subprime crisis which shook the whole world.Role of CDS in Subprime Crisis
We already learned about the basics of Credit Default Swaps. Let's now understand the role played by CDSs in the subprime crisis.
We learnt about the securitization process in which the collateral of borrowings was pooled and tranches at different levels were created. The subprime crisis is the unravelling of a stupendously leveraged speculative bubble on real estate that built itself up for about seven years from the beginning of this decade (and century); this speculative bubble was mediated by fancy financial instruments fashioned by Wall Street, running all the way from sub-prime mortgages, asset backed securities (ABS) and mortgage backed securities (MBS), collateralized debt obligations (CDO) to credit default swaps (CDS).
Let's understand with real life example to know where exactly CDS fits in. Suppose you take a loan from Countrywide Financial (the largest US mortgage lender) for purchasing a house. Many such loans are collateralized, put into many tranches, rated by Moody's as investment grade securities and bought by Lehman Brothers. Now Lehman Brothers sells. This clearly indicates how severely the market was interlinked and perforated.
The purpose of this chapter is to justify the research methodology framework used for this study and the results and conclusions to be derived. It consists of the explanation of the entire research process, followed by the definition of the research problem methods used for the collection and analysis of research data. It begins with a description of the stages of the research process, followed by the research method classification and the definition of the research problem. Further the research method used for this study is explained which links the literature and the results obtained in the following chapters. The various stages of the research process described are formulating research problem and definition, development of the chosen technique, collection of primary and secondary data.THE RESEARCH PROCESS
Research process is defined as the systematic and objective process of generating information to aid in decision making. (Zickmund, 2002). The research process includes a number of stages starting from the formulating research problem and definition, collection of secondary data and information, research design, sampling, collection of primary data and information, analysis and interpretation of the data obtained, the formulation of results and finally the conclusions and the report. Research process is not just a simple method of following the steps as described but always involves moving from one stage to the other randomly, revisiting each stage more than once. The process consists of the highly interrelated activities as shown in the figure 1. All these steps are necessary to be anticipated in order the research to be successful and meaningful (Boyd, Westfall & Stach, 1989).
Formulating research problem and definition is the first stage in which the researcher defines the objectives of the research (Schiffmann and Kanuk, 2004). Here the researcher seeks to identify a clear - cut statement of the research question (Zickmund, 2002). This stage is the most difficult, and yet the most important, part of the research (Saunders et al, 2001). It gives an idea of the practicability and the worth of the topic. A wrong formulation of the research problem statement and its definition will misdirect the study and lead to the collection of data that will not be as valid and reliable as desired (Boyd et al., 1989).
Formulating Primary Data and Information Collection of the secondary data and information follows the statement of objectives and problem definition. Secondary information is any data originally generated for some purpose other than the present research objectives (Saunders et al, 2001). The clues and direction for the design of the primary research is provided by the secondary information. Secondary data are the published data (Kinnear & Taylor, 1991) and the secondary data can be obtained from academic journals, trade journals, books, business and trade magazines, commercial data, the government publications and internet. The secondary data and information are examined and checked before getting the primary data for the research. The advantages of the secondary data are the enormous savings in resources, in particular, money and time (Ghauri et al, 1995). It is much less expensive to use secondary data set than to collect the data for the research. Secondary data are likely to be higher quality data than could be obtained by the researcher by collecting them (Stewart and Kamins, 1993). But the unreliability and inaccuracy of the secondary data are the drawbacks when the data is outdated or obtained from some unreliable source. Also the gaining access may be difficult or costly. Although most of the data sources are good for relative comparisons, almost no source is perfectly accurate in an absolute sense. Hence, for an effective research, the primary research is considered to be an absolute necessity (McDaniel and Gates, 1999)
Research design is an important stage of the research activity. It is the overall plan for relating the conceptual research problem to relevant and practicable empirical research (Ghauri and Gronhaug, 2002). Research design details the procedures for obtaining the information. It should consider the extent to which the researcher should be able to collect the data from the research population (Saunders et al, 2001). It lays a foundation for conducting the study (Malhotra, 1993). The problem definition formulated is incorporated in the design to come up with the approach that allows for answering the research problem in the best possible way (Ghauri and Gronhaug, 2002). According to Ghauri and Gronhaug (2002) the research design should be effective in producing the wanted information within the constraints put on the researcher, e.g. time, budgetary and skill constraints. The maximization of the accuracy of the information generated with the constraints is the primary goal of the research design (Tull and Hawkins, 1987). Analysis and interpretation of the data is the next stage of the research process after the collection of the primary data. The purpose of analysis is to obtain meaning from the collected data (Ghauri and Gronhaug, 2002). This stage includes the preparation of the data, editing of the data, coding of data and finally the recording of the data (Saunders et al, 2001). This stage includes the researcher's effort for checking for the errors in the data. The final stage of the research process is the formulation of the results obtained from the data and the preparation of the reports. It consists of the exploration and presentation of the data which are interpreted and analyzed. The data collected are put into a logical, consistent and persuasive report (Ghauri and Gronhaug, 2002).RESEARCH METHOD USED FOR THIS STUDY
To achieve the objective of this study, a qualitative method, which includes primary and secondary research was chosen. Since qualitative research generally tends to be associated with participant observations, unstructured in-depth interviewing, and flexible data collection from relative small respondent sample (Silverman, 1993). The flexibility and openness of qualitative research allows access to some unexpected issues and areas which might not be visible at the time of planning the research or framing the research questions (Creswell, 1994).QUALITATIVE RESEARCH
Qualitative research is a type of research that situates activity and locates the observer in the world. It enhances the possibility to study things in their natural settings and make sense of the happenings. This type of research profoundly involves with interpretive techniques, which seeks to describe, decode, translate and come to term with the meaning, not the frequency of the phenomena in the social world (Strausse and Corbin, 1998). The qualitative research is suitable for examining topics with different levels of meaning by looking at change processes over time to understand the essence and to adjust to new issues and ideas as they emerge (Cassell and Symon, 1994). However, the characteristics of qualitative research involve some problems (Creswell, 1994). This type of research methodology has been criticized for its be deficient in scientific rigors, problems of interpretation and generalization, as well as the concomitant biases, which could destroy confidence in the entire process. Moreover, being an interpretive study, it is difficult to safeguard against biases, values and judgments of the researchers that can creep into their interpretation of the data (Goodyear, 1990). Contrary to the qualitative research is the quantitative research method. The quantitative approach is primarily concerned with the measurement and the casual relationships between different variables. According to Bryman (1988), the quantitative paradigm, based on positivist philosophy, seeks the facts or causes of social phenomena without subjective element of interpretation, even the involvement of the researchers will be merely an outsider. Although quantitative research has its strength and reliability, Denzin and Lincoln (2000) argued that in qualitative research it is assumed that qualified and competent researchers can, with objectivity, clarity and precision, report on their observations of the experiences of others and the social world. As a result through interviews, life story, case study and other documents, researchers can combine their observations with self-reports provided by the targeted subjects. Considering the characteristics and drawbacks of both qualitative and quantitative research in relation to the objective of the study, it can be justified that qualitative research will provide a better way of proceeding. This is due to the fact that it allows an in-depth perspective on the subject to take place. Although qualitative research remains to some extent problematic with its objectivity, this can be appeased through a careful conduct of research process. Nonetheless, in the case of quantitative method, if chosen, it would discriminate the access of the rich and meaningful information, which renders this study almost impossible.RESEARCH OBJECTIVES
The objectives of this work are to find out if the growing credit derivatives market will threaten the stability of the financial markets especially in developing country like India. By adopting an inductive research this work will find out the general understanding that persists within the market and discover the main concerns regarding CDS.PRIMARY RESEARCH
Primary research(also calledfield research) involves the collection ofdatathat does not already exist. This can be through numerous forms, includingquestionnairesand telephone interviews amongst others. This information may be collected in things like questionnaires and interviews.
Themain advantagesof primary research and data are that it is:
- Up to date.
- Specific to the purpose - asks the questions the business wants answers to.
- Collects data which no other business will have access to (the results are confidential).
- In the case of online surveys and telephone interviews, the data can be obtained quite quickly (think about how quickly political opinion polls come out).
Themain disadvantagesof primary research are that it:
- Can be difficult to collect and/or take a long time to collect.
- Is expensive to collect.
- May provide mis-leading results if the sample is not large enough or chosen with care; or if the questionnaire questions are not worded properly.
- Sample should be aware of the object being researched upon.
Secondary data include both raw data and published summaries (Saunders et al, 2001). This research will include both the quantitative and qualitative data that will be used as descriptive and explanatory sources. Documentary secondary data will include historical articles from different sources such as BBA surveys, Fitch ratings surveys, newspapers, tutorials and general information provided on the internet. The secondary research will be used to support the findings in the primary research and also to provide a greater insight for this work.
The types of data collected comprises of Primary data and Secondary data. As CDSs are yet to be properly established in India the project relied mostly on secondary data. Secondary data for the study has been compiled from the reports and official publication of the organization, educational institutions (like Stanford University), online forums, textbooks, BBA surveys, Fitch ratings surveys, newspapers, tutorials and general information provided on the internet etc. which helped in getting an insight of the present scenario in the settlement of CDSs abroad and in India.Research Design & Method:
The Research design is purely and simply the framework of plan for a study that guides the collection and analysis of data. The framework included studying the global derivatives market and the role of credit derivatives in global market and recent turmoil. Understand about Credit Default Swaps (CDS) and how it had cascading effect on subprime crisis. Understand the OTC derivatives market, its settlement procedures and role of Central Counterparty (CCP) in CDS settlement. Understand about Indian Derivatives market and possible settlement procedures and role of central counterparty for the settlement of CDSs in India.
Qualitative Research design was used for this research.
Chapter 4 : Data Analysis
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.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 looses 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 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.
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.
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:
- Commercial banks and Primary dealers
- A protection buyer shall have an underlying credit risk exposure in the form of permissible underlying asset / obligation
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.
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.
- Physical Settlement
- Cash Settlement
- Fixed Amount Settlement (binary CDS)
- Obligation Acceleration
- Obligation Default
- Failure to pay
- Repudiation/ Moratorium
- 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
- Bankruptcy, insolvency or inability of the obligor to pay its debts
- 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)
The reference asset must rank pari passu or more junior than the underlying asset/ obligation; and
There are legally effective cross-reference clauses between the reference asset and the underlying asset.
- 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 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. [Source: "RBI warms up to credit default swaps", The Economic Times, dated 30 June 2009]
CDS Settlement in India:
The CDS market is 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 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.
When JPMorgan created CDS they never must have thought that the same will bring them the write downs worth $5.5 billion. When CDS were launched they were meant to separate the risk and providing new avenues of generating business/profit. But during the evolution of CDS it turned to many complex products which were difficult to understand even for those dealing in it. Being an OTC market many problems did not came to fore. Once the market reached a huge volume the problems became eminent.
The efforts are being taken to bring in more regulation to CDS market and to preserve its credibility. After all the products were never bad it's just that the users were incompetent. Many of the auctions are conducted by ISDA; the determination committee has resolved the legal conflicts to a great deal, the central counterparties have already started their operations and gaining good response. With many other CCPs to follow the transparency, price discovery, liquidity will improve.
With the feedback being asked for by RBI on the launch of CDS to the banks, India is all poised to introduce CDS. The lessons learnt from the west will allow India to do away with the drawbacks or the product and to exploit the advantages. So with Basel II norms adopted by India and clearing house/ regulations to be in place, India will be launching the CDS soon.
The west has already experienced the glory and perils of CDS. India is now set to launch the Credit Default Swaps and for India this is just a new beginning.
Development of the Derivatives Market in India
Factors driving the growth of financial derivatives
- Increased volatility in asset prices in financial markets,
- Increased integration of national financial markets with the international markets,
- Marked improvement in communication facilities and sharp decline in their costs,
- Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and
- Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.