Credit Default Swap

Credit Default Swap


Credit Default Swap

As of today one of the most important facts in life of every individual is uncertainty. One cannot predict what their future may be. This uncertainty may bring both benefit as well as loss to an individual. Today, we have tools to curb in this uncertainty. Although these tools cannot avoid the uncertain events but can help to make good the losses. The common world calls this word as Insurance. We have uncertainty that fire may broke down in the godown, so we have fire insurance. Similarly, we may be afraid of losing our import consignment and we make marine insurance. There are various such insurance covers available in the market to make good the losses. One such insurance cover is Credit Default Swap. It is basically for banks whose are afraid that the borrowing party may default and bank will not be able to recover the loss. The premium amount paid by Protection Buyer to protection seller is known here as Credit Default Swap.

This loss which we are talking about here is the unexpected loss to bank. For expected loss the banks have the provisioning norms and the scheme of loan pricing.  In credit default swap there are three entities:

(i) Reference Entity: To whom the loan is given and may default

(ii) Protection Buyer: Who needs the protection from the chance that loan may not be recovered

(iii) Protection Seller: One who assures to make good the loss.

Reading the above norm it seems that this scheme is utmost same as that of insurance. However, there are few differences between insurance contract and Credit Default Swap which are as follows:

(a) This swap can be used for the purpose of speculation. Bank may think just to enter the swap because it feels that xyz person may default if the loan is given to him.

(b) These swaps are traded/ marketed in market as like options, futures etc.

(c) The doctrine of utmost good faith shall not be applicable for these swaps i.e. it is not necessary that the protection buyer have complete knowledge about the reference entity.

RBI guidelines on Credit Default Swap (CDS)

Participants in the CDS market are classified as either users or market makers. User entities are permitted to buy credit protection (buy CDS contracts) only to hedge their underlying credit risk on corporate bonds. Such entities are not permitted to hold credit protection without having eligible underlying as a hedged item. The users cannot buy CDS for amounts higher than the face value of corporate bonds. This is the most important point of difference, as there was no such limitation in United States of America prior to 2008, and hence many Institutional players had taken huge long positions (in CDS) without having any exposure  to  reference asset.

Since the users are envisaged to use the CDS only for hedging their credit risks, assumed due to their investment in corporate bonds, they shall not, at any point of time, maintain naked CDS protection i.e. CDS purchase position without having an eligible underlying bonds held by them and for periods longer than the tenor of corporate bonds held by them.

The eligible entities under user’s category would be Commercial Banks, PDs, NBFCs, Mutual Funds, Insurance Companies, Housing Finance Companies, Provident Funds, Listed Corporates, Foreign Institutional Investors (FIIs) and any other institution specifically permitted by the Reserve Bank of India.

CDS will be allowed only on listed corporate bonds as reference obligations. However, CDS can also be written on unlisted but rated bonds of infrastructure companies. This is another major area of difference between the US markets and RBI guidelines. In United States of America, the CDS were written on various pass through securities like Mortgage Backed Security (MBS), Collateralized Debt Obligation (CDO) etc, whereas as per the RBI guidelines, the CDS are specifically restricted for listed corporate bonds, the obvious reason being that there is no big market of pass through securities in India as it is in US.

The credit events specified in the CDS contract may cover: Bankruptcy, Failure to pay, Repudiation/moratorium, Obligation acceleration, Obligation default, Restructuring approved under Board for Industrial and Financial Reconstruction (BIFR) and Corporate Debt Restructuring (CDR) mechanism and corporate bond restructuring.

Since, CDS are traded mainly over-the-counter (OTC), the contracting parties therefore have to agree upon the terms and conditions of the CDS individually. In order to facilitate documentation, and to avoid disputes as to whether a credit event had actually occurred and how a contract should best be settled, CDS contracting parties (in the international and US market) generally refer to the International Swaps and Derivatives Association (ISDA) Master Agreement. In India, the RBI guidelines specifically states that  Fixed Income Money Market and Derivatives Association of India (FIMMDA) shall devise a Master Agreement for  Indian  CDS

Regarding the Settlement procedures, the RBI Guideline states that the parties to the CDS transaction shall determine upfront, the procedure and method of settlement (cash/physical/auction) to be followed in the event of occurrence of a credit event and document the same in the CDS documentation. However it further adds that for transactions involving users, physical settlement is mandatory. For all other transactions, market-makers have been permitted to opt for any of the three settlement methods (physical, cash  and auction), provided the CDS documentation envisages such settlement

Further, the guidelines specifically provide norms for Prevention of mis-selling and market abuse, wherein it requires protection sellers to ensure that CDS transactions shall be undertaken only on obtaining from the counterparty, a copy of a resolution  passed by  their Board of Directors, authorizing the counterparty to transact in CDS.

RBI has also incorporated certain reporting requirements in the guidelines which would require market makers to report their CDS trades with both users and other market makers on the reporting platform of CDS trade repository within 30 minutes from the deal time. The users would be required to affirm or reject their trade already reported by the market- maker by the end of the day. In addition to these reporting requirements the participants are also required to report to respective regulators (e.g. IRDA for Insurance companies) information as required by them such as risk positions of the participants vis-à-vis their net worth and adherence to risk limits, etc.




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