2009

The Future of Credit Derivatives in India

A Study of India’s Readiness to Credit Derivative Market

By

Neeraj Kumar Ojha

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1. Introduction

The global economy is under stress facing the most dangerous shock in financial markets
since the 1930s. The collapse of Bear Stearns, Lehman Brothers and the near-collapse of
American International Group (AIG) has panicked investors as well as public across the
world. The subprime crisis in America has deepened people's suspicion that financial markets
are glorified casinos which are manipulated by speculators. Many claim that the global
downturn is going to drag India down with it, bringing massive unemployment and a period
of prolonged recession.

So, is this an inauspicious time to call on India to reform its financial system and shed its
suspicion of complex credit derivatives? Critics argue that India is dangerously complacent.
Its concerns about over-sophisticated markets have stifled the development of financial
market. The result is that the country suffers from financial malnutrition.

2. What do we mean by credit derivatives

Credit derivatives are instruments to transfer credit risk. Financial institutions use them as a
flexible credit risk management tool and as an easy way to receive extra returns. They are
usually defined as off-balance sheet financial instruments that permit one party (beneficiary)
to transfer credit risk of a reference asset, which it owns, to another party (guarantor) without
actually selling the asset. It, therefore, unbundles credit risk from the credit instrument and
trades it separately.
According to the International Swaps and Derivatives Association (ISDA), the notional
outstanding volume of credit derivatives was $54.6 trillion at the end of June, 2008. The
notional amount of a derivatives contract is a hypothetical underlying quantity upon which
interest rate or other payment obligations are calculated. These notional amounts are an
approximate measure of derivatives activity. The two most important types of credit
derivatives are credit default swaps and collateralised debt obligations.
2.1 Credit default swap (CDS): A credit default swap is a credit derivative contract in
which one party sells risk to another party who is willing to take the risk. It is
essentially an insurance contract in which if a default occurs (which is referred as a
credit event) on a bank loan or bond (called reference obligation), then the buyer of

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the swap receives a payment from the seller. To obtain this coverage, the buyer of the
swap pays a premium to the seller of the swap.
A credit default swaps transaction:

Protection Seller Protection Buyer

Payment only if credit event occurs
Sells credit Buys credit
protection protection

Do not own CDS premium paid regularly Tends to own

underlying asset underlying asset

2.2 Collateralized debt obligations (CDO): CDOs are marketable instruments/ securities
created by securitising a pool of debt assets. CDOs are supported by a variety of
underlying collateral, such as, bonds, loans, credit default swaps, asset-backed
securities, sovereign debt, equity default swaps or CDO tranches from other deals.
CDOs generate immediate cash flows from assets, which would otherwise generate
cash flows over a longer period of time. A CDO deal is generally set up as a Special
Purpose Vehicle (SPV) which functions as an independent company. The assets
owned by the SPV are the collateral while the liabilities are the tranches issued by the
SPV.

Source: Bionic
Turtle

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Investors in CDOs purchase the tranches, and the SPE uses the proceeds from the sale
of the tranches to purchase the collateral assets. Periodically, the interest and principal
cash flows generated by the collateral assets are collected together and used to make
interest and principal payments to the tranches. There are a set of rules to determine
how the funds are to be distributed to various tranches and these rules are known as
the cash flow waterfall for the CDO. The senior tranche contains the least risk due to
its position of getting paid first and hence it is paid the smallest coupon. Similarly, the
other tranches are paid in order of seniority with coupons and risk increasing as
payments move down the structure. The most junior tranche at the bottom of the
waterfall is known as the equity tranche and is paid the highest coupon.

3. Lost opportunities

1. Buoyancy in Indian
economy has made it
possible for corporates
to come up with huge
expansionary plans
which require large
amounts of capital for
longer tenures. Indian
bank/ debt market is
still not well
developed to meet the
requirements of the
corporate sector. This
is evident from the
chart below which
shows that the
corporate debt, which amounts to less than 10% of the GDP, barely shows up on this
scale. A well developed credit derivative market would allow banks to retain assets on
their balance sheet and at the same time will relieve them of the credit risk, thereby,
promoting banks to finance these projects.
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2. Capital Adequacy under Basel II: Indian banks have to maintain capital adequacy at 9%.
Banks can use CDS to reduce their capital requirements. In a banking book asset, the
protection provider has a risk weight of 85% and the weight of the underlying is 15%.
Thus, by finding a protection provider that has a lower risk weight than the underlying,
the investor can reduce the amount of regulatory capital required.
3. Earlier securitization was the only option available to banks for managing their credit
risks. But now banks averse to securitization due to the costs/ legal/ regulatory reasons
could use CDS for credit risk management.
4. CDS spread could be used as an indicator to assess the risk profile of debt in a well
developed corporate debt market. This information is probably more reliable and timely
than credit ratings published by rating agencies. Thus credit derivatives could serve as an
additional source of information about the reference entities’ financial health.
5. RBI statistics shows that the percentage of Non Performing Assets (NPAs) is higher in
non-priority advances as compared to priority sector advances. The NPAs at the existing
level are not a cause of concern, but they may increase during an economic downturn.
CDS can help banks to check the growth in NPAs and also free up capital for regulatory
requirements.

4. Issues Associated with Credit Derivatives

1. Impact of credit derivatives on systemic risk: Credit derivatives apparently seem to
reduce systemic risk by dispersing credit risk among numerous financial institutions. But
the subprime experience has shown how credit derivatives amplified the systemic risk by
spreading the crisis to different corners of the world. When one institution gets in to
trouble, it takes all those who deal with it in to trouble. Bear Stearn was counter party to
some $10 trillion of over-the-counter swap options and if it had gone bust, the contracts
(of which it was counterparty) would no longer have been honoured and this would have
infected the world's derivatives markets. Thus counterparty problems can generate
systemic risks through so-called "domino" effects, where shocks propagate across
financial institutions that have assets or liabilities directly linked to each other through the
payments system.
Fig.1 shows the severity of subprime crisis as compared to other crises of the world
economy. The duration of subprime crisis is also expected to be much larger than the
previous ones.

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Source: The Economist

Fig.2 shows the write-downs by various banks since January 2007 due to their exposure in
subprime market.

Source: The Economist

2. Credit derivatives reduce the banks’ incentives to monitor their borrowers. Credit
derivatives can also increase and redistribute credit risk in an undesirable manner. They
were probably one of the reasons why the banks did not correctly monitor Enron. The risk
takers (protection sellers) in credit derivatives lack a direct relationship with the
borrowers to monitor them adequately, and they are also less skilled and experienced in
evaluating risk. Credit derivatives may even give incentives to a buyer of protection to
force a borrower to default.
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3. Credit derivative markets are quite opaque, as most of the transactions are traded over the
counter. In addition, a substantial part of ISDA documentation is not freely available to
the public. This relative opacity makes it difficult for supervisory authorities and scholars
to have a clear view of the risks involved. The credit derivatives market is largely self-
regulated which has its own downsides.

5. Where we stand

The liberalization in the Indian financial sector started more than a decade back. But it is only
now that the Reserve Bank of India is considering the use of derivatives in the market.
Although derivatives in the equity market were permitted way back in 2001, the currency and
the interest rate sectors were not allowed to use derivatives. The only derivatives allowed in
the money market segment of the financial sector are ‘plain- vanilla’ credit default swaps and
some foreign currency option deals. A plain-vanilla CDS is the most traditional form of swap
where a single party buys protection for some credit default event. However, RBI is now
keen to open up the segment and allow for options on both currency (the Indian Rupee) as
well as the interest rate applicable in the Indian markets.
Types of participants in Indian market

Market Domestic Domestic Domestic Foreign

Institutions retail
Equity & equity derivatives Y Y
Interest rate swaps Y -
Other interest rate derivatives - -
Credit derivatives N N
Currency derivatives Y -
Commodity futures N Y
Commodity options N N
Corporate Institutions
Y Y
Y -
- -
N N
Y Y
Y N
N N
Table-1

Table-1 highlights various derivative products operating in different market segments of

India. We find that the market for credit derivatives has yet to develop in India.

A well developed credit derivatives market is supposed to provide liquidity in the financial market.
Liquidity has three dimensions:

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1. Immediacy: Immediacy refers to the ability to execute trades of small size

immediately without moving the price adversely (in the jargon, at low impact cost).
2. Depth: Depth refers to the impact cost suffered when doing large trades.
3. Resilience: Resilience refers to the speed with which prices and liquidity of the
market revert back to normal conditions after a large trade has taken place.

Table-2 highlights our accomplishments in achieving liquidity in financial markets with the
help of various types of derivatives. At the same time, it also highlights that achieving a
sound set of financial markets is synonymous with achieving a ‘Y’ in all the cells of Table-2.

Market Immediacy Depth Resilience

Stocks/ Futures and Index futures Y Y Y
Options on index and liquid stocks Y N N
Other stock options N N N
Interest rate swaps Y Y N
Commodity futures Y N N
Table-2

6. The Road Ahead

The market for credit derivatives in India is shallow. Although, public sector banks account
for over 70 percent share in Indian banking assets, foreign and private banks dominate the
derivative market. India can focus on introducing some tried and tested credit derivatives.
This is the reason RBI is planning to introduce these tools. RBI had issued the draft
guidelines for credit derivatives in March, 2003. However, since then the central bank has
been deferring its decision to introduce credit derivatives. RBI, in its annual policy for 2007-
08, said it will introduce credit derivatives in a calibrated manner as a part of financial sector
liberalisation. The Reserve Bank has formulated comprehensive guidelines on derivatives for
banks in view of the growing complexity, diversity and volume of derivatives used by banks.

A cautious approach needed

The present economic crisis brings several lessons for us. First and foremost is that risk
management practices of many financial institutions were deficient and managers need to be
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more active in scrutinizing derivatives and in pursuing a stringent stress testing for these
products, particularly in good times, when risks are less obvious.
The second lesson is related to credit rating agencies which failed to capture the risks in
derivatives. The rating agencies need to improve their methodologies and to adopt a
differential rating system for structured instruments to take in to account the different risks
inherent in different tranches of structured products.
Creating market for foreign exchange derivatives will help domestic firms with exposure to
international trade protect themselves from currency fluctuations. But it will also create the
risk of foreign investors using these markets for speculative trading on the currency and that
domestic firms might get burned if they buy those derivatives without fully understanding
them. The solution is not to choke off these markets but to make them more transparent,
subject participants to uniform disclosure standards, and prevent fraudulent behaviour.
A well developed credit derivative market is part of the larger objective of developing the
domestic corporate debt market. Such a market will help the players to transfer risk from risk-
averse players to those who are willing to take risk. We must be prepared to accept that India
will witness a developed and regulated credit derivatives market in the coming time.

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7. References

1. IMF report on Global Prospects and Policies.

2. World economic and financial surveys: Global financial and stability report.

3. CDO primer: By Victoria Ivashina

4. IMF working paper on ‘Systemic banking crises: A new database’: By Luc Laeven
and Fabian Valencia

5. Risk managers take a hard look at themselves: Illustration by Simon Pemberton

Bibliography
6. The J.P. Morgan Guide to credit derivatives

Websites

7. http://www.imf.org/external/pubs/ft/fandd/2008/06/dodd.htm
8. http://www.economist.com/

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