The Future of Credit Derivatives

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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 itssuspicion 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:

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

Protection Buyer

Buys credit

protection

Tends to own

underlying asset

Payment only if credit event occurs

Protection Seller

Sells credit

protection

Do not own

underlying assetCDS premium paid regularly



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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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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 toforce 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 DomesticInstitutions

Domesticretail

DomesticCorporate

ForeignInstitutions

Equity & equity derivatives Y Y Y Y

Interest rate swaps Y - Y -

Other interest rate derivatives - - - -

Credit derivatives N N N N

Currency derivatives Y - Y Y

Commodity futures N Y Y N

Commodity options N 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 ResilienceStocks/ 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/

http://www.imf.org/external/pubs/ft/fandd/2008/06/dodd.htm



The Future of Credit Derivatives

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