Comment

Credit default swaps (CDS) are the new derivatives bomb in-waiting, we read in this column last month. This month, let us look at some of the uses of CDS.

Recall that CDS is purchasing protection against a credit default by the reference entity. In the international market, CDS is normally linked to outstanding bonds issued by the reference entity. In case of default, the buyer of the protection can deliver any of the underlying bonds indicated in the contract.

As such, there may be an advantage in delivering a particular bond, which would maximise his gain from the CDS contract. Even if the contract is not physically settled but cash-settled by paying the loss on the underlying bond, this loss is determined within a defined period of 30-60 days after the default event. If the bonds do not trade or lack liquidity, then polled price is determined and settlement effected.

In the Indian context, the debt on the books of most borrowers includes loans from banks and financial institutions. Default recovery cases drag on for as long as 20 years with multiple appeals.

A CDS market cannot wait for a long time for settlement after default. It would thus be interesting see what the draft regulations will provide in this regard. One alternative could be to determine the value at which the Asset Reconstruction Company (India) Ltd Arcil would be willing to take over the asset. This must be acceptable to the writers of the CDS as well as buyers.

The primary use, which incidentally is the focus of RBI, is purchasing credit protection. If any bank has lent money to any corporate and feels that it must reduce the risk of that exposure on its books, it can buy protection.

Consequential impact on its capital adequacy and risk rating would also matter. If there is no benefit in that, banks may be reluctant to buy protection. Likewise, a dedicated contract manufacturer for a Pharma company or a component manufacturer for an auto company run the risk of being wiped out if the parent defaults on their outstanding. At least in theory, they can buy credit protection.

The protection could be purchased on average outstanding at any given point in time. In case the parent organistion fails, the buyer subcontractor can recover his money from the writer of the protection. The trick in such cases would be to determine whether to buy protection for five years or for one year at a time and roll it over. Buying for one year would be cheaper only if there is no credit deterioration.

If that happens, the future rollover premiums can be very high. To buy protection, there must be a counter party, typically a banker, who is willing to write the option. That means he has to take a credit exposure to that reference entity for the first time or may add to his existing exposure.

RBI’s focus (post-credit crisis) would be to ensure that the writer has set aside adequate capital to meet his obligations when a default event triggers a call for payment. A supplier would have to weigh the cost of CDS against other protection methods like letters of credit, non recourse factoring, bank guarantee etc. He must also remember that future business would be dead in any case. Only he would escape the loss of his receivables.

If CDS is permitted, there must be a clear mandate under law for assignment of the receivables for the writer to take over the position of the creditor and demand payment of the recoverable amount.

Buying credit protection is both straight forward and most likely the only contract to be permitted. Who all will be permitted is the question we need to wait for the regulations to answer. Other uses that I am outlining here may not be available in India in the initial stages but may be opened up later. Some of these are, as under:

Trading credit spread: Credit spreads tend to widen when the perception of default increases and narrow when the threat of potential default decreases.

A speculator with a view of either the spread widening or narrowing can use the CDS market to trade his view. Assume that Speculator A has view that spread on Corporate M is likely to narrow. He can write a CDS contract and receive the premium.

Later, when the spread narrows, the premium payable will come down, at which point he can buy a CDS for the same maturity at a lower cost and then receive the difference for the rest of the maturity period. As with any speculation, if the view is wrong and spread widens instead of narrowing, he can lose his shirt. If he expects the spread to widen, he would do exactly the opposite.

Relative value trade: Here one bets on the spread between two reference entities. Let us say spread on Corporate A is 300 basis points (bps) and on Corporate B is 400 bps and the speculator expects this spread to narrow to 50 bps.

He can buy protection on A and sell protection on B. Note that credit spread on both can go up or down, but the spread between them is expected to reduce. When that happens, he sells protection on A and buys protection on B. In the first contract, he earns a spread of 100 bps and on the second he pays a spread of 50 bps, netting the difference. If the spread widens, bad luck!

Credit curve steeping: The focus is on a single reference entity. Let us say for a top rated corporate the 5 year protection is quoted at 65 bps and 10 year protection at 90 bps. He will sell protection for 5 years and buy protection for 10 years. The contract is structured on the basis value point basis, i.e. for a basis point change in interest rates how the CDS spread would move. Hence, the notional principle on 5 year will be more than on 10 year to ensure the gain/loss to offset on the two contracts. When the credit steepens, this spread will widen and contracts can be reversed.

In all these contracts, it is also important to note that there is an implicit credit risk on the writer of the CDS and if the writer defaults, there could be consequential loss. Further, if the market turns out against the view point, there could be losses.

Nobel Laureate Joseph Stiglitz makes a scathing attack on CDS as self inducing credit problems in the market. “People were not buying insurance, they were gambling. Some of the gambles were most peculiar and gave rise to perverse incentives,” he writes in his book Fee Fall. He goes on to say that an institution buying a protection against a reference entity without an exposure can manipulate a thin market to drive the spreads up.

Increase in spreads leads to market perception of higher risk, reducing the share price, increasing cost of borrowing etc, leading to a self fulfilling prophesy of default on the underlying.

The writer is a chartered accountant and can be reached at rl@rlco.biz. The column, slated for publication on the last Thursday of the month, was delayed because of technical reasons.