Credit default swaps: The new derivative bomb in-waiting

In its last credit policy statement, released in April, the Reserve Bank of India (RBI) indicated that it is actively working towards the finalisation of rules for credit default swaps (CDS).

“As indicated in the Second Quarter Review of October 2009, the Reserve Bank constituted an internal Working Group to finalise the operational framework for introduction of plain vanilla over-the-counter (OTC) single name CDS for corporate bonds for resident entities subject to appropriate safeguards.

The Group is in the process of finalising a framework suitable for the Indian market, based on consultations with market participants/experts and study of international experience.

Accordingly, it is proposed to place the draft report of the internal Working Group on the Reserve Bank’s website by end-July 2010,” went the policy statement.

A credit default swap is an option/ insurance contract but called a swap more due to its longer tenor and pricing methodology, which is akin to pricing a swap contract. In short, it is a mutual contract between a protection buyer and protection seller. The protection is against the credit default by a reference entity with respect to a reference asset or assets.

The buyer pays the premia, called spreads, denominated in basis points. Bank A can buy protection from Bank B on credit default by Corporate A either on a specific bond issued by Corporate A or a loan taken by it or multiple bonds issued by it.

If the spread quoted is 156 basis points on a protection on Rs 100 million, then Bank A will pay Rs 1.56 million per annum for the protection to Bank B. If the protection is for five years, it will pay this premium until expiry of five years or a credit default by Corporate A, whichever is earlier. The normal market practice is for the premium to be paid quarterly.

It is easy to see that the success of the contract lies in the ability of the protection seller to settle on his obligation when the claim is made consequent to a credit default. In the case of insurance also, the success lies in the ability of the company to meet its obligations when claims are made.

For this reason, insurance companies are regulated and the risks they take are examined periodically. The premium they charge is expected to be commensurate with the risk they take, except when the premium itself is prescribed by the regulator or government. In the same way, market makers in this product would have to be monitored to ensure that they have adequate capital when a claim is made.

If a market maker sells too many credit default swaps against the same reference entity, it could result in problems for them when that reference entity defaults. How this issue is proposed to be addressed by RBI will be known only when we see the draft guidelines as and when they are issued.

As a derivative, CDS can be used for speculation, arbitrage, trading and hedging.

A lot would depend on the guidelines. If the guidelines prescribe that only those with an exposure to the underlying credit can buy a CDS, then speculation and trading would be ruled out. The users would also depend on the regulations and participation by insurance companies and mutual funds would depend on the respective regulator’s permission.

It is unique to India that committees appointed by the regulator mandate the product structure, whereas in other countries the market players or exchanges come up with the product. Regulatory intervention is only in approving the product.

It can only be hoped that the committee does not come up with a scheme that destroys the demand for the product, making it a non-starter as in the case of interest rate futures. A more appropriate method would have been to let FIMMDA come up with the product design.

The regulatory concern should be with fairness to the buyers of the product, ensuring ability of the seller to meet its obligations when claims are made and an orderly mechanism to determine the amount payable in the event of a credit default. But regulators are loath to give up their importance and more so while the RBI is currently basking in the glory of its regulatory success in steering the banks from being trapped in sub-prime and similar crises.

Ramesh Lakshman is a chartered accountant and can be reached at rl@rlco.biz. His column will appear on the last Thursday of every month. The next piece will detail the uses of CDS.