CDS is a very popular hedging instrument against credit counter party risks. However off late this instrument has lost some shine in the western markets after the recent financial melt down. In India RBI feels that this
instrument will prop up the shallow Bond market and hence permitted it, albeit with a lot of precautions and that too as an OTS product. Let us now look in to the proposed new product and understand its utility and
limitations.
It is a financial derivative contract which allows one party (Protection Buyer) to transfer, for a premium, the credit risk (losses due to Credit Events) of a reference obligation (Underlying loans, Bonds etc.), to another party (Protection Seller) without transferring its ownership. It is an off balance sheet financial instrument.
The credit events may cover Bankruptcy, Failure to pay, Obligation acceleration etc. However, the original credit relationships are neither changed nor newly established due to a CDS transaction.
RBI Guidelines on CDSIn view of the complexities involved in the valuation, accounting, and risk management aspects of
credit derivatives RBI has decided to initially allow only plain vanilla credit default swaps.
Advantages of CDS
1. Hedging the credit risk: Gains from CDS offset losses on an investment which arise due to an adverse credit event.
2. Investment to earn profits. CDS is transfer of credit risk in lieu of the credit spread in the form of premium. In case of no credit event, the CDS premium received is the profit to the market maker. It makes leverage possible and helps those with high funding costs.
3. Increase investors’ interest in corporate bonds and help development of the corporate bond market in India.
4. Trading profits. The CDS premium reflects the present value of the expected loss on a default risky asset. It increases or decreases with the shift in credit quality of the underlying reference entity or/and
obligation. Hence CDS can be used to take a view on both the deterioration and improvement in the credit quality of the reference obligation and earn trading profits.
5. Relief to capital charge. When credit risk gets hedged with a CDS contract, the credit risk capital is freed to support fresh credit exposure case of Banks, financial institutios and NBFCs etc., The exposure
level is reduced for protection buyer. For protection seller it becomes his credit obligation.
6. Exposure Management:
v CDS helps in transferring exposures from one counterparty to another.
v To release credit exposure limits to a counterparty;
v To reduce concentrations by shedding exposures to a counter-party (without affecting the
relationship with the borrower since there is no transfer of title of the asset) or to a sector;
v To assume exposures to a counter-party or to a sector to diversify risks or to fill gaps in credit quality spectrum
CDS PRODUCT FEATURES:ü The CDS contract outlines potential exchange of payments between the two parties in which at least
one leg of the cash flow (payout) is linked to the “performance” or “credit event” of a specified
Reference Entity/ Asset.
ü At the minimum, the contract specifies
ü Reference Entity: Issuer of bond/Lender
ü Reference Asset: The bonds/loans for which credit protection is bought or sold
ü Credit Event: The credit service/ quality related event that triggers claim for compensation.
ü Notional Amount: The amount for which the protection is bought or sold
ü Premium: The present value of the expected loss on a default risky asset
ü Term of Contract: The tenure for which the protection is bought or sold.
CDS INTERNATIONAL MARKET OVERVIEW• The total CDS outstanding trades have declined from 36,098 to 29,878 billion USD from H1-2009 to
H2-2010.
• The share of CDS in total Global OTC derivatives contracts outstanding has declined from 6.07% in H1-2009 to 4.97% in H1-2010.
CDS FOR INDIAN MARKETS – PRODUCT DESIGN:
Eligible Participants
v Users: Entities permitted to buy credit protection (buy CDS contracts) only to hedge the underlying credit risk on corporate bonds.
v Market Makers: Entities permitted to quote both buy and/or sell CDS spreads. They would be permitted to buy protection without having the underlying bond.
Exiting CDS transactions by usersv Users cannot exit their bought positions by entering into an offsetting sale contract.
v User can exit their bought position by either unwinding the contract with the original counterparty or, in the event of sale of the underlying bond, by assigning (novating) the CDS protection, to the purchaser of the underlying bond (the “transferee”) subject to consent of the original
protection seller (the “remaining party”).
Credit Eventsv Bankruptcy, Failure to pay, Repudiation/moratorium, Obligation acceleration, Obligation default,
Restructuring approved BIFR/CDR mechanism and corporate bond restructuring.
Determination Committee (DC)v The DC shall be formed by the market participants and FIMMDA and shall deliberate and resolve CDS related issues such as Credit Events, CDS Auctions etc.
Other Regulatory Requirementsv User (except FII) & market-maker shall be resident entities
v CDS contract shall be denominated and settled in INR
v No CDS on securities with original maturity up to one year
v CDS contract must be irrevocable.
v dealing in any structured financial product with CDS as one of the components shall not be permitted
SETTLEMENT METHODOLOGIESFor transactions involving users, physical settlement is mandatory. For other transactions, any of three settlement methods (physical, cash and auction), may be opted
v Physical settlement:
It is delivery of reference asset to the protection seller in exchange of the Par value plus accrued Interest (Computed with reference to the Notional Value).
v Cash settlement
Protection seller pays the difference of Par value including accrued Interest (Computed with reference to the Notional Value) minus its market value at the time of credit event as determined by a pre-agreed
dealer poll mechanism. The calculation agent plays an important role in the process of settlement.
Cash SettlementThe Reference Asset will normally retain some value after a credit event has triggered settlement of the
contract. The recovery value is normally determined within 3 months after the credit event, by a dealer poll or auction.
DocumentationFIMMDA shall devise a Master Agreement for Indian CDS.
The standardization of CDS contracts shall be achieved in terms of coupon, coupon payment dates, etc. as put in place by FIMMDA in consultation with the market participants.
• Pricing & Valuationü Market participants shall Mark to Market (MTM) the CDS contracts on a daily basis with methods
validated by external validators periodically. FIMMDA published daily CDS curve shall be used for valuation.
ü If a proprietary model results in a more conservative valuation, the market participant can use that too.
ISSUES GOING FORWARD
• Exiting CDS trades
v Guideline 2.6.2 of RBI circular: The users would be given a maximum grace period of ten business days from the date of sale of the underlying bond to unwind the CDS position.
v Guideline 2.6.3 of RBI circular: In the case of unwinding of the CDS contract, the original counterparty (protection seller) is required to ensure that the protection buyer has the underlying at the
time of unwinding.
Ideally, at the time of unwinding the CDS buyer need to have the underlying securities i.e sale of bond should be only after unwinding of CDS.
(BOTH ARE CONTRADICTORY TO EACH OTHER)
• Collateralisation and MarginingThe regulator has sought to achieve standardisation in the OTC CDS trades, but has left open the margining policy to be decided by each participant individually. Although an efficient market ensures the parity, it may prove as a hindrance in taking off for the product.
• Pricing & Valuation
v The intrinsic value of the CDS is a function of probability of occurrence of credit events & losses associated with it. Mapping the probability of unique credit events require extensive & reliable data
which is a challenge. The rating agency’s accuracy would be instrumental in determining ‘no arbitrage prices’.
AccountingThe user has to replace its credit exposure to the reference entity by the protection seller. Accounting methods will need to evolve keeping an eye on following complications:
v How the exposure reduction would be accounted when the funds still remain due from the reference entity?
v Exposure to the protection seller is Non Fund Based & Contingent in nature. How it would replace a fund based exposure in books?
Exposure assessmentRegulator has sought for daily credit exposure monitoring for reckoning various prudential limits.
Daily credit exposure monitoring on account of loans is a big challenge.
ValuationValuation of unlisted/unrated/SPV issued instruments is a big challenge subjected to absence of secondary market and two way quotes.
Credit EventRBI has identified “Restructuring approved under (BIFR)” as a credit event. However approval may sometimes take 2-3 years. It means that compensation would be triggered after approval whereas the
premium would be required to be paid for the intervening period. It seems a grey area as premium payment seems unfair when credit quality has already deteriorated. Getting referred to BIFR should be sufficient enough to be considered as a credit event.
Determination Committee (DC)
The market participants in the DC having vested interests may lead to a problem of moral hazard.
To conclude, although the CDS is an excellent hedging derivative product introduced in the Indian market, because of the above complexities, it may take some time by the players and market makers to properly develop a market for the same.
This article has been published in the Dec 2011 magazine of KSCAA. The Author is a senior banker and is currently working as General Manager with Punjab National Bank, Head Office, Delhi. Author can be reached at krammohanpnb@gmail.com.
instrument will prop up the shallow Bond market and hence permitted it, albeit with a lot of precautions and that too as an OTS product. Let us now look in to the proposed new product and understand its utility and
limitations.
It is a financial derivative contract which allows one party (Protection Buyer) to transfer, for a premium, the credit risk (losses due to Credit Events) of a reference obligation (Underlying loans, Bonds etc.), to another party (Protection Seller) without transferring its ownership. It is an off balance sheet financial instrument.
The credit events may cover Bankruptcy, Failure to pay, Obligation acceleration etc. However, the original credit relationships are neither changed nor newly established due to a CDS transaction.
RBI Guidelines on CDSIn view of the complexities involved in the valuation, accounting, and risk management aspects of
credit derivatives RBI has decided to initially allow only plain vanilla credit default swaps.
Advantages of CDS
1. Hedging the credit risk: Gains from CDS offset losses on an investment which arise due to an adverse credit event.
2. Investment to earn profits. CDS is transfer of credit risk in lieu of the credit spread in the form of premium. In case of no credit event, the CDS premium received is the profit to the market maker. It makes leverage possible and helps those with high funding costs.
3. Increase investors’ interest in corporate bonds and help development of the corporate bond market in India.
4. Trading profits. The CDS premium reflects the present value of the expected loss on a default risky asset. It increases or decreases with the shift in credit quality of the underlying reference entity or/and
obligation. Hence CDS can be used to take a view on both the deterioration and improvement in the credit quality of the reference obligation and earn trading profits.
5. Relief to capital charge. When credit risk gets hedged with a CDS contract, the credit risk capital is freed to support fresh credit exposure case of Banks, financial institutios and NBFCs etc., The exposure
level is reduced for protection buyer. For protection seller it becomes his credit obligation.
6. Exposure Management:
v CDS helps in transferring exposures from one counterparty to another.
v To release credit exposure limits to a counterparty;
v To reduce concentrations by shedding exposures to a counter-party (without affecting the
relationship with the borrower since there is no transfer of title of the asset) or to a sector;
v To assume exposures to a counter-party or to a sector to diversify risks or to fill gaps in credit quality spectrum
CDS PRODUCT FEATURES:ü The CDS contract outlines potential exchange of payments between the two parties in which at least
one leg of the cash flow (payout) is linked to the “performance” or “credit event” of a specified
Reference Entity/ Asset.
ü At the minimum, the contract specifies
ü Reference Entity: Issuer of bond/Lender
ü Reference Asset: The bonds/loans for which credit protection is bought or sold
ü Credit Event: The credit service/ quality related event that triggers claim for compensation.
ü Notional Amount: The amount for which the protection is bought or sold
ü Premium: The present value of the expected loss on a default risky asset
ü Term of Contract: The tenure for which the protection is bought or sold.
CDS INTERNATIONAL MARKET OVERVIEW• The total CDS outstanding trades have declined from 36,098 to 29,878 billion USD from H1-2009 to
H2-2010.
• The share of CDS in total Global OTC derivatives contracts outstanding has declined from 6.07% in H1-2009 to 4.97% in H1-2010.
CDS FOR INDIAN MARKETS – PRODUCT DESIGN:
Eligible Participants
v Users: Entities permitted to buy credit protection (buy CDS contracts) only to hedge the underlying credit risk on corporate bonds.
v Market Makers: Entities permitted to quote both buy and/or sell CDS spreads. They would be permitted to buy protection without having the underlying bond.
Exiting CDS transactions by usersv Users cannot exit their bought positions by entering into an offsetting sale contract.
v User can exit their bought position by either unwinding the contract with the original counterparty or, in the event of sale of the underlying bond, by assigning (novating) the CDS protection, to the purchaser of the underlying bond (the “transferee”) subject to consent of the original
protection seller (the “remaining party”).
Credit Eventsv Bankruptcy, Failure to pay, Repudiation/moratorium, Obligation acceleration, Obligation default,
Restructuring approved BIFR/CDR mechanism and corporate bond restructuring.
Determination Committee (DC)v The DC shall be formed by the market participants and FIMMDA and shall deliberate and resolve CDS related issues such as Credit Events, CDS Auctions etc.
Other Regulatory Requirementsv User (except FII) & market-maker shall be resident entities
v CDS contract shall be denominated and settled in INR
v No CDS on securities with original maturity up to one year
v CDS contract must be irrevocable.
v dealing in any structured financial product with CDS as one of the components shall not be permitted
SETTLEMENT METHODOLOGIESFor transactions involving users, physical settlement is mandatory. For other transactions, any of three settlement methods (physical, cash and auction), may be opted
v Physical settlement:
It is delivery of reference asset to the protection seller in exchange of the Par value plus accrued Interest (Computed with reference to the Notional Value).
v Cash settlement
Protection seller pays the difference of Par value including accrued Interest (Computed with reference to the Notional Value) minus its market value at the time of credit event as determined by a pre-agreed
dealer poll mechanism. The calculation agent plays an important role in the process of settlement.
Cash SettlementThe Reference Asset will normally retain some value after a credit event has triggered settlement of the
contract. The recovery value is normally determined within 3 months after the credit event, by a dealer poll or auction.
DocumentationFIMMDA shall devise a Master Agreement for Indian CDS.
The standardization of CDS contracts shall be achieved in terms of coupon, coupon payment dates, etc. as put in place by FIMMDA in consultation with the market participants.
• Pricing & Valuationü Market participants shall Mark to Market (MTM) the CDS contracts on a daily basis with methods
validated by external validators periodically. FIMMDA published daily CDS curve shall be used for valuation.
ü If a proprietary model results in a more conservative valuation, the market participant can use that too.
ISSUES GOING FORWARD
• Exiting CDS trades
v Guideline 2.6.2 of RBI circular: The users would be given a maximum grace period of ten business days from the date of sale of the underlying bond to unwind the CDS position.
v Guideline 2.6.3 of RBI circular: In the case of unwinding of the CDS contract, the original counterparty (protection seller) is required to ensure that the protection buyer has the underlying at the
time of unwinding.
Ideally, at the time of unwinding the CDS buyer need to have the underlying securities i.e sale of bond should be only after unwinding of CDS.
(BOTH ARE CONTRADICTORY TO EACH OTHER)
• Collateralisation and MarginingThe regulator has sought to achieve standardisation in the OTC CDS trades, but has left open the margining policy to be decided by each participant individually. Although an efficient market ensures the parity, it may prove as a hindrance in taking off for the product.
• Pricing & Valuation
v The intrinsic value of the CDS is a function of probability of occurrence of credit events & losses associated with it. Mapping the probability of unique credit events require extensive & reliable data
which is a challenge. The rating agency’s accuracy would be instrumental in determining ‘no arbitrage prices’.
AccountingThe user has to replace its credit exposure to the reference entity by the protection seller. Accounting methods will need to evolve keeping an eye on following complications:
v How the exposure reduction would be accounted when the funds still remain due from the reference entity?
v Exposure to the protection seller is Non Fund Based & Contingent in nature. How it would replace a fund based exposure in books?
Exposure assessmentRegulator has sought for daily credit exposure monitoring for reckoning various prudential limits.
Daily credit exposure monitoring on account of loans is a big challenge.
ValuationValuation of unlisted/unrated/SPV issued instruments is a big challenge subjected to absence of secondary market and two way quotes.
Credit EventRBI has identified “Restructuring approved under (BIFR)” as a credit event. However approval may sometimes take 2-3 years. It means that compensation would be triggered after approval whereas the
premium would be required to be paid for the intervening period. It seems a grey area as premium payment seems unfair when credit quality has already deteriorated. Getting referred to BIFR should be sufficient enough to be considered as a credit event.
Determination Committee (DC)
The market participants in the DC having vested interests may lead to a problem of moral hazard.
To conclude, although the CDS is an excellent hedging derivative product introduced in the Indian market, because of the above complexities, it may take some time by the players and market makers to properly develop a market for the same.
This article has been published in the Dec 2011 magazine of KSCAA. The Author is a senior banker and is currently working as General Manager with Punjab National Bank, Head Office, Delhi. Author can be reached at krammohanpnb@gmail.com.
I read your article, very informative and userinformatic info are mentioned. For Best Debt Restructuring Companies also a Debt Restructuring Companies. Keepit up bro to share more article like that. Thanks for sharing this ones.
ReplyDeleteThanks for sharing your ideas and thoughts! Loans, Insurance, Estate Planning, Probate & More. We'll help you make life's biggest decisions while saving you up to 75% on high-street prices. Please click on write off debt loophole for more information.
ReplyDelete