Credit Derivatives

Credit Derivatives : A Welcome Move

As India is paving the way for the entry of credit derivatives, its credit and bond markets could get the much-needed boost.

There's been a lot of interest in credit derivatives in India because it does take Indian financial markets to the next stage of evolution. It's important to have these instruments to provide transparency, depth, liquidity and to avoid concentration of risk.

- Pavan Sukhdev
Deutsche Bank's head of global markets in India

Credit risk, one of the biggest risks of the financial system, poses a great challenge to banks and bond investors at times when the borrower is in default. Nevertheless, an effective management of credit risk largely aids in enhancing the efficiency and resilience of the financial system of any economy. To serve this very purpose, credit derivatives have globally emerged as a potential risk management tool for banks, financial institutions and bondholders.

According to the International Swaps and Derivatives Association (ISDA)'s report, the global market for credit derivatives has more than doubled in size for the third consecutive year. The notional amounts outstanding at the end of 2006 grew by leaps and bounds from a meager $632 bn in 2001 to $34.5 tn in 2006. After witnessing the phenomenal success of credit derivatives globally, RBI has recently proposed to introduce them in India also, albeit in a calibrated manner. The move, which will help banks and primary dealers to hedge against loan defaults, is poised to largely reduce the risk of default in the Indian financial system.

Global glory

Though credit derivatives have been in existence since the beginning of 1990s, they became popular only in the late 1990s during the Asian and Russian financial crises when some smart banks demonstrated these instruments' ability to shed the risk. Interestingly, credit derivative is the latest among the raft of financial innovations after the loan sales of the 1980s and securitization of the 1990s. However, it has emerged as the fastest growing financial instrument in the world.

A credit derivative, typically, is a contract where the lender (default protection buyer) repackages and transfers the credit risk to another party (default protection seller) in exchange for regular periodic premium payments. In the event of the borrower's default, the protection seller has to compensate the protection buyer for the remaining interest and principal payments. Essentially, it works on the lines of the concept of insurance where the insured pays regular premiums to the insurance company which will, in turn, make the payment good when the insured event happens.

Globally, these instruments are, by and large, used by banks, broker-dealers, institutional investors, insurers, reinsurers, money managers, hedge funds, and corporate treasurers to hedge and diversify their credit risk. Though a host of exotic credit derivatives, such as total return swaps, credit spread options, credit-linked options, Collateralized Debt Obligations (CDOs), Collateralized Loan Obligations (CLOs), floating Collateralized Mortgage Obligations (CMOs), swaptions, etc., are available in the market, the plain vanilla Credit Default Swaps (CDSs) are the most popular and largely traded instruments. Indeed, in recent times, global banks are more inclined to use them as trading instruments rather than hedging instruments.

Credit derivatives are today the fastest growing segment of the OTC derivatives market. India has recently opened its doors to credit derivatives. Do you see this as a welcome move? The Reserve Bank of India (RBI) came up with draft guidelines on credit derivatives in March 2003. The governor's credit policy in April this year stated that the RBI will introduce credit derivatives in India in a calibrated manner and that the RBI will come up with guidelines by May 15, 2007. On May 16, 2007, the RBI posted yet another draft of the guidelines for public comments. Between March 2003 and May 2007, more than four years have elapsed and there are several developments that speak aloud of the opportunities that we have missed. One, during this time, the global credit derivatives volume zoomed from $2.2 tn (end 2002) to $34 tn (end 2006)—a growth of nearly 1600%. Credit derivatives are today the fastest growing segment of the OTC derivatives market. Two, almost every country that one can compare India with has had full-fledged regulatory rules on credit derivatives for quite sometime now. Three, several Indian names are traded on a regular basis in global credit derivatives markets and two Indian names are a part of a popular traded credit derivatives called iTraxx Asia ex-Japan. In the absence of regulations locally, several banks have been forced to export their credit derivatives business with reference to Indian names through their overseas subsidiaries. There have, in fact, been some synthetic CDOs with all Indian names. Fourth, the global market has come a long way from the bilateral credit default swaps—today, the market is abuzz with hundreds of thousands of trades in index tranches, which is a pool of synthetic exposures on selected names in different countries and different geographies. Let no one make the mistake of believing that India lacks the know-how or expertise to handle credit derivatives. Anyone who knows the derivatives market would agree that world over, credit derivatives desks in most global investment banks are manned by Indians. In addition, several of the large credit derivatives dealers, investors and hedge funds have exported credit derivatives pricing and administration to India. Hence, a large part of the $34 tn trade is one way or the other stationed in Bombay or Bangalore. In short, for no particular reason, India has delayed the introduction of credit derivatives. However, it is better late than never. Therefore, the move is welcome. What are the risks and benefits associated with credit derivatives? All derivatives are, to an extent, based on a speculative motive, in more refined language, called the trading motive. The volume of credit derivatives itself is several times that of the outstanding debts of world banking. The biggest risk is the sheer volume, which itself implies that the debt of major corporates of the world is being traded several times over. Assuming that the total amount of bets on X Corp, a global name, is 10 times its actual debt outstanding, X Corp's bankruptcy would mean 10 times as much losses to the market. That apart, the credit derivatives business today works in structured tranches. A tranche implies breaking of credit risk into several slices. There is more money to make in the junior slices, which indicate a very high level of economic leverage. Thus, any major deterioration in the credit quality of a few corporates may send the whole market into a tizzy because of the extreme level of leverage. It is notable that the development of credit derivatives and that of the hedge fund industry have moved hand in hand. Both have supported each other. Today, statistics reveal that about 60% of credit derivatives trades are coming from hedge funds. Hedge funds are hot funds—their mandates, most often, contain triggers which require them to wind down or scale down operations when losses go beyond a level. So, if things start turning bad, hedge funds will have to withdraw their equity support to the credit derivatives market, creating a tremendous liquidity pressure. What is bad may turn worse very quickly. How is this product different from taking an insurance cover for the loan portfolio? Insurance is based on principles of indemnity. An insurer pays for the actual losses of the insured. Credit derivatives are stand-alone contracts. There is a risk transfer, but the protection buyer does not have to hold the asset that he is buying protection against, and therefore, the losses of the protection buyer are neither affected by nor limited to his actual loss. This critical distinction has allowed credit derivatives to play as a parallel market to bonds and equities. Given the underdeveloped bond market scenario of India, do you think there would be any investors in local markets who will be interested in buying these products? Internationally, the credit derivative market is far more liquid than bonds. Bonds require actual investment by the buyer, and actual availability of the bond from the viewpoint of the seller. Credit derivatives require neither. Bonds cannot be short sold; credit derivatives entail both long and short trades. I have no doubt that the market for credit derivatives will be far more liquid than that for bonds. If not, do you opine that any foreign investors would be allowed to trade in these derivatives? It is a pity that lots of Indian names are already been traded in the overseas market and it is only Indian banks that have been denied the opportunity of trading in Indian names due to regulations. So, I would say, there is a lot of international trade already happening on Indian names and there is a strong India interest. As to whether foreign trades should be allowed to trade in India, I would say, the existing capital account/current account restrictions may be allowed to have their play. How do you foresee the impact of credit derivatives on the growth of the banking industry as well as bond markets? I would see the cost of credit coming down. I would see more efficient pricing of credit risk of entities. I would see in general more maturity in the market. - Vinod Kothari Credit Derivatives Consultant Author and Trainer, India

India's inclination

Although the RBI framed the draft guidelines for the introduction of credit derivatives in March 2003, absolutely nothing much happened after that. Nonetheless, after gazing at the explosive growth of these instruments globally, India has made another attempt to open its door to credit derivatives. Again in May 2007, the RBI put up draft guidelines for public comments.

Industry experts feel that the RBI is allowing credit derivatives at a right time when the lending is soaring. Also, the credit growth rate is soaring significantly at 30% per annum as the Indian economy is growing at a rate of 9% per annum. Moreover, since corporate India is planning to invest $500 bn in the coming three years, banks are gearing up to increase their lending capacity to meet this prospective rise in capital expenditure. However, at the same time, they do need an avenue to offload the associated risk. It's here the credit derivatives serve the purpose by effectively shedding the risk.

However, the RBI's draft guidelines impose many restrictions on parties who wish to transact in credit derivatives. All the parties involved in the deals should be resident Indians and all the deals should be denominated in Indian currency only. Also, it is mandatory that credit should be extended only to the borrowers who are rated.

Keeping the valuation, risk management and accounting complexities of the credit derivatives in view, the RBI has decided to allow them in a calibrated manner. Therefore, it has initially allowed only the plain vanilla CDS which provides protection to a single borrower rather than many. Also, the guidelines allow only local banks and primary dealers to transact in CDSs. The objective of a CDS should be to hedge against the credit risk. However, as the banks don't have to take on the credit risk through this way, it definitely enhances the lending capacity of conservative banks who usually hesitate to lend to a single borrower beyond a point.

Besides this, it provides an opportunity for banks who act as protection sellers to diversify their concentrated loan portfolio. For instance, if a particular bank has extended loans only to a particular sector and is now worried about the risk of concentrated loan portfolio, it can diversify its portfolio and get exposed to other sectors by acting as a protection seller. Even the bondholder, who is not comfortable with the issuer's credit repayment capacity, can opt to hedge the risk of default through credit derivatives. However, industry experts are anticipating that premium amounts paid by the banks could be eventually passed on to the customers, thereby impacting the loan pricing.

Boosting liquidity

The fact that a few Indian borrowers such as ICICI Bank, Reliance Industries, SBI, and Tata Motors, are already trading in credit derivatives in the overseas markets signals the need for these instruments in domestic markets as well. Though the introduction of credit derivatives was delayed for long, it is, however, better late than never.

Though it's the plain vanilla CDS which could rule the roost initially, analysts are anticipating that other risk hedging options will also enter the market as it matures. It is expected that credit derivatives will make the credit and bond markets more liquid, transparent and efficient by enabling better price discovery in India's illiquid bond markets.

- Y Bala Bharathi