Credit Default Swaps in India

Credit Default Swaps
Praveen P. Mishall
MMS 2008-10
Welingkar Institute of Management Development & Research
praveen.mishall@gmail.com
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Credit Default Swaps 8/18/2009
Agenda
 What are Derivatives?
 What are Credit Derivatives?
 What are Credit Default Swaps
 Subprime Crisis and its implications
 Role of CDS in Subprime Crisis
 CDS Auction
 CDS Data Sources
 Central Counterparty Settlement for CDS
 Credit Derivatives Market in India
 CDS and its settlement in India
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Derivatives  Derivatives Contract Types
– Forward & Future
 What are Derivatives? – Options
– Derivatives are financial – Swaps
contracts, or financial
instruments, whose prices
 Risks with Derivatives
are derived from the price – Large losses due to leverage
of underlying. – Counterparty risk
 Uses of Derivatives – Large notional amounts
– Hedging – Complicated nature of
– Speculation Derivatives
– Arbitrage  Driving forces for growth
 Types of Derivatives – Volatility in asset prices
– OTC Derivatives – Integration of national
market with international
– Exchange Traded
Derivatives – Communication facilities
– Risk Management Tools
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OTC Derivatives Growth
“Blaming derivatives for financial losses is akin to blaming cars for drunken driving fatalities”
Christopher L. Culp
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Credit Derivatives
 What are Credit Derivatives?
– Credit derivatives can be defined as arrangements that allow one
party (protection buyer or originator) to transfer, for a premium,
the defined credit risk, or all the credit risk, computed with
reference to a notional value, of a reference asset or assets, which
it may or may not own, to one or more other parties (the
protection sellers).
 Credit Derivatives Risks

 Types of Credit Derivatives – Credit Risk
– Credit Default Swap – Market Risk
– Total Return Swap – Legal Risk
– Credit linked notes
 Driving forces for growth
– Credit spread option
– Securitization
– Index products
– Tranching (slicing in French)
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Credit Default Swap
 What is Credit Default Swap?
– A credit default swap (CDS) is a credit derivative contract between
two counterparties. The buyer makes periodic payments to the seller,
and in return receives a payoff if an underlying financial instrument
defaults.
 General Characteristics
– Quarterly CDS premium
(spread) payment
– Spread inversely related
to quality of underlying
– Standard range for deals
$10-20 million
– Standard maturity of 5 yrs
– Maturity directly related
to quality of underlying
– Important Trigger events
 Bankruptcy
Simple CDS contract (Source: Bionic Turtle)  Failure to pay
 Restructuring 6
Growth of CDS Market
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Credit Default Swap
 Types of CDS  Speculation in CDS
– Single-name CDS – Structured Investment
– Multi-name CDS Vehicle (SIV) market
 Settlement Methods – Naked CDS
– Secondary market for CDS
– Physical Settlement
– Cash Settlement  How is CDS different
– Fixed Amount Settlement
from insurance?
– Seller is not regulated entity
 Uses of CDS
– No need to own reference
– Hedging
entity
– Speculation
– No need to maintain
reserves for pay-off
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CDS Pricing
Value of CDS (to the protection buyer) = PV [contingent leg] –
PV [fixed (premium) leg]
Where,
D(ti) = Discounting
Factor,
q(ti) = Survival
Probability,
S = CDS Premium,
di = Accrual days as a
fraction of a year,
{q(ti-1) - q(ti)} =
Survival Probability till
credit default event,
R = Recovery Rate.
Source: CDS Primer by Nomura Fixed Income Research

9
End
Subprime Crisis
 Reasons for subprime loans  Types of subprime loans
– Lower interest rates
– Interest Only Mortgage
– Increase in prices of houses
– Adjustable Rate Mortgage
– Home equity loans (ARM)
– Additional profits to FIs  2/28 ARM
– Low Initial Fixed Rate

Mortgage
 Predatory Borrowing/
Lending
– Lack of information
(Options available)
 Moral Hazards
– Loan servicer/ Borrowers
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The sequence of events
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Securitization Process
Source: Infosys
 Traching Process  Predatory Borrowing and

– Senior Tranche Lending
– Subordinate/Mezzanine  Adverse Selection
Tranche
 Moral Hazards
– Equity Tranche
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Role of CDS in Subprime Crisis
Source:YieldCurve.com
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CDS Statistics
Source: Infectious Greed

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CDS Market
 OTC Market – Disadvantages
– Due diligence for counterparty creditworthiness (additional cost)
– Dealer market (dealers acts as market makers)
– No valuation by an independent valuation agent, etc.
 Credit Derivative Indices – CDX/ iTraxx
– CDX – North American & Emerging Market companies
– iTraxx – Rest of the world
– Benefits – tradability, liquidity, operational efficiency,
transaction cost, transparency
 BIS Recommendations
– Delays in documenting & confirming transactions
– Expanding use of collateral
– Potential use of clearing house
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The Changes in CDS Market
 Central Counterparty
 Hardwiring the Auction Protocol
 ISDA Determination Committee
 What is Central Counterparty?

– buyer to every seller and the seller
to every buyer
 Benefits of CCPs
– Increased liquidity
– Multilateral netting
– Mitigating counterparty risk
– Neutral, transparent valuation
– Improve operational efficiency
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CDS Auction
 Rationale behind Auction Process
– Physical Settlement of CDS contracts
– CDS outstanding greater than the volume of bonds issued
– Artificial rise in the price of the bonds
– Need for transparent, trustworthy price for Cash Settlement
– Elimination of Basis Risk
 Overview of CDS Auction Process
 CDS Auction – Stage 1  Stage 1 Results published are –
– 2-way market quotes – The inside market midpoint
– Physical settlement request – The size and direction of the
– Inside Market Midpoint open interest
– Open Interest – Any Adjustment Amounts
 CDS Auction – Stage 2
– matching open interest and
creating a final price
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Auction Process: Lehman Brothers
Quotation Size
– $5 million
Inside Market Midpoint
– 9.75
Open Interest –
$4.92 billion to sell
Adjustment Amount
– $12500
Final Settlement Price
– 8.625
Note: Prices are expressed relative to a par value of 100
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CDS Data Sources
 International Swaps and  The Office of the Comptroller
Derivatives Association of the Currency
– ISDA Master Agreement – Quarterly report on bank
– Administrating Auction Process derivatives activities in US
– ISDA Determination committee – OCC shared the regulatory
information on CDS after its
– Semiannual Reports introduction to market
 Bank for International  The Depository Trust and
Settlement Clearing Corporation
– BIS semiannual data for single- – Trade Information Warehouse,
name, multi-name instruments comprehensive trade database
– CDS by counterparty, sector and – Weekly information on credit
rating derivative products, transaction
 British Bankers' Association types, etc.
– Reports every two years on credit  Other data sources –
derivatives activities in London/ – Bloomberg, Markit, S&P,
Europe Moodys, Fitch Rating, etc.
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Central Counterparty Settlement
 TriOptima
– Elimination of USD 30.2 trillion of CDS notional trades (in 2008)

– Elimination of USD 5.5 trillion of CDS notional trades (first quarter
of 2009)
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Central Counterparty Settlement
 IntercontinentalExchange Trust
 NYSE Euronext LIFFE &
LCH.Clearnet SA
 CME Group Inc./ Citadel
Investment Group
 Eurex AG.
21
Comparison of CCPs
NYSE Euronext CME
Parties ICE Trust/ CCorp Eurex AG
LIFFE/ LCH Group/Citadel
Program
CCP CCP E-trading & CCP CCP
Type
Presence in US/ Europe Europe Europe/ US Europe
Started on 09/03/2009 22/12/2008 Yet to start Yet to start
Currently - North Currently - iTraxx

American CDX Europe CDS
indices indices in UK
Proposed – CDX Proposed –
Proposed - American Proposed - iTraxx
indices, iTraxx European index
Products single names in 3Q09 European indices
indices, and single and single name
European iTraxx by Dec 2009
name CDS CDS
indices in 2Q09 US indices by
European single H12010
names in 3Q09
Eurex clearing
Pricing by Markit Markit Markit pricing team,
Markit
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Comparison of CCPs
ICE Trust/ NYSE Euronext
Parties CME Group/Citadel Eurex AG
CCorp LIFFE/ LCH
Leverage of existing
Integration Novation within Open architecture, enabling OTC CDS and Eurex
and co- a Eurozone legal market participants to Clearing infrastructure
existence framework execute or book CDS trades No additional technical
with other LCH.Clearnet through party-to-party connectivity required for
elements of SA to act as the negotiation, IDB brokered, existing Clearing
CDS CCP CMDX Request for Quote Members, STP
Features processing (RFQ) platform, or other processing with the
ISDA
infrastructur documentation electronic matching venues DTCC Deriv/SERV
e (like compliance Migration Utility to migrate Trade Information
DTCC) DTCC TIW as existing bilateral OTC Warehouse
central registrar contracts to standardized, Dedicated clearing fund
centrally cleared contracts for CDS
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General Global Settlement Procedure
 Functional Model
– DTCC TIW for trade
capturing,
confirmation and
settlement
– Check various criteria
before novation by
central counterparty
 Trade Lifecycle
– Flags, novation,
netting, collateral,
etc.
 CDS Pricing  Risk Management  End of day processing
– Markit pricing info. Model – Reports with current
– Eurex clearing – Margins & positions, margin
pricing team Collaterals summary, collateral
reports
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Credit Derivatives Market in India
 Need for Credit Derivatives  Benefits of credit derivatives
– Eliminate uneven distribution – Transfer credit risk & free up
of risk in market capital by banks
– Banks & FIs highly skewed – Retaining existing client
with loan portfolios with no relationship
bond portfolio – Construct & manage the credit
– Mutual funds, Hedge funds, risk portfolio of own choice
Insurance companies & – Diversification of credit risk
Pension funds mostly have  Minimum Conditions
bond portfolio and no loan
portfolio – Direct
 Expected Participants – Explicit
– Banks, Financial Institutions, – Irrevocable
Insurance companies, Mutual – Unconditional
funds
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RBI Draft Guidelines
 Participants allowed  Product Requirements
– Protection buyers: – Credit Events
Commercial Banks, Primary  Bankruptcy
Dealers  Obligation Acceleration
– Protection seller: Commercial  Obligation Default
Banks, Primary Dealers  Failure to pay
 Product Requirements  Repudiation/ Moratorium
– Protection buyer must have a  Restructuring
credit risk exposure – Minimum Requirements
– Settlement Methods  Direct, Explicit, Irrevocable
 Physical Settlement
& unconditional
 No recourse to protection
 Cash Settlement
buyer for losses
 Fixed Amount Settlement
 Specified post-credit-event
– ISDA Master Agreement valuation period
compliance
 Legal enforceability
Continued… 26
RBI Draft Guidelines
 Product Requirements  Risk Management
– Minimum Requirements – Sound risk management policies &
Credit events specified at procedures (due diligence)
minimum are – – Counterparty limits by PBs
- Failure to pay – Awareness of legal risk
- Bankruptcy, insolvency – Adequate oversight by Board of
- Restructuring Directors and senior management
– Seniority of underlying  Procedures
– Right/Ability to transfer – Measuring, monitoring, reviewing,
underlying asset/obligation reporting and managing the risks
– Grace period < Loan period – Analysis & minimization of risk
– Protection buyer has right to – Management of market risk in
inform Protection Seller about trading books
the occurrence of credit event – Management of legal risk
– Management of liquidity reserve
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CDS and its settlement in India
 Feelers sent out to many banks to check the acceptability
 Possible CDS Settlement –
– OTC Market
– Trade Reporting Platform
– Once market matures Central Counterparty Settlement
 Role of CCIL
 Some issues to be addressed are –
– Regulatory approvals for insurance companies & mutual funds to
maximize the number of participants
– More lights on restructuring as credit event
– Clear distinction between insurance contracts and CDS contracts
“There is surely a need for such a product (CDS)”
- Ashish Vaidya, Head of interest rate trading, HDFC Bank.
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References
 BIS Quarterly Review – BIS
 CDS Trading and Clearing Solution – CME Group
 Credit Default Swap – Wikipedia
 A simple explanation of the subprime crisis – David Waring (InformedTrade)
 Derivative (finance) – Wikipedia
 CDS: changing the contract – HSBC Global Research
 Draft CDS Guidelines – RBI
 European OTC Clearing Solution for CDS – Eurex Clearing
 Options, Futures and Other Derivatives – John C. Hull
 Credit Default Swap (CDS) Primer – Nomura Fixed Income Research
 OCC's Quarterly Report on Bank Derivatives Activities – OCC
 Report of the Working Group on Introduction of Credit Derivatives in India –
Department of Banking Operations and Development
 Subprime Mortgage Crisis – Wikipedia
 Introduction to Credit Derivatives – Vinod Kothari
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Thank You
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Credit Default Swaps

 Credit Derivatives Risks

Source: CDS Primer by Nomura Fixed Income Research

– Low Initial Fixed Rate

 Traching Process  Predatory Borrowing and

Source: Infectious Greed

 What is Central Counterparty?

– Elimination of USD 30.2 trillion of CDS notional trades (in 2008)

Currently - North Currently - iTraxx

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