Indian Corporate Debt Markets – Risk and Hedging Related Issues (Part I)

This post is part of our series of posts on Long Term Debt Markets in the Indian context.

One of the standard instruments used to hedge against risk in a corporate debt market is the credit default swap or CDS instrument. A 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 or experiences a similar credit event. Development of a CDS market may lead to a gradual deepening of the corporate bond market as CDSs can enhance the bond market investors’ appetite for lower rated issuers, beyond their traditional favorites in the high-safety category. Before going into the details of the CDS market in India it maybe useful to understand the different elements of risks associated with CDS.

Default Risk: When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk i.e. the buyer takes the risk that the seller may default (in which case the buyer loses its protection against default by the reference entity) while the seller takes the risk that the buyer may default on the contract, depriving the seller of the expected revenue stream. More important, a seller normally limits its risk by buying off-setting protection from another party — that is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, which may be at a lower price than the original CDS and may therefore involve a loss to the seller.

Jump Risk: Another kind of risk for the seller of credit default swaps is jump risk or jump-to- default risk. A seller of a CDS could be collecting monthly premiums with little expectation that the reference entity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers. This risk is not present in other over-the-counter derivatives.

Systemic Risk: This risk arises from the interconnectedness of the different parties involved in a CDS transaction. One of the factors contributing to systemic risk in a CDS market is a ‘naked’ CDS contract–a CDS in which the buyer does not own the underlying debt. These “naked credit default swaps” allow traders to speculate on the creditworthiness of reference entities and were widely prevalent in the US financial markets before the Global Recession of 2008. If participants are permitted to purchase CDS without having the underlying risk exposure, there could be huge build-up of positions resulting in a scenario where the amount of protection purchased is higher than the total bonds outstanding. Such a position, if concentrated among a handful of participants and unregulated, can have systemic implications and lead to a dangerous build up of risks.

Counterparty default as mentioned earlier is also another factor that can contribute to systemic risk. The risk of counterparties defaulting has been amplified during the 2008 financial crisis, particularly because Lehman Brothers and AIG were counterparties in a very large number of CDS transactions. This is a classic example of systemic risk that threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk.

CDS market in India

India’s fledgling credit default swap (CDS) market kicked-off on Dec 6, 2011 with two deals covering 100 million rupees ($1.9 million) worth of bonds. The deals, both 1-year trades were between ICICI Bank and IDBI Bank (underwriter), at 90 basis points and covered 50 million rupees each of 10-year bonds issued by Rural Electrification Corp (REC) and India Railway Finance Corp, according to details on the Clearing Corp of India Ltd’s website. The RBI has since then allowed banks to begin hedging their banking and trading books using CDS, signaling that the infrastructure is finally in place for the launch of the instruments in Asia’s fourth biggest bond market.

According to paragraph 113 of the Second Quarter Review of Monetary Policy for year 2009-10, an Internal Group was constituted by the RBI to finalize the operational framework for the introduction of plain vanilla OTC single-name CDS for corporate bonds in India. Draft guidelines on CDS based on the recommendations of the Group were placed on the RBI website on February 23, 2011 and were open for comments from all concerned. Comments were received from a wide spectrum of banks, primary dealers and other market participants and accordingly the guidelines were suitably revised in the light of the feedback received. The guidelines became effective from October 24, 2011.

The RBI guidelines which incorporate learning from the CDS markets worldwide ensure that CDS is neither used for speculative purposes nor to build up excessive leveraged exposures. Following stipulations are directed particularly at avoiding any serious systemic threat that maybe caused by such an innovative and complex financial product:

1. Only investors who own the underlying securities are allowed to purchase CDS insurance thereby ruling out the entire gamut of ‘naked’ CDS contracts and ensuring that the CDS market cannot get bigger than the underlying debt market. The investors are required to submit an auditor’s certificate or custodian’s certificate to the protection sellers, of having the underlying bond while entering into/unwinding the CDS contract. This is good for ensuring liquidity in the bond market without inviting systemic risk related troubles by curbing speculation but bad for the CDS market development per se.
2. Trading in the derivative contracts will remain confined to lenders based in India thereby limiting the number of participants and making it easier to regulate and monitor. At the moment only banks can sell protection whereas in markets like the US, the sellers would include hedge funds, insurance companies, and asset managers. In India, only Banks, primary dealers, financially strong non-bank finance companies and any institution approved by the RBI will be eligible as market makers and will be allowed to sell protection. Foreign participants and hedge funds, which typically have a big appetite for credit risk, are not allowed to sell protection. Foreign institutional investors are allowed as “users”, which means that they can buy credit protection to only hedge their credit risk. Although RBI’s guidelines allow insurance companies and mutual funds to be sellers, this is subject to their respective regulators (IRDA and SEBI) permitting them to do so. This is not likely to happen until the market has become a bit more developed.
3. Entities permitted to quote both buy and/or sell CDS spreads — market makers — need a minimum capital to risk (weighted) assets ratio (CRAR) of 11 percent and Net NPAs of less than 3 per cent.
4. Users or buyer of CDS contracts are not allowed to sell protection and are not permitted to hold net short positions in the CDS contracts.
5. Investors can exit their bought CDS positions by unwinding them with the original counterparty or by assigning them in favor of buyer of the underlying bond. The RBI has also included restructuring under credit events for CDS. Buyers will have a grace period of 10 business days from the sale of the underlying bond to unwind the CDS position.
6. CDS will be allowed only on listed corporate bonds as reference obligations. However, CDS can also be written on unlisted but rated bonds of infrastructure companies.
7. The CDS contract shall be denominated and settled in Indian Rupees.
8. The RBI does not permit dealing in any structured financial product with CDS as one of the components neither will it allow dealing in any derivative product where the CDS itself is an underlying.
9. Fixed Income Money Market and Derivatives Association of India (FIMMDA) shall devise a Master Agreement for Indian CDS. There would be two sets of documentation: one set covering transactions between user and market-maker and the other set covering transactions between two market-makers.
10. The CDS contracts shall be standardized. The standardisation 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. This guards against customized contracts wherein the market-makers and users are free to determine the terms.
11. Protection seller in the CDS market shall have in place internal limits on the gross amount of protection sold by them on a single entity as well as the aggregate of such individual gross positions. These limits shall be set in relation to their capital funds. Protection sellers shall also periodically assess the likely stress that these gross positions of protection sold, may pose on their liquidity position and their ability to raise funds, at short notice.
12. Market-makers shall report their CDS trades with both users/investors and other market-makers on the reporting platform of CDS trade repository within 30 minutes from the deal time. The users would be required to affirm or reject their trade already reported by the market- maker by the end of the day.
13. For CDS transactions, the margins would be maintained by the individual market participants. Participants may maintain margins in cash or Government securities.

The vast majority of the Indian corporate debt market consists of bonds from state banks and quasi government entities. The rest comprises mostly of debt from high investment-grade corporate borrowers where the motivation of the bondholder to buy CDS protection is low. The volume of medium to low investment-grade corporate bonds in India is insignificant but the availability of CDS protection may help it grow substantially.

Increased use of CDS, over the medium term, has the potential to impart additional liquidity to the bond markets, which have so far been predominantly illiquid. It will help lower rated borrowers diversify their funding sources by accessing the bond markets. CDS also holds promise of providing a thrust to the much-needed infrastructure financing. RBI has allowed dealing in CDS for infrastructure companies even on unlisted bonds, rather than only on the listed ones. A coordinated action by the other regulators can allow insurance companies, pension funds, and provident funds to also participate in this space through the CDS route.