Credit Default Swaps In India

Credit Default Swaps

Praveen P. Mishall MMS 2008-10 Welingkar Institute of Management Development & Research [email protected]

Credit Default Swaps

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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 

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Types of Derivatives – OTC Derivatives – Exchange Traded Derivatives

Credit Default Swaps

Risks with Derivatives – – – –

Uses of Derivatives – Hedging – Speculation – Arbitrage

Derivatives Contract Types – Forward & Future – Options – Swaps

What are Derivatives? – Derivatives are financial contracts, or financial instruments, whose prices are derived from the price of underlying.

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Large losses due to leverage Counterparty risk Large notional amounts Complicated nature of Derivatives

Driving forces for growth – Volatility in asset prices – Integration of national market with international – Communication facilities – Risk Management Tools 3 8/18/2009

OTC Derivatives Growth

“Blaming derivatives for financial losses is akin to blaming cars for drunken driving fatalities” Christopher L. Culp Credit Default Swaps

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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). 

Types of Credit Derivatives – – – –

Credit Default Swap Total Return Swap Credit linked notes Credit spread option

Credit Default Swaps

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Credit Derivatives Risks – Credit Risk – Market Risk – Legal Risk

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Driving forces for growth – Securitization – Index products – Tranching (slicing in French) Back

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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. 

Simple CDS contract (Source: Bionic Turtle) Credit Default Swaps

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  Failure to pay  Restructuring 6 8/18/2009

Growth of CDS Market

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Credit Default Swap 

Types of CDS

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– Structured Investment Vehicle (SIV) market – Naked CDS – Secondary market for CDS

– Single-name CDS – Multi-name CDS 

Settlement Methods – Physical Settlement – Cash Settlement – Fixed Amount Settlement

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Uses of CDS – Hedging – Speculation

Credit Default Swaps

Speculation in CDS

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How is CDS different from insurance? – Seller is not regulated entity – No need to own reference entity – 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 Credit Default Swaps

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Subprime Crisis 

Reasons for subprime loans – – – –

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Lower interest rates Increase in prices of houses Home equity loans Additional profits to FIs

Types of subprime loans – Interest Only Mortgage – Adjustable Rate Mortgage (ARM)  2/28 ARM – Low Initial Fixed Rate Mortgage

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Predatory Borrowing/ Lending – Lack of information (Options available)

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Moral Hazards – Loan servicer/ Borrowers

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The sequence of events

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Securitization Process

Source: Infosys

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Traching Process – Senior Tranche – Subordinate/Mezzanine Tranche – Equity Tranche

Credit Default Swaps

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Predatory Borrowing and Lending Adverse Selection Moral Hazards Back

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Role of CDS in Subprime Crisis

Source:YieldCurve.com

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CDS Statistics

Source: Infectious Greed Credit Default Swaps

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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.

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Credit Derivative Indices – CDX/ iTraxx – CDX – North American & Emerging Market companies – iTraxx – Rest of the world – Benefits – tradability, liquidity, operational efficiency, transaction cost, transparency

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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

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Benefits of CCPs – – – – –

Credit Default Swaps

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

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Overview of CDS Auction Process

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CDS Auction – Stage 1 – – – –

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Stage 1 Results published are – – The inside market midpoint – The size and direction of the open interest – Any Adjustment Amounts

2-way market quotes Physical settlement request Inside Market Midpoint Open Interest 

CDS Auction – Stage 2 – matching open interest and creating a final price

Credit Default Swaps

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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 Derivatives Association – – – –

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– Quarterly report on bank derivatives activities in US – OCC shared the regulatory information on CDS after its introduction to market

ISDA Master Agreement Administrating Auction Process ISDA Determination committee Semiannual Reports

Bank for International Settlement

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– BIS semiannual data for singlename, multi-name instruments – CDS by counterparty, sector and rating 

Credit Default Swaps

The Depository Trust and Clearing Corporation – Trade Information Warehouse, comprehensive trade database – Weekly information on credit derivative products, transaction types, etc.

British Bankers' Association – Reports every two years on credit derivatives activities in London/ Europe

The Office of the Comptroller of the Currency

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Other data sources – – Bloomberg, Markit, S&P, Moodys, Fitch Rating, etc. Back

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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) Credit Default Swaps

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Central Counterparty Settlement

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IntercontinentalExchange Trust NYSE Euronext LIFFE & LCH.Clearnet SA CME Group Inc./ Citadel Investment Group Eurex AG.

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Comparison of CCPs Parties

ICE Trust/ CCorp

NYSE Euronext LIFFE/ LCH

Program Type

CCP

CCP

E-trading & CCP

CCP

Presence in

US/ Europe

Europe

Europe/ US

Europe

Started on

09/03/2009

22/12/2008

Yet to start

Yet to start

Products

Currently - North American CDX indices Proposed - American single names in 3Q09 European iTraxx indices in 2Q09 European single names in 3Q09

Currently - iTraxx Europe CDS indices in UK Proposed - iTraxx European indices by Dec 2009 US indices by H12010

Proposed – CDX indices, iTraxx indices, and single name CDS

Proposed – European index and single name CDS

Markit

Eurex clearing pricing team, Markit

Pricing by

Markit

Credit Default Swaps

Markit

CME Group/Citadel

Eurex AG

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Comparison of CCPs Parties

Features

ICE Trust/ CCorp Integration and coexistence with other elements of CDS processing infrastructur e (like DTCC)

Credit Default Swaps

NYSE Euronext LIFFE/ LCH Novation within a Eurozone legal framework LCH.Clearnet SA to act as the CCP ISDA documentation compliance DTCC TIW as central registrar

CME Group/Citadel

Eurex AG

Open architecture, enabling market participants to execute or book CDS trades through party-to-party negotiation, IDB brokered, CMDX Request for Quote (RFQ) platform, or other electronic matching venues Migration Utility to migrate existing bilateral OTC contracts to standardized, centrally cleared contracts

Leverage of existing OTC CDS and Eurex Clearing infrastructure No additional technical connectivity required for existing Clearing Members, STP processing with the DTCC Deriv/SERV Trade Information Warehouse Dedicated clearing fund 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

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Trade Lifecycle – Flags, novation, netting, collateral, etc.

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CDS Pricing

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– Markit pricing info. – Eurex clearing pricing team Credit Default Swaps

Risk Management Model – Margins & Collaterals

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End of day processing – Reports with current positions, margin summary, collateral reports Back

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Credit Derivatives Market in India 

Need for Credit Derivatives – Eliminate uneven distribution of risk in market – Banks & FIs highly skewed with loan portfolios with no bond portfolio – Mutual funds, Hedge funds, Insurance companies & Pension funds mostly have bond portfolio and no loan portfolio

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Expected Participants – Banks, Financial Institutions, Insurance companies, Mutual funds

Credit Default Swaps

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Benefits of credit derivatives – Transfer credit risk & free up capital by banks – Retaining existing client relationship – Construct & manage the credit risk portfolio of own choice – Diversification of credit risk

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Minimum Conditions – – – –

Direct Explicit Irrevocable Unconditional

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RBI Draft Guidelines 

Participants allowed – Protection buyers: Commercial Banks, Primary Dealers – Protection seller: Commercial Banks, Primary Dealers

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Product Requirements – Protection buyer must have a credit risk exposure – Settlement Methods  Physical Settlement  Cash Settlement  Fixed Amount Settlement – ISDA Master Agreement compliance

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Product Requirements – Credit Events      

Bankruptcy Obligation Acceleration Obligation Default Failure to pay Repudiation/ Moratorium Restructuring

– Minimum Requirements  Direct, Explicit, Irrevocable & unconditional  No recourse to protection buyer for losses  Specified post-credit-event valuation period  Legal enforceability Continued…

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RBI Draft Guidelines 

Product Requirements – Minimum Requirements Credit events specified at minimum are – - Failure to pay - Bankruptcy, insolvency - Restructuring – Seniority of underlying – Right/Ability to transfer underlying asset/obligation – Grace period < Loan period – Protection buyer has right to inform Protection Seller about the occurrence of credit event

Credit Default Swaps

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Risk Management – Sound risk management policies & procedures (due diligence) – Counterparty limits by PBs – Awareness of legal risk – Adequate oversight by Board of Directors and senior management

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Procedures – Measuring, monitoring, reviewing, reporting and managing the risks – Analysis & minimization of risk – Management of market risk in trading books – Management of legal risk – Management of liquidity reserve Back

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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

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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. Credit Default Swaps

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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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