50023871 a-project-report-on-credit-default-swaps

A PROJECT REPORT ON

Credit Default Swaps- An Emerging Financial ProductIts Effect On Indian Market

IN PARTIAL FULFILLMENT OF

REQUIREMENT OF POST GRADUATE DIPLOMA IN MANAGEMENT PROGRAMME

Submitted To:- Submitted By:- Sukumar Dutta Varun Narang Faculty (Finance) Ashish Ghosh

Northern Integrated Institute Of Learning ManagementCentre for Management Studies

Greater Noida,New Delhi

Emergence of Credit Default Swaps in India

NIILM- Centre for Management Studies

CREDIT DEFAULT SWAPSEFFECT ON INDIAN MARKET


Contents

EXECUTIVE SUMMARY.............................................................................................................5

EVOLUTION OF CREDIT DEFAULT SWAPS...........................................................................9

The Rise of the Credit Default Swap Market............................................................................10

UNDERSTANDING OF CDS AS A BUILDING BLOCK OF CREDIT DERIVATIVES........20

UNDERSTANDING RISK IN CREDIT DEFAULT SWAP.......................................................29

LIQUIDITY AND CREDIT DEFAULT SWAP SPREADS........................................................44

CREDIT DEFAULT SWAP INDEX OPTIONS..........................................................................51

Credit Default Swap Indexes.....................................................................................................52

OTC Credit Default Swap Index Derivatives............................................................................54

Exchange Traded Options..........................................................................................................54

Exchange-Traded CDX Options................................................................................................55

Market and Customers...........................................................................................................55

Pricing and Liquidity Issues of CDS.....................................................................................57

Pricing of Exchange-Traded CDX Options...........................................................................58

Structure of Exchange-Traded CDX Options........................................................................59

Practical Considerations........................................................................................................60

CREDIT DEFAULT SWAPS, CLEARING HOUSE AND EXCHANGES................................62

CREDIT DEFAULT SWAPS AND COUNTERPARTY RISK...................................................70

EFFECT OF CREDIT DEFAULT SWAPS IN INDIAN MARKET...........................................90

CASES ON CREDIT DEFAULT SWAPS...................................................................................96

Falling Giant: A Case Study Of AIG.............................................................................................97

CONCLUSION............................................................................................................................115


BIBLIOGRAPHY........................................................................................................................119

EXECUTIVE SUMMARY

The credit default swap (CDS) market is a large and fast-growing market that allows investors to

trade credit risk. Multiple derivatives on CDS currently trade over the counter including CDO-

like tranches and options. The rise of standardized, liquid, and high-volume CDS indexes has

created the possibility of exchange-traded CDS index options. Exchange-traded options would

increase liquidity in the CDS option market and allow retail and smaller investors to trade credit

risk much more easily than with current products. The primary users of the exchange-traded

options will be speculators as existing products, such as individual CDS or the CDS indexes, are

cost-effective hedges for most players.

CDS index options could be an attractive new product for the CBOE but there are several

major issues to overcome before exchange-traded CDS index options are viable. The most

significant barrier to offering exchange-traded CDS index options is the risk that the CDS trading

infrastructure will fail during a credit crisis. The CBOE can mitigate, but not eliminate, this risk

by carefully drafting contract provisions. The easy hedgability of CDS index options should be

attractive to market-makers but current OTC CDS option dealers might be unwilling to support a

competitive exchange-traded product. There are also practical barriers to the product such as

SEC and index licensing issues.

The proposed contract is a European option on the current on-the-run series of the North

American Investment Grade CDX. The size of the contract is one hundred times the current

spread of the underlying CDX index and the contract is settled based on the CDX spread. In

order to lessen competition with the OTC market, the contract is sized to appeal to smaller

players and the retail market, a new customer base for CDS options

Credit risk has been attracting a great deal of attention recently. Risk-management practitioners

and regulators have all been working intensively on the development of methodologies and

systems to quantify credit risks. At the same time, the market for credit derivatives has grown

rapidly in recent years, and it is expected to continue growing. Credit Default Swaps (CDS) have

become the most liquid credit derivative instruments. In terms of outstanding notional, they

represent around 85% of the credit derivatives market, which has a total outstanding notional in

excess of USD 4000 billions. Not only are they the most important credit derivative instrument,


but they are also the building block for many of the other more exotic structures traded in the

credit derivatives market.

Briefly, CDS are instruments by which an investor, referred to as protection buyer, buys

protection against the losses derived from the default of a given firm. The party which acts as

insurer in a CDS contract, referred to as protection seller, receives, from the protection buyer, a

periodic fee as payment for the insurance. In return for such payments, the protection seller is

responsible to, in case of default of the firm, reimburse the protection buyer the losses derived.

With India having grown at an average of 8.6% in the past 4 years, there has been an

excessive demand for capital from all sorts of businesses to further fuel their growth. Banks seek

to address this need for capital and in turn assume risk. But for India to continue to grow at over

9% it’s an imperative that we have healthy financial institutions which are able to manage their

risks well. Credit derivatives which emerged globally nearly a decade ago and created a rage as

effective tools for credit risk management are set to make their debut in India to help banks better

manage their credit risks.

This paper seeks to address the immense relevance of credit derivatives, particularly CDS,

in the Indian context. The introduction shall provide an overview of the significant features of the

recent guidelines on the introduction of CDS. The paper highlights the positive/negative

implications of the introduction of CDS and the issues that may emerge as the market gains scale.

The paper shall also endeavor to identify issues which demand urgent attention of the regulators

to ensure the healthy growth of credit derivatives in India.

The RBI recently released the “Draft Guidelines on Credit Default Swaps”, as a small first

step towards creating an onshore credit derivatives market. The guidelines aim to introduce CDS

in a calibrated manner in India and are reflective of a conservative approach adopted by the RBI.

The conservatism possibly stems from the inexperience of the Indian markets with such products,

but could in-part also be attributed to derivatives being viewed as “financial weapons of mass

destruction”. The role credit derivatives had to play in the recent Sub-prime crisis does to an

extent validate the adopted approach. The guidelines regulate credit derivative transactions by

Indian resident commercial banks & primary dealers. Currently only 'plain vanilla' credit default

swaps (CDS) have been permitted. The guidelines limit CDS trades to transactions referenced to


single rated, resident entities only, with both the protection buyers (PB) and protection sellers

(PS) being resident. The PB must be in a position to identify a specific credit exposure which it is

hedging, and this exposure may have to be referenced in the CDS. The reference obligation and, if

different, the deliverable obligation must be rated and denominated in Indian Rupees. Related

party transactions have been disallowed and the CDS must be denominated and settled in Indian

rupees.

The rather disheartening feature of the guidelines is that banks are allowed to use CDS but only

for hedging purposes. Globally, credit derivatives are being used not only for hedging purposes

but also for creating exposures to certain assets. This policy measure also deprives the credit

derivatives market of the much needed liquidity extended by the presence of

speculators/arbitragers. The guidelines stipulate that the CDS contract shall not have a materiality

threshold and this shall help further reduce the credit exposure of banks. The guidelines require

that the reference obligation be identical with the underlying exposure and this may be rather

impossible to achieve practically.


CHAPTER – 1

EVOLUTION OF CREDIT DEFAULT

SWAPS


EVOLUTION OF CREDIT DEFAULT SWAPS

The Rise of the Credit Default Swap Market

A credit default swap (CDS) is a contract between two parties where a protection buyer pays a

premium to the protection seller in exchange for a payment if a credit event occurs to a reference

entity. CDS are customizable, over-the-counter products and can be written to trigger in the

event of bankruptcy, default, failure to pay, restructuring, or any other credit event of the

reference entity. Despite the potential to customize CDS, most of the contracts are standardized

to increase the tradability of the contract. The contracts are often written to trigger in the case of

the specified credit event for any of the debt of the entity, even subordinated debt.1 In addition,

CDS are typically 5 year contracts, although 3, 7, and 10 year contracts are also traded. CDS can

be physically settled or cash settled. If a physically-settled CDS is triggered, the protection seller

pays the face value of the debt (or another pre-specified amount) to the protection buyer in

exchange for the debt itself, which would be worth less than face value given the recent credit

event. Triggering a cash-settled CDS would require the protection seller to make a payment to

the protection buyer of the difference between the original value of the debt (typically the face

value) and the current value of the debt based on a specified valuation method. Unlike hedging

with less risky bonds which requires a cash outlay upfront, CDS do not subject the buyer to

interest rate risk or funding risk. CDS allow hedgers or speculators to take an unfunded position

solely on credit risk.

The CDS market is an important market that has grown dramatically over a short period of time.

The market originally started as an inter-bank market to exchange credit risk without selling the

underlying loans but now involves financial institutions from insurance companies to hedge

funds. The British Bankers Association (BBA) and the International Swaps and Derivatives

Association (ISDA) estimate that the market has grown from $180 billion in notional amount in

1997 to $5 trillion by 2004 and the Economist estimates that the market is currently $17 trillion

in notional amount.2 This rapid growth was spurred by the ISDA creating a set of standardized

documentation. This standardized industry standards and benchmarks which greatly lowered the

transactions costs to trading CDS.


The credit default swap (CDS) market is one of the purest and most responsive indicators of

corporate financial health. Since the release of ISDA’s “Master Agreement,” CDS transactions

have become simpler and CDS markets have become available to a whole new universe of

investors. As Goldman Sachs expressed in a bulletin published in May 2001: “…use of default

swaps will increasingly become a necessary component of any successful portfolio management

strategy.”

EMERGENCE OF CREDIT DEFAULT SWAPS

Credit Default Swaps (CDS) were originally created in the mid-1990s as a means to transfer

credit exposure for commercial loans and to free up regulatory capital in commercial banks. By

entering into CDS, a commercial bank shifted the risk of default to a third-party and this shifted

risk did not count against their regulatory capital requirements.

In the late 1990s, CDS were starting to be sold for corporate bonds and municipal bonds. By

2000, the CDS market was approximately $900 billion and was viewed as, and working in, a

reliable manner, including, for example, CDS payments related to some of the Enron and

Worldcom bonds. There were a limited number of parties to the early CDS transactions, so the

parties were well-acquainted with each other and understood the terms of the CDS product. In

most cases, the buyer of the protection also held the underlying credit asset (loan or bond).

However, in the early 2000s, the CDS market changed in three substantive manners:

Numerous new parties became involved in the CDS market through the development of a

secondary market for both the sellers of protection and the buyers of protection.

Therefore, it became difficult to determine the financial strength of the sellers of

protection

CDS were starting to be issued for Structured Investment Vehicles, for example, ABS,

MBS, CDO and SIVs. These investments no longer had a known entity to follow to

determine the strength of a particular loan or bond (as in the case of commercial loans,

corporate bonds or municipal bonds.); and


Speculation became rampant in the market such that sellers and buyer of CDS were no

longer owners of the underlying asset (bond or loan), but were just "betting" on the

possibility of a credit event of a specific asset.

The result was that by the end of 2007, the CDS market had a notional value of $45 trillion, but

the corporate bond, municipal bond, and structured investment vehicles market totaled less than

$25 trillion. Therefore, a minimum of $20 trillion were speculative "bets" on the possibility of a

credit event of a specific credit asset not owned by either party to the CDS contract.

Another result was that the original two parties that entered into the CDS contract may very well

not be the current holders of the rights of the protection buyer and protection seller. Some CDS

contracts are believed to have been passed through 10-12 different parties. The financial strength

of all the multiple parties may not be known. Therefore, it has become very difficult to

determine, or "unwind," the parties of the CDS in the event of a "credit event."

Finally, a "credit event" that triggers the initial CDS payment may not trigger a downstream

payment. For example, AON entered into a CDS as the seller of protection. AON resold its

interest to another company. The bond at issue defaulted and AON paid the $10 million due to

the default. AON then sought to recover the $10 million from the downstream buyer, but was

unsuccessful in litigation - so AON was stuck with the $10 million loss even though they had

sold the protection to another party. The legal problem was that the downstream contract to

resell the protection did not exactly match the terms of the original CDS contract.

Sub-Prime Mortgages and other Asset-Backed Problems

The problems in the subprime mortgage area which started in the summer of 2007 exposed the

problems in the CDS market. As the subprime mortgage and their related CDOs started to have

valuation problems, and ultimate defaults, the sellers of protection in the CDS market started to

realize that the CDS tied to collateralized subprime mortgages and other CDO-type securities

were going to require substantial payments.

For example, Swiss Reinsurance entered into two CDS as the seller of protection for two CDOs

totaling $1.5 billion that contained collateralized subprime mortgages and other collateralized


assets. The CDO's "credit event" was triggered due to reduced values of the CDO's underlying

mortgages. In October 2007, Swiss Re wrote down the value of the CDS a total of $1.1 billion

based on the reduced values of the two CDOs (and the subsequent payment required to cover

those losses). In April 2008, Swiss Re took another $240 million write-down for continued

reduced value in the two CDOs.

Insurance Company Risks

Insurance company may be exposed as both buyers of protection and sellers of protection in the

CDS market. Many insurance companies have entered into CDS as buyers of protection as a

hedge against the potential decline in their vast bond holdings, including holdings of ABS, MBS

and CDO. The risk to the insurance companies on the buyer side is that the counterparty (seller

of protection) will not have sufficient assets to pay if a "credit event" occurs. This is commonly

referred to as counterparty liquidity risk. If the counterparty does not have the ability to pay, the

insurance company realizes a loss on the bond holding and loses its premiums that it paid for the

protection.

The bigger problem most likely occurs when the insurance company is the seller of protection as

Swiss Re was in the earlier example. Insurance companies often enter into the CDS as a seller of

protection since the CDS pays a stream of premiums that is a consistent source of investment

income for the company. Premiums are generally 3%-5% of the value of the underlying asset and

are paid on a quarterly basis. However, the risk of payment unknowingly increased when the

CDS were related to securities such as CDOs, ABS and MBS which are fraught with structural

problems, but were offered as secure investments. In this scenario, the insurance company may

have to pay large amounts to the buyer of protection, which dwarfs the stream of premiums

received.

The value of a CDS is based on computer modeling of cash flows including the stream of

premium payments less projected pay-outs due to anticipated events of default in the underlying

debt or, at least, the risk of payment for such events of default. As the stream of premiums is

often set by the contract terms, the volatility of values in CDS is primarily due to changes in the

risk of projected pay-outs due to events of default. For example, AIG wrote-down the value of


its CDS portfolio by $20 billion during the past two quarters. AIG sold credit default swaps to

holders of CDOs guaranteeing payments in the event of default in the underlying debt, which

were pools of subprime mortgages. In simple terms, as the risk of higher subprime mortgage

defaults increased in the CDOs, the credit default swap values decreased due to the risk of

anticipated higher pay-outs by the CDS seller (in this example, AIG) to cover the increased

events of default.

Speculation Enters the Market

Speculation entered the CDS market in three forms: 1) using structured investment vehicles such

as MBS, ABS, CDO and SIV securities as the underlying asset, 2) creating CDS between parties

without any connection to the underlying asset, and 3) development of a secondary market for

CDS.

Much has been written about the structured investment vehicle market and the lack of

understanding of what was included in the various products. Sellers of protection in the CDS

market more than likely did not have sufficient understating of the underlying asset to determine

an appropriate risk profile (plus there was no history of these products to assist in determining a

risk profile). As it has become clear, the structured investment vehicle market was a speculative

market which was not really understood, which led to speculative CDS related to these products.

A larger problem is the pure speculation in the CDS market. Many hedge funds and investment

companies started to write CDS contracts without owning the underlying security, but were just a

"bet" on whether a "credit event" would occur. These CDS contracts created a way to "short"

sell the bond market, or to make money on the decline in the value of bonds. Many hedge funds

and other investment companies often place "bets" on the price movement of commodities,

interest rates, and many other items, and now had a vehicle to "short" the credit markets.

A still larger problem was the development of a secondary market for both legs of the CDS

product, particularly the seller of protection. The problem may be like the AON example above.

The problem may be that a "weak link" would occur in the chain of sales even if the CDS terms

are the same. The "weak link" is often a speculative buyer that offers to sell protection, but, in

fact, is just looking to quickly turn the product to another investor. This problem becomes


particularly acute when the CDS is based on structured investment vehicles and firms looking for

a quick profit.

An insurance company may unknowingly be pulled into one of these speculative aspects of the

CDS market. The insurance company would be viewed as "the deep pocket" and may be asked

(or sued) to recover losses by the buyer of protection.

Litigation Issues

CDS are sold as individual contracts and appear not to be subject to securities laws (further legal

research in this area is warranted). There is no regulatory body that governs the buying and

selling of CDS. The International Swaps and Derivatives Association (ISDA) does provide

recommended CDS documentation guidelines, but the ISDA is not a regulatory body that issues

regulations which are enforceable.

Causes of action in the CDS market are most likely tied to the underlying CDS contract(s) in

place, in both the original market and the secondary markets, related to the underlying asset that

suffered a "credit event." Further, CDS as an industry is in its infancy, especially, regarding the

structured investment vehicles and the speculative products and, as such, the litigation history is

limited to date and is still being developed.

WHAT ARE CREDIT DEFAULT SWAPS?

Credit Default Swaps (CDS) are a private contract between two parties in which the buyer of

protection agrees to pay premiums to a seller of protection over a set period of time, the most

common period being five years. In return, the seller of protection agrees to pay the buyer an

amount of loss created by a "credit event" related to an underlying credit asset (loan or bond) -

the most common events are bankruptcy, restructuring or default. Each individual contract lays

out the specific terms of their agreement including identifying the underlying asset (loan or

bond) and what constitutes a credit event.


Even though CDS appear to be similar to insurance, it is not a form of insurance. Rather it is an

investment (more akin to an option) that "bets" on whether a "credit event" will or will not

occur. CDS do not have the same form of underwriting and actuarial analysis as a typical

insurance product rather is based on an analysis of the financial strength of the entity issuing the

underlying credit asset (loan or bond). There are no regulatory capital requirements for the seller

of protection (such as exists with insurance companies and banks).

CDS are not regulated and are "sold" through "brokered" arrangements. Initially, commercial

banks were the "broker" that put together the two sides of the CDS contract. However,

investment banks became very involved in "brokering" the CDS contracts for corporate bonds,

municipal bonds and, later, structured investment vehicles. CDSs are a product within the credit

derivative asset class, constituting a type of OTC derivative. They are bilateral contracts in which

a protection buyer agrees to pay a periodic fee (called a “premium”) and/or an upfront payment

in exchange for a payment by the protection seller in the case of a credit event (such as a

bankruptcy) affecting a reference entity or a portfolio of reference entities such as a CDS index .

The market price of the premium is therefore an indication of the perceived risk related to the

reference entity. There are three main types of CDS.


First, the “single-name CDS” offers protection for a single corporate or sovereign reference

entity.

Second, CDS indices are contracts which consist of a pool of single-name CDSs, whereby each

entity has an equal share of the notional amount within the index. The standardization and

transparency of indices has contributed strongly to the growth of index contracts.8 In June 2009

this segment accounted for almost half of all CDS contracts in terms of notional outstanding

amounts, compared with virtually nil in 2004.

Liquidity for benchmark indices is enhanced by including only the most liquid single-name

CDSs. Market participants have come to view the CDS indices as a key source of price

information. Official prices for these indices are collected by Markit and published on a daily

basis. CDS indices do not cease to exist after credit events, instead continuing to trade with

reduced notional amounts.

In addition, a market has also developed for CDS index tranches, whereby CDS contracts relate

to specific tranches (also known as “synthetic CDOs”) within an established CDS index. Each

tranche covers a certain segment of the losses distributed for the underlying CDS index as a

result of credit events.

Third, basket CDSs are similar to indices, as they relate to portfolios of reference entities, which

can comprise anything from 3 to 100 names. However, basket CDSs may be more tailored than

index contracts and are more opaque in terms of their volumes and pricing. Basket CDSs, for

example, include specific sub-categories such as first-to-default CDSs (where investors are

exposed to the first default to occur within the basket of reference entities). In addition,

derivative instruments such as CDS options (called “CDS swaptions”) are now also being traded.


Holders of these instruments are entitled – but not obliged – to enter into forward-start CDS

contracts to buy or sell protection. This type of instrument may benefit from increased investor

interest in the environment of increased transparency that may result from stronger migration of

CDSs to CCPs. It is important to distinguish between standard single-name CDSs or index

contracts and the more complex bespoke CDS contracts, as the latter can be very different

(having, among other things, different degrees of liquidity and embedded leverage) and are

frequently used for different purposes. Although disentangling the various uses of CDSs is

somewhat artificial, one approach has been to distinguish between CDSs for hedging and trading

purposes. In the first category, CDSs can be used to hedge the credit risk of on-balance sheet

assets (e.g. corporate bonds or asset-backed securities) by acquiring CDS protection on them.

Such protection provides capital relief and insures the acquirer of protection against credit losses

(assuming the terms of the CDS contract provide for perfect hedging). Commercial banks and

other lenders are natural buyers of

CDS protection for such purposes, while highly rated dealers, insurance companies, financial

guarantors and credit derivative product companies were the typical protection sellers prior to the

financial crisis. They can also be used to hedge counterparty exposure. As part of their daily

trading activities, dealers take on unsecured exposures to other financial institutions. Credit

default swaps provide a mechanism for the hedging of such counterparty exposures and are

highly sought after by market participants during periods of considerable market distress. They

provide protection by producing a gain if credit spreads on their counterparties widen.

Derivatives can also be used as trading tools, for speculating or arbitrage purposes. Speculators

and arbitragists add liquidity to the market by “connecting” markets and eliminating pricing

inefficiencies between them. First, they allow a counterpart to acquire long exposure to credit

assets in an unfunded (synthetic) form when selling CDS protection.

The leverage embedded in credit default swaps (like that in other derivative instruments) offer a

higher return on equity than acquiring the credit assets outright. In the presence of widening

credit spreads, CDSs can offer equity-like returns and are therefore attractive to hedge funds, or

even the more traditional bond funds. In addition, credit default swaps, by their very nature as

OTC products, can be used to create bespoke exposures by enabling counterparties to choose

either single-name or multi-name reference entities and by customizing their pay-off triggers and

amounts.


These highly customized products are usually illiquid and consequently require a substantial

amount of sophisticated modeling to estimate potential pay-off scenarios.

Second, CDSs also allow the acquisition of uncovered short exposure to credit assets when

buying CDS protection. The acquirer of CDS protection effectively shorts the underlying

reference asset(s). Shorting cash bonds is considerably more difficult because it requires the

short-seller to borrow the assets, which is usually difficult to accomplish with fixed income

securities, particularly if the short-seller seeks to go short on a portfolio of assets. Hedge funds,

or dealers with long CDS exposures, which need to be hedged, are active acquirers of CDS

protection.

To conclude, CDSs are not only risk management tools for banks but also contribute to the

completeness of the market, by providing market participants with a possibility to take a view on

the default risk of a reference entity, on a company or a sovereign borrower. Thereby and as

shown during the crisis, derivatives allow for pricing of risk that might otherwise be difficult due

to lack of liquidity in the underlying assets.


CHAPTER – 2

UNDERSTANDING OF CDS AS A BUILDING BLOCK OF

CREDIT DERIVATIVES


UNDERSTANDING CREDIT DEFAULT SWAPS AS A BUILDING BLOCK FOR

CREDIT DERIVATION

What are credit derivatives?

Derivatives growth in the latter part of the 1990s continues along at least three

dimensions. Firstly, new products are emerging as the traditional building blocks – forwards and

options – have spawned second and third generation derivatives that span complex hybrid,

contingent, and path-dependent risks. Secondly, new applications are expanding derivatives use

beyond the specific management of price and event risk to the strategic management of

portfolio risk, balance sheet growth, shareholder value, and overall business performance .

Finally , derivatives are being extended beyond mainstream interest rate, currency , commodity ,

and equity markets to new under lying risks including catastrophe, pollution, electricity ,

inflation, and credit .

Credit derivatives fit neatly into this three-dimensional scheme . Until recently, credit

remained one of the major components of business risk for which no tailored risk-management

products existed. Credit risk management for the loan portfolio manager mean t a strategy of

portfolio diversification backed by line limits, with an occasional sale of positions in the

secondary market . Derivatives users relied on purchasing insurance, letters of credit, or

guarantees, or negotiating collateralized mark- to-market credit enhancement provisions in

Master Agreements . Corporates either carried open exposures to key customers’ accounts

receivable or purchased insurance, where available, from factors. Ye t these strategies are

inefficient, largely because they do not separate the management of credit risk from the asset

with which that risk is associated.

For example, consider a corporate bond, which represents a bundle of risks, including

perhaps duration, convexity, callability, and credit risk (constituting both the risk of default and

the risk of volatility in credit spreads). If the only way to adjust credit risk is to buy or sell that

bond, and consequently affect positioning across the entire bundle of risks, there is a clear

inefficiency. Fixed income derivatives introduced the ability to manage duration, convexity, and

callability independently of bond positions; credit derivatives complete the process by allowing

the independent management of default or credit spread risk.


Formally, credit derivatives are bilateral financial contracts that isolate specific aspects of

credit risk from an underlying instrument and transfer that risk between two parties. In so doing,

credit derivatives separate the ownership and management of credit risk from other qualitative

and quantitative aspects of ownership of financial assets. Thus, credit derivatives share one of

the key features of historically successful derivatives products, which is the potential to achieve

efficiency gains through a process of market completion. Efficiency gains arising from

disaggregating risk are best illustrated by imagining an auction process in which an auctioneer

sells a number of risks, each to the highest bidder, as compared to selling a “job lot” of the same

risks to the highest bidder for the entire package. In most cases, the separate auctions will yield a

higher aggregate sale price than the job lot. By separating specific aspects of credit risk from

other risks, credit derivatives allow even the most illiquid credit exposures to be transferred from

portfolios that have but don’ t want the risk to those that want but don’ t have that risk, even

when the underlying asset itself could not have been transferred in the same way.

What is the significance of credit derivatives?

Even today, we cannot yet argue that credit risk is, on the whole, “actively” managed.

Indeed, even in the largest banks, credit risk management is often little more than a process of

setting and adhering to notional exposure limits and pursuing limited opportunities for portfolio

diversification. In recent years, stiff competition among lenders, a tendency by some banks to

treat lending as a loss-leading cost of relationship development, and a benign credit cycle have

combined to subject bank loan credit spreads to relentless downward pressure, both on an

absolute basis and relative to other asset classes. At the same time, secondary market illiquidity,

relationship constraints, and the luxury of cost rather than mark-to-market accounting have made

active portfolio management either impossible or unattractive. Consequently, the vast majority

of bank loans reside where they are originated until maturity. In 1996, primary loan syndication

origination in the U.S. alone exceeded $900 billion, while secondary loan market volumes were

less than $45 billion.

However, five years hence, commentators will look back to the birth of the credit

derivative market as a watershed development for bank credit risk management practice. Simply

put, credit derivatives are fundamentally changing the way banks price, manage, transact,

originate, distribute, and account for credit risk. Yet, in substance, the definition of a credit


derivative given above captures many credit instruments that have been used routinely for years,

including guarantees, letters of credit, and loan participations. So why attach such significance

to this new group of products? Essentially, it is the precision with which credit derivatives can

isolate and transfer certain aspects of credit risk, rather than their economic substance, that

distinguishes them from more traditional credit instruments. There are several distinct

arguments, not all of which are unique to credit derivatives, but which combine to make a strong

case for increasing use of credit derivatives by banks and by all institutions that routinely carry

credit risk as part of their day-to-day business.

First, the Reference Entity, whose credit risk is being transferred, need neither be a party

to nor aware of a credit derivative transaction. This confidentiality enables banks and corporate

treasurers to manage their credit risks discreetly without interfering with important customer

relationships. This contrasts with both a loan assignment through the secondary loan market,

which requires borrower notification, and a silent participation, which requires the participating

bank to assume as much credit risk to the selling bank as to the borrower itself.

The absence of the Reference Entity at the negotiating table also means that the terms

(tenor, seniority, compensation structure) of the credit derivative transaction can be customized

to meet the needs of the buyer and seller of risk, rather than the particular liquidity or term needs

of a borrower. Moreover, because credit derivatives isolate credit risk from relationship and

other aspects of asset ownership, they introduce discipline to pricing decisions. Credit

derivatives provide an objective market pricing benchmark representing the true opportunity cost

of a transaction. Increasingly, as liquidity and pricing technology improve, credit derivatives are

defining credit spread forward curves and implied volatilities in a way that less liquid credit

products never could. The availability and discipline of visible market pricing enables

institutions to make pricing and relationship decisions more objectively.

Second, credit derivatives are the first mechanism via which short sales of credit

instruments can be executed with any reasonable liquidity and without the risk of a short

squeeze. It is more or less impossible to short-sell a bank loan, but the economics of a short

position can be achieved synthetically by purchasing credit protection using a credit derivative.

This allows the user to reverse the “skewed” profile of credit risk (whereby one earns a small

premium for the risk of a large loss) and instead pay a small premium for the possibility of a

large gain upon credit deterioration. Consequently, portfolio managers can short specific credits


or a broad index of credits, either as a hedge of existing exposures or simply to profit from a

negative credit view. Similarly, the possibility of short sales opens up a wealth of arbitrage

opportunities. Global credit markets today display discrepancies in the pricing of the same

credit risk across different asset classes, maturities, rating cohorts, time zones, currencies, and so

on. These discrepancies persist because arbitrageurs have traditionally been unable to purchase

cheap obligations against shorting expensive ones to extract arbitrage profits. As credit

derivative liquidity improves, banks, borrowers, and other credit players will exploit such

opportunities, just as the evolution of interest rate derivatives first prompted cross-market

interest rate arbitrage activity in the 1980s. The natural consequence of this is, of course, that

credit pricing discrepancies will gradually disappear as credit markets become more efficient.

Third, credit derivatives, except when embedded in structured notes, are off-balance-

sheet instruments. As such, they offer considerable flexibility in terms of leverage. In fact, the

user can define the required degree of leverage, if any, in a credit investment. The appeal of off-

as opposed to on-balance-sheet exposure will differ by institution: The more costly the balance

sheet, the greater the appeal of an off-balance-sheet alternative. To illustrate, bank loans have

not traditionally appealed as an asset class to hedge funds and other nonbank institutional

investors for at least two reasons: first, because of the administrative burden of assigning and

servicing loans; and second, because of the absence of a repo market. Without the ability to

finance investments in bank loans on a secured basis via some form of repo market, the return on

capital offered by bank loans has been unattractive to institutions that do not enjoy access to

unsecured financing. However, by taking exposure to bank loans using a credit derivative such

as a Total Return Swap (described more fully below), a hedge fund can both synthetically

finance the position (receiving under the swap the net proceeds of the loan after financing) and

avoid the administrative costs of direct ownership of the asset, which are borne by the swap

counterparty. The degree of leverage achieved using a Total Return Swap will depend on the

amount of up-front collateralization, if any, required by the total return payer from its swap

counterparty. Credit derivatives are thus opening new lines of distribution for the credit risk of

bank loans and many other instruments into the institutional capital markets.


Basic credit derivative structures and applications

The most highly structured credit derivatives

transactions can be assembled by combining three main

building blocks:

1 Credit (Default) Swaps

2 Credit Options

3 Total Return Swaps

The most common type of credit derivative is

the credit default swap. A credit default swap or option is simply an exchange of a fee in

exchange for a payment if a “credit default event” occurs. Credit default swaps differ from

Total Rate of Return Swaps in that the Investor does not take price risk of the Reference Asset,

only the risk of default. The Investor receives a fee from the Seller of the default risk. The

Investor makes no payment unless a Credit Default Event occurs.

The traditional or “Plain Vanilla” credit default swap is a payment by one party in exchange for a

credit default protection payment if a credit default event on a reference asset occurs. The

amount of the payment is the difference between the original price of the reference asset and the

recovery value of the reference asset. The following schematic shows how the cash flow of this

credit derivative transaction work:

If the fee is paid up front, which may be the case for very short dated structures, the agreement is

likely to be called a credit default option. If the fee is paid over time, the agreement is more

likely to be called a swap. Unless two counterparties are actually swapping and exchanging the


credit default risk of two different credits, I prefer to call the former structure a credit default

option. Cash flows paid over time are nothing more than an amortization of an option premium.

Because the documentation references ISDA master agreements, however, swap terminology has

crept into the market. Since the credit derivatives business at many commercial and investment

banks is often run by former interest rate swap staff, the tendency to use swap terminology

persists. Therefore, I will most often refer to these transactions as credit default “swaps”.

The credit default premium is usually paid over time. For some very short dated

structures, the credit default premium may be paid upfront. In fact, professionals new to this

market often ask if the premium should be paid upfront, instead of over time. After all, if the

credit defaults, the default protection Seller will get no additional premiums.

The credit default option or swap is a contingent option, and not to be confused with an

American option. A Termination Payment is only made if a Credit Event occurs. If the credit

event does not occur, the default protection Seller has no obligation. The premium can be

thought of as the credit spread an Investor demands to take the default risk of a given Reference

Asset. If the Investor bought an asset swap, the Investor would earn a spread to his funding cost

representing the compensation, the premium, the Investor would need to take the credit default

risk of the Reference Asset in the asset swap.

For an American option, the premium is paid upfront (or over time, but with the proviso

that the total premium is owed, even if exercise occurs before the expiration date). The

American option can be exercised any time that it is in the money. The holder of the option does

not have to exercise, however, and can wait and hope the option will go further in the money. If

the market reverses direction, the American option can again become out-of-the money, and the

holder who failed to exercise the option when it was in the money cannot exercise. With a credit

default option, once the trigger event has occurred, the holder must exercise and the option stays

exercisable.

Default Protection can be purchased on a loan, a bond, sovereign risk due to cross border

commercial transactions, or even on credit exposure due to a derivative contract such as

Counterparty credit exposure in a cross currency swap transaction. Credit protection can be

linked to an individual credit or to a basket of credits.

At first glance, a credit default swap or option looks structurally simpler than a total

return swap. We already know that a total return swap is simply a form of financing. In this


chapter we will explore the complex, various, and interesting features of the credit default swap

and the credit default option market. Complex? Various? Wait a minute. Didn’t I mention that

a total return swap already has a credit default swap imbedded in its structure? After all, if my

Counterparty is taking the default risk of a bond or a loan, I have reduced my credit exposure to

that reference asset. We understand everything there is to know about credit default swaps

already. Don’t we?

That is the question most practitioners ask themselves the first time they enter into a

credit default contract. The first key difference is that although the price or premium of a credit

default swap or option may increase, it is never actually in-the-money until a credit default event

as defined by the confirm language has occurred. That seems like a knock-in option or a knock-

in swap, which is a type of barrier option. Knock-in options have been around since the 1960’s.

When a market price reaches a pre-determined strike price, the barrier, the knock-in option

comes into existence. But this “knock-in” is not linked to traditional market factors, but rather to

either credit default or a credit “event”. If the option “knocks in” then, and only then, is the

option in the money. The termination payment is usually not binary or pre-defined, although we

will explore exceptions in this chapter. The termination payment is linked to a recovery value or

recovery rate for the reference credit or reference credits involved.

The terminology is further complicated by the US market’s use of the word swap to refer

to an exchange of one bond for another (usually accompanied by a cash payment to make up for

any discrepancy in relative values), and the UK market’s use of the term “switch” for the same

transaction. US market practitioners are often mystified when they first hear of “asset swap

switches”, an exchange of one asset swap package risk for another asset swap package risk. We

will discuss this product later in this chapter.

As we will see later, a variety of structures have evolved in this market. The risk

characteristics of these structures are different from the structures we have discussed so far and

merit close scrutiny. One structure known by such names as: Digital, binary, all-or-nothing, and

the zero-one structure has a substantial amount of risk. The Investor loses the entire notional

amount – not merely coupon and some principal loss- if there is a default event.

Other structures such as the ‘par value minus recovery value’ structure can leave a

position of premium bonds partially unhedged or can overhedge a position of bonds trading


below par. Exposure management officers evaluating the suitability and appropriateness of such

deals must be fully aware of the full exposures implied in these transactions.

The credit swap becomes even more interesting when one realizes that the term “default

event” does not even apply to many credit agreements. The event, which triggers a termination

payment under the terms of the credit default swap confirmation, is negotiable. The event may

be defined as a spread widening, an event in a foreign country that may cause its sovereign debt

to decline in price, or just about any event upon which the two parties can agree and define a

price. Even the termination payment is negotiable. It may be pre-set at a fixed amount, or based

on the recovery value of a reference asset, to mention only two structures.

Some credit “default” options, those linked to spread widening, for instance, sound

suspiciously like put options which are struck out-of-the-money.

Importance of the Default Protection Seller

If an Investor is purchasing credit default protection, what kind of credit default

protection Seller is most desirable? If prices were the same, a default protection Seller with a

triple A credit rating and a 0% correlation with the asset the Investor is trying to hedge would be

the most desirable. But as we saw in the section on Total Rate of Return Swaps, a default

protection Seller with these characteristics will probably sell very expensive protection.

Therefore, it is beneficial to relax the criteria and find another provider. The Investor should be

aware that there are unsuitable providers, however.

There are unsuitable applications, too. One must as the right questions before trying to

apply a solution. Credit derivatives are sometimes seen as the panacea, the answer to any finance

problem, which cannot be solved by conventional market strategies.

The whole point of using credit derivatives is to diversify credit risk.

Asset swap spreads are independent of the credit quality of the Investor. A market asset

is swapped to a LIBOR based floating coupon, for instance. The market is indifferent to the

credit quality of the Investor, who pays cash up front for the asset swap package. Unlike an asset

swap, the premium paid to the “Investor”, the credit default protection Seller, is sensitive to the

credit quality of the Investor. The premium is further sensitive to the correlation between the

“Investor” and the reference asset on which one is buying the credit default protection.


Depending on the structure, the credit default swap contract may require an un-collateralized

payment by the “Investor” if there is a credit default event.

.

CHAPTER – 3

UNDERSTANDING RISK IN

CREDIT DEFAULT SWAP


UNDERSTANDING RISK IN CREDIT DEFAULT SWAPS

Credit derivatives offer unique opportunities and risks to investors. They allow investors to have

exposure to a firm without actually buying a security or loan issued by that firm. Because the

exposure is synthetic, the transaction can be tailored to meet investors’ needs with respect to

currency, cash flow, and tenor, among other things. However, if the transaction is not structured

carefully, it may pass along unintended risks to investors. Significantly, it may expose investors

to higher frequency and severity of losses than if they held an equivalent cash position. Moody's

has rated numerous structured transactions — mostly synthetic collateralized

debt obligations (CDOs) and credit-linked notes (CLNs) — whose key feature is a cash-settled

credit default swap. Under the swap, losses to investors are determined synthetically, based on

“credit events” occurring in a reference portfolio.

Investors’ risk, thus, is driven largely by the definition of “credit events” in the swap. The

definitions published by the International Swaps and Derivatives Association (ISDA) are, in

many respects, broader than the common understanding of “default,” and thus impose risk of loss

from events that are not defaults. For example,

Moody's — and much of the market — considers certain types of “restructuring” events to be

“defaults.” However, the current ISDA definition of “restructuring” is broader than Moody's

definition of “default,” and includes events that would not be captured by a Moody's rating.

Likewise, the ISDA definitions for other credit events — e.g., bankruptcy, obligation

acceleration, and obligation default — are broader than Moody's definition of “default.” For the

Moody's rating of a reference portfolio to capture the risks to investors, the “credit events“

should be narrowed such that they are consistent with “defaults” — the events captured by a

Moody's rating.

Many of the risks in these transactions are driven by moral hazard — the inherent conflicinterest

that exists because the sponsoring financial institution (which is buying protection from

investors) determines when a loss event has occurred as well as how much loss is imposed on

investors. The sponsor's incentive, of course, is to construe “credit events” as expansively as

possible and to calculate losses as generously as possible. Moody's considers these risks carefully

when issuing its ratings. In addition to tightening the credit event and loss calculation provisions,


these risks can be addressed by increasing transparency and providing mechanisms for

objectively verifying loss determinations and calculations.

Setting aside moral hazard, risks also arise based on the inherent difficulty in valuing a defaulted

credit to determine the extent of loss to investors. Calculated losses may vary based on liquidity,

market conditions, and the identity of the parties supplying bids. In analyzing a credit default

swap, Moody's looks carefully at the methods and procedures for calculating loss given default,

to ensure that all calculations are meaningful, realistic, and fair.

The ISDA Credit Derivatives definitions, as currently drafted, do not effectively unbundle

“credit risk” from other risks. If not structured carefully, a credit default swap using the ISDA

definitions can pass along risks other than “credit risk.” For example, the swap may pass along

the risk of loss following credit deterioration short of default. Such a risk is not necessarily

captured by a

Moody's rating of the reference portfolio, and, with some exceptions (e.g., when the loss event is

a rating downgrade) is not readily capable of being measured.

The capital markets have an enormous capacity for absorbing credit risk, and this capacity has

only been partially tapped by the credit derivatives market. In Moody’s opinion, for capital

markets investors to participate fully in the credit derivatives market, the risks inherent in credit

default swaps must be more precisely defined, more transparently managed, and more readily

quantifiable.

This special report will describe the typical cash-settled credit default swap underlying a

synthetic CDO or CLN,1 compare Moody’s definition of default with the credit event definitions

currently used in the ISDA documentation, and discuss how different structural features and

parameters of a credit default swap can affect risks to investors and impact Moody’s analysis and

ratings.

A swap can be structured to provide for either physical settlement or cash settlement following

a credit event. In a physically settled swap, the buyer of protection delivers to the seller an

obligation of the reference entity that has experienced a credit event. The seller pays par for that

asset, thus reimbursing the buyer for any default-related loss that it would otherwise suffer.

In a cash-settled swap, the buyer of protection is not required to deliver the defaulted credit, but

values the credit — for example, by marking it to market or by using a final workout value —


and is reimbursed for the loss (measured by the difference between par and the value following

default).

THE TYPICAL STRUCTUREThrough synthetic CDOs or CLNs, financial institutions utilize credit default swaps to “buy”

credit protection — usually from the capital markets in the form of issued securities, but also

directly from counterparties in the form of over-the-counter swap transactions. The structure

allows financial institutions to remove credit exposure from their balance sheets while retaining

ownership of the assets, and thus (1) manage risk more efficiently, and (2) obtain economic

and/or regulatory capital relief.

In the typical structure, the sponsoring financial institution (the entity seeking protection against

credit losses) sets up a special purpose vehicle (SPV) to serve as counterparty to the credit

default swap (making the SPV the provider of protection). The SPV is funded with the proceeds

of notes issued to investors; it will use those proceeds to make credit event payments to the

financial institution, and to return any remaining principal to investors at the deal’s maturity. The

proceeds of the securities are typically invested in highly rated securities in such a way that the

ratings of the notes can be “de-linked” from the rating of the sponsoring institution.


Under the swap, the SPV is the “seller” of protection, and the financial institution is the

“buyer.”The swap references a credit exposure, or portfolio of credit exposures, for which

protection is being provided. The arrangement is similar to an insurance policy, in which the

financial institution is buying insurance against losses due to default in its portfolio. The credit

exposures can be assets physically owned by the sponsor (e.g., loans, bonds, other securities),

exposures to counterparties (e.g., by way of currency or interest rate swaps), or synthetic

exposures (e.g., if the sponsor has sold protection on particular assets by way of credit default

swaps). Typically, in a synthetic CDO, the financial institution retains the firstloss piece, and the

mezzanine tranches are securitized and sold to investors. There is often a “super senior” piece

that is either retained by the sponsor or passed off to a counterparty by way of a swap. There are

a number of key variations on the structure that can have a significant impact on the analysis of

the transaction:

The reference pool can be static — remaining the same throughout the life of the

transaction — or it can be dynamic, permitting removal and substitution of the individual

reference credits pursuant to portfolio guidelines.

The swap can provide for ongoing cash settlement — as defaults happen and losses are

incurred — or it can provide for cash settlement only at the maturity of the deal.

The procedure and timing for determining severity of loss on a defaulted credit reference

can vary — from a bidding procedure that takes place shortly after a default, to reliance

on a final “work-out“ value established after the formal workout process has been

completed.


The swap can reference specific credits, or it can reference the general, unsecured debt of

a reference entity.

If the swap references the general, unsecured debt of an entity, credit events under the

swap can be triggered by defaults only on “bonds or loans”, on a broader class of

“borrowed money,“ or on an even broader class of “payment obligations.“

Perhaps most significantly, the definition of “credit event” can be tailored to meet the

needs of the various parties to the transaction. While each of these variations is important,

the most heavily negotiated component is most often the designation and characteristics

of the “credit events” that will trigger a cash settlement under the swap.

MOODY’S DEFINITION OF DEFAULT AND LOSS

In assigning ratings and compiling its historical default statistics, Moody’s considers the

following events to be defaults:

• Any missed or delayed disbursement of interest and/or principal;

• Bankruptcy or receivership; and

• Distressed exchange where

(i) the borrower offers debt holders a new security or package of securities that amount to a

diminished financial obligation (such as preferred or common stock, or debt with a lower coupon

or par amount), or (ii) the exchange has the apparent purpose of helping the borrower avoid

default. Severity of loss is defined as the difference between par and the recovery rate —

measured as a percentage of par — following default. Moody’s uses the market value of

defaulted instruments, approximately one month after default, as an estimate of recovery rate.5

These are the events that constitute “defaults“ in Moody’s historical studies, and these are the

events that can be predicted by a Moody’s rating.

ISDA CREDIT EVENTS

The 1999 ISDA Credit Derivatives Definitions6 currently list six “credit events” that can be

incorporated into credit swaps:

• Bankruptcy;

• Failure to pay;

• Restructuring,

• Repudiation/moratorium;

• Obligation default; and


• Obligation acceleration.

While these are the so-called “standard” credit events, their inclusion and scope are always

heavily negotiated in the context of Moody’s-rated synthetic CDOs and CLNs. The choice and

characterization of these events is crucial, because they determine the probability of a loss

occurring under the swap, as well as the extent of any such loss. Some of the ISDA credit events

are consistent with Moody’s definition of “default,” and some are not.

Bankruptcy

The definition of “Bankruptcy” in the ISDA Credit Derivatives Definitions was copied wholesale

from the ISDA Master Agreement. Thus, while most of the definition is consistent with a

“default,“ there are some components that are not.

The last clause of the definition, a catchall provision, is problematic because it makes a “credit

event” any action by the reference entity “in furtherance of, or indicating its consent to,

approval of, or acquiescence in” one of the listed bankruptcy events. This clause exposes

investors to potentially greater risks; because it includes events that are vague, difficult to

identify, and do not clearly indicate default.7

Another potentially troublesome item in the ISDA bankruptcy definition is “insolvency.” The

ISDA definition does not specify what is intended by “insolvency.”

However, there are different definitions — for example, by reference to balance sheet or income

statement tests — and, depending on the definition used, the timing of an insolvency “credit

event“ could vary. Under a very broad definition, it is conceivable that an “insolvency” could

occur without being followed by an actual bankruptcy or failure to pay. Thus, a broad

interpretation could lead to a “credit event“ being called under the swap when no “default“ has

actually occurred.

Failure to Pay

The ISDA “failure to pay” definition is consistent with Moody’s definition of “default.” The key

issue under this definition is materiality — i.e., the missed payment should be in an amount that

is material, such that it would be captured by a Moody’s rating.

To ensure that a credit event is not triggered by the failure to pay a trivial amount, a minimum

amount — referred to as the “Payment Amount” in the ISDA definitions — should be specified

under the swap. While there is a standard minimum amount, that amount may not be appropriate

in all transactions, and it should be considered carefully for each swap. In some cases, the choice


of a Payment Amount will depend on whether the swap is referencing (1) a specific obligation,

(2) bonds or loans, (3) borrowed money, or (4) the more general “payment obligations” — all of

which are options under the current ISDA documentation. A Moody’s rating will capture the risk

of a “failure to pay” on the obligations rated by Moody’s — usually bonds and loans. However,

it may not capture the risk of non-payment on all of an entity’s payment obligations — e.g.,

disputed trade obligations, certain fees, etc. An entity may choose not to make a payment on one

of its “payment obligations” for reasons other than credit problems. To ensure that a Moody’s

rating will capture the risk of payment default, the category of obligations being referenced

should be carefully considered. In some circumstances, a higher minimum payment amount may

be appropriate.

Restructuring

Moody’s considers certain types of “restructuring“ events — known as “distressed exchanges”

— to be defaults, and captures those events in its ratings. Thus, Moody’s does not believe that

“restructuring,” as a concept, needs to be excluded from the credit derivatives definitions. In

many respects, however, the current ISDA definition of “restructuring” is broader than Moody’s

definition of “distressed exchange,“ and includes events that are not captured by a Moody’s

rating.9 Thus, for a Moody’s rating of the reference portfolio to capture the risk to investors, the

definition of “restructuring“ should be tightened to make it consistent with “distressed

exchange.”

Under the current ISDA “restructuring” definition, five events can qualify as a “restructuring.”

Each event must meet the following requirements to qualify as a “credit event:” the restructuring

(1) must not have been provided for in the original terms of the obligation, and (2) must be the

result of a deterioration in the obligor’s creditworthiness or financial condition. While these

requirements are helpful in restricting the events that could constitute “credit events,” they are

not sufficient to prevent overbroad applications of the definition.

The first three events under the definition — restructuring of an obligation that leads to (1) a

reduction in interest payment amounts, (2) a reduction in principal repayment amounts, or (3) a

postponement or deferral of interest or principal payments — can constitute “distressed

exchange” defaults under Moody’s definition. Any one of these events, by itself, would arguably

lead to a “diminished financial obligation.” However, if combined with other changes to the

obligation, they may not. For example, an obligation that has been restructured to defer principal


payments may not be considered a “diminished financial obligation” — and thus not a

“distressed exchange” — if the lender has been compensated for the deferral.

Thus, any “restructuring” definition should look at the totality of the circumstances — e.g.,

whether the lenders/investors have been compensated for the reduction or deferral — to

determine whether the restructured obligation is truly a “diminished financial obligation.”

The fourth ISDA “restructuring” event — a restructuring that leads to a change in an obligation’s

priority, causing it to be subordinated — can be overbroad. The subordination of a debt

obligation to equity or preferred stock would clearly be a “default.” (It would probably lead to a

failure to pay as well — thus, rendering this “restructuring” event unnecessary). However, a

restructuring that merely lowers an obligation from a senior to a subordinated position in the

capital structure (but not to equity) could also trigger a “credit event” under the current ISDA

definition.

Repudiation/Moratorium

Repudiation/moratorium was included in the ISDA definitions mainly to address actions by

sovereign lenders, and thus, is not included in many synthetic CDO’s, where the exposure is

primarily to corporate credit. When applied to corporate credits, repudiation/moratorium is

generally consistent with Moody’s views of default — although it is unclear how it would be

different from “failure to pay.” However, there is concern with respect to the provision that

includes as a credit event when a borrower “challenges the validity of . . . one or more

Obligations.” This provision could be construed overbroadly to include situations where there is

a legal dispute over a borrowing — in which, for example, the borrower unsuccessfully

challenges some terms of the borrowing — that does not ultimately lead to a failure to pay

interest or principal. Moody’s would not necessarily consider such an event to be a default.

In addition, if this event is to be included, the “Default Amount,” or minimum amount that can

be subject to a repudiation in order to trigger a credit event, should be material, so that the

repudiation of a trivial amount will not trigger a credit event.

Obligation Default

ISDA defines “Obligation Default” as a non-payment default — i.e., a default other than a failure

to pay — that renders an obligation capable of being accelerated. Moody’s has not been asked to


rate a transaction that includes this credit event, and the market has moved away from including

it. This is because the event is much broader than Moody’s — and most of the market’s —

definition of “default.”

Most bonds and loans contain representations, warranties, financial covenants, and non-financial

covenants, the violation of which can give lenders the right to accelerate. While such violations

can indicate credit deterioration (e.g., failure to maintain a minimum financial ratio, taking on

additional debt, etc.) Many such violations can be technical (e.g., failure to send a report).

Of course, Moody’s ratings do not capture the probability of a technical violation occurring.

Moreover, even a covenant violation that represents serious credit deterioration would not be

captured if the obligation is still current on interest and principal, and has not carried out a

“distressed exchange” or become bankrupt. Moody’s simply does not have data concerning such

events that would allow it to assign a rating to them.

Because inclusion of this event forces counterparties to mark-to-market an obligation before a

payment default occurs, it will cause investors (i.e., “sellers” of credit protection) to take losses

that they would not incur if they actually bought and held the obligation.

For example, even though an obligation has suffered credit deterioration giving rise to a financial

covenant violation, there is still a good chance that the obligation will pay both interest and

principal in full. However, at the time of the violation, market bids will likely come in below par,

because of concerns about the credit, or because of market sentiment, interest rate movements, or

other systematic factors. Thus, while an investor that actually holds the obligation to maturity

will get out whole, the investor “selling” protection will not.

Obligation Acceleration

“Obligation acceleration” is similar to “obligation default.” However, to trigger a credit event,

the non-payment default — i.e., default other than a failure to pay — must lead to a reference

loan, bond, or other obligation actually being accelerated. Like obligation default, an

acceleration, by itself, would not be captured by a Moody’s rating. A failure to pay, bankruptcy,

or distressed exchange following acceleration would be captured, but the acceleration itself

would not.

Acceleration is simply a lender’s exercise of its contractual right, under certain circumstances, to

declare a debt immediately due and payable.14 As with “obligation default,“ the events giving


rise to a right to accelerate under “obligation acceleration” — defaults other than a failure to pay

— are not considered by Moody’s to be “defaults” and would not be captured by a

Moody’s rating. Consequently, a lender’s decision to exercise its acceleration right following

such events is not captured either. There are three possible outcomes following an acceleration:

(1) the borrower repays less than it owes (or becomes bankrupt), (2) the debt is renegotiated, or

(3) the borrower repays everything that it owes. The first outcome is already captured by other

credit events — failure to pay and bankruptcy.

The second outcome, depending on the circumstances, may be a “distressed exchange”

restructuring. The third outcome — the lender receives everything it is owed — is not a default.

Because the first and second outcomes are already captured by other credit events, and the third

outcome is not a default, it is unclear what additional scenarios this “credit event“ is intended to

capture.16 It has been suggested that the purpose of this credit event is “timing” — i.e., because

many accelerations are followed closely by either a payment default, bankruptcy, or

restructuring,17 including this event allows credit protection payments to be made earlier than

they otherwise would. However, if the acceleration precipitates a true default, the default is likely

to occur, at most, two or three months later, and it is difficult to justify why a counterparty

cannot wait until it has suffered a true credit event to be compensated.

More fundamentally, an acceleration where the lender receives everything it is owed — clearly

not a “default” — would trigger a credit event under the ISDA definition. While historically rare,

there have been instances of bond accelerations where investors have been paid par, thus leaving

them with no loss. Moody’s has not compiled its own data on such events, because they are not

“defaults.” Moreover, while Moody’s is unaware of any data with respect to accelerations of

loans and private placements, anecdotal evidence suggests that acceleration followed by total

recovery — i.e., the lender gets all of its money back — is more common. Inclusion of

“obligation acceleration” as a credit event would not be as problematic if the market value of an

obligation is always par when the lender will be fully paid off following acceleration.

If that were the case, there would never be any loss following such credit events. However, it is

very possible that the market value would come in at less than par — even if the accelerated debt

is fully repaid.

Another concern with “obligation acceleration” is that its inclusion as a credit event may create

additional incentives. A protection “buyer” that accelerates a reference obligation will be


reimbursed regardless of the outcome. Indeed, the “buyer” could get all of its money back on the

loan and get additional compensation if bids on the non-accelerated debt come in at less than par.

Because occurrence of the “obligation acceleration” credit event is often within the protection

“buyer’s“ control, the additional incentive means that the event is more likely to occur in the

presence of a swap than under normal circumstances. If the “buyer” has the right to accelerate, it

is more likely to exercise that right if it can receive additional compensation for doing so. Thus,

any historical data regarding the likelihood of acceleration would probably understate the

likelihood of its occurring when it is covered by a swap.

“Obligation Acceleration” and the Problem of Basis Risk

Sponsors of synthetic CDO and CLN transactions can fall under two different categories: (1)

those who are credit default swap “end users,” and (2) those that are not. The “end users” are

buying protection on cash exposure to the reference credits. In other words, they have actual

exposure to the credits through loans or other business relationships with the obligors. Sponsors

that are not “end users” are buying protection on synthetic exposure to the reference credits.

They are exposed to the credits by way of credit default swaps — i.e., they are “selling”

protection on the credits to other counterparties, and if there is a credit event on those swaps they

will be required to make a credit event payment to the other counterparties.

“End user” sponsors recognize that “obligation acceleration” is not necessary, and, unless

required to do so by regulators, have typically not asked for its inclusion their transactions.

However, institutions that are hedging, or buying protection on, synthetic exposure have argued

that inclusion of this event is necessary, because most of the swaps giving rise to their exposure

include “obligation acceleration.” If the synthetic CDO or CLN does not include this credit

event, there are potential loss events for which they are not hedged. Believing this additional risk

to be significant, these institutions are often unwilling to take the incremental basis risk and have

asked Moody’s to rate the transactions with this event. Moody’s is reluctant to rate a credit event

that is not a default and is only present because of a quirk in the ISDA definitions that has

become “standard.” The optimal solution is to remove “obligation acceleration” all together, or

for it no longer to be “standard.” However, Moody’s has been able to rate transactions including

this event with the following modifications to the ISDA definition:


Acceleration is only a “credit event“ if, after the later of a minimum time period and the

time to the next payment date on the obligor’s obligations, the accelerated obligation has

not been fully repaid. The rationale is that if the accelerated obligation is not fully repaid

by the next payment date, it will likely never be fully repaid.

Following acceleration, instead of cash settlement, the protection buyer delivers to the

SPV an obligation of the reference entity (1) that has been accelerated, or (2) if the

delivered obligation has not been accelerated, that matures earlier than the transaction

matures. The SPV would only be permitted to sell the delivered obligation if it actually

defaults; otherwise, it must hold it until it matures or is paid down.21 This should remove

the incremental market risk inherent in this event under a cash settled swap. Moody’s has

considered numerous alternatives to these solutions, and additional solutions may be

acceptable.22 However, the best solution would be to exclude this event all together.

THE PROBLEM OF “SOFT” CREDIT EVENTS: SYNTHETIC VS. CASH

Credit default swaps are intended to mimic the default performance of a reference obligation.

Thus, for example, owning a CLN is often considered equivalent to having a cash position in the

underlying reference obligation, except that the maturity, coupon, or other cash flow

characteristics may be different. If an investor holds the CLN to its maturity, it should have the

same risk of loss as if it held the reference obligation to its maturity.23 Put another way, the CLN

should only default if the reference obligation defaults. However, if so-called “soft” credit events

— events that are not truly “defaults” — are included in the swap, that will not be the case.

Selling protection through a cash-settled credit default swap — e.g., owning a CLN (or a

synthetic CDO) — can actually be more risky than actually owning the reference obligation(s).

This is because cash-settled credit default swaps essentially force investors to “cash out” of their

position following a credit event.24 If the swap includes credit events associated with credit

deterioration short of default — e.g., a broadly defined restructuring or obligation acceleration —

the CLN can default (the investor will receive less than the full part of the CLN) when the

reference obligation has not.

Thus, if a cash-settled credit default swap includes “soft” credit events, the investor may suffer

losses that are not captured by a Moody’s rating of the reference obligation(s), subjecting it to

greater risk of loss than if it actually owned the reference obligation(s).


MORAL HAZARD

In virtually every synthetic CDO and CLN, the “buyer” of protection — the sponsoring financial

institution — determines whether a credit event has occurred in the reference portfolio. More

significantly, the “buyer” calculates the severity of its losses following a credit event, and how

much the SPV will be required to pay under the swap (i.e., how much investors will lose under

the transaction). Because of the moral hazard inherent in such an arrangement, credit swaps

should be structured such that the occurrence and severity of losses can be objectively and

independently identified, calculated, and verified.

Occurrence Of A Credit Event. Moody’s generally believes that, in order for a credit

event payment to be triggered, the occurrence of the event should be published in (1) a

well-known news source, (2) a corporate filing, or (3) a court document. This should

deter protection “buyers” — acting either alone or in collusion with a reference obligor

— from staging credit events for the sole purpose of being reimbursed under the swap.

The rationale is that parties will be less likely to assert spurious credit events if the events

have to be made public. There may be instances, however, where there is no published

information available regarding a credit event. For example, the reference obligor may be

a private, unrated company whose only outstanding debt is to a bank. There may be no

press release, no public corporate filings, and no court documents to support the existence

of the credit event. However, the sponsor should be able to get protection under the swap

for that credit if there is a true default. Thus, in some limited circumstances, Moody’s-

rated synthetic CDO’s provide that, for certain credit events, if there is no “publicly

available information,” at least one senior officer who is part of the sponsor’s credit

underwriting or monitoring department may provide written certification that the credit

event has occurred and that the obligation has been treated internally as a defaulted asset.

The certification may also contain contact information at the defaulted obligor so that the

protection “seller” can verify the claim and, if necessary, dispute it. Here, too, the

rationale is that a sponsor is less likely to assert a spurious credit event if a senior officer

who is not directly involved with the transaction is required to sign a certification that the

event occurred.


Loss Severity Following Credit Event. The amount of loss following default should be

calculated either (1) by obtaining bids from third parties, or (2) by going through a formal

workout process to arrive at a workout value. The former is the most common. Because it

may not always be possible to obtain public bids, however, most transactions provide for

contingency calculation methods. These methods are often a formal appraisal by an

objective third party. The “buyer” should not be the sole source for determining its losses

under the transaction. The existence of a meaningful dispute resolution mechanism will

also help to eliminate the moral hazard inherent in these situations. In some cases,

permitting investors to make firm bids — or designate other parties to make firm bids —

for defaulted obligations can also be an effective solution.

The Case of Blind Pools. Occasionally, because of regulatory and/or legal restrictions, a

bank may not be permitted to disclose certain names in a reference pool. Disclosure to

Moody’s has usually been permitted, but the bank is not permitted to disclose to investors

or others associated with the deal.25 This becomes a serious problem when a credit event

occurs with respect to one of those names. It may be difficult to obtain a meaningful bid

— and thus mark the defaulted name to market — without disclosing the name to

potential bidders. The bank may also be unable to obtain an appraisal from an objective,

unaffiliated third party. In these circumstances, it may be possible to get comfortable with

an appraisal by the bank’s auditors, so long as the bank retains a portion of loss (e.g.,

10%) on each such name.


CHAPTER – 4LIQUIDITY AND CREDIT

DEFAULT SWAP SPREADS

LIQUIDITY AND CREDIT DEFAULT SPREAD

Credit default swaps (CDS) are a type of insurance contracts against corporate default that are

traded in the over-the-counter market. Over the last decade, the CDS market has grown rapidly


to more than $17 trillion in notional value. Much of this development has been driven by the

demand from banks and insurance companies to hedge their underlying bond and loan exposures

and by the need of hedge funds and investment banks' proprietary trading desks for more liquid

instruments to speculate on credit risk. Given the tremendous growth and the formidable size of

the market, trading in CDS contracts can have a pervasive market-wide impact, as demonstrated

by the GM/Ford credit debacle in 2005. The rapid growth and the lax regulatory supervision of

the CDS market have raised a number of policy concerns about market stability and risk of

adverse selection, both of which would influence investors' propensity to trade in the market and

hence the liquidity of CDS contracts.

There are a number of indications that liquidity may play a crucial role in the further growth of

credit derivatives markets and in the pricing of these derivatives contracts. For instance, even

with the tremendous size of the CDS market, the usage of CDS contracts by banks is still

surprisingly low despite its obvious hedging advantage. Minton, Stulz, and Williamson (2005)

that only 5% (19 out of 345) of large banks in their sample use credit derivatives. They argue

that \the use of credit derivatives by banks is limited because adverse selection and moral hazard

problems make the market for credit derivatives illiquid for the typical credit exposure of banks."

Parlour and Plantin (2007) show in a theoretical model that the liquidity e®ect can arise

endogenously in the credit derivative market when banks are net protection buyers. Because

banks may utilize CDS contracts either for managing their balance sheet obligations or for

trading on their private information about the underlying, their presence in the market may

increase the risk of adverse selection and affect the liquidity of CDS contracts. Acharya and

Johnson (2007) provide evidence of informed trading in CDS contracts that highlights this risk of

adverse selection in the CDS market. In addition, several papers have documented that CDS

spreads seem too high to be accounted for by default risk alone, and some have suggested that

liquidity may be a factor determining CDS prices.

The effect of liquidity characteristics captures the impact of liquidity for trading today, the

variation of liquidity measures over time can pose liquidity risk that may affect future trading,

and hence this liquidity risk should also be priced in CDS spreads.

Although the liquidity effects for traditional securities, such as stocks and bonds, have been

studied extensively in the literature,4 relatively little is known about the liquidity effects for

derivative contracts, as the contractual nature of these instruments and their zero net supply in


the market distinguish them from stocks and bonds. Several recent papers have explored the role

of liquidity in pricing options. For instance, Bollen and Whaley (2004), Cetin, Jarrow, Protter,

and Warachka (2006), and Garleanu, Pedersen, and Poteshman (2007) illustrate the effect of

supply/demand imbalance on equity option prices. Brenner, Eldor, and Hauser (2001) a

significant illiquidity discount in the prices of non-tradable currency options compared to their

exchange-traded counterparts. Deuskar, Gupta and Subrahmanyam (2006) argue that there are

liquidity discounts in interest rate options markets.

Default Risk and CDS Spreads

CDS spreads are the required periodic payment for providing insurance for default risk of the

underlying firm. Therefore, theoretical determination of CDS spreads should capture the risk of

default and the potential loss upon default, similar to the credit spread for corporate bonds.

Recent empirical studies, including Blanco, Brennan, and Marshall (2005), Houweling and Vorst

(2005), Hull, Predescu and White (2004), and Zhu (2006), have confirmed an approximate parity

between the CDS spreads and bond spreads. Berndt et al (2005) find that default probabilities,

measured by Moody's KMV's Expected Default Frequencies (EDF), can account for a large

portion of CDS spreads. While these results imply that CDS spreads reflect well the underlying

credit risk, Blanco et al (2005), Hull et al (2004) and Zhu (2006) also document that the CDS

market is more likely to lead the bond market in price discovery as CDS spreads are more

responsive to new information.

A number of empirical studies of corporate bond spreads have shown that a large component of

corporate bond yield spreads may be attributed to the effects of taxes and liquidity (see, e.g.,

Elton, Gruber, Agrawal, and Mann (2001), Ericsson and Renault (2006) and Chen, Lesmond,

and Wei (2007)). In contrast, it has been argued that prices of CDS contracts may not be

significantly affected by liquidity because of their contractual nature that affords relative ease of

transacting large notional amounts compared to the corporate bond market, and hence CDS

spreads may better reflect default risk premium (e.g., Longstaff, Mithal and Neis, 2005). This has

led to a few studies that use CDS spreads as a benchmark to control for credit risk in order to

study liquidity effects in bond markets (Han and Zhou (2007), Nashikkar and Subrahmanyam

(2006), etc.). However, Berndt, Douglas, Ferguson,and Schranz (2005) and Pan and Singleton

(2005) have documented that CDS spreads seem too high to be accounted for by default risk


alone and suggested a liquidity factor as a possible mechanism for filling the gap. We discuss the

role of liquidity in the CDS market in the next subsection.

CDS Trading and Liquidity

CDS contracts are traded over the counter in this market, an interested party searches through a

broker or a dealer to find a counter-party. The two parties negotiate the terms of a contract.

Information about the trade is then passed along through the back once and sent to a clearing

house. Because the entire process has not been sufficiently standardized, there may be delays in

clearing the trades. Recently, inter-dealer brokerages (IDB) have gained popularity. A dealer can

register with an IDB and use either an online trading platform or a voice quoting system. An IDB

maintains a limit order book, which substantially facilitates both the quoting and trading

processes. Traders can also remain anonymous until the order Is filled. Presently, CDS trading is

done through a hybrid of voice-brokered and electronic platforms.

Credit default swaps allow for the transfer of credit risk from one party to another. For investors

who only want the exposure for a limited period of time, such as hedge funds, the ability to take

or remove the exposure with relative ease and at a fair price is an important consideration of

using CDS contracts. This requires an adequate level of liquidity in the CDS market. Liquidity is

an important issue for securities traded on more transparent and centralized exchanges, and it is a

particularly acute concern for CDS contracts because of their over-the-counter, non-standardized

trading mechanics.

In general, liquidity is vaguely defined as the degree to which an asset or security can be bought

or sold in the market quickly without affecting the asset's price. Liquidity has multiple facets and

cannot be described by a sufficient statistic. Usually, a security is said to be liquid if its bid-ask

spread is small (tightness), if a large amount of the security can be traded without affecting the

price (depth), and if price recovers quickly after a demand or supply shock (resiliency).

Compared to other established markets, the CDS market is relatively illiquid. The bid-ask spread

is high {at 23% on average {with a sizable fixed component. The market is not continuous, as

one trader has to search for another trader who can match his trade. Generally speaking, the

aspects that affect liquidity of stocks and bonds should also affect liquidity of CDS contracts.

These aspects include: adverse selection, inventory costs, search costs, and order handling costs.


Acharya and Johnson (2007) find evidence indicating informed trading in the CDS market. This

implies that uninformed traders in the market face the risk of adverse selection.

Consequently, they will seek to pay less when they buy protections and demand for more when

they sell protections in order to compensate for the risk of trading against informed traders. This

may also deter potential liquidity providers from participating in the market and hence increase

search frictions and transaction costs.

Inventory costs matter for risk averse dealers who also face funding constraints (Brun nermeier

and Pedersen, 2007). Dealers with excessive inventory will worry about the risk of front-running

and the costs of dynamic hedging. Cao, Evans, and Lyons (2006) show that inventory

information can have a significant impact on prices even in the absence of changes in

fundamental risk, and Hendershott and Seasholes (2007) illustrate how specialists' inventory

influences stock prices. In the CDS market, inventory can become restrictive for dealers with

funding constraints, which will in turn affect the supply of contracts in the market.

Order handling costs can be substantial for CDS contracts, which may be reflected in bid-ask

spreads. Credit derivatives deals have so far largely been processed manually. The market is

opaque and a substantial backlog is suspected. Of particular concern is the post- trade clearing

and settlement process. Federal Reserve Bank of New York has requested major CDS

participants in the U.S. to clean up their processing of derivatives trades. A survey by the

International Securities and Derivatives Association (ISDA) shows that one in five credit

derivatives trades by large dealers in 2005 contained mistakes. Even though virtually all market

participants are sophisticated institutional investors, the opacity of the trading mechanics in the

CDS market has raised concerns about its vulnerability at the time of crisis (see, e.g., IMF

(2005)).

A salient feature of opaque and decentralized markets is search frictions. CDS dealers can only

fill an order through a match with a counter-party. Even with IDBs, CDS dealers will have to

wait for the next trader to appear because IDBs do not take positions themselves.

Search costs therefore directly affect market liquidity and market prices, as indicated in a

theoretical model of OTC markets by Duffe, Garleanu and Pedersen (2005, 2006). Market

makers in this search-based market may also have pricing power (Chacko, Jurek, and Stafford,


2007). The over-the-counter market in which CDS contracts are traded thus provides a good

laboratory for investigating the effect of search frictions on asset valuation, and the impact of the

interaction between adverse selection and matching intensity on liquidity.

Proxies for CDS Liquidity

Liquidity in the CDS market reflects the ease with which traders can initiate a contract at an

agreeable price. It is difficult to find a single summary measure to capture the various facets of

liquidity.

Liquidity Measures

Volatility-to-Volume Ratio (V2V): One aspect of liquidity is the depth, namely, the price

sensitivity to the amount of market activity, usually indicated by volume. This is the essence of

the Amihud (2002) illiquidity measure for stock.

Number of Contracts Outstanding (NOC): In the inter-dealer market of CDS contracts,

inventory control may be a major concern for dealers who face funding constraints.

When funding constraints become binding, the capacity for dealers to take sides in additional

contracts is severely impaired, and this will consequently affect the liquidity of the related

contracts (Brunnermeier and Pedersen, 2007).

Trade-to-Quote Ratio (T2Q): In a search-based market, such as the CDS market, the likelihood

of finding a trading counter-party is a measure of liquidity that directly affects the price the asset

is traded at, as shown in Duffe, Garleanu and Pedersen (2005, 2006) and Chacko, Jurek, and

Stafford (2007).

Bid-Ask Spread (BAS): Bid-ask spread is arguably the most widely used liquidity proxy

in the equity market and its importance for asset prices has been established since Amihud and

Mendelson (1986).


Hence the findings highlights the need of a CDS pricing model that explicitly takes liquidity

effects into account. In an over-the-counter market of derivatives contracts that are in zero net

supply, the supply curve for CDS contracts may be a function of order flows. The demand-

supply dynamics are affected by search frictions, market maker's pricing power, hedging costs

and the risk of adverse selection that endogenously determine the liquidity of the securities and

in turn their prices. While some recent studies have provided insights into this new aspect of

asset pricing dynamics, more theoretical and empirical research on this subject is certainly

warranted.


CHAPTER – 5

CREDIT DEFAULT SWAP INDEX OPTIONS


EVALUATING THE VIABILITY OF CDS

The credit default swap (CDS) market is a large and fast-growing market that allows

investors to trade credit risk. Multiple derivatives on CDS currently trade over the counter

including CDO-like tranches and options. The rise of standardized, liquid, and high-volume

CDS indexes has created the possibility of exchange-traded CDS index options. Exchange-

traded options would increase liquidity in the CDS option market and allow retail and

smaller investors to trade credit risk much more easily than with current products. The

primary users of the exchange-traded options will be speculators as existing products, such

as individual CDS or the CDS indexes, are cost-effective hedges for most players.

CDS index options could be an attractive new product for the CBOE but there are several

major issues to overcome before exchange-traded CDS index options are viable. The most

significant barrier to offering exchange-traded CDS index options is the risk that the CDS

trading infrastructure will fail during a credit crisis. The CBOE can mitigate, but not

eliminate, this risk by carefully drafting contract provisions. The easy hedgability of CDS

index options should be attractive to market-makers but current OTC CDS option dealers

might be unwilling to support a competitive exchange-traded product. There are also

practical barriers to the product such as SEC and index licensing issues.

The proposed contract is a European option on the current on-the-run series of the North

American Investment Grade CDX. The size of the contract is one hundred times the current

spread of the underlying CDX index and the contract is settled based on the CDX spread. In

order to lessen competition with the OTC market, the contract is sized to appeal to smaller

players and the retail market, a new customer base for CDS options.

Credit Default Swap Indexes

As the CDS market increased in importance, tradable CDS indexes arose to allow players to

trade a broader spectrum of credits at a lower cost. There are two primary tradable index

families: the Dow Jones CDX and the International Index Company Itraxx. Both of the

companies have indexes for various types of debt including US investment grade, US high

volatility investment grade, US high yield, European bonds, and even emerging market bonds.


The composition of each index is determined by member banks and a particular name remains in

the index until the CDS is triggered due to a credit event. A new index is formed periodically but

each incarnation of the index shares the majority of its names with the previous index. The Dow

Jones US Investment Grade CDX, for example, is recreated every six months with 125 CDS. The

member banks that help compose and price the index include sixteen major international banks.

Each of the member banks makes a market in the CDS index and it is freely tradable with low

bid-ask spreads of ½ to ¼ of a basis point. CDS indexes are important innovations that allow

financial players to trade a broader spectrum of credits at lower cost and in a more liquid market.

For the purposes of this paper, I will hereafter use the Dow Jones Investment Grade CDX index

as the example and that index will serve as the underlying of the proposed options.

The Dow Jones Investment Grade CDX is intended to trade exposure to the credit risk of North

American investment grade firms. The index is made up of 125 of the most liquid investment

grade credits and composition is determined by Dow Jones and the member banks. Initial credits

are all investment grade but names are not removed from a given series if the quality of a credit

decreases over time as long as the CDS protection event has not been triggered. Albertson’s

remains in the Series 5 Investment Grade CDX, for example, because the company was

investment grade when the index was composed but has since been excluded from Series 6 due

to its BBB- rating. The CDX is an equally-weighted index with each credit initially making up

0.8% of the index although that weighting changes when a CDS is removed due to a credit event.

The index is intended to reflect multiple industry sectors and provide a broad exposure to North

American investment grade credits

The mechanics of the CDX index are fairly simple. Each year, the protection buyer pays the

protection seller the initial price of the index (for example 45 basis points) on a given notional

amount of the index. If the index value changes over the next 90 days, the protection buyer will

make a payment to the protection seller equal to the present value of change in the value of the

index over the remaining life of the contract. As a result, entering into the CDX after inception

requires the exchange of an up-front payment representing the probability weighted present value

difference between the current market value of the CDX and the initial deal value of the CDX. In

addition, upon entering the CDX the seller pays the accrued premium from the last payment date

to the settlement date in order to receive a full 90 days of premium on the next payment date. In

the event of a triggering credit event, the index is typically physically settled. The protection


buyer will deliver to the protection seller a face amount of the defaulted debt equal to 1/125 of

the original notional value of the index purchased and the protection seller will deliver an equal

amount of cash. After the default, the notional value of the index held is lowered by the amount

of cash delivered by the seller to the buyer.

OTC Credit Default Swap Index Derivatives

Since the CDS indexes were introduced, an array of over-the-counter derivatives have arisen

which permit trading of specific portions of risk. CDS indexes work very well for hedging or

gaining exposure to certain specific areas of the credit market. There are now tradable CDS

indexes that cover specific sectors, points on the credit curve, geographies, and credit qualities.

In addition, banks offer both CDS index tranches and index options to allow speculators to tailor

their exposure to credit risk. Banks use CDX tranches to subdivide the credit risk of the 125

companies in the index and sell off the pieces to different customers. Each tranche holds a

certain priority in providing insurance on the basket of CDS and, thus, carries a much different

risk profile. For example, the equity tranche will typically cover the first 3% of defaults while the

junior mezzanine tranche would cover the next 4% of defaults. This structure allows investors to

leverage (invest in the equity tranche) or deliver (invest in the senior tranche) their exposure to

the credit risk of the index. The tranches are standardized and liquid and banks quote bid-ask

spreads daily. Trading CDX tranches allows traders to take positions on correlation between

credit events within a CDX index or across different CDX indexes.

Similarly, over-the-counter CDX options allow speculators to take a position on the volatility of

CDS market spreads. The size of the over-the-counter CDX option market is unclear. A Risk

Magazine survey found that the market was only $1.5 billion

Exchange Traded Options

Exchange-traded options offer multiple benefits over over-the-counter options. Exchanges

greatly enhance the liquidity of the option and lower the transactions costs of trading an option.

This increased liquidity frequently results in improved price discovery. Additionally, exchange-

trading can allow new parties to trade an option because the exchange absorbs the counter-party

risk of trading the options which lowers transactions costs of smaller trades.


Exchange-traded options have many benefits but not all options can or should be exchange

traded. Exchange traded options must be traded in order for the exchange to make profits. If an

option is not expected to trade in a minimal volume an exchange like the CBOE cannot

profitably offer the option. In order to generate this trading volume and liquidity, exchange

traded options must be standardized but must also attract a wide range of potential users.

Hedgers are an important user of options but are not necessary to create a successful exchange

traded option. Large hedgers greatly increase the dollar volume outstanding of an option but

frequently-trading speculators such as hedge funds are usually much more profitable for an

exchange.

Exchange traded options require both end users and market makers to generate the required

liquidity. To attract the market makers required to facilitate exchange-traded option transactions,

it is important that the price of the underlying asset is a transparent price and that the option is

hedgeable. In this case, a transparent price is a price that reflects the actual price from a liquid

market without significant delays or manipulation. Illiquidity or settlement lags with the

underlying asset can create significant risk for option market makers. Likewise, the market

maker must be able to hedge their position to make a market. Market makers are not in the

business of taking bearing price risk and prefer to make their money on the bid-ask spread.

Market makers are attracted to options that are both hedgeable and based on an underlying with a

reliable market price.

In derivatives with a robust OTC market, it can be difficult for exchange-traded options to

succeed. Exchanges depend on dealers to generate or attract a large portion of the volume in a

new product. A new product that appeals to the dealers’ existing customer base, however, is a

direct competitor and a threat to the dealers’ profits. Despite assuring the exchange before a new

product offering, historically dealers have not supported exchange-traded products that competed

with their robust and profitable OTC products. Due to this, successful exchange-traded products

are frequently tailored to attract a different customer base than the OTC market.

Exchange-Traded CDX Options

Market and Customers

CDX options are a strong new product candidate for the CBOE but it is not clear that the market

in the underlying is mature enough right now. As discussed above, the CDS market is one of the


hottest financial product markets and is expected to continue its growth in the future. Given the

historical growth rate of the OTC CDS index options market, the current market size is estimated

at between $1 trillion and $800 million in notational amount. The Dow Jones North America

Investment Grade CDX, the underlying for the proposed options, has a volume of several times

the option market. In the very near future, the market for CDX options will clearly be large

enough to create an attractive product for the CBOE. In addition, successfully introducing the

first exchange-traded options based on CDS will give the CBOE a significant first-mover

advantage in introducing the next generation of CDX or other CDS options.

While the attractive size of the market is apparent, the composition of the users of the CDX

options is a bit murky. The options will certainly attract speculators who want to take a position

on the volatility of credit risk but it is not clear whether a significant hedger market will develop.

CDS are themselves a derivative which are used to hedge credit risk. CDS options could also be

used to hedge credit risk although the options would not be as useful for hedging as the

underlying swap. As an exchange-traded option, the CDX option would necessarily be more

standardized than the custom products available in the OTC market. Therefore, CDX options

will not be as close of a hedge for the credit risk of the vast majority of bond portfolios as a

customized OTC product. In addition, most CDS are five year contracts which can provide a

long-term hedge. In order to maintain high liquidity exchange-traded CDX options will likely

have a maximum maturity of six months. Considering rollover and transactions costs, the cost of

a long-term options hedge is, therefore, unlikely to be competitive with the cost of a CDS swap-

based hedge. With the lower transactions cost of the exchange-traded option, however, the CDX

option may be an attractive “disaster insurance” option for shorter term hedges on portfolios that

are similar to the underlying CDX portfolio. For example, the credit risk of a diversified

portfolio of North American investment grade credits would tie closely to movements in the

CDX index. (Note that the actual bond spreads may not tie closely due to embedded options).

The correlation of credit events across companies works in favor of hedging using a CDX option

as increases in the price of credit insurance are likely to be systemic, rather than fully

idiosyncratic. Therefore, the CDX options will be a better hedge for portfolios that do not

perfectly match the underlying credits in the CDX because the credit risks are correlated across

bonds.


Pricing and Liquidity Issues of CDS

The lack of a larger hedger base of users is a minor consideration but the quality of CDS prices is

a much more significant issue. The explosive growth of the CDS market has led to well-

publicized issues with trade settlement as the infrastructure has not kept up with the growth of

the market. According to the ISDA, credit derivatives as a group experienced 128% growth from

2004 to 200523. Recent improvements, spear-headed by the International Swap and Derivatives

Association (ISDA), have improved settlement efficiency. The bankruptcies of companies such

as Collins & Aikman, Delta, Northwest, Delphi, and Calpine still caused a significant settlement

lag and the settlement system has not been tested by a closely-timed string of triggering events

since the explosion in market growth. More recently, settlement in the CDS market has improved

from 17.8 business days in 2004 to 11.6 business days in 2005 according to an ISDA survey.

According to the same survey, the trade processing error rate has fallen from 18% in 2004 but

remains at an unacceptably high 9% in 2005. Much of the improvement is due to an increase in

automated trade generation from 24% to 40%. Historically trades have been done by the error-

prone process of phone calls and manual order confirmations described by Alan Greenspan as a

“19th century technology.” Given the state of CDS trade settlement, there is a significant risk

that the price of the ultimate underlying asset of the CDX options, the CDS and the CDX index,

would not reflect accurate market prices during a shock to the credit markets. Pricing the CDX

indexes depends on a LIBOR-like survey of the member banks and requires that these banks can

produce accurate prices for the individual CDS. The risk of poor price transparency in the CDS

market and the risk that it would cause liquidity in the CDX option market to dry up are both

significant risks for market makers and potential deterrents for CDX option users.

The difference in liquidity between on-the-run and off-the-run CDX indexes creates a similar but

less significant liquidity issue. As discussed above, every six months Dow Jones and the member

banks choose a new index of 125 CDS to make up the North American investment grade index.

Each index is given a new series number (i.e. Series 5 for the fifth new index) while the old

series continue trading. Ninety-plus percent of the names are carried over from series to series of

the index but new names are brought in to the new series replace names that are no longer

investment grade credits. The “on-the-run” series is the most current series while all other series

are termed “off-the-run.” Historically, when a series goes off-the-run the volume drops after a

few months as speculators switch to the more liquid on-the-run series. This drop in the volume of


the underlying creates additional risk that the price of the off-the-run index is not a true market

price.

The CBOE could avoid this risk by initially limiting options to on-the-run CDX. Given

the six month time between series of the index, this limitation would cut the potential maturity of

the options down to only six months. This maturity limitation is not significant as about 70% of

the current OTC CDS index option trading is for three month or shorter options. On the other

hand, this limitation would not allow CBOE option traders to take an option position including

multiple CDX series. Only one CDX series is on the run at any time so options on only one

series of CDX would trade on the CBOE at a time under the limitation. Traders often take

positions in one series of CDX versus another series and limiting CDX options to the on-the-run

index would keep that volume off the exchange. While limiting exchange-traded CDX options to

the on-the-run index will lower trading volume, it is a good initial step to temper the CBOE’s

risk and ensure liquidity.

Pricing of Exchange-Traded CDX Options

Despite these risks to the CDX options, under normal market conditions pricing and

hedging the options for market makers and users is not difficult. There are several academic

models to price options on individual CDS options including a SSRD model and a Black’s-like

model. These models require the user to estimate two unobservable variables: credit spread

volatility and the recovery rate on the reference asset. Options on CDS indexes would also

require the user to estimate the correlation between the CDS in the index using historical data or

current CDX tranche prices. While there is no single accepted model for pricing CDX options,

there are enough decent models to allow players to price and trade the CDX options. In fact there

are already software packages, such as FinCAD, that have functions for pricing CDS index

options. Any model of CDX options will generate an option delta that will allow a user to delta

hedge the CDX options with the frequently-traded CDX index. In general, exchanges are

agnostic to pricing models. Contracts currently trade on the VIX volatility index, options for

which there is no agreed-upon pricing model and for which traders use different models. Pricing

and hedging the CDX options will not be a limiting factor on the exchange-traded CDX option

market.


Structure of Exchange-Traded CDX Options

The mechanics of exchange-traded CDX options will be different from a regular swaption,

although the pricing will be similar. Settlement of a typical swaption gives the exerciser a

position in a swap if the option is exercised. The exchange-traded CDX, on the other hand, will

settle in cash based on the current spread of the CDX index. The value of the two methods of

settlement will be exactly the same because the CDX index price is based on the market price of

the basket of swaps in the CDX at any point.

Given the potential pricing issues with CDS, another possible option is a binary contract

which would deliver a predetermined value upon the occurrence of a stated event. One possible

example of a stated event would be the downgrade of a certain number of names in the CDX

index. While this binary option would abstract away from CDS pricing issues, it would not be as

effective as a hedge, nor would it be as hedgable as an option based on the CDX spread.

Every CBOE contract has provisions that determine settlement in the event that there is

no market price for the underlying and these provisions would be critical for a CDX option

contract. One example of such a provision is to use the closing price on the underlying from the

previous day in the event that there is no current market price. Another option is to accelerate the

expiration of the contract in the case of pricing issues. Accelerated expiration is not an attractive

option given that it would break the market maker’s hedge at precisely the time that the liquidity

in the market has dried up. After researching existing contracts, none of the currently traded

contracts on the CBOE present the same type of risk in the pricing of the underlying as would the

CDX-based options. Carefully writing the contracts for pricing contingencies will be crucial to

mitigate the risks of the exchange and the market makers in the event of a CDS pricing crisis.

The sizing of the CDX options contracts is also critical to driving volume to the exchange.

Individual trades of the CDX traded on the OTC market can be very large, up to and over a

hundred million dollars in notional value. The exchange, however, would prefer a much smaller

contract in order to enhance volume and liquidity. There is a balance in sizing because larger

contracts are more attractive to institutional players while smaller contracts will appeal more to

the retail market. The CBOT’s experience with pricing the Dow contracts shows that sizing

greatly affects the market for a contract. The initial Dow contracts were unsuccessful because

they were too large for the retail market, $25, while the “baby-Dow” contracts at $5 have traded

at a much higher volume.


It will be difficult for the exchange to compete with the well-established OTC market for

large institutional buyers. Retail investors, on the other hand, are not currently able to access the

CDS option market. These two factors argue for sizing the CDX option contracts on the smaller

side if you believe that there will be a significant retail market for the CDX options. In addition,

attracting a retail market will encourage the dealers to cooperate with the launching of the new

product. If the exchange-traded product is tailored to a different customer base, the dealers will

not see the new product as directly competitive with their OTC offerings and are more likely to

trade the product. With the CDX recently trading around 40 to 60 basis points and including the

100X unit multiplier for all CBOE options, an option based directly on the CDX would have a

contract size of about $4,000 to $6,000. Using simplified valuation assumptions34, the premium

on this contract would be about $4.50, right in line with the below $10 premiums preferred by

the retail market.35 A contract sized directly on the CDX spread would generate a premium that

would be attractive to the target retail market.

While the notional value of a position in the CDX changes as a name is removed due to a

triggering credit event, the contract value of the exchange-traded CDX contract will not change.

While this will require market players to rebalance their hedges after a triggering credit event

and creates some basis risk, the added complexity in the option would likely confuse retail

consumers. The difficulty and cost of trading the liquid CDX index does not outweigh the

increased difficulty in modeling and valuing the basis-changing option. The CBOE should

discuss this issue with market makers to evaluate their tolerance for handling this basis risk.

Practical Considerations

There are several other practical issues that the CBOE should consider in deciding whether to

offer CDX options. Dow Jones and the member banks have not yet licensed the CDX index to

any exchange. In order to exchange-trade CDS index options, the CBOE would have to license

or create a liquid index to underlie the option. Basing the options on a well-known and liquid

index is the easiest and best option but it may be difficult to convince Dow Jones to license the

index. Another potential practical issue is the regulatory hurdles that the SEC might impose.

CDX options have different risks than other exchange traded products and it is likely that the

review process by the SEC could take months, if not years. With such a different risk profile

from other products, there is no guarantee that the SEC would be willing to approve a CDS


option product at all, especially a product partially targeted to retail customers. The trading

method of the contracts is another practical consideration. Electronic trading is likely to work

fine with the lower-priced contracts described in the paper but many constituents prefer floor

trading for larger contracts. The systems requirements for a CDX contract are not likely to be a

significant roadblock as the CDX contract could probably use the CBOE’s existing systems.

While it is beyond the scope of this paper, the CBOE should also do a break-even study to

determine the minimum volume required to break-even on the CDX contracts. This break-even

study, along with review of pricing and risk considerations reviewed above, could help

determine whether and when to introduce options based on CDX other than the North American

Investment Grade index.

Options on the CDX index could be an exciting new product for the CBOE if several issues are

worked out. The primary barrier to introducing the options is the risk of price failure in the

underlying CDS market. The CBOE should keep a close watch on the improvements in the CDS

trading infrastructure in order to assess changes in this risk. Meanwhile, the CBOE should begin

initial discussions with Dow Jones on licensing and seek input from market makers, potential

customers, and regulators in order to further refine the design of the product.


CHAPTER – 6

CREDIT DEFAULT SWAPS, CLEARING HOUSE AND

EXCHANGES


INTRODUCTION

As its name suggests, the payoff on a credit default swap (CDS) depends on the default of a

specific borrower, such as a corporation, or of a specific security, such as a bond. The value of

these instruments is especially sensitive to the state of the overall economy. If the economy

moves toward a recession, for example, the likelihood of defaults increases and the expected

payoff on credit default swaps can rise quickly. The Depository Trust and Clearing Corporation

(DTCC) estimates that in April 2009, the notional amount of credit default swaps outstanding

was about $28 trillion. As a result of the overall size of the CDS market and the sensitivity of

CDS payoffs to economic conditions, large exposures to credit default swaps can create

substantial systemic risk.

Because of this potential for systemic risk, some have argued that credit default swaps should be

cleared through central clearing counterparties, or clearinghouses. This paper analyzes the

market for credit default swaps and makes specific recommendations about appropriate roles for

clearinghouses and about how they should be organized. Clearinghouses are not a panacea and

the benefits they offer will be reduced if there are too many of them. Further, clearinghouses that

manage only credit default swaps but not other kinds of derivative contract may actually increase

counterparty and systemic risk, contrary to the assumption of many policy makers.

THE MARKET FOR CREDI T DEFAULT SWAPS

A credit default swap can be viewed as an insurance contract that provides protection against a

specific default. CDS contracts provide protection against the default of a corporation, sovereign

nation, mortgage payers, and other borrowers. The buyer of protection makes periodic payments,

analogous to insurance premiums, at the CDS rate specified in the contract. If the named

borrower defaults, the seller of protection must pay the difference between the principal amount

covered by the CDS and the market value of the debt. When Lehman Brothers defaulted, for

example, its debt was worth about eight cents on the dollar, so sellers of protection had to pay

about ninety-two cents for each notional dollar of debt they had guaranteed.

Although credit default swaps can be used as insurance against a default, the buyer of protection

is not required to own the named borrower’s debt or to be otherwise exposed to the borrower’s

default.


Both buyers and sellers may use credit default swaps to speculate on a firm’s prospects. Some

have suggested that investors should not be allowed to purchase CDS protection unless they are

hedging exposure to the named borrower. This argument is flawed. Buying and selling credit

default swaps without the underlying bond is like buying and selling equity or index options

without the underlying security. The advantages of these activities are well understood.

Eliminating this form of speculation would make CDS markets less liquid, increasing the cost of

trading and making CDS rate quotes a less reliable source of information about the prospects of

named borrowers.

Credit default swaps are currently traded over the counter (OTC), rather than on an exchange.

Each contract is negotiated privately between the two counterparties. CDS counterparties

typically post collateral to guarantee that they will fulfill their obligations. (According to data

from the International

Swaps and Derivatives Association, about two-thirds of CDS positions are collateralized.) The

collateral posted against a position is usually adjusted when the market value of the position

changes. For example, if the estimated market value of a CDS contract to the buyer of protection

rises— perhaps because the probability of default rises or the expected payment in the event of

default rises— the seller of protection may be required to post additional collateral.

CLEARINGHOUSES, COUNTERPARTY RISK AND SYSTEMATIC RISK

Although credit default swaps can be valuable tools for managing risk, they can also contribute

to systemic risk. One concern is that systemically important institutions may suffer devastating

losses on large unhedged CDS positions. Counterparty risk, which arises when one party to a

contract may not be able to fulfill its commitment to the other, is also a systemic concern. The

failure of one important participant in the CDS market could destabilize the financial system by

inflicting significant losses on many trading partners simultaneously. Derivatives dealers, for

example, are on one side or the other of most CDS trades and, according to data from DTCC,

dealers hold large credit default swap positions. If a large dealer fails, whether because of CDS

losses or not, counterparties with claims against the dealer that are not fully collateralized may

also be exposed to substantial losses.

The immense losses AIG suffered on credit default swaps during the current crisis (and the

resulting increase in the collateral it was obligated to post) are a more vivid example of systemic


risk. Apparently, regulators decided to subsidize AIG after its losses because they feared that

some of AIG’s CDS counterparties would be irreparably harmed if AIG were unable to fulfill its

commitments. Of course, financial institutions try to control their exposure to such losses, but

risk management can fail.

After two counterparties agree on the terms of a credit default swap, they can “clear” the CDS by

having the clearinghouse stand between them, acting as the buyer of protection for one

counterparty and the seller of protection to the other. Once the swap is cleared, the original

counterparties are insulated from direct exposure to each other’s default, and rely instead on the

performance of the clearinghouse. Thus, with adequate capitalization, the clearinghouse can

reduce systemic risk by insulating the financial system from the failure of large participants in

the CDS market.

A clearinghouse not only insulates one counterparty from the default of another, it can lower the

loss if counterparty does default. Suppose, to pick an ideal example, that Dealer A has an

exposure on credit derivatives to Dealer B of $1 billion, before considering collateral. That is, if

Dealer B fails, then A would lose $1 billion. Likewise, B has an exposure to Dealer C of $1

billion, and C has an exposure to A of $1 billion. Without a clearinghouse, default by A, B, or C

leads to a loss of $1 billion.

With clearing, however, the positive and negative exposures of each counterparty cancel, and

each poses no risk to anyone, including the clearinghouse. In practice, counterparty exposures

are to some degree collateralized. This lowers the potential losses from a default, but collateral is

expensive and only partially offsets counterparty risk.

This simple example illustrates two important advantages of clearinghouses. First, by allowing

an institution with offsetting position values to net their exposures, clearinghouses reduce levels

of risk and the demand for collateral, a precious resource, especially during a financial crisis.

Second, by standing between counterparties and requiring each of them to post appropriate

collateral, a wellcapitalized clearinghouse prevents counterparty defaults from propagating into

the financial system.

Because of these advantages, the U.S. Treasury Department has announced that in the future all

credit default swaps that are sufficiently standard must be cleared.


Clearinghouses, however, are not panaceas. In the fight for market share, they may compete by

lowering their operating standards, demanding less collateral from their customers, and requiring

less capital from their members. To ensure that clearinghouses reduce rather than magnify

systemic risk, regulatory approval requires strong operational controls, appropriate collateral

requirements, and sufficient capital. Clearinghouses should be subject to ongoing regulatory

oversight that is appropriate for highly systemic institutions.

Most of the systemic advantages of a clearinghouse require standardized contracts. The CDS

losses AIG suffered in the current crisis again illustrate the point. Most of their credit default

swaps were customized to specific packages of mortgages and would not have met any

reasonable test of standardization. As a result, they would not have satisfied the requirements for

clearing under any of the current clearinghouse proposals. AIG’s failure was driven by its

concentrated position in credit default swaps and by the fact that its huge bets were not

recognized or acted upon by either its regulators or its counterparties. Only better risk

management by AIG, better supervisory oversight by its regulators, or clearer disclosure of its

positions to counterparties would have prevented the AIG catastrophe, even if clearinghouses for

credit derivatives had been in place years ago.

One should not conclude that a ban on non-standardized contracts is appropriate. An important

function of financial institutions and insurance companies is precisely to meet the needs of

individual businesses and owners of specific idiosyncratic securities for non-standardized

contracts. However, those institutions and their regulators must regularly evaluate and hedge the

systematic risks of their retail businesses, and not doing so was the central failure that led to the

AIG fiasco. Standardized and especially indexed contracts are useful for institutions to hedge the

exposures they generate from writing specific contracts for their customers, not a substitute for

that activity.

Because well-functioning clearinghouses can reduce systemic risk, financial institutions should

be encouraged to use them to clear credit default swaps and other derivatives contracts. Banks

and other regulated financial institutions should have higher capital requirements for contracts

that are not cleared through a recognized clearinghouse.

Financial institutions should not be required to clear all their CDS trades. Such a requirement

would stifle innovation and possibly destroy the market for all but the most popular CDS


contracts. Appropriate differences between capital requirements for contracts that are cleared and

contracts that are not cleared will create the right incentives for firms to internalize the costs

created by nonstandard contracts.

HOW MANY CLEARINGHOUSES?

Although competition created by multiple clearinghouses might lead to lower clearing fees and

technical efficiencies, important opportunities to net offsetting credit default swaps may be lost if

clearing is scattered across several institutions. Two CDS clearinghouses in the United States and

five in Europe have already been established or proposed. It would be difficult if not impossible

to net long and short positions that are cleared through different institutions. In the example

above, Dealer B will be unable to net its contracts with A and C unless both contracts are cleared

at the same clearinghouse.

(With sufficient standardization of contracts, collateral, and risk management, netting across

clearinghouses might be feasible, but this is not part of any of the existing proposals.)

Other netting opportunities will be lost if clearinghouses are dedicated solely to credit default

swaps. In addition to their CDS positions, the major dealers also have large positions in interest

rate swaps and other OTC derivatives. Most credit default swaps are part of a master swap

agreement in which the two counterparties net their aggregate bilateral exposure across multiple

contracts. If two dealers clear a CDS through the dedicated clearinghouse, they cannot net their

exposure from this contract against their exposures from other non-CDS contracts.

The potential benefits from netting credit default swaps against other types of contracts are large.

According to the Bank for International Settlements, dealer exposures on interest rate swaps, for

example, are about three times larger than those from credit default swaps. Research by Duffie

and Zhou suggests that, given the size of these and other OTC derivatives markets in 2009, a

dedicated

CDS clearinghouse would actually increase average counterparty exposures. In essence, if the

clearinghouse is limited to only credit default swaps, the increased opportunities to net CDS

positions within the clearinghouse are dominated by the lost opportunities to net CDS positions

against other derivatives contracts outside the clearinghouse. Duffie and Zhou also demonstrate

that, even if the introduction of a dedicated clearinghouse reduces average counterparty

exposures, adding a second clearinghouse dedicated to the same class of derivatives must


increase average exposures. Finally, any increase in average counterparty exposure will be

accompanied by more demand for collateral (a scarce resource) and for contributions to

clearinghouse guarantee funds. (In the United States, the CME Group’s proposal integrates

clearing of credit default swaps with financial futures, somewhat mitigating this concern.

However, interest rate swaps continue to trade over the counter, and current proposals do not

integrate them with CDS clearing.)

In short, widespread use of a dedicated CDS clearinghouse or fragmentation of clearing across

several competing institutions will reduce the opportunities to net offsetting exposures. This will

increase counterparty risk and, in turn, systemic risk.

A single clearinghouse for all OTC derivatives also has drawbacks. First, the competition created

by multiple clearinghouses is likely to lead to innovation, more efficient operations, and lower

cost.

Second, even well-capitalized clearinghouses can fail. The failure of a clearinghouse for all OTC

derivatives is likely to have enormous systemic consequences. Despite these drawbacks,

regulators and lawmakers should not intentionally or unintentionally promote the proliferation of

redundant or specialized clearinghouses. The proliferation of clearinghouses would create

unnecessary systemic risk by eliminating opportunities to reduce counterparty risk.

EXCHANGE TRADING OF CREDIT DEFAULT SWAPS?

Although clearing does not require exchange trading, some have suggested that CDS trading

should be conducted only on exchanges, which offer clearing and superior price transparency.

Because the current OTC market is relatively opaque, in many cases bid-ask spreads are likely to

shrink if trading moves to an exchange. This benefit, however, should be weighed against the

benefits of innovation and customization that are typical of the OTC market.

Most important, requiring exchange trading for all credit default swaps is impractical. Credit

default swaps are traded on an enormous number of named borrowers and specific financial

instruments. DTCC provides data, for example, on the outstanding amounts of credit default

swaps on 1,000 different corporate and sovereign borrowers. Although the most actively traded

default swaps, such as CDS index products, are natural candidates for exchange trading, many

less active swaps would not be viable on an exchange.


An attractive alternative to mandatory exchange trading is regulation that improves the

transparency of trading for more active and standardized CDS contracts in the OTC market. U.S.

dealers trading corporate and municipal bonds in the OTC market must quickly disclose the

terms of most trades through TRACE, a reporting system maintained by the Financial Industry

Regulatory Authority. Research by Edward, Harris, and Piwowar, Goldstein, Hotchkiss, and

Sirri, Green, Hollifield, and Schurhoff, and Bessembinder and Maxwell suggests that

dissemination of trade data through TRACE reduces the bid-ask spreads for some important

classes of bonds.

A similar system in the CDS market would increase the transparency of trades and improve the

ability of participants to gauge the liquidity of the market and of regulators to identify potential

trouble spots. Although increased transparency can in some cases limit market depth and stifle

innovation, the benefits of greater transparency for established and active standardized contracts

almost certainly exceed the costs. Industry efforts to achieve greater transparency in the CDS

markets have been helpful and should be pursued aggressively. These efforts have improved

competition by increasing awareness of trade prices and volume, but they have not been as

successful providing information about liquidity and trading costs. Serious consideration should

therefore be given to the introduction of a reporting system for the more active standardized

index and single-name contracts, similar to the TRACE reporting system for corporate and

municipal bonds. If implemented judiciously, such a system would improve the quality of the

market for these contracts.


CHAPTER – 7

CREDIT DEFAULT SWAPS

AND COUNTERPARTY

RISK


INTRODUCTION

The financial market turmoil has highlighted the importance of counterparty risk in the over-the-

counter (OTC) derivative markets. The role played by credit default swaps (CDSs) has been the

subject of lively debate, with some commentators claiming that the CDS market has increased fi

nancial contagion or even proposing an outright ban on these instruments. CDSs are derivative

instruments which enable market participants to transfer or redistribute credit risk. For example,

a bank can buy CDS protection to protect itself against a default by a CDS reference entity.

Given the relatively liquid nature of the CDS market, it is also a useful source of information on

the price of credit under normal circumstances.

However, to an outside observer, the size of the CDS market, combined with its structural

opacity, concentration and interconnectedness, may be a sign that the CDS market also poses a

systemic risk to financial market stability. Given the international nature of the CDS market,

these aspects could usefully be considered from a global perspective.

This Banking Supervision Committee (BSC) report aims to provide an assessment, at the EU

level, of the sources of counterparty risk and related challenges. Areas that deserve particular

attention by public authorities and market participants will also be highlighted.

The CDS market is relatively small by comparison with other OTC instruments (accounting for

less than 7% of the OTC market in terms of notional amounts), despite experiencing very

considerable growth over the last few years.

Recent BIS statistics place the notional value of CDS contracts outstanding in December 2008 at

over USD 41 trillion. The net mark-to-market exposure, which represents the true counterparty

risk in the CDS market (taking into account the netting of multiple trades between pairs of

counterparties and the relevant collateralisation) is probably a fraction of this amount, but still

difficult to quantify with available data.

Being an unregulated market, CDSs have always been opaque credit risk transfer instruments,

and their effective contribution to risk dispersion has always been difficult to measure and

assess. Statistics on CDS volumes have recently improved following the release of more detailed

statistics by a service provider in the CDS market in November 2008. However, the available

data remain only loosely related to the actual credit risk and still do not provide any indication of

individual counterparty risk exposures.


Assessing CDS-related counterparty risk in the EU has therefore proved to be very challenging

owing to the lack of information on the market value of CDS positions, on the identity of

counterparties or on collateral practices (including the extent of collateralisation).

In this regard, this report has benefited greatly from the availability of a unique set of data, in

particular data made available by 31 of the largest European financial institutions in response to

an ad hoc qualitative and quantitative survey.

Drawing on these data, the report sets out four main features of the CDS market in the EU that

deserve attention for financial stability purposes.

First, the CDS market remains highly concentrated in the hands of a small group of

dealers, which is European banks’ main concern as regards CDS counterparty risk. In

Europe, the top ten counterparts of each surveyed large bank account for 62-72% of its

CDS exposures (when measured in terms of gross market value). In addition, the

concentration of the CDS market is now higher than it was before the crisis, since some

major players – for instance dealers (e.g. Bear Stearns, Lehman Brothers and Merrill

Lynch), or counterparties that used to be sellers of protection, such as monolines, credit

derivative product companies (CDPCs) and hedge funds – have exited the market. This

concentration has increased the liquidity risk in the event of another dealer failure.

Market participants have also indicated concerns regarding the relative scarcity of sellers.

Second, the interconnected nature of the CDS market, with dealers being tied to each

other through chains of OTC derivative contracts, results in increased contagion risk. In

practice, the transfer of risk through CDS trades has proven to be limited, as the major

players in the CDS market trade among themselves and increasingly guarantee risks for

financial reference entities. Another finding is that, on the basis of the data provided by a

CDS market provider, euro area banks are currently net sellers of CDSs, although the net

amount of protection sold is relatively small and relates to the reference point in time for

which this data was collected (April 2009). This contrasts with the traditional net buyer

position indicated by BIS data. The “risk circularity” within the CDS market may be a

concern for financial stability, as banks may be replacing one type of risk (i.e. credit risk)

with another – counterparty risk.

Third, CDSs are widely – and increasingly – used as price indicators for other markets,

including loan, credit and even equity markets. Thus, these instruments are playing a


broader role in the determination of prices. On the loan market, CDSs may have an

impact on access to credit and the cost of funding, as they are now widely used by larger

banks for active credit portfolio management. Some financial institutions have CDS

premium-dependent pricing guidelines for new loans, while some credit rating agencies

may place greater emphasis on the price discovery function of CDSs by actively offering

market implied ratings. In the cash bond market, investors are increasingly using CDSs as

an indicator for their investment decisions. The equity and CDS markets have also

become more interlinked where CDS price movements have a feedback effect on the

equity market. Indeed, a trading strategy commonly employed by banks and other market

participants consists of selling a CDS on a reference entity and hedging the resulting

credit exposure by shorting the stock. While linkages and circular feedback effects on the

underlying reference entities cannot be ruled out, comprehensive empirical studies have

not yet been undertaken to determine the strength or otherwise of those links.

Fourth and finally, the report also highlights the risk factors related to the significant

widening observed in sovereign CDS spreads in mid-March 2009. Given that sovereign

CDS spreads are, in most circumstances, also viewed as lower limits for the corporations

of those countries, further research is warranted to assess the causes of these

developments. The potential policy implications in terms of the impact that these

exceptional CDS spreads could have on the credit ratings of sovereign governments in

illiquid environments and the possibility of negative feedback loops would thus seem to

warrant further research for financial stability monitoring purposes. This applies in

particular to the liquidity of this market for the purpose of ensuring market integrity. The

report also provides an overview of a number of regulatory and market initiatives that are

under way with a view to addressing these weaknesses, including details of the latest EU

consultation for OTC derivatives (including CDSs), and reviews the various initiatives to

establish central counterparty clearing houses (CCPs) for CDSs. The potential systemic

importance of CCPs was mentioned by the Governing Council of the ECB on 27

September 2001. The importance of CCPs was then confirmed on 18 December 2008,

when the Governing Council stated that there was a need for at least one European CCP

for credit derivatives.


CDS COUNTERPARTY RISK MEASURESThis section will review various measures of counterparty risk and specific attributes of each

such measure.

GROSS NOTIONAL AMOUNTSThe notional amount of a credit default swap refers to the nominal amount of protection bought

or sold on the underlying bond or loan. Notional amounts are the basis on which cash flow

payments are calculated.

The gross notional amount reported by the BIS is the total of the notional amounts of all

transactions that have not yet matured, prior to taking into account all offsetting transactions

between pairs of counterparties. As outlined above, gross notional amounts thus represent a

cumulative total of past transactions. Using gross notional amounts as an indicator of

counterparty risk may be misleading, as many trades are concluded with a single counterparty.

Once negotiated, CDSs bind both counterparties until the agreed maturity. Market participants

basically have three choices when increasing or reducing their CDS exposures.

First, they can terminate the contract, provided the counterparty agrees to the early termination.

Second, they can find a third party to replace them in the contract, provided the counterparty

consents to the transfer of obligations (“novation”). As a third option, dealers that want to

unwind or hedge their positions can also enter into offsetting transactions, sometimes (though not

necessarily) negotiated with the same counterparty as the hedged deal.

The third solution is used extensively, and so the number of trades has surged, resulting in an

increase in total gross notional amounts. Indeed, this technique, by contrast with the other two,

does not eliminate previous deals and instead adds them together. The end result is that external

market commentators tend to pay too much attention to the gross market values in relation to

other measures of the real economy such as GDP, whereas net notional amounts, where

accounted for, may be downplayed or perceived as being very low or moderate in relative terms

given the huge gross notional amounts outstanding.

NET NOTIONAL AMOUNTS

Having taken into account all offsetting transactions between pairs of counterparties (i.e.

outstanding transactions relating to exactly the same reference entity – whether a specific


borrower, a CDS index or a tranche of a CDS index), the net notional amount is the basis for

calculating the net payment obligation in a credit event. In the event of a default, the payment

made (under cash settlement) by the protection seller is equal to:

Net notional value × (1-recovery rate (%) of a reference obligation).

The net notional value is thus a proxy for the contribution made by CDSs to an institution’s risk

exposure, as it represents the maximum amount of funds that could theoretically be transferred

from the seller of protection to the buyer, assuming a zero recovery rate following a default by

the reference entity.

In the case of CDSs which reference an index tranche, the net notional value represents the

maximum amount of money that the seller of protection could be asked to transfer, assuming

losses exceed the tranche’s attachment point.

The DTCC provides aggregate net notional data for single reference entities. These comprise the

sum of net protection bought (or sold) across all counterparties.

MARKET VALUES

The mark-to-market value of a CDS on a given reporting date is the cost of replacing the

transaction on that date. The market value of a CDS is equal to the discounted value of all cash

flows expected in the default leg (i.e. the payment to be made by the protection seller in the event


that the reference entity defaults) and the fee leg (i.e. the agreed spread that the protection buyer

has to pay every quarter), taking into account the probability of the reference entity defaulting. If

that entity does indeed default, the market value should be equal to the notional value of the

CDS, less the expected recovery value. The BIS, in its derivative statistics, defines “gross market

value” as the value of all open contracts before counterparty or other netting.

Thus, the gross positive market value of a firm’s outstanding contracts is the sum of all the

positive replacement values of a firm’s contracts. Similarly, the gross negative market value is

the sum of all the negative values of a firm’s contracts.

Gross market value is not an accurate measure of counterparty risk, as it does not take into

account the effect of netting for each pair of counterparties. However, this measure reflects the

changes that take place in trades’ market values between the inception date and the reporting

date.

NET MARKET VALUE/GROSS COUNTERPARTY EXPOSURE

The net market value is not calculated solely for dealers’ CDS positions, but across all of their

OTC derivative positions. Thus, this measure of gross counterparty risk is not available for CDSs

alone, as dealers do not manage their counterparty risk exposure by asset class. The net market

value across counterparties is also referred to as “gross credit exposure”. Counterparty risk

reflects the risk of being forced to replace positions in the market were a counterparty to default,

and net market values would therefore be a measure of counterparty risk, assuming there was no

collateralization. Unfortunately, however, neither gross nor net market values for CDS contracts

are currently available from the DTCC.

COUNTERPARTY RISK AND ISSUES FOR FINANCIAL STABILITY

This section will review the transmission channels through which CDSs may have contributed to

increases in systemic risk. CDS contracts are commonly regarded as a zero-sum game within the

financial system, as there is always a buyer for each seller of CDS contracts, as with all other

OTC derivative contracts. The financial turmoil has shown, however, that both buyers and sellers

of

CDSs may suffer losses if counterparty risks materialize.


Indeed, with CDSs, both parties are exposed to credit risk derived from the counterparty (or

“counterparty risk”), which reflects the potential for the counterparty to fail to meet its payment

obligations. In other words, counterparty risk reflects the risk of being forced to replace positions

in the market, were

a counterparty to default.

The replacement cost is of the same magnitude for the two counterparties concerned, but with a

different sign. For instance, if there is a deterioration in the creditworthiness of the underlying

reference entity (i.e. spreads widen), a trade will have a positive value for the protection buyer

(i.e. that buyer is “in the money”), as the protection it already has is now worth more.

This positive value is the additional cost of conducting exactly the same trade with the original

spread. Thus, a value of USD 10 billion would mean that it was necessary for a buyer to pay an

additional USD 10 million to persuade a seller to take on the trade at the lower spread.

Equally, a seller of CDS protection is “out of the money” by USD 10 million, as that party would

now require USD 10 million to take on the original trade at the lower spread. If the seller were to

then default, the buyer would be entitled to claim from the seller the cost of replacing the trade:

USD 10 million. Equally, if the buyer were to default, the seller would still be required to pay

USD 10 million to the buyer.

This requirement to pay even if the money is owed to the defaulting party is a legally binding

obligation under the ISDA Master Agreement. Dealers hedge market risk exposures resulting

from a CDS by means of offsetting transactions with another party. If the second party is also a

dealer undertaking additional hedging transactions, a chain of linked exposures will arise in

which the market participants know their direct counterparties, but not the parties further along

the chain.

A number of structural features in the CDS market have helped to transform counterparty risk

into systemic risk.

First, the majority of the CDS market remains concentrated in a small group of dealers. Second,

the case of Lehman Brothers has shown that the interconnected nature of this dealer-based

market can result in large trade replacement costs for market participants in the event of dealer

failures. Third, as regards the euro area banking sector, euro area banks appear to have become

net sellers of standard single-name and index CDS contracts (although for limited amounts),

which would imply exposure to market risk if there is a general increase in CDS spreads – for


instance in the event of a dealer failing within the CDS market. Given the limited net values, this

could change in the coming months, although the net position of euro area banks remained

negative at the end of June 2009.

In addition to the shift from those institutions’ historically net positive positions (i.e. as net

purchasers), it should also be noted that banks seem to have been net sellers of protection for

sovereign CDSs, which may in some cases constitute wrong-way risk. Finally, the low levels of

liquidity resulting from the crisis and the current high levels of concentration in the market have

both increased trade replacement costs and resulted in significant bid-ask spreads for market

participants, particularly for non-dealers.

Concentration

The results of interviews and the survey responses of market participants indicate

possible over-concentration in the sense of a scarcity of sellers. This, together with liquidity risk,

is the main concern of European banks as regards CDS-related counterparty risk. A reduced

number of counterparties results in increased concentration risk and, consequently, greater

systemic risk.

In the CDS market, as in other OTC markets, the major banks (i.e. dealers) trade actively

among themselves and account for a large share of the daily turnover in these markets. Indeed,

the CDS market is concentrated around a few large players. In 2008 the five largest CDS dealers

were JPMorgan, the Goldman Sachs Group, Morgan Stanley, Deutsche Bank and the Barclays

Group (see Table 4.2). This ranking has been calculated on the basis of public fillings and seems

to be comparable to that listed in Fitch’s 2009 derivative survey.

A recent survey of U.S firms by Fitch also indicate that 96% of credit derivatives

exposures at the end of Q1 2009 of one hundred surveyed firms was concentrated to JP Morgan,


Goldman Sachs, Citigroup, and Morgan Stanley and Bank of America. According to DTCC data,

the five largest CDS dealers were counterparties to almost half of the total outstanding notional

amounts as at 17 April 2009 and the ten largest CDS dealers were counterparties to 72% of the

trades. As regards BIS data, the market share of major players seems to be larger in Europe than

it is for the total global market. This, however, is explained by the difference between the BIS

and DTCC data in terms of scope.

The quantitative survey included details of the percentage of trades that the largest

dealers conducted with their ten largest clients. The results of that survey, which are similar to

the DTCC data, showed a high level of concentration in the CDS market when looking at

individual CDS-dealing banks. The survey collected both notional outstanding amounts and

positive market value positions. In principle, the latter measure is a better proxy for counterparty

risk than notional amounts, as reflects the costs that may arise if trades with counterparties need

to be replaced. The survey concluded that 62-72% of the largest EU banks’ CDS exposures

(measured in terms of gross market value) were against those banks’ ten largest counterparts.


Exposure relative to bank capital is higher for the largest EU banks, for which gross

positive market values account for more than 350% of their tier 1 capital, compared with 125%

for the average bank in the sample. It should, however, be noted that this indicator does not take

into account the collateral underlying these exposures.

The current high levels of concentration in the CDS market probably exceed those

observed before the crisis, as the market has seen the exits of the independent CDS dealers Bear

Stearns, Lehman Brothers and Merrill Lynch. This has also coincided with the reduction of

proprietary trading activities by several European banks and reduced amounts of CDSs sold by

hedge funds and exits from the market by large CDS sellers such as AIG, the monolines and the

CDPCs. It is difficult to demonstrate an increase in concentration using the CDS data provided


by the DTCC, as these statistics were first published in November 2008, showing the outstanding

amounts of CDS at the end of October 2008, after Lehman Brothers’ failure. This report has

therefore used the only existing historical series available – the BIS data – to demonstrate this

reconcentration of the market and to illustrate non-bank players’ retreat from the market since

the crisis began.

First, BIS data show that non-bank players have retreated from the CDS market since the

crisis began. At the global level, from 2005 to 2007 non-bank financial institutions accounted for

12% of sales of protection to BIS dealers. This share was 10% in June 2008 and only 7% in

December 2008. One possible explanation is that, post-crisis, significant losses have eroded

capital and the institutions’ appetite for the selling of protection. In the non-bank sector, there are

fewer active pure protection sellers. Hedge funds, financial guarantors, credit derivative product

companies, and synthetic CDOs and SIVs are all examples of net sellers of CDSs prior to the

onset of the crisis. In addition, according to some market participants, the market has

experienced a flight-to-quality effect, which has benefited the sounder large institutions and may

have been detrimental to the non-bank sector.

Market participants have indicated that a number of hedge funds were increasingly

pursuing credit-oriented strategies in the run up to the financial crisis, and that these players

accounted for significant daily CDS trading volumes. This was also the finding of a Fitch survey


in 2006. The level of CDS trading activity has, however, fallen sharply in conjunction with

financial deleveraging and fund closures. A record number of hedge funds were levered less than

once during the months of September and October 2008 in the face of investor redemption

requests, losses, aggressive deleveraging and – potentially – reduced credit lines extended by

prime brokers and increased margin calls. This, in combination with bilateral collateral

management procedures, may have prevented considerable concentration risk from materializing

within the hedge fund community in relation to the CDS market. In the absence of detailed CDS-

specific corporate disclosures by institutions, it is not possible to identify the losses sustained by

non-banks such as hedge funds.

The reduced level of activity by hedge funds is particularly visible within BIS data,

which show that the market values of the notional amounts bought and sold by hedge funds

increased only modestly during the second half of 2008. Although the overall CDS market

decreased owing to compression cycles, it should be noted that gross market values for

outstanding CDS contracts increased significantly for all sectors in tandem with rising market

volatility. Hedge funds were the exception. Hedge funds and SPVs’ share of total contracts sold

to dealers is substantially lower in Europe(at 5%) than it is globally (at 7%). However, a further

review of the causes of this difference, including an analysis of the data quality of individual

institutions’ reports, is warranted. Until 2007, hedge funds sold approximately 8% of the gross

notional amount of CDSs bought by dealers. Their share then declined to stand at 5% in

December 2008.

Interconnectedness

There is plenty of support in the literature for the fact that derivatives increase the

interconnectedness between banks. However, this crisis has shown at least three new interesting

areas for further study in this respect.

First, when the underlying reference entity for a CDS is a financial institution, the

counterparty risk effect can be substantial, as the intermediaries in the CDS market are other

financial institutions. In particular, the values of large global financial firms fluctuate together,

owing to their interconnectedness in the global markets. The fact that such institutions are tied to

each other through chains of OTC derivative contracts means that the failure of one institution

can substantially raise CDS spreads on other institutions, making it difficult for investors to


separate the credit risk of the debtor from CDS counterparty risk. The need to hedge counterparty

exposures has therefore increased for risk management purposes.

Second, the increasing correlation between counterparties and reference entities has

recently taken on a new dimension in those countries whose banking sector has been supported

by public authorities. The sovereign CDS market for developed countries has surged following

the launch of national bank rescue packages.

Third, market participants which were not perceived to be key or major players within the

CDS market prior to the outbreak of the crisis in terms of gross notional amounts have been

shown to be too large to fail owing to their links with other key market participants. This was the

case with AIG, for instance. AIG was ranked as the 20th largest market participant in the Fitch

derivative survey in 2006, with its gross notional exposures only a tenth of the size of the gross

exposures of the current largest CDS dealer. Given its position as a “one-way” seller, however,

AIG proved to be too systemically important for the insurance market and too interconnected to

fail, which required the US Treasury to support it in order to prevent knock-on effects for the

financial system.

Risk Circularity

As mentioned, the first noticeable feature is that this market has experienced increasing

demand for guarantees against the failure of financial institutions. In terms of net notional

amounts (i.e. the maximum amount at risk), six dealers were among the top ten non-sovereign

reference entities at the end of July 2009, compared to seven at the end of 2008.

Furthermore, a breakdown of euro area entities’ net positions indicates that euro area

banks are net sellers for single-name financial reference entities, as well as single-name

sovereign governments.

Although the majority of the protection sold for financial entities relates to non-euro area

reference entities, the relationships between financial players mean that these exposures deserve

closer attention, as shown by the cases of Lehman Brothers and AIG.

Sovereign Reference Entities And Wrong-Way Risk

The increased correlation in the CDS market between reference entities and sellers of

CDS protection lessens the effectiveness of the clean transfer of risk and amplifies the effect of


this interconnectedness. This risk, called “wrong-way risk”, occurs when the creditworthiness or

credit quality of a CDS reference entity is correlated with the CDS counterpart’s ability or

willingness to pay. This wrong-way risk could, for example, apply to affiliates within the same

corporate group, but could in principle also apply to wholly separate legal entities which are

exposed to similar economic or external risks. Stress testing should be used to identify any

wrong-way risk in existing portfolios, with risk mitigants and/or the adjustment of capital

employed to reflect any existing wrong-way risk.

An extreme example of wrong-way risk is CDSs sold by banks on their host sovereign reference

countries. A bank benefiting from state rescue packages and then selling protection on the

sovereign credit risk of the country in which that bank’s parent company is located could be

considered a textbook case for wrong-way risks. A bank may sell CDS protection against its

own sovereign government, although its ability to honor its commitment may be closely linked

to the financial health of that sovereign government.

The bank may argue that the market’s pricing of its host country’s credit risk was excessively

high at the time of the sale and that it is unlikely for the economic conditions faced by the host

country’s central government to deteriorate to such an extent that a sovereign default

materializes. It may therefore be economically attractive for the bank to sell CDSs on its host

country and accept exposure to this sovereign credit risk. To a certain extent, the bank could also

be regarded as acting as a stabilizing force in the market, mitigating the effects of speculation

regarding widening sovereign CDS spreads.

The actual amount of outstanding wrong-way risk cannot be determined accurately without

further details at trade level with regard to CDS protection sellers, CDS reference entities and the

amounts bought and sold. The DTCC has conducted a review on the basis of a narrow definition

of wrong-way risk for banks which have sold CDS protection on their host governments. This

review shows a notional amount of €10 billion of CDS contracts being sold by banks against

their host sovereign governments as at 17 April 2009, of which €7 billion was sold by European

and Swiss banks.

Although this amount may be considered relatively small by comparison with the

outstanding nominal amounts on the overall market, additional DTCC data relating specifically

to euro area banks indicate that euro area banks are currently net sellers of CDSs against euro

area governments.


The findings of the DTCC, together with the current net positions of euro area banks,

imply that euro area banks have sold CDSs not against their own host governments, but mainly

against other euro area countries.

AIG: Too Interconnected To Fail

Another example of an entity which was too interconnected and too big to fail was AIG.

On 30 September 2008 the aggregate gross notional amount of credit derivatives sold by AIG

was USD 493 billion – or USD 372 billion on a net basis. This was an amount which could

potentially affect the entire financial network. The net notional amount was almost double the

aggregate net notional amount sold by all DTCC dealers combined at the end of October 2008.

Nevertheless, in 2006 AIG was not ranked among the largest CDS players in Fitch’s

survey, having just the 20th largest gross notional amount (with net notional amounts not

available at that time), showing that aggregate gross notional amounts are not a good measure of

risk for financial stability purposes. Furthermore, AIG mainly sold bespoke CDS contracts,

which were not covered by the DTCC data, demonstrating a gap in its data coverage which is

currently being addressed.

The public support extended to AIG Financial Products enabled its counterparties to

maintain their CDS protection.

Added disclosures would have shed light on the scale of the large and concentrated

exposures of several systemically important participants towards AIG. However, some banks’

responses to the qualitative questionnaire have indicated that they have since implemented

industry best practices, applying nominal maximum limits for net counterparty exposures, as

well as single-name CDSs. In addition, some banks have begun requiring the use of liquidity

inputs such as bid-ask spreads in their daily portfolio reconciliation processes in order to enhance

collateral management practices, with lists of counterparts that are to be monitored closely. The

counterparts on such lists are also monitored via their CDS spreads. However, although an

institution’s accumulation of concentrated exposure to the market may be mitigated by means of

prudent bilateral collateral management, such practices may not prevent the general build-up of

systemic risk or a high degree of concentration in such risk. Added disclosures for large

counterparties and the the largest derivative exposures – i.e. those that exceed certain thresholds

– would therefore be very useful in order to enable market participants to better assess their


counterparty risk and the potential for systemic spillover effects. However, there are currently no

disclosure requirements within the FASB or IASB accounting standards with regard to the main

counterparts for derivative transactions.

Liquidity

Dealers play an important role in OTC derivative markets, acting both as prime brokers,

taking on counterparty risk, structuring products and providing liquidity. Market liquidity is a

general precondition for market efficiency, and a sudden worsening of market liquidity may

degenerate into a systemic crisis. One of the most pernicious threats to market participants is thus

the illusion or expectation that market liquidity will be maintained. This illusion means that

market participants overestimate their ability to unwind transactions or hedge their positions

smoothly and rapidly to meet requirements in unforeseen circumstances, which could, ex ante,

lead them to take excessive risks. For example, in the case of AIG, it is highly unlikely that

AIG’s counterparts would have been able to undertake novation given the total collapse of the

CDO market to which AIG’s bespoke CDS contracts were linked.

The IMF (2006) indicates that narrow bid-ask spreads and high volumes may be

imperfect yardsticks by which to measure secondary market liquidity. These measures are

susceptible to one-way flows (i.e. dealers only), particularly if there is a lack of diversity among

market participants, if search and other costs are signicant, and if the cost of holding inventory

becomes an issue with regard to the dealer’s own funding position. Tang and Yan (2007) argue

that inventory may become restrictive for dealers in the presence of funding constraints, which

has a knock-on effect on the supply of contracts in the market. More importantly, if the liquidity

characteristics of these contracts vary over time and there are common liquidity shocks across

these markets and the underlying markets, investors may systematically price in a liquidity risk

component.

Some researchers and rating agencies have developed liquidity scores, which mainly

combine several aspects of liquidity measures. They usually combine measures of trade

inactivity and staleness of quotes, the dispersion of mid-quotes across contributors and the size

of bid-ask spreads, resulting in an illiquidity index (i.e. the higher the index, the lower the

liquidity). A deterioration in liquidity could be observed only in the fourth quarter of 2008

following Lehman Brothers’ default. During the last quarter of 2008 CDS spreads widened very

rapidly, reflecting market participants’ view of the increased probability of other entities


suddenly defaulting. In this situation, the valuation and quotation of CDS prices became very

difficult, having a negative impact on liquidity within the CDS market.

The illiquidity indices show that CDS liquidity is not strictly correlated with credit

quality and that some credit risk has to exist in order for CDS contracts to be traded actively.

However, CDS liquidity disappears if the probability of default is high, as market participants

will be less willing to provide quotes for a CDS reference entity when the probability of a default

or a “jump to default” is high for the entity in question. This is supported by the observations of

market participants following the collapse of Lehman Brothers. According to these available

liquidity indices, CDS market liquidity seems not to have changed significantly over time.

By contrast, interviews with market participants belie this assessment. While the largest

players do not report facing liquidity problems, smaller players do. Survey responses indicate

that standard index products such as iTraxx Main and CDX.IG and single-name CDSs with large

corporations as reference entities tend to be relatively liquid, with two-way flows. Trade sizes

have also generally been reduced, particularly for high-yield names, as some market-makers no

longer quote high-yield names.

On one hand, the market currently appears to be better balanced for longer maturities,

such as five and ten-year maturities. On the other hand, there has, until recently, been a lack of

buyers for single-name CDSs with maturities of less than one year, with the exception of some

reference entities with jump-to-default risk. This liquidity shortage for short maturities may

reflect liquidity constraints. The interconnectedness and high levels of concentration among a

small group of dealers in the market have helped to increase the liquidity risk for the market.

This has also led to wide bid-ask spreads in the market.

COUNTERPARTY RISK MANAGEMENT

The failure of Lehman Brothers and the near failures of Bear Sterns and AIG have demonstrated

the importance of counterparty risk management. This chapter discusses the challenges related to

the management of counterparty risk exposures resulting from CDSs and other OTC derivatives.

It also looks at state of the art collateralization practices and provides an overview of European

banks’ counterparty risk exposures. The techniques currently used to limit, forecast and manage

counterparty risk (including netting and the posting of collateral) will also be outlined. The


section concludes with an assessment of current collateral management practices and the

difficulties encountered by European banks during the recent crisis.

Counterparty Risk Management Techniques

Recent work by the Counterparty Risk Management Policy Group, the Financial Stability

Forum and the BIS has outlined weaknesses in the OTC derivative markets’ ability to handle the

default of a major counterparty and indicated a need to enhance the resilience of the market

infrastructure. Parties to OTC transactions are highly dependent on the ongoing creditworthiness,

liquidity and operational robustness of their counterparties. This is particularly true for dealers,

which act as market-makers by accepting clients’ trades and entering into matching contracts

with other participants. The existence of counterparty risk – which reflects the risk embodied in

the positions that would have to be replaced were the counterparty to default – adds an additional

layer of complexity to the management of financial risks stemming from derivatives, making the

design of hedging strategies more complex. These more advanced techniques complement the

basic counterparty risk management processes (e.g. sound due diligence and diversification),

which remain a fundamental element of risk mitigation. By way of illustration, consider the very

simplest derivative contract: a forward agreement written on underlying asset “S” for delivery

time “T”. As the pay-off function of such a contract is linear in relation to the value of S, the

hedging strategy is straightforward and identical for the two counterparties, apart from the sign

of their hedging positions.

Things change if counterparty risk is introduced into the picture, as in this case when the two

counterparties’ ex ante contract pay-offs diverge. Namely, from the point of view of the party

that purchased the asset forward, a counterparty default equates to assuming that the purchasing

party sold its counterparty a call-type option on S, the strike price of which is equal to the agreed

forward price. Exercising that option would be contingent on the counterparty being unable to

delivery the asset at the contract’s maturity, which would prevent the forward purchaser from

being able to benefit from the potential increase in the price of S.

To offset such a risk, the dealer could implement a more complex hedging strategy, taking into

account the probability of the counterparty defaulting over the maturity of the contract. It could

also factor in the counterparty’s creditworthiness when pricing the forward contract, ending up


with a different price for each counterparty. A third solution would be to cap the value of the

options implicitly sold to its counterparties, requesting that they pay the amount of money owed

each time the value of the forward contract exceeds an agreed threshold.

In the real world, banks make use of all three options, with the collateralization of reciprocal

credit exposures arising from the evaluation of OTC derivatives being the most frequently

adopted means of reducing credit exposures arising from transactions negotiated between

dealers.

CDSs play a special role in this situation, as they are simultaneously (i) a driver of counterparty

risk similar to other OTC derivatives, and (ii) an instrument used to hedge such a risk, as dealers

tend to use CDSs to hedge against the risk of a counterparty defaulting on its derivative

exposures. Counterparty risk for the buyers and sellers of CDSs arises from the mark-to-market

changes driven by changes in the CDS spreads of the underlying reference entity between the

time of the initial agreement and the valuation time. What distinguishes CDSs from other

derivatives is the fact that the skewed distribution of credit risk could suddenly raise the

protection buyer’s exposure to the protection seller to very high levels, such that the latter could

suddenly be asked to pay the former huge amounts of money, with all the resulting interlinkages

between counterparty and liquidity risks. This makes CDS instruments particularly significant in

terms of risk.

Dealers can hedge such CDS-related exposures by means of offsetting transactions with another

party. If the second party is also a dealer, and that dealer in turn undertakes an additional hedging

transaction, a chain of linked exposures will arise in which the market participants know their

direct counterparties, but not the parties further along the chain. Recent market events have

shown that market participants and regulators have been unable to effectively manage credit

exposures, as they have not known the actual location or level of concentration of the credit risk

in question. In addition, almost all survey participants and interviewed market participants agree

that counterparty risk remains one of the main concerns of European banks.


CHAPTER – 8EFFECT OF CREDIT DEFAULT SWAPS IN

INDIAN MARKET


RBI GUIDELINES ON CREDIT DEFAULT SWAPS

Reserve Bank of India (RBI) has come out with draft guidelines on Credit Default Swap(CDS)

per notification dated May 2007. The guidelines could not have come at a more opportune time,

as several players are waiting eagerly to get appropriate instruments to manage credit risk in their

portfolio.

The guidelines initially are addressed to commercial banks and primary dealers only and the

scope is limited to usage of Credit Default Swap by the banks and primary dealers for sale and

purchase of credit protection in respect of single resident reference entity. Down the line, it

seems that insurance companies and mutual funds also would get to participate in the exciting

field of credit derivatives.

For the uninitiated, credit derivatives are synthetic instruments for transfer of credit risk in a

financial transaction or a portfolio consisting of financial assets. Most commonly used form of

credit risk transfer that we in India are conversant with, is securitization. Securitization has focus

on selling assets with credit risk. Banks can sell their loans directly or they can securitize. Or

pool together their assets with credit risk and sell parts of the pool to outside investors. Either

way it reduces credit risk because the credit exposure is transferred to the new owner.

Unfortunately, these methods are insufficient for managing the credit exposure of many financial

institutions.

Credit derivatives are financial contracts that provide insurance against credit-related losses.

These contracts give investors, debt issuers, and banks new techniques for managing credit risk

that complement the loan sales and asset securitization methods.

A credit derivative is usually a bilaterally entered contract. The value of the contract is derived

from the credit risk of the underlying like a bond, a bank loan, or some other credit instrument.

The value of a credit derivative is linked to the change in credit quality of these instruments.

Different variants of credit derivatives are Credit Default Swap, Total Return Swap, Credit

Linked Notes, Collateralized Debt / Loan Obligations (CDO/CLO), both index tranched and

bespoke, Credit Spread Options etc. CDOs on CDOs or CDO2 are new variants of credit

derivatives.

Since most of these are well known to most of the discerning readers, we are dwelling on the

draft guidelines of Reserve Bank of India and are submitting observations hereunder as to what


according to us are required to be additionally addressed to make the world of credit derivatives

in India more meaningful and in line with the expectation of the market:

1. At the very beginning we draw attention to a statement in the draft that declares that the

document does not supersede any previous guidelines. While this is partially true, a clearer

statement on why the draft guidelines of 2003 are not pursued to logical end could have put

things in proper perspective.

2. It is not also understood as to why the scope is kept limited to Banks and PDs and that too in

respect of single resident reference entity, leaving other financial institutions and retail assets

outside the purview. At a time when infrastructure development through public private

partnership is encouraged and deepening and widening of debt market is spoken about, the

option is required to be extended to other financial institutions as well including but not limited

to registered NBFCs and institutions dedicated to infrastructure financing in particular.

3. It is the experience of the undersigned that Public Sector Banks with overseas presence write

protections freely in respect of Credit Linked Notes referencing to FCCBs issued by Indian

corporates in the international market. It is not clear whether the Banks will continue to be

permitted to write such protections in the international market but not in the domestic market.

4. We expected RBI to appreciate the problems of NBFCs more closely and to appreciate that

not all NBFCs that are in the business of creation of physical assets in the country are doing so

for narrow business gains. Some of them are in the business to address the gap in the physical

infrastructure of the country that deters foreign investments to come in. Unfortunately they are in

the finishing segment of the infrastructure vertical and are not yet officially recognized as

infrastructure activities.

5. It is well known that the NBFCs, particularly Asset Finance Companies run huge asset

liability mismatches in their books in the absence of alternative source of funding other than

credit lines from Banks. In order to address this issue they normally enter in to bilateral deals for

sale of assets or undertake vanilla securitization. Recent guidelines of RBI indirectly restricting

flow of credit to NBFC ND SI have further put such NBFCs in a spot as assets they finance are

funded at a much cheaper rate in the market than the rate at which they can raise resources from

Banks.

6. In the absence of variety of players interested in loans proposed to be sold / securitized, the

counter parties are almost always banks only. Availability of CDS to NBFCs would have


afforded some alternatives (CDOs in particular) to them to go for tranched securitization and sell

them to different players according to the risk appetite / comfort level. CDOs take a debt

portfolio and partition the credit risk to suit different investors’ demands. This is done by placing

a basket of bonds into an SPV, and issuing a series of notes against the basket, which

consecutively bears the losses on the portfolio. The arrival of the credit default swap has enabled

product structurers to replicate cash CDO portfolios without actually using the underlying debt –

the synthetic CDO.

7. From the point of view of regulatory oversight also RBI would rather like to encourage

securitization / CDOs than continuing with popular bilateral deals where isolation of assets from

the seller (true sale) and establishing bankruptcy remoteness of seller (putting the beneficial cash

flow from the sold assets beyond the reach of the transferor, or any consolidated affiliate of the

transferor, and their creditors either by a single transaction or a series of transactions taken as a

whole even in the event of bankruptcy or receivership of the transferor or any consolidated

affiliate), appear at times to be extremely di fficult and tend to vary from one legal expert to

another. Besides, tranched securitization will attract many players in to the debt market thereby

lending solidity to its process of maturity.

8. As far as the institutional mechanism to facilitate credit derivative transaction is concerned,

RBI has stopped short of announcing the initiatives they are required to take. In order to make

credit derivatives attractive, it is important that indices like the CDX and iTraxx indices are

launched to serve as true benchmarks in credit trading. Constructed as baskets of a sample of

single-name default swaps with standardized maturity dates and coupons, they instantly give the

market the liquidity it needs. Understandably Indian market does not have adequate data to build

such indices. However, our Rating Agencies are eminently competent to provide a solution for

this going forward and a role for them should be defined in the guidelines.

9. RBI may also contemplate identification and approval of select legal firms to undertake legal

due diligence and sign off on all contracts that represent transfer of credit risk whether through

securitization / loan sales route or through credit derivatives. At a time when Indian economy is

getting integrated and transnational are evincing interests in the Indian market, such calibration

of the institutional mechanism is felt to be essential prerequisite. In this context it may be stated

that though the guidelines have referred to ISDA Master Agreement, contemporary literature

suggests that the ISDA is not to be taken as an omnibus solution. According to Mr. Joris Vlug of


Zanders & Partners, “In a more 'volatile' world it is sensible and strongly recommended to

thoroughly negotiate ISDA schedules. At least two main items in the schedule should receive

special attention. One is the fact that the parties (especially corporates) tend to forget that a

trigger for a termination event in an ISDA schedule automatically triggers other funding facilities

through the cross default sections in those funding facilities. The second concern is the tendency

of banks to propose a schedule, which is not realistic from the other party's point of view, either

due to stringent covenants or unrealistic terms and conditions. Remember one important thing:

an ISDA Agreement is a bilateral agreement, so you must negotiate thoroughly.” Select legal

firms may give necessary consultancy in this context and enable deals to go through without any

doubt about their enforceability, particularly when the concept of ‘restructuring’, ‘modified

restructuring’ and ‘modified modified restructuring’ as default events create some doubts /

haziness.

10. Besides, taking a cue from SOX (Sarbanes Oxley) compliance requirements, RBI might as

well obligate entities using credit derivatives to induct in their Audit Committees with at least

one independent financial expert who is conversant with derivatives and derivative accounting.

Such members along with others in the Audit Committee, may be requested to examine internal

controls at a desired level of detail (e.g., about the structure of derivatives, the risks they hedge,

the model used for their mark-to-market, their hedge effectiveness over time, the management

and procedural controls between the front and back offices, and the conformance with trading

policies and limits etc). It is stated “treasurers who are infrequent users of derivatives may not

have adequate systems, controls and processes in place. They may also be unaware of the

leverage implicit in the transactions, and could end up with transactions that have a huge

negative impact on their financial statements. The identified expert in the Audit

Committee should develop a statement that specifies what hedging techniques and instruments

should be used to support strategy. This involves de tailed descriptions of the risk appetite,

forecasted transactions, partial term hedges and other issues. Without it the risk policy is often

left to the whims of treasury officials, who could pursue policies that are at odds with the board's

wishes.”

11. RBI has rightly prescribed that banks should address issues regarding conflicts of interest

while structuring CDS. For that matter it is equally important for securitization and other credit

derivatives too. Like in treasury operations, the concept of middle office is equally important in


credit derivative transactions. In this context the prescription given by Mr. Joel Bessis in the

following statement is worth recalling: “ Even though banks have always followed well-known

diversification principles, classical emphasis of credit analysis is at the transaction level.

Portfolio analysis that has significant potential to improve risk return trade off calls for

separation of origination from portfolio management.”

12. Lastly, given the fact that process automation in different banks and PDs are at different

levels of maturity, giving across the board authority level to write protection might not be free

from risks. The more comprehensive the process automation is the lesser is the degree of

operational risk. Hence a benchmark requirement of process automation could have been made

mandatory for writing derivative contracts. While concluding, we draw attention to the

recommendations of the Joint Forum of Basel Committee on Banking Supervision (BCBS) on

the issue of Credit Risk Transfer (CRT) in October 2004. BCBS proposes that any CRT / player

in CRT space should satisfy the following tests:

1. Whether the instruments/transactions accomplish a clean risk transfer,

2. The degree to which CRT market participants understand the risks involved, and

3. Whether CRT activities are leading to undue concentrations of credit risk inside or outside the

regulated financial sector. It has also been stated, “some transactions are not really intended to

transfer a large portion of credit risk in the first place. For example, some structured transactions

may only transfer the “catastrophic” risks associated with the most extreme set of portfolio

outcomes; these risks may be more macroeconomic than credit events. It is therefore important

that all participants have a good understanding of the relevant transactions and the circumstances

in which they do and do not transfer credit risk.”


CHAPTER – 9

CASES ON CREDIT

DEFAULT SWAPS

Falling Giant: A Case Study Of AIG

What was once the unthinkable occurred on September 16, 2008. On that date, the federal

government gave the American International Group - better known as AIG (NYSE:AIG) - a

bailout of $85 billion. In exchange, the U.S. government received nearly 80% of the firm’s


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equity. For decades, AIG was the world's biggest insurer, a company known around the world

for providing protection for individuals, companies and others. But in September, the company

would have gone under if it were not for government assistance.

The decline of AIG's financial condition can be traced back to March 2005, when the company's

Longstanding AAA credit rating was reduced to AA+ following the resignation of Hank

Greenberg, AIG's longstanding CEO. According to Standard and Poor's, the downgrade resulted

in part from the company's involvement in a number of questionable financial transactions and a

"revised assessment of AIG's management, internal controls, corporate governance and culture."

The questionable financial transactions included certain reinsurance transactions that were

subsequently questioned by the SEC.

High Flying

The epicenter of the near-collapse of AIG was an office in London. A division of the company,

entitled AIG Financial Products (AIGFP), nearly led to the downfall of a pillar of American

capitalism. For years, the AIGFP division sold insurance against investments gone awry, such as

protection against interest rate changes or other unforeseen economic problems. But in the late

1990s, the AIGFP discovered a new way to make money.

A new financial tool known as a collateralized d ebt o bligation (CDO) became prevalent among

large investment banks and other large institutions. CDOs lump various types of debt - from the

very safe to the very risky - into one bundle. The various types of debt are known as tranches.

Many large investors holding mortgage-backed securities created CDOs, which included

tranches filled with subprime loans. (For more on this concept, check out ourSubprime Mortgage

Meltdown special feature.)

The AIGFP was presented with an option. Why not insure CDOs against default through a

financial product known as a credit default swap? The chances of having to pay out on this

insurance were highly unlikely, and for a while, the CDO insurance plan was highly successful.

In about five years, the division's revenues rose from $737 million to over $3 billion, about

17.5% of the entire company's total. (Read Credit Default Swaps: An Introduction to learn more


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about the derivative that took AIG down.)

One large chunk of the insured CDOs came in the form of bundled mortgages, with the lowest-

rated tranches comprised of subprime loans. AIG believed that what it insured would never have

to be covered. Or, if it did, it would be in insignificant amounts. But whenforeclosures rose to

incredibly high levels, AIG had to pay out on what it promised to cover. This, naturally, caused a

huge hit to AIG's revenue streams. The AIGFP division ended up incurring about $25 billion in

losses, causing a drastic hit to the parent company's stock price. (Read more about the lead-up to

the credit crunch in The Fuel That Fed The Subprime Meltdown.)

Accounting problems within the division also caused losses. This, in turn, lowered AIG's credit

rating, which caused the firm to post collateral for its bondholders, causing even more worries

about the company's financial situation. It was clear that AIG was in danger of insolvency. In

order to prevent that, the federal government stepped in. But why was AIG saved by the

government while other companies affected by the credit crunch weren't? (Read about one

company that didn't survive financial crisis in The Rise And Demise Of New Century Financial.)

To Big To sale

Simply AIG was considered too big to fail. An incredible amount of institutional investors-

mutual funds, pension funds and hedge funds - both invested in and also were insured by the

company. In particular, many investment banks that had CDOs insured by AIG were at risk of

losing billions of dollars. For example, media reports indicated that Goldman Sachs (NYSE:GS)

had $20 billion tied into various aspects of AIG's business, although the firm denied that figure.

Money market funds - generally seen as very conservative instruments without much risk

attached - were also jeopardized by AIG's struggles, since many had invested in the company,

particularly via bonds. If AIG was to become insolvent, this would send shockwaves through

already shaky money markets as millions of investors - both individuals and institutions - would

lose cash in what were perceived to be incredibly safe holdings. (To learn more about the rough

times money market funds saw, read Why Money Market Funds Break the Buck.)


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However, policyholders of AIG were not at too much risk. While the financial-products section

of the company was facing extreme difficulty, the vastly smaller retail-insurance components

were still very much in business. In addition, each state has a regulatory agency that oversees

insurance operations, and state governments have a guarantee clausethat will reimburse

policyholders in case of insolvency.

While policyholders were not in harm's way, others were. And those investors - from individuals

looking to tuck some money away in a safe investment to hedge and pension funds with billions

at stake - needed someone to intervene

Stepping In

While AIG hung on by a thread, negotiations were taking place among company and federal

officials about what the next step was. Once it was determined that the company was too vital to

the global economy to be allowed to fail, the Federal Reserve struck a deal with AIG's

management in order to save the company.

By November 2008, the company was almost entirely dependent on the Federal Reserve and the

Treasury for funding. According to Federal Reserve data, AIG had borrowed a total of almost

$128 billion by the end of the year.

$40 billion from a bridge loan designed to help the company continue operating while it

sells off non‐core assets;

$28 billion to purchase the collateralized debt obligations on which AIGFP had sold

protection.

$20 billion of the $22.5 billion allotted to purchase subprime mortgage backed securities

in which AIG had invested as part of its securities lending program (note: these are not

the only

mortgage backed securities in which AIG invested); and

$40 billion capital investment through the TARP program.

As these figures show, most of the federal "bailout" funds were directed at enabling the

company to

Continue to fund its activities and not directly related to losses incurred in connection

with AIG's credit default swaps.


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The Federal Reserve was the first to jump into the action, issuing a loan to AIG in

exchange for 79.9% of the company's equity. The total amount was originally listed at

$85 billion and was to be repaid over two years at the LIBOR rate plus 8.5 percentage

points. However, since then, terms of the initial deal have been reworked. The Fed and

the Treasury Department have loaned even more money to AIG, bringing the total up to

an estimated $150 billion. (Learn how these two agencies work to stabilize the economy

in tough times in The Treasury And The Federal Reserve.

Conclusion

AIG's bailout has not come without controversy. Some have criticized whether or not it is

appropriate for the government to use taxpayer money to purchase a struggling insurance

company. In addition, the use of the public funds to pay out bonuses to AIG's officials has only

caused its own uproar. However, others have said that, if successful, the bailout will actually

benefit taxpayers due to returns on the government's shares of the company's equity.

No matter the issue, one thing is clear. AIG's involvement in the financial crisis was important to

the world's economy. Whether the government's actions will completely heal the wounds or will

merely act as a bandage remedy remains to be seen.

CONTAGION IN THE CREDIT DEFAULT SWAP MARKET: THE CASE OF THE GM AND FORD CRISIS IN 2005

ABSTRACT

Has the General Motors (GM) and Ford crisis in 2005 spread to the whole credit default Swap

(CDS) market? To answer this question, we study the correlations between CDS Premia, by

using a sample of 226 CDSs on major US and European firms. We show that Correlations


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significantly increased during the crisis, especially in the first week. We also test the links

between markets at the firm level, using VECM and VAR models. The lead of CDS market over

the bond market appears to have weakened during the crisis. The links with the equity market

were also mitigated.

INTRODUCTION

Are credit derivatives markets particularly vulnerable to contagion effects? Is a crisis likely

spread rapidly on these markets? The sharp increase in credit default swap (CDS) premia during

the crisis of summer 2007 tends to suggest this. These questions are important given that

derivatives markets play a key role in asset pricing.

Analyzing the GM and Ford crisis in 2005 enables us to tackle these issues. This event had

important consequences on the credit market due to the huge size of the two leading

multinational firms. Considering this precise crisis has also the advantage of being well

circumscribed in time, as the origin can be clearly identified. At that time, the CDS premia and

bond spreads of both firms posted a sharp rise in the wake of their financial difficulties.

The whole of the CDS market was affected, as well as the bond market.

Contagion on financial markets can be broadly defined by a simultaneous drop in asset prices,

triggered by an initial fall in one specific market. The rationales for contagion have been

abundantly studied in the economic literature (Masson, 1998; Kaminsky and Reinhart, 2000;

Kumar and Persaud, 2001; Coudert and Gex, 2008). They are basically linked to the uncertainty

about the fundamental value of financial assets: a crisis in one market can convey information

about the other asset prices and lead investors to revise their price expectations downwards;

portfolio management can also contribute to spread crises through rises in the value at risk,

pushing investors to liquidate risky positions simultaneously; a crisis could also trigger an

increase in investors’ risk aversion… Whatever the theoretical mechanisms at stake, contagion

phenomena are generally characterized by increased correlations between the prices of risky

assets, while risk-free assets benefit from a “flight to quality”, raising their relative price. In fact,

the rise in correlations is frequently considered as the key symptom of contagion (Baig and

Goldfajn, 1998; DeGregorio and Valdes, 2000).


That is why we set out to test the hypothesis of an increase in correlations between the CDSs

during the GM and Ford crisis. To do so, we construct a sample of 224 CDSs of European and

US firms included in the major indices (CDX and iTraxx). We calculate correlations using

different methods in order to cross-check the results. We first compare the correlations during

the crisis period with those during a reference period, by adjusting them to take account of the

rise in volatilities, as recommended by Boyer et al. (1999) and Forbes and Rigobon (2001). This

method gives a first insight, but has its limitations because the period under review must be

sufficiently long to include a sufficient number of observations. However, the CDS market’s

response to the GM and Ford crisis was very prompt. We therefore calculate conditional

correlations by using Exponentially Weighted Moving Averages (EWMA) and Dynamic

Conditional Correlation Generalized Autoregressive Conditional Heteroskedasticity (DCC-

GARCH). Then we test for their increase in the crisis period.

THE GM AND FORD CRISIS AND THE CDS MARKET

Stylised facts

The difficulties encountered by GM and Ford started to raise concerns in March 2005. On 16

March, GM announced a profit warning for the first quarter, forecasting a loss of roughly USD

850 million, compared to a previous target of breakeven. This would reduce the earnings per

share to USD 2, i.e. half what had been forecasted (USD 4 to USD 5). On 8 April, Ford also

announced a profit warning, revising its annual earnings expectations down by 25% compared to

forecasts i.e. USD 2.5 billion instead of USD 3.4 billion. As a result, investors started to expect

major difficulties and reassessed both firms’ default risk, in March 2005, before their ratings

were actually downgraded by rating agencies4. The CDS premium of GM climbed from 304 to

567 bp in March 2005, while that of Ford rose from 244 to 357 bp (Chart 1). The ratings of both

firms were successively downgraded by the three major rating agencies between 5 May and 19

December 2005 (Table 1). The downgrading was particularly harsh since the two firms were

downshifted from investment grade to speculative grade. GM and Ford CDS premia continued to

increase over this period.


Given the importance of these two firms, investors probably reassessed the risks attached to all

borrowers. At any rate, all of the CDS market was affected: index premia almost doubled in

March 2005 (Chart 2). After having reached a peak on 18 May, the CDS indices started to

decline, which suggests that the market had managed to absorb the shock.


Identification of the crisis period

Because financial crises are generally characterised by a rise in volatility, we measure the

variations in the volatility of CDS premia for GM and Ford in order to identify the crisis period

more accurately. We use an EWMA volatility (Exponentially Weighted Moving Average) which

is defined as the weighted sum of quadratic yields5 with exponentially decreasing weightings

over time (J.P. Morgan, 1996). The results show a sudden increase in volatility on 16 March

2005 (Chart 3). This date, which coincides with the profit warning announced by GM, marks the

start of the crisis. CDS volatility rose by a factor of 3.5 between 15 and 18 March in the case of

GM (jumping from 32% to 110%) and almost twofold in the case of Ford (climbing from 30% to

56%). Volatility remained high until end-August 2005. We consider that the crisis period

corresponds to this period of pronounced volatility. It started on 16 March 2005 and ended on 24

August 2005, when the two firms were downgraded by Moody’s and when volatility had already

notably decreased. It is possible to identify three sub-periods:

1. A reference period just before the crisis, when premia were particularly low. This period is

arbitrarily defined as running from 15 December 2004 to 15 March2005 (3 months);

2. The crisis period, from 16 March to 24 August 2005;

3. The post-crisis period, running from August 2005 to February 2007, i.e. prior to the

turbulences of summer 2007.


The behaviour of the CDS market around the time of the crisis

During the reference period, i.e. just before the crisis (15 December 2004 – 15 March2005), CDS

premia were particularly low and stable: 33 bp on average for the CDS IG index and 73 bp for

our global index (Table 2). During this period, default rates were low and investors’ risk appetite

was high. Then, during the crisis, CDS premia posted a sharp increase in all sectors, reaching 94

bp in the case of the global index.

CDS volatility rose sharply during the crisis, jumping on average from 42% to 60%. The whole

automotive industry was affected, with volatility increasing threefold between the first two

periods. The European and US high yield segment were also impacted.


Stock prices of GM and Ford

The crisis hardly impacted the equity prices of GM and Ford, probably because they had already

been falling for a long time. Prices hit a low point on 21 and 22 April 2005 for GM and Ford

respectively (Chart ); they then picked up slightly until early May, before dropping again. In the

case of GM, prices even rose during the crisis following the tender offer made by Kirk

Kerkorian.

While the equity prices of GM and Ford were not directly affected by the crisis, their volatility

increased in line with that of CDSs (Chart 10). In the case of GM, volatility peaked right at the

start of the crisis period, on 17 March 2005, jumping from 19% to 61% in one day. A second

volatility peak occurred on 5 May, the day on which the ratings of GM and Ford were

downgraded. Volatility then stood at 74%. Price volatility increased to a lesser extent in the case

of Ford. Volatility peaked at 45% on 5 May, rising up from 16% at the end of the pre-crisis

period. Average volatilities for GM and Ford increased sharply between the pre-crisis period and

the crisis period (from 17% to 46% for GM and 17% to 32% for Ford)


The empirical relationship between CDSs and stocks

We now study the empirical relationship between CDSs and stocks. Up to now, research on the

links between these two markets has yielded mixed results. According to Byström (2005),

information is first embedded into stock prices, in Europe. Acharya and Johnson (2007) conclude

that there is a continuous flow of information from the CDS market to the stock market, when

analysing a sample of 79 US firms. Scheicher (2006) highlights the existence of simultaneous


linkages between the two markets but does not detect any lagged effects when using a sample of

250 North American and European firms.

CONCLUSION

In this paper, we analyze the possible contagion of the crisis experienced by General Motors and

Ford in May 2005 to the whole CDS market. At that time, both firms’ CDS premia increased

sharply and all other CDS premia rose markedly for US and European firms. As contagion is

often characterized by increasing correlations between risky assets, we study the changes in the

correlations between CDS premia around the time of the crisis, by calculating them through

different measures. To do so, we construct a sample of 226 CDSs that are representative of the

US and European indices (CDX and iTraxx). The estimated correlations increased significantly

during the crisis, especially in the first week, which suggests contagion phenomena. Both the US

and the European markets were affected. Their similar response points to the strong international

integration of the credit markets.

Usually, CDSs premia are close to bond spreads, but the relationship between the bond market

and the CDS market is affected by the crisis. Our results confirm that the CDS market leads the

bond market in the price discovery process, which has been evidenced in previous papers. In

other words, bond spreads tend to adjust to the innovations on the CDS market, and not the

reverse. However, the crisis mitigated this leading position of the CDS market. Especially, GM

and Ford’s CDS premia surged well above their bond spreads.

The links to the equity market were also disrupted. We find that the two markets are usually

linked by a negative relationship, the equity market being the leader. However, they were

somewhat decoupled during the crisis. Indeed, many stock prices continued to rise during the

crisis, while CDS premia were surging for the same firms. Therefore, contagion seemed confined

to the CDS market. The speculative nature of the CDS market may be at stake in this

phenomenon.


Credit Default Swap by Tata to acquire Corus Group

On 20 October 2006 the board of directors of Anglo-Dutch steelmaker Corus accepted a $7.6

billion takeover bid from Tata Steel, the Indian steel company. The following months saw a lot

of negotiations from both sides of the deal. Tata Steel's bid to acquire Corus Group was

challenged by CSN, the Brazilian steel maker. Finally , on January 30, 2007, Tata Steel

purchased a 100% stake in the Corus Group at 608 pence per share in an all cash deal,

cumulatively valued at USD 12.04 Billion. The deal is the largest Indian takeover of a foreign

company and made Tata Steel the world's fifth-largest steel group.

The involved companies are: 'Tata Steel', formerly known as TISCO (Tata Iron and

Steel Company Limited), was the world's 56th largest and India's 2nd largest steel company with

an annual crude steel capacity of 3.8 million tonnes. It is based

in Jamshedpur, Jharkhand, India. [1] [2] It is part of the Tata Group of companies. Post Corus

merger, Tata Steel is India's second-largest and second-most profitable company in private sector

with consolidated revenues of Rs 1,32,110 crore and net profit of over Rs 12,350 crore during

the year ended March 31, 2008. [3][4]. The company was also recognized as the world's best steel

producer by World Steel Dynamics in 2005. The company is listed on BSE and NSE; and

employs about 82,700 people (as of 2007).

Corus was formed from the merger of Koninklijke Hoogovens N.V. with British Steel Plc on 6

October 1999. It has major integrated steel plants at Port Talbot, South Wales; Scunthorpe,North

Lincolnshire; Teesside, Cleveland (all in the United Kingdom) and Ijmuiden in the Netherlands.

It also has rolling mills situated at Shotton, North Wales (which

manufactures Colorcoatproducts), Trostre in Llanelli, Llanwern Newport, South

Wales, Rotherham and Stocksbridge, South Yorkshire, England, Motherwell, North

Lanarkshire, Scotland, Hayange, France, andBergen, Norway. In addition it has tube mills

located at Corby, Stockton and Hartlepool in England

and Oosterhout, Arnhem, Zwijndrecht and Maastricht in the Netherlands. Group turnover for the

year to 31 December 2005 was £10.142 billion. Profits were £580 million before tax and £451

million after tax.

Proposed funding of the Deal


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Tata surprised the credit default swap segment of the derivative markets by deciding to raise

$6.17bn of debt for the deal through a new subsidiary of Corus called 'Tata Steel UK', rather than

by raising the debt itself. Tata's security credit rating is investment grade, whereas the new

subsidiary may not be. The higher risk associated with raising debt through a subsidiary with a

lower credit rating prompted Fitch Ratings to downgrade its rating of the credit swap risks in the

takeover to 'negative'. Fitch also stated that Corus' responsibility for the debt may lead to Corus'

own unsecured debt rating being downgraded. This does not affect the rating of bonds issued by

Corus which are secured debt.

Mumbai-based Tata blindsided traders when it decided to borrow as much as $6.17 billion

through a non-investment-grade Corus subsidiary to fund the takeover of the largest U.K.

steelmaker. Tata, whose debt is rated investment grade, is using high-yield high-risk loans and

bonds, prompting Fitch Ratings to change its assessment of the merger to ``negative,'' with a

warning it may downgrade the securities of London-based Corus.

Many traders who sold credit-default swaps on the assumption that a takeover would be

completed with an investment-grade financing are losing money on the deal. Since Oct. 20,

credit- default swaps based on $2 billion of Corus debt have climbed 21 percent. An increase

indicates a worsening in the perception of credit quality. The contracts, based on bonds and

loans, are used to speculate on a company's ability to repay debt.

``It's clear that this came as a surprise to a certain part of the market,'' said Graham Neilson, a

fund manager at Credaris in London, which oversees $1.6 billion of assets.

Fitch said the plan to make Corus responsible for the additional borrowing may prompt it to cut

the company's senior unsecured credit rating from B+, four levels below investment grade. High-

yield debt is rated Ba1 or lower by Moody's Investors Service and BB+ or lower by Standard &

Poor's or Fitch.

More Flexible


http://en.wikipedia.org/wiki/Fitch

http://en.wikipedia.org/wiki/Credit_default_swap

``The combination of the two businesses at first seemed positive for Corus; now it's not clear

what kind of access Corus will have to financial support to service the debt and to Tata's stronger

operations,'' said Peter Archbold, a London-based analyst at Fitch.

Tata is seeking to create the world's fifth-largest steelmaker through its $8 billion acquisition of

Corus, formerly British Steel Plc. The deal would be the industry's second biggest this year,

behind Rotterdam-based Mittal Steel Co.'s $38.3 billion purchase of Arcelor SA in Luxembourg.

``The proposed financing ensures financial flexibility of Tata Steel'' to fund projects ``while

addressing the issues of risk,'' Koushik Chatterjee, Tata Steel's vice president of finance, said in

an e-mail, without providing details.

Tata Steel, India's second-biggest steelmaker, has expanded in Southeast Asia by buying

Thailand's Millennium Steel PCL and Singapore's NatSteel Ltd. in the past two years.

``The funding structure of the acquisition of Corus may suggest that Tata Steel may want to

pursue further expansion,'' said Roberto Pozzi, an analyst at Societe Generale SA in London.

`Caught Out'

Credit-default swaps based on Corus debt were quoted today at 162,000 euros, up from 133,800

euros on Oct. 19. The prices are based on 10 million euros of debt. The five-year contracts,

conceived to protect bondholders against default, pay the buyer face value in exchange for the

notes should the company fail to adhere to its debt agreements.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and

commodities, or linked to specific events like changes in the weather or interest rates.

``This has caught the market out,'' said Marwan Dagher, HSBC Holdings Plc's London-based

head of credit sales to hedge funds. ``The lesson here is that whenever an acquisition is about to

happen, you shouldn't go out and take a view'' on credit quality improving because ``there are

many ways to finance these.''


The debt, to be issued under the new name Tata Steel U.K., will rely on Corus's revenue for

payment, Fitch said in its Oct. 20 report. It includes a 1.35 billion-pound ($2.5 billion) high-

yield loan that will be repaid with a bond once Corus shareholders approve the acquisition, said a

banker working on the transaction who asked not to be identified.

Higher Costs

Corus will pay interest on its loans between 1.5 and 2 percentage points above the London

interbank offered rate, a benchmark for lenders, said a banker involved in the deal, who declined

to be named because the information hasn't been publicly disclosed. That's about five times the

interest margin of 0.34 percentage point that Tata is paying on a $750 million seven-year loan

taken out earlier this month, said an arranger of that deal.

The planned bond sale is likely to cost Corus annual interest of about 2.64 percentage points

more than benchmark government debt with similar maturities based on a B rating from Fitch,

according to data compiled by Merrill Lynch & Co. The spread is 1.87 percentage points more

than Tata would pay, based on its Baa2 rating from Moody's and BBB ranking from S&P. The

additional annual interest would cost the company at least $47 million, according to data

compiled by Merrill and Bloomberg.

Competitors for Corus

Tata's planned acquisition may face competition. Companhia Siderurgica Nacional SA, a

Brazilian steelmaker, hired New York- based investment bank Lazard Ltd. to advise on a

possible bid for Corus, the Sunday Times in London reported on Oct. 22, without saying where it

got the information. Russia's OAO Novolipetsk Steel may also bid for the company, the

Financial Times reported on Oct. 18.

``There is no 100 percent certainty that the deal will go through, as another bidder could emerge

or the current offer could be rejected,'' said Pozzi at Societe Generale.

Moody's, which ranks Corus's senior unsecured debt at B1, said on Oct. 23 it hadn't yet decided

whether to revise its ranking. S&P hasn't issued a report on Corus since an Oct. 18 statement that

the acquisition was likely to boost Corus's BB- credit ratings ``given the higher ratings'' for Tata.


``If they were prepared to just merge the whole thing, the debt would be rated a similar way as

Tata Steel, and it would probably be somewhat cheaper for them to do,'' said Rick Mattila, a

credit analyst at Dresdner Kleinwort in London.

Bond Buyback

Corus's bonds have gained since the takeover offer because Tata said it will buy them back.

Corus's 800 million euros of 7.5 percent notes due in 2011 increased to 108 percent of face value

from 105 percent last month, according to RBC Capital Markets Ltd. The bonds yield 5.56

percent, or 1.78 percentage points more than benchmark government debt with the same

maturities.

``For the bonds it's fairly straightforward, they're going to get bought back,'' said Robert Jones,

head of high-yield research at Barclays Capital in London. ``The way the financing is structured,

the credit-default swaps could end up being a lot wider than they are now.''


CONCLUSION

The Reserve Bank of India (RBI) has taken the first step towards introducing credit default

swaps (CDS) to India’s financial markets by sending out feelers to a number of banks with a

view to gauging the acceptability of CDS contracts. The questionnaire sent by RBI to the banks

enquires about bankers’ expectations from the derivative instrument. Although CDSs for the

Indian companies like ICICI Bank, Tata Motors, SBI etc. are already traded in US and some

Asian market it is yet to be traded in Indian market. And RBI is looking at CDS for debt issued

in the domestic market. The move by RBI to launch CDS in India is considered significant

considering its cautious nature and the role CDS played in subprime crisis. The move is

welcomed by some of the banks. “There is surely a need for such a product (CDS)” said Ashish

Vaidya, head of interest rate trading at HDFC Bank. “Indian regulators have the benefit of

learning from the difficult experience (in derivatives) in the West and can build in a robust

system that effectively curtails the concentration of risks in a few hands”. RBI expects to develop

the corporate bond market through the introduction of CDS contracts.

The CDS market will be an OTC market in India which means the deals between the protection

buyer and the protection seller will be bilateral deals making them do the negotiation and pricing

for the CDS contracts. In the infancy stage of CDS market in India one can have a trade

reporting platform which will be gathering all the information about the trades happening.This

will provide the required transparency and help in gaining the confidence in the product. Once

the market matures one can think of having an electronic order matching platform with central

counterparty settlement (like CCIL).

The Clearing Corporation of India (CCIL) was set up with the prime objective to improve

efficiency in the transaction settlement process, insulate the financial system from shocks

emanating from operations related issues, and to undertake other related activities that would

help to broaden and deepen the Money, Gilts and Forex markets in India. The roleof CCIL is

unique as it provides settlement of three different products under oneumbrella. It has been

instrumental in setting up and running electronic trading platformslike NDS-OM, NDS-Call and

NDS-Auction system for the central bank that had helpedthe Indian market to evolve and grow


immensely. It had also immensely bolstered CCIL's image in terms of ability to provide

transparent, efficient, robust and cost effective end to end solutions to market participants in

various markets. The introduction of ClearCorp14Repo Order Matching System (CROMS), an

anonymous Repo trading platform, has also changed the trading pattern in Repo market i.e.

shifting of interest from specific security to basket of securities. The success of its money market

product 'CBLO' has helped the market participants as well as RBI to find a solution to unusual

dependence on uncollateralized call market. The total settlement volume during 2009-10 in

government securities, forex market and CBLO stood at Rs.14934 billion, Rs.25424 billion,

andRs.20433 billion respectively.

The CCIL already has the necessary infrastructure for the settlement of OTC products like

interest rate swaps and forward rate agreement. CCIL already has a trade reporting platform for

IRS which provides non-guaranteed settlement for the reported trades. NowCCIL is moving

towards the guaranteed settlement of IRS which will involve tradematching, initial and MTM

margining, exposure check, novation, multilateral netting,default handling etc. On this backdrop

one can say CCIL is well equipped with all its experience to act as central counterparty for the

settlement of CDS contracts.

But before the introduction of CDS contracts in India, there are some issues that need to

be handled for the effective CDS market. Those are -

Although RBI has allowed insurance companies and mutual funds as protection buyer or

protection seller, the permission of respective regulators needs to be addressed quickly

before making CDS market open. Otherwise it may obstruct the stipulated expeditious

growth of the CDS in India and will also defeat the purpose of CDS, i.e., to maximize the

number of participants in the market and transmit the credit risk from the banking system

to other risk seeking financial entities.

As per the draft guidelines provided by RBI restructuring is considered as a credit

event which has created many legal disputes in the global CDS market. Considering the

complexities associated with the restructuring, restructuring as acredit event has been

removed from North American CDS contracts. So more clear information on

restructuring as credit event is required.


As CDS contract in India is only allowed if the protection buyer bears the loss making

it similar to insurance. Considering this close proximity of CDS contract with that of

insurance contract, CDS contract should be made to be out of the purview of regulations

of insurance contract making it in controvertible

Although CDS has helped in perforation of subprime crisis which has created negativevibes

about CDS but CDS as in instrument is very effective means of hedging your risk.And in India it

is expected to provide the needed push to the corporate bond market. So itwon’t be long for the

CDS market to pick up in India.


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