Credit Default Swaps-a balance between vigilance and fair play
Credit Default Swaps a balance between vigilance and free play In recent times the issue of credit risk management has been attracting a great deal of attention globally. Despite various structural developments risk-management practitioners and regulators are still overtly concerned about risk exposure and the issues related to credit default. Credit risk is defined as the loss associated with unexpected changes in credit quality. It can be incurred through the issuance of loans, as also by taking positions in corporate bonds or transactions in over-the counter (OTC) markets, which might involve the risk of default by a counter party. However the issues of credit risk management in the Debt markets is complicated by problems related to market imperfections (i.e. adverse selection-moral hazard issues), relatively longer tenures of credit and skewed nature of credit risk. Credit Derivatives have been used as hedging instrument to reduce credit risk associated with a loan or a bond and Credit Default Swap is one of the credit derivative instruments to reduce the credit risk on such loan or bond. In its last credit policy statement, released in April 2010, the Reserve Bank of India (RBI) indicated that it is actively working towards the finalisation of guidelines for credit default swaps (CDS). “As indicated in the Second Quarter Review of October 2009, the Reserve Bank constituted an internal Working Group to finalise the operational framework for introduction of plain vanilla over-the-counter (OTC) single name CDS for corporate bonds for resident entities subject to appropriate safeguards. The Group is in the process of finalising a framework suitable for the Indian market, based on consultations with market participants/experts and study of international experience. Accordingly, it is proposed to place the draft report of the internal Working Group on the Reserve Bank’s website by end-July 2010,” went the policy statement. (The same has been placed on Rbi website on August 04,2010) A credit default swap is an option/ insurance contract but called a swap more due to its longer tenor and pricing methodology, which is akin to pricing a swap contract. In short, it is a mutual contract between a protection buyer and protection seller. The protection is against the credit default by a reference entity with respect to a reference asset or assets. The buyer pays the premia, called spreads, denominated in basis points. Bank A can buy protection from Bank B on credit default by Corporate A either on a specific bond issued by Corporate A or a loan taken by it or multiple bonds issued by it. If the spread quoted is 156 basis points on a protection on Rs 100 million, then Bank A will pay Rs 1.56 million per annum for the protection to Bank B. If the protection is for five years, it will pay this premium until expiry of five years or a credit default by Corporate A, whichever is earlier. The normal market practice is for the premium to be paid quarterly. Example of A typical CDS Contract It is easy to see that the success of the contract lies in the ability of the protection seller to settle on his obligation when the claim is made consequent to a credit default. In the case of insurance also, the success lies in the ability of the company to meet its obligations when claims are made. For this reason, insurance companies are regulated and the risks they take are examined periodically. The premium they charge is expected to be commensurate with the risk they take, except when the premium itself is prescribed by the regulator or government. In the same way, market makers in this product would have to be monitored to ensure that they have adequate capital when a claim is made. If a market maker sells too many credit default swaps against the same reference entity, it could result in problems for them when that reference entity defaults. As a derivative, CDS can be used for speculation, arbitrage, trading and hedging. If those with an exposure to the underlying credit can buy a CDS, then speculation and trading would be ruled out. The users would also depend on the regulations and participation by insurance companies and mutual funds would depend on the respective regulator’s permission. The regulatory concern should be with fairness to the buyers of the product, ensuring ability of the seller to meet its obligations when claims are made and an orderly mechanism to determine the amount payable in the event of a credit default. CDS is purchasing protection against a credit default by the reference entity. In the international market, CDS is normally linked to outstanding bonds issued by the reference entity. In case of default, the buyer of the protection can deliver any of the underlying bonds indicated in the contract. As such, there may be an advantage in delivering a particular bond, which would maximise his gain from the CDS contract. Even if the contract is not physically settled but cash-settled by paying the loss on the underlying bond, this loss is determined within a defined period of 30-60 days after the default event. If the bonds do not trade or lack liquidity, then polled price is determined and settlement effected. In the Indian context, the debt on the books of most borrowers includes loans from banks and financial institutions. Default recovery cases drag on for as long as 20 years with multiple appeals. A CDS market cannot wait for a long time for settlement after default. One alternative could be to determine the value at which the Asset Reconstruction Company (India) Ltd Arcil would be willing to take over the asset. This must be acceptable to the writers of the CDS as well as buyers. The primary use, as focussed by RBI, is purchasing credit protection. If any bank has lent money to any corporate and feels that it must reduce the risk of that exposure on its books, it can buy protection. Consequential impact on its capital adequacy and risk rating would also matter. If there is no benefit in that, banks may be reluctant to buy protection. The protection could be purchased on average outstanding at any given point in time. In case the parent organisation fails, the buyer can recover his money from the writer of the protection. The trick in such cases would be to determine whether to buy protection for five years or for one year at a time and roll it over. Buying for one year would be cheaper only if there is no credit deterioration. If that happens, the future rollover premiums can be very high. To buy protection, there must be a counter party, typically a banker, who is willing to write the option. That means he has to take a credit exposure to that reference entity for the first time or may add to his existing exposure. RBI’s focus (post-credit crisis) would be to ensure that the writer has set aside adequate capital to meet his obligations when a default event triggers a call for payment. A supplier would have to weigh the cost of CDS against other protection methods like letters of credit, non recourse factoring, bank guarantee etc. If CDS is permitted, there must be a clear mandate under law for assignment of the receivables for the writer to take over the position of the creditor and demand payment of the recoverable amount. A speculator with a view of either the spread widening or narrowing can use the CDS market to trade his view. Assume that Speculator A has view that spread on Corporate M is likely to narrow. He can write a CDS contract and receive the premium. Later, when the spread narrows, the premium payable will come down, at which point he can buy a CDS for the same maturity at a lower cost and then receive the difference for the rest of the maturity period. As with any speculation, if the view is wrong and spread widens instead of narrowing, he can lose his shirt. If he expects the spread to widen, he would do exactly the opposite. Relative value trade: Here one bets on the spread between two reference entities. Let us say spread on Corporate A is 300 basis points (bps) and on Corporate B is 400 bps and the speculator expects this spread to narrow to 50 bps. He can buy protection on A and sell protection on B. Note that credit spread on both can go up or down, but the spread between them is expected to reduce. When that happens, he sells protection on A and buys protection on B. In the first contract, he earns a spread of 100 bps and on the second he pays a spread of 50 bps, netting the difference. If the spread widens, bad luck! Credit curve steeping: The focus is on a single reference entity. Let us say for a top rated corporate the 5 year protection is quoted at 65 bps and 10 year protection at 90 bps. He will sell protection for 5 years and buy protection for 10 years. The contract is structured on the basis value point basis, i.e. for a basis point change in interest rates how the CDS spread would move. Hence, the notional principle on 5 year will be more than on 10 year to ensure the gain/loss to offset on the two contracts. When the credit steepens, this spread will widen and contracts can be reversed. In all these contracts, it is also important to note that there is an implicit credit risk on the writer of the CDS and if the writer defaults, there could be consequential loss. Further, if the market turns out against the view point, there could be losses. Nobel Laureate Joseph Stiglitz makes a scathing attack on CDS as self inducing credit problems in the market. “People were not buying insurance, they were gambling. Some of the gambles were most peculiar and gave rise to perverse incentives,” he writes in his book Fee Fall. He goes on to say that an institution buying a protection against a reference entity without an exposure can manipulate a thin market to drive the spreads up. Increase in spreads leads to market perception of higher risk, reducing the share price, increasing cost of borrowing etc, leading to a self fulfilling prophesy of default on the underlying. Is underlying required in CDS? CDS without the underlying cash market position is one of the most important issues which has emerged post sub prime crisis. A CDS without an underlying is one where the buyer of protection has no risk exposure to the underlying entity. This enables market participants to go short on credit risk. Such CDS position, i.e., holding long CDS positions while not having the underlying credit exposure, permits participants to speculate on the future credit events and also increases market liquidity. For example, if the participants expect the credit rating on a particular corporate to worsen due to bad financial results, they may purchase CDS and reverse the position when the credit event actually happens. inability to take naked CDS positions would limit participation to only a handful of counterparties having underlying exposure, thus impeding market liquidity and development. However allowing purchase of CDS without having the underlying risk exposure may result in huge build-up of CDS positions that have systemic implications. A scenario where the amount of outstanding CDS is significantly higher than the total bonds outstanding is fraught with settlement risks. The risk of moral hazard (i.e., protection sellers like banks and insurance companies taking too much credit risk without adequate risk appraisal and monitoring) also exists. Thus underlying appears to be a more feasible and appropriate option Standardisation of CDS contract. Standardisation improves the trading of the derivative instruments and it helps to shift the trading from OTC market to Exchanges with a Central Counter party. Pricing Methodology of the CDS Credit Default Swaps require the development of sophisticated risk modelling techniques in order to be marked-to-market. There are multiple valuation models available to price / value CDS contracts. Theoretical models used in pricing/valuation of CDS including CDS pricing through ‘cash market replication’ by way of creating an arbitrage-free, risk-less hedge. As the CDS contract is a bilateral transaction, there are no regulator-prescribed valuation models. However, with the clearing and settlement of CDS contracts migrating to centralised platforms, there is an emergence of common valuation models brought out by entities like Markit / ISDA. In the Indian context, while most of the participants uniformly use FIMMDA valuation prices for valuing their G-sec portfolio, no similar uniform valuation model is available for Interest Rate Swaps. As regards end of day valuation of positions, Markit plays a crucial role in European and the US markets by polling the end-of-day rates from dealers and ensuring that the rates polled are indeed reflective of market prices. The role is specialized as it requires modifing the data for outliers, checking the consistency between similar risk grades and valuation of positions. FIMMDA can assume this responsibility. Variables that affect CDS prices - In a risk-neutral valuation, the price of a single-name CDS over time will be given by: • Marginal Probability of Default • Timing of Default • Recovery Rate The important thing is to ensure that the assumptions in the model are: • Realistic • Periodically reviewed and changed, if necessary Types of Risk in CDS 1 Basis Risk In CDS, it is caused by a maturity mismatch wherein a CDS covering the exact remaining maturity of a bond may not be readily available. Credit Risk Counterparty risk is the risk that the counterparty to a CDS contract will default and not meet its contractual payment obligations. For CDS, as with other OTC derivatives, counterparty risk is an important risk that needs to be managed. Wrong way Risk It is the probability of simultaneous default of both the reference entity and the protection seller Wrong way risk is a source of risk for the protection buyer and not for protection seller. Concentration Risk Concentration risk results from disproportionately large net exposure in similar types of CDS. This has been evident in recent financial crisis when few large entities underestimated the risk and sold significant amount of CDS protection on related reference entities without holding offsetting position Operational Risk CDS involves a number of steps to process the trade which are prone to operational risks. One of the major risks is related to outstanding trade confirmation. The backlog of unconfirmed trades may allow errors to go undetected that might subsequently lead to losses and other problems Legal Risk Legal risks in CDS may arise due to non-adherence to the legal framework (laws, guidelines, etc.) prevailing in the country The lack of standardization and clarity in the definition of credit events and settlements can also lead to misunderstandings and legal problems. It is hardly surprising that the Reserve Bank of India’s (RBI’s) decision to revive a plan, first mooted in 2007, to introduce credit default swaps (CDSs) in India has met with considerable apprehension. CDSs along with another set of financial instruments described by a similar acronym, CDOs (credit default obligations), earned a fair share of notoriety during the global financial meltdown of 2008. In fact, the collapse in the markets for these instruments was one of the key factors that brought the western banking to its knees. The Indian central bank’s critics would argue that in introducing this instrument, it has chosen to ignore the lessons of the financial crisis, a decision that it is likely to rue later. The counter-argument is that instead of somewhat naively withdrawing into a shell of anti-market dogma, RBI has taken a far more nuanced view of the financial crisis and the lessons it has to offer. This is incidentally not the first financial instrument that RBI will promote since the advent of the financial meltdown. It introduced both currency and interest rate futures in 2009. The RBI’s decision to go down the path of financial market development suggests that, in its assessment, it was not the existence of these instruments per se that precipitated the financial collapse in the western markets. Instead, it was the over-sophistication of the markets (manifested in the creation of bewilderingly complex instruments and equally complex transactions) coupled with leveraged speculative positions that proved to be their undoing. This was abetted by a lax regulatory regime. Credit default swaps are akin to insurance and offer protection against default by bond-issuers. The problem in the western markets was that CDSs were offered for all sorts of exotic, “structured” products like CDOs and mortgage-backed securities (MBS), not just for plain vanilla bonds. This along with liberal guidelines for reporting these transactions severely compromised transparency. Loose regulations meant that CDS purchases were not confined to actual holders of the underlying bonds or financial assets but were actually exploited by hordes of speculators to bet on the markets. Of the notional value of outstanding CDSs of $45 trillion in 2007, $20 trillion was estimated to be “speculative”. RBI guidelines for CDSs in India guard against both these problems. CDSs can be offered only for simple corporate bonds and can be bought only by actual holders of the underlying assets. Besides, the central bank has insisted on a standardised instrument and has laid down strict guidelines for reporting transactions to ensure transparency. The payoff from a thriving CDS market can be significant. Most importantly, by offering bond-holders a way to hedge risks, it can breathe life into the moribund corporate bond market. The danger, ironically enough, is that in order to reduce systemic risk, RBI could “over-regulate” these new markets and effectively smother them. This has happened with the interest rate futures market. RBI has taken a correct step in promoting new instruments. It now has to strike a balance between regulatory vigilance and creating the right set of incentives to attract participants into these nascent markets.