Credit Default Swaps – India

FIMMDA – PDAI 13th Annual Conference 2012

DATE: 27th January 2012

Ben Davies
Head of Credit Trading, DBS Singapore
 The Evolution Of A Product
1994 : The First Ticket
Ms Blythe Masters of JP Morgan closes what’s widely acknowledged as the first CDS
trade by buying protection from the EBRD on the corporation Exxon after the Exxon
Valdez oil disaster spiked failure concerns on the worlds second largest oil company.

1995 - 1999: The Wild West

All major Wall Street and London dealing houses create their first CDS desks.

•Documentation, bespoke & a mess

•Liquidity, none to a little more
•Intent, a rapid change in customer focus
•ISDA 99, the first true milestone

2000 - 2003: Over Taking Bonds

Single name CDS now quoted across the capital structure and Rating spectrum.
Volumes spike to eclipse the products that CDS was created to hedge. The death of
Enron & the Dot Com collapse test the fledgling settlement process’s.

•IBOXX & TRAC X – The birth of the indices

•Documentation back logs, errors & fears… A scary paper trail
•Mark-It Partners & DTCC. Transparency surges volumes once again.
•ISDA 2003 sets the standard for standardization.
Private & Confidential
2
 The Evolution Of A Product
2004 - 2007: The Ugly Years
As CDO’s mutated from Cash to Synthetic the market first ran then sprinted before its time. Many
good lessons however were learned from the mistakes.

•Tranches, CDO Squares, SPV’s, The great correlation unwind….

•Delphi & Dana personify physical settlement “Price Squeezes” & the market takes notice.
•Market moves to IMM settlement.

2008 - 2011: Hank Paulson Understands ISDA 2003

CDS in the Great Credit Crisis... Suddenly EVERYONE is in the same boat.

•The importance of the word “Conservatorship”… The effect on CDS enters the decision line.
•Big Bang, Little Bang & Standardised coupon initiatives.
•Central clearing evolves… Dodd-Frank enforces.
•Explosion in volumes of global index.

2012 & Beyond :

The market nears what its always set out to need….

•Standardised & trusted documentation representing a solid and defined legal structure.
•True Assimilation in structure & central clearing as the norm.
•A balance of market participants to truly reflect true value and avoid skewed pricing

Private & Confidential

3
Credit Default Swaps – India
FIMMDA – PDAI 13th Annual Conference 2012

DATE: 27th January 2012

Gigi P. Tan
Global Content Specialist – Credit
1995/1996:
The concept of
a Credit Dec’11: Indian market
protection 2009: More sees first INR-
instrument is Later in 2004 standardisatio denominated CDS
created by JP 1999/2000: The they were n mainly in trades (Rural
Morgan and market opens to merged to form valuation with Electrification Corp
Single Name more parties. We iTraxx for Asia the Big Bang and India Railway
CDS starts to see some first and Europe, and (Apr) and Finance Corp)
trade real volume from the DJ CDX for Small Bang
IDBs North America. (Jul) Protocols.

1995 1997 1999 2001 2003 2005 2007 2009 2011

1998: first basket Mar 2003: ISDA Jun 2005: ISDA Nov’10: The Chinese
trades definitions creates market opens for
become the definitions for Credit Mitigation
market standard. CDS on ABS Instruments with
Oct 2003: IBOXX CRMA and CRMW.
and TRAC-X CDS
Indexes are
created.

5
Evolution of CDS: Global Growth (2001~2012)

Source: ISDA Market Survey (2001~10), DTCC (2010~12)

6
 Challenges in the Asian Market

Negative Mindset on CDS

Pricing
- Lack of Default Statistics/ Empirical Data
Market Liquidity
- Reference vs. Deliverable Obligations
- Standardisation of Contracts
Settlement issues
- Proper legal framework
- Central clearing
- Determination Committee

7
 Challenges in the Asian Market

• A Negative Mindset
– CDS at market inception = Hedging Tool
– implies exposure to highly risky credits
– As market evolves CDS becomes THE primary tool to take a
position on a Credit
– a very active market in CDSs written on credits in which neither
the buyer nor the seller of protection believes there is the
remotest possibility of default

• China: Credit Risk Mitigation Instruments

– Hesitation to use the term “Default”
– Hesitation to expose volume information (NAFMII)

8
 Challenges in the Asian Market : Pricing
• Lack of Empirical Data/Default Observations
• Asia (ex-Japan)*

*Asia refers to Cambodia,

China, Fiji, Hong Kong,
India, Indonesia, Korea,
Malaysia,Marshall Islands,
Mongolia, Pakistan, Papua
New Guinea, Philippines,
Singapore, South Korea, Sri
Lanka, Taiwan, Thailand, and
Vietnam

• 48 defaults in 17
years
• Japan: 3 CDS
defaults since 2003

9
 Challenges in the Asian Market : Pricing

• Lack of Empirical Data/Default Observations

• India

• Fitch India
National
Ratings 2010
Transition and
Default Study
• 18 defaults in 11
years

10
 Challenges in the Asian Market : Liquidity

Opaque Market
• Banks Price approximately 2,500 Single Names
• The liquid part of the Market is no more than 1,000.
• Many do not price daily, most do not have pricing in the full term
structure.
• 5Y Contracts are by far the most liquid.

Reference vs. Deliverable Obligations (CRMs)

• CRMs specify a deliverable obligation
• No naked positions
• Standardisation of Contracts

11
 Other Challenges: Settlement issues

Proper legal framework

• Weak bankruptcy laws in Asia
• E.g. Takefuji

Central Clearing
• transparency of CDS volumes trading
• DTCC has 98%* visibility

Determination Committee

*source: ISDA media comment Nov 2011

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Credit Default Swaps – India
FIMMDA – PDAI 13th Annual Conference 2012

DATE: 27th January 2012

H. Jayesh
Founder Partner, Juris Corp
 Eligible Participants
 Market Makers
• Commercial Banks
• Primary Dealers
• NBFCs#
• Mutual Funds*
• Insurance Companies*

 Users
• Market Makers
• Housing Finance Companies
• Provident Funds
• Listed Companies
• FIIs

* Subject to permission from their respective regulators

#
Currently only as Users
 User Restrictions / Obligations
 Only Indian Resident or Registered FIIs

 Only hedging / buy protection

 No naked CDS
• Hold Reference Obligation or Unwind
• CDS protection value ≯≯ FV of Reference Obligation
• CDS tenor ≯≯ Reference Obligation maturity

 Submit auditor / custodian certificate of holding underlying bond when

entering into / unwinding the CDS contract
 User Restrictions / Obligations …contd
 On selling the Reference Obligation:
• Assign CDS with the Reference Obligation or
• Negotiate termination
 Hardwired termination:
• Uncovered CDS Event occurs within 10 Business Days
• CDS terminated and Buyer pays the Seller CDS Transaction Costs (one
way payment only)

 Failure / Non compliance - Not an Event of Default or Termination

Event

 Cannot enter into an offsetting trade

 Reference Obligation
 Must satisfy ALL of the following at ALL times:
• Bond denominated in INR
• Direct obligation of the Reference Entity (no guarantees)
• Dematerialised format
• Freely transferrable without any contractual, statutory or
regulatory restriction (including SEBI lock-in requirements)
 Reference Obligation …contd

 Any ONE of the following:

• Listed
• Rated by any Rating Agency
• Obligation in respect of which the Reference Entity is an SPV
that is an Affiliate of an Infrastructure Company
 Reference Obligation …contd

 Must NOT be:

• Short Term Instrument (commercial paper)
• Asset-Backed Security
• Convertible Obligation
• Exchangeable Obligation
• Interest Receivable
• Puttable or Callable

 Consequences of failing Reference Obligation criteria on Trade Date

(or date of identifying Substitute Reference Obligation) - Terminate at
zero cost (no MTM, no Event of Default or Termination Event)
 Deliverable Obligations
 User MCA
• Reference Obligation Only (consistent with User obligation to hold the
Reference Obligation)

 Market-maker MCA:
• Reference Obligation
• Deliverable Obligation Category: Bond
• Deliverable Obligation Characteristics: Not Subordinated, Not Sovereign
Lender, Not Contingent, Transferable, Maximum Maturity (30 years) and Not
Bearer
• Denominated in INR and dematerialised format
• Other than:
• Short Term Instruments (commercial paper)
• Asset-Backed Securities
• Convertible Obligations
• Exchangeable Obligations
• Interest Receivables
• Puttable or Callable obligations
 Obligations
 Reference Obligation
 Obligation Category: Bond or Loan
 Obligation Characteristics:
• Not Subordinated and Not Sovereign Lender
 Excluded Obligations
• Short Term Instruments (commercial paper)
• Interest Receivables
 No guarantees
 No currency limitations
 Credit Events
 Restructuring (Article 4.7) – substituted clause:
• BIFR decision
• Reference Entity is declared a Relief Undertaking or is granted
statutory protection from its creditors or from enforcement of any
monetary claims
• Reference Entity is referred to Corporate Debt Restructuring
Credit Default Swaps – India
FIMMDA – PDAI 13th Annual Conference 2012

DATE: 27th January 2012

Jacqueline ML Low
Senior Counsel, Asia - ISDA
 Indian Determinations Committee
 Determinations of Indian DC are legally binding on anyone who uses the
Market-maker MCA or User MCA.
 Representation on DC.
• 7 Market-maker FIMMDA members:
 2 Public Sector Banks.
 2 Private Indian Banks.
 2 Foreign Banks.
 1 Non-Banking Financial Company.

• 4 User members.
 Transparency.
 International experience.

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 Basis Risk
 Between Indian and offshore CDS.
 Between Market-maker and User CDS.
• Ref Ob CDS for User.
• Physical Settlement Period.
• Uncovered CDS Event.
• Substitution Trigger Event c/f Substitution Characterisation Event.

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Credit Default Swaps – India
FIMMDA – PDAI 13th Annual Conference 2012

DATE: 27th January 2012

Mr. Vaidya Nathan

Director, Quantum Phinance
 Credit Default Swap

A privately negotiated, off balance sheet

agreement that explicitly transfers credit
risk from one party to another

Buyer of CDS protection need not

Buyer of protection need not
suffer an actual loss to receive own the defaulted asset in order to
compensation receive compensation

Credit
C R E D I T   D E F A U L T   S W A P S

Default
Swaps

Vaidya Nathan

1
 Credit Default Swaps market completion

Bond / Loan Asset Swap Credit Default

Swap

Credit Risk
Credit Risk

Funding Risk Credit Risk

Funding Risk
C R E D I T   D E F A U L T   S W A P S

Risk Free Rate

Vaidya Nathan

2
 CDS in the context of financial markets growth

New applications
expanding financial
instruments use

s are As
se
t n e
d u sp d te t cla
c a x
o
pr g to thir mtsar nded sses
w in & ke
Ne erg nd oduc ts bey gett
C R E D I T   D E F A U L T   S W A P S

o
em sec n pr on i
d t ng
io rad
e rat itio
e n na
g l

Vaidya Nathan

3
 Role of CDS
Uses
Uses of
Uses
Uses ofCredit
ofof Credit Default
Credit Default
Credit Default
Default Swaps
Swaps
Swaps
Swaps
Hedge,
transfer and/or
Synthetically mitigate credit Decompose
create loan- exposure and separate
bond; credit risks
alternative to embedded in
equity financial
derivatives instruments

Generate Proactively
leverage or manage credit
yield risk on a
enhancement Manage portfolio basis
C R E D I T   D E F A U L T   S W A P S

regulatory
capital ratios

Vaid Nathan

4
 CDS isolate and transfer credit risk
• Broad definition
– bilateral financial contract which allows specific aspects of credit risk to be
isolated from the other risks of an instrument, and passed from one
counterparty to another

Credit 60 bps
Loan/bond

FX, 6.60 %
C R E D I T   D E F A U L T   S W A P S

Interest yield
Rate

On-balance sheet Off-balance sheet Vaidya Nathan

5
 Efficiency gains arising from disaggregating risk
through CDS

Auctioneer sells a number of risks,

each to the highest bidder

JOB LOT
C R E D I T   D E F A U L T   S W A P S

Vaidya Nathan

6
 Applications for CDS in the global market
Motivations
Motivations for
for using
using Credit
Credit Default
Default Swaps
Swaps

1. Trading/ market making

2. Product structuring

3. Hedging trading
instruments

4. Active portfolio/ asset

management

5. Management of
economic capital
C R E D I T   D E F A U L T   S W A P S

6. Management of
regulatory capital

7. Management of
individual credit lines

Vaidya Nathan

7
 Breakdown of market participation

Market
Market Composition
Composition
C R E D I T   D E F A U L T   S W A P S

Vaidya Nathan

8
 Credit Derivatives by region
Credit
Credit Derivatives
Derivatives by
by region
region
C R E D I T   D E F A U L T   S W A P S

Vaidya Nathan

9
CREDIT DEFAULT SWAPS
Global Credit Derivatives Product Usage

Vaidya Nathan
10
 Global Credit Derivatives Product Usage

Global
Global Credit
Credit Derivatives
Derivatives Product
Product Usage
Usage
C R E D I T   D E F A U L T   S W A P S

11
Vaidya Nathan
 Credit rating of underlying reference entity in CDS

Credit
Credit rating
rating of
of the
the underlying
underlying reference
reference entity
entity
C R E D I T   D E F A U L T   S W A P S

Vaidya Nathan
12
 Tenor distribution of CDS
Maturity
Maturity
C R E D I T   D E F A U L T   S W A P S

Vaidya Nathan

13
 Market Constraints
Constraints
Constraints in
in using
using Credit
Credit Default
Default Swaps
Swaps

1. Lack of client
knowledge of the product

2. Regulatory constraints

3. Systems / Infrastructure

4. Pricing – lack of data

5. Lack of agreed
accounting conventions
C R E D I T   D E F A U L T   S W A P S

6. Lack of homogenous
documentation

7. Lack of market liquidity

and depth
Vaidya Nathan

14
Credit Default Swaps – India
FIMMDA – PDAI 13th Annual Conference 2012

DATE: 27th January 2012

Mr. Gaurav Pradhan

MD & Head, Global Credit Trading,
Deutsche Bank, Mumbai
 Journey so far...
2011 – Capital adequacy
2010 – Internal Group report in
guidelines released in November
Introduction of CDS released in
July
First trade printed in December
between ICICI and IDBI
Detailed policy framework with
2003 – 1 Draft Guidelines
st discussion on international
practices
Scope of allowing banks
and financial institutions to
use credit derivatives

2007– 2nd Draft Guidelines

2011 – 3rd Draft Guidelines
To permit Banks and PDs in Feb and Final Guidelines
to deal in single-name in May
CDS. Kept in abeyance on
account of global financial Final guidelines published
crisis to be effective from October

42
 Global Experience

RBI introduced CDS in the Indian market at the right time. It could draw upon the
experience of the western world during the Financial Crisis of 2008 and incorporate
important safeguards since the inception:
 Avoid complexity: Products like CDOs, ABS, MBS not allowed
 Curb Speculative activity: Users allowed to only hedge long positing in cash bonds
 Regulatory limits: Avoid excessive risk taking by putting limits like single name
exposure, gross PV01 limits
 Standardized contracts: Enable trade reporting; enable trde compression thereby
reducing systemic risks on account of large number of open contracts
 Regulatory oversight: Mandatory reporting of trades on central platform; Regulator
can monitor activity of participants and avoid any misuse/ large concentration of risk
 Central Clearing Counterparty: Important to avoid counterparty risk; Will be
introduced when volumes pick up and viable to implement

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 Role of FIMMDA – So far

FIMMDA played a key role in developing the market infrastructure:

 Documentation:
FIMMDA in liaison with ISDA and market participants helped in developing market
standard documentation (MCAs)
 Determinations Committee:
Scope and role of DC was defined; Initial list of DC members finalized
 Market-Makers
Market maker volunteers were identified
 Valuation Methodolgy
Methodology for daily valuation of CDS positions was developed. External vendor
was identified and mandated with the task of polling/ publishing curves

44
 Role of FIMMDA – Future

Next steps required for market to develop:

 Activation of DC for continuous monitoring
 Standardized Margining policy
 Various supporting regulators like SEBI/ IRDA to evolve a framework allowing for
participants like Insurance companies/ Mutual Funds/ FII
 Central counterparty settlement
 Support training and development requirements for banks – Front office/ Middle
office/ Back office/ legal etc.

45
 Market participants

Market Makers Users

Banks Mutual Funds

PDs Insurance Cos

NBFCs

FIIs

Corporates

Banks and PDs have been permitted by their Regulator to be market-makers (Onus
on them to ensure that the market develops)
Insurance cos/ MFs/ FIIs are yet to receive support from their respective regulators

46
 Key Contributions
On behalf of FIMMDA, we would like to thank the market participants for their active involvement and
contribution in making the product go live:
 ICICI Bank
 IDBI Bank
 SBI
 Central Bank of India
 HSBC
 Standard Chartered
 Morgan Stanley
 Barclays
 Citi
 JP Morgan
 Bank of America
 ICICI Securities Primary Dealership

Additionally we would like to thank the following agencies

 Thomson Reuters, Markit, Bloomberg, Newswire18
 ISDA
 Juriscorp

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Thank you!
Questions?

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