Draft Report of the Internal Group
Introduction of Credit Default Swaps for
Reserve Bank of India
LETTER OF TRANSMITTAL
Internal Working Group on CDS
Reserve Bank of India
Mumbai – 400 001
July 28, 2010
Smt. Shyamala Gopinath
Reserve Bank of India
I have great pleasure in submitting the Draft Report of the Internal Working Group to finalise the operational framework for introduction of plain vanilla OTC single-name CDS for corporate bonds for resident entities. The Group, in consultation with the various market participants and taking into account international experience in the working of CDS, has finalised the operational framework for introduction of CDS in India.
On behalf of the Members of the Working Group, and on my behalf, I sincerely thank you for entrusting this responsibility.
(Mohua Roy) (Rajinder Kumar) (K.Sivaraman)
Member Member Member
(R.Subramanian) (A.Unnikrishnan) (G.Seshsayee)
Member Member Member
Chapter Details Page No. No.
I Introduction 4
II 11 CDS for Indian Markets - Product Design
III Regulation and Risk Management in CDS 28
IV Trade Reporting & Information Dissemination 39
V Centralised Clearing and Settlement of CDS 43
VI Summary of Recommendations 48 Annex I Constitution of the Group and the Terms of Reference 55 Annex II Credit Derivatives – Concepts 57 Annex III Types of Risks in CDS 69 Annex IV CDS contract reporting formats 73 Annex V Working of CCPs for CDS in US & Europe 74
LIST OF ABBREVIATIONS AS - Accounting Standard
BIS - Bank for International Settlements BSE - Bombay Stock Exchange
CCIL - Clearing Corporation of India Limited CCM - Credit Clearing Member
CCP - Central Counterparty
CD - Certificate of Deposit
CDS - Credit Default Swap
CFTC - Commodity Futures Trading Commission CME - Chicago Mercantile Exchange
CP - Commercial Paper
CPSS - Committee on Payment and Settlement Systems CRAR - Capital to Risk (Weighted) Assets Ratio DC - Determination Committee
DTCC - Depository Trust & Clearing Corporation FIMMDA - Fixed Income Money Market and Derivatives Association of India
FRBNY - Federal Reserve Bank of New York FSA - Financial Services Authority, UK ICE - Inter Continental Exchange
IIFCL - India Infrastructure Finance Company Limited IOSCO - International Organization of Securities Commissions IRDA - Insurance Regulatory and Development Authority ISDA - International Swaps and Derivatives Association, Inc. MTM - Mark-to-market
NBFC - Non-Banking Financial Company NCD - Non-convertible Debenture
NDS - Negotiated Dealing System
NPA - Non-performing Assets
NSCCL - National Securities Clearing Corporation Limited NSE - National Stock Exchange of India OTC - Over-the-Counter
PDs - Primary Dealers
SEBI Securities and Exchange Board of India SEC - Securities and Exchange Commission SPAN - Standardised Portfolio Analysis of Risk SPV - Special Purpose Vehicle
TIW - Trade Information Warehouse
1.1 Need for Credit Risk Mitigants
Effective management of credit risk has become increasingly critical for banks‟ and other
financial institutions‟ risk management strategy to ensure that their financial health remains sound. Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures. Financial entities can use a number of techniques to mitigate the credit risks to which they are exposed. For example, exposures may be collateralised by first priority claims, in whole or in part with cash or securities; a loan exposure may be guaranteed by a third party; through securitization of the exposure or through buying a credit derivative to offset various forms of credit risk. In the absence of credit derivatives market, the options available to the participants for controlling or transferring their credit risks are confined to the aforementioned traditional means. Besides providing hedge against credit risk in the existing portfolio, credit derivatives also facilitate price discovery in the credit market and help the banks and financial institutions in better pricing of the credit risk in future. Thus, availability of credit derivatives enables the participants to easily trade in credit risk and hive off/assume credit risk and facilitate to complete markets.
1.2 Growth of Credit Default Swaps (CDS) market
1.2.1 Since mid-1990s, growth of the credit derivatives market in global arena has been phenomenal. As per the data available on the Depository Trust & Clearing Corporation (DTCC) website, the notional outstanding amount of CDS has increased from USD 4.8 trillion in 1998 to USD 30.4 trillion in 2009. Credit derivatives have become important credit risk transfer products and are integrated with credit trading and risk management at many firms. The growth in the credit derivatives market has been driven by the standardisation of documentation, increase in product applications and diversification of participants.
1.2.2 A driver of the growth in credit derivatives is the ability of market participants to use them to express credit views which were not as easily done in the underlying bonds, such
as: views about the shape of a company‟s credit curve, credit volatility, capital structure,
timing and pattern of defaults, etc.
1.2.3 Globally, single-name CDS is the most widely used product. As per the latest data published by DTCC (week ending July 23, 2010), Single Name CDS accounted for 58 per cent of total volume of CDS, while Credit Default Index and Credit Default Tranche accounted for 32 per cent and 10 per cent respectively.
1.3 Recent International Developments – Policy Initiatives
1.3.1 In September 2008, CDS assumed center-stage as one of the causes of Lehman Brothers' bankruptcy which accentuated the global financial crisis. In the case of Lehman collapse, market participants and supervisors were confronted with the failure of a CDS counterparty that was also an important reference entity. This was followed by near-collapse of AIG, a global insurance major and its eventual bailout which was one of the largest bailouts in the US history costing over USD 170 billion of tax payers‟ money. The
reasons for AIG‟s problems were large exposures to un-hedged CDS contracts written on sub-prime mortgage securities and acceleration of collateral calls due to housing crisis leading to severe financial strain.
1.3.2 These cases along with a host of other credit events revealed a number of structural deficiencies in the OTC derivatives markets during the financial crisis. Inadequate management of counterparty risk, interconnectedness of large market participants, non-transparency of transactions and positions, complexity concerning actual risk exposures and danger of contagion, were the issues which engaged the attention of legislators, regulators and market participants.
1.3.3 Further, the OTC derivatives markets were thinly regulated in the US and Europe. In the US, bilateral transactions like CDS between sophisticated counterparties are excluded from regulation under Commodities and Futures Modernisation Act of 2000. Several concerns have been expressed with regard to CDS and its negative impact on credit markets such as the existence of perverse incentives in CDS markets, the idiosyncratic risks such as jump-to-default risk which are difficult to measure or anticipate, shallowness in terms of participation by a few big investment banks taking majority of positions with considerable power to set prices, and problems associated with moral
hazard etc. As the CDS is a bilateral over-the-counter derivative contract under minimal regulatory oversight, the possibility of building up of massive speculative positions and also the incentives for coordinated manipulation exist. Further, the informational effects of the CDS volumes and prices due to speculative activity can spill over to the cash markets with a potential to increase the borrowing costs for sovereigns / firms, making it difficult to raise funds, especially in situations of financial stress.
188.8.131.52 CDS could also impact the real sector as the viability of the firms would be threatened due to increase in borrowing costs; imposing significant economic and social costs. Several observers commented on this aspect during the recent Greek sovereign debt crisis wherein spreads on Greek sovereign CDS rose in anticipation of fiscal troubles. This made the rollover of Greek sovereign debt very costly. There exists an apprehension that unbridled speculation through CDS would, result in increasing the borrowing costs for the governments which would impose significant social / economic costs on the people. As various negative externalities were attributed to CDS, recently Germany banned European sovereign CDS in May 2010. China had also reconsidered its decision to introduce CDS
1.3.4 As these markets possess considerable systemic importance and their efficient functioning has implications for financial stability, internationally, the following initiatives have been launched in various jurisdictions to deal with the issues relating to CDS :
a) Increased policy attention on CDS: Considerable policy attention is focused on the
OTC markets in general and CDS markets in particular. G20, European
Commission, OTC Derivatives Regulators Forum and American and European
legislators and regulators are taking steps to reform the OTC derivatives markets
and reduce systemic risk. In the aftermath of the crisis, the US government
proposed a comprehensive regulatory regime for OTC derivatives. Legislative
initiatives like the Dodd Bill (which was enacted in July 2010 as Wall Street Reform
and Consumer Protection Act) in the US and European Market Infrastructures
Legislation (EMIL) contain proposals to regulate the markets. The European
Commission (EC) is working on initiatives such as review of Financial Instruments
Directive, the Securities Law Directive, which aim to harmonise legislation across
the EU to regulate central counterparty operations. In line with the G20
recommendations, the EC is proposing that by the end of 2012 all standardised
OTC derivative contracts be traded on exchanges or electronic trading platforms and cleared through central counterparties (CCP). To strengthen Europe‟s clearing
houses, measures such as introduction of common safety, regulatory and operational standards for CCPs are being contemplated.
In the US, the Dodd Bill proposed to bring transparency and accountability to the derivatives market through closing regulatory gaps by providing the Securities and Exchange Commission (SEC) and Commodities and Futures Trading Commission (CFTC) with authority to regulate over-the-counter (OTC) derivatives and curtail irresponsible practices and excessive risk-taking through regulatory oversight. The bill also mandates central clearing and exchange trading for eligible derivatives and proposed to empower regulators to impose position limits on various derivatives transactions, if required. The bill also focused on market transparency through data collection and dissemination.
b) Increased Co-ordination: Co-ordination between public authorities and private market participants resulted in addressing some of the issues cited above. In the US, industry had given commitments to clear by October 31, 2009, 80 per cent of the eligible dealer-to-dealer trades and 95 per cent of the eligible new trades through centralised clearing and has achieved the targets.
c) Industry initiatives: Several initiatives like trade compression; standardisation of CDS contracts and default handling procedures, trade processing, price transparency and improved risk management practices were taken up by the market participants. Focusing on straight-through-processing (STP) of trades and efficient back office functions, registering of trades with Trade Information Warehouse of Depository Trust & Clearing Corporation (DTCC) and dissemination of CDS volumes, trade compression to bring down the notional CDS volumes, moving towards central counterparty clearing are some of the developments impacting the CDS markets. Through trade compression, market participants brought gross exposures closer to the net risk positions and outstanding notional CDS contracts fell by around 37 per cent in 2009. Standardisation of CDS contract is another major development in CDS markets in order to facilitate their migration to CCPs. Earlier, the CDS contracts were created and traded based on the prevailing
market spreads and, therefore, each CDS contract was a unique contract with the coupon of its own. However, with standardisation, the CDS contracts will have uniform coupons and, hence, become fungible. With the standardisation of coupons (spreads), the variability of the current market spreads is captured through the upfront premium. The upfront premium is the present value of the difference in coupon i.e. fixed coupon on the standard contract and the current market spread. The settlement dates have also been standardised to four, viz., March 20, June 20, September 20 and December 20.
d) Streamlining trading and settlement procedures: As regards the new developments
post the global financial crisis, the ISDA together with the market participants has brought out Big Bang and Small Bang protocols and supplements to streamline the CDS trading and settlement procedures. The changes in the Big Bang protocol include setting up of Determination Committees, conduct of auctions and creating Credit Event and Succession Event Backstop dates. Earlier, the mode of settlement was left to the discretion of the contracting counterparties and the parties could choose between the cash and physical settlement. The auction process was voluntary. However, keeping in consideration settlement-related issues such as CDS outstanding volumes being higher than the deliverable obligations, ISDA has hardwired the auction settlement into the documentation with a view to standardise the CDS settlements. The Small Bang protocol and its supplement extended the auction hardwiring provisions to the restructuring credit events, which were specifically excluded in Big Bang Protocol.
e) Centralised Clearing and Central Counterparty: In order to minimise counterparty
risk, regulators are pushing for increased use of central counterparty (CCP) clearing for OTC products with close regulatory oversight as the CCP can impose robust risk management practices, aid market liquidity and reduce systemic risk. However, certain issues like the optimum number of CCPs, implications of customization and concentration risk, etc. need to be addressed.
While examining the issue of introduction of CDS in India, these global developments were
studied and international experience was taken into account.
1.4 Credit Derivatives: Initiatives in India
1.4.1 Introduction of credit derivatives in India was actively examined in the past to provide the participants tools to manage credit risk in their portfolio. A Working Group on introduction of credit derivatives in India was constituted in 2003 with membership from banks, insurance companies and related departments in the Reserve Bank. The Group dealt with conceptual issues, examined the scope for allowing banks and financial institutions in India to use credit derivatives and submitted its report in March 2003. Based on the recommendations of the Working Group, draft guidelines on introduction of credit derivatives were brought out on March 26, 2003. However, taking into account the status of the risk management practices then prevailing in the banking system, the issuance of final guidelines was deferred.
1.4.2 Subsequently, the matter was revisited in the Annual Policy Statement for the year 2007-08 wherein it was indicated that as a part of the gradual process of financial sector liberalisation in India, credit derivatives would be introduced in a calibrated manner. To begin with, it was decided to permit commercial banks and primary dealers (PDs) to deal in single-entity Credit Default Swaps (CDS). Accordingly, draft guidelines were issued on CDS on May 16, 2007 and based on the feedback received, a revised draft was again placed for comments on October 24, 2007 for a second round of consultation. However, the status was reviewed in the wake of the global financial crisis and introduction of CDS was kept in abeyance so as to be able to draw upon the experience of developed countries.
1.4.3 The matter has since been reviewed and the Second Quarter Review of Monetary Policy of 2009-10 has proposed introduction of plain vanilla OTC single-name CDS for corporate bonds for resident entities subject to appropriate safeguards. To begin with, all CDS trades will be required to be reported to a centralised trade reporting platform and in due course, they will be brought on a central clearing platform.
1.4.4 The objective of the measure is to provide credit risk transfer tool to the Indian market participants and enable them to manage credit risk in an effective manner through redistribution of risk. Introduction of credit enhancement of corporate bonds through CDS may also increase investor‟s interest in corporate bonds. Since CDS have benefits like