Credit default swaps likely by next year

Credit default swaps likely by next year

New Delhi: A popular and controversial financial instrument that insures creditors against defaults on loans owed by them may be introduced in India next year as the country tries to initiate financial market reforms that do not require legislative approval in the background of a global credit crisis.

Credit default swaps (CDS) could be traded in India next year following the finance ministry’s suggestion to the central bank, the Reserve Bank of India (RBI), to consider introducing them.

“I think they (CDS) will be here next year," said a senior finance ministry official, who did not want to be named.

A CDS is an important tool to offset risks in debt markets, making its introduction a logical step in widening financial instruments on offer, the official said. It is a derivative used by creditors to insure themselves against the possibility that a borrower might default.

Derivatives are financial instruments that reflect the value of an underlying instrument. In the case of CDS, the underlying instrument is a bond.

Also See Insuring Creditors (PDF)

If an investor in a company’s bond wants to buy some kind of insurance against the possibility that the company might default, the investor could buy CDS for a price (this is also referred to as CDS spread). The CDS seller, in turn, guarantees to pay the buyer a pre-determined amount if the company that has borrowed money defaults on repayment.

The instrument, first introduced a little more than a decade ago, has recorded a sharp rise in trading over the past few years. According to data on the website of the Bank for International Settlements, the outstanding notional amount in the CDS market at the end of June was $57 trillion (Rs2,833 trillion today).

A paper on the website said that CDS contracts had surged by more than five times the outstanding principal of corporate bonds worldwide by the end of 2007, compared with 85% of the size of the corporate bond market at the end of 2004.

In India, however, the swaps will be traded on the exchange and not on the telephone-driven over-the-counter (OTC) market. Thus far, such swaps have been primarily traded in OTC markets across the world.

The finance ministry and RBI have usually derivatives as exchange-traded products because this enhances transparency and makes for better price discovery, the finance ministry official said. Government-appointed committees on financial sector reforms have suggested introducing financial instruments in exchange-traded form, the official added.

RBI’s spokesperson could not be reached for comment on Tuesday evening.

According to Jayant Varma, professor of finance at the Indian Institute of Management, Ahmedabad, and member of the board of capital markets regulator Securities and Exchange Board of India, in 2000-01, the US had also begun to take steps towards transforming CDS from a pure OTC product into one that was also traded on exchanges.

“I think there is better price discovery today in CDS than underlying bonds. It is more liquid," Varma said about the general state of CDS markets in the world.

CDS spreads have also served as an early indicator of the problems in debt markets, or in individual companies. “It (CDS) is useful. It clearly shows where stresses are," said James McCormack, managing director (sovereign ratings) in the Asia Pacific region for credit rating firm Fitch Ratings.

Currently, CDS contracts are available on debt raised by Indian companies overseas. According to Bloomberg data, on 18 November, five-year CDS spreads on overseas debt of the country’s two largest banks, State Bank of India (SBI) and ICICI Bank Ltd, were 520.500 basis points and 916.500 basis points, respectively. One basis point is one-hundredth of a percentage point. The number means that for every $100 of bonds of SBI or ICICI Bank, it would cost $5.20 and $9.16 to buy CDS, respectively.

The 2007 Percy Mistry committee report on making Mumbai an international financial centre had observed that there was a large credit derivatives market overseas on Indian debt. In a liberal financial regime, the overseas credit derivatives markets could shift to India, the report said.