DISSERTATION

On
CREDIT DEFAULT SWAPS

By

SESHAN BALASUBRAMANIAN

In Partial Fulfillment of the Requirements for the Degree of

Bachelors of Business Administration (general)

At
Amity University, Dubai Campus

Under the Guidance of

Mrs.Anita Mirchandani

FACUTY GUIDE
 CERTIFICATE OF COMPLETION

Date: 1st June 2015.

This is to certify that Mr. Seshan Balasubramanian has successfully completed the Dissertation on
Credit default swaps in the academic year 2015-17, during the partial fulfillment of Bachelors
of Business Administration(general) at Amity University, Dubai Campus.

During the project he exhibited disciplined approach and excellent determination. He holds
tremendous career potential in management and I extend my best wishes for all future endeavors.

Anita Mirchandani
Faculty Guide

Amity University, Dubai Campus

1
 DECLARATION

Title of project report:

I declare,

a That the work presented for assessment in this Dissertation is my own, that it has
not previously been presented for another assessment and that my debts (for
words, data, arguments and ideas) have been appropriately acknowledged.

b That the work conforms to the guidelines for presentation and style set out in the relevant
documentation.

Date:

(name)

BBA (GEN) - Class of 2017

2
 ACKNOWLEDGEMENT

I take this opportunity to express my thoughtful gratitude and deep regards to my Faculty guide
and programme leader, Mrs.Anita Mirchandani, for her ideal guidance, monitoring and constant
encouragement throughout the course of this project. The blessing and guidance given by her ,
time to time, shall carry me a long way in the journey of life on which I am about to get on.

I would also like to thank Dr. Narayanan Ramachandran, our Pro Vice Chancellor for his vital
encouragement and support.

I am obliged to the faculty members of Amity University Dubai, for the valuable information
provided by them in their respective fields. I am grateful for their cooperation during the period of
my project task.

I would also like to thank my parents and my friends for their constant encouragement without
which this report would not be possible.

And finally, to The Almighty God, who made all things possible.

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 EXECUTIVE SUMMARY

Financial derivates have developed around the world in a large volume. . But at the same time the product
once created for hedging the risk currently allows you to bear more risk sometimes making the whole
financial system to tremble. May be thats why Warren Buffet called it a financial weapon of mass
destruction. Whatever it may be but derivatives have grown exponentially and are necessary for the
market to flourish.
The credit derivatives are nothing but the logical extension to the family of derivatives and have already
made its presence felt globally. The credit derivatives have played a significant role in the development of
debt market but also share a blame for the proliferation of subprime crisis.
The various measures include formation of central counterparty for CDS, hardwiring of auction protocol
and ISDA determination committee. On the backdrop of global crisis the movement of CDS is being
watched carefully. The various data sources now provide data even on weekly basis. The efforts are being
paid off and the market size of CDS has reduced considerably. And now with the central counterparties in
place the CDS market will have more transparency and better control.
After opening up of the economy the equity market of India have grown significantly bringing in more
transparency. But the corporate bond market is still in undeveloped mode and the efforts being taken on
developing it have not provided expected returns. Under this light, India is now all set to launch Credit
Default Swaps which are expected to ignite the spark which will flourish the corporate bond market.
Considering the cautious nature of RBI and the havoc created by CDS in global market the move by RBI
is significant. From the move of RBI one can say as the knife itself is not harmful but it depends whether
its in doctors hand or a robbers hand. Similarly CDS as a product is certainly not harmful but its utility
will depend on the judicious use of the same.

OBJECTIVES

The main objective of the project was to understand about Credit Default Swaps, its global footprint, its
role in subprime crisis, its settlement in global arena and to check the feasible settlement of CDS in India,
after its introduction in India, by understanding about Indian Credit Derivatives market. Research is
concerned with the systematic and objective collection, analysis and evaluation of information about
specific aspects to check the feasible settlement of CDSs in India

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 TABLE OF CONTENTS

EXECUTIVE SUMMARY........................................................................................................................III
RESEARCH METHODOLOGY................................................................................................................V
DERIVATIVES .................................................................................................................. 1
CREDIT DERIVATIVES.................................................................................................................... 7
CREDIT DEFAULT
SWAPS........................................................................................................................... 12
SUBPRIME CRISIS............................................................................................................................ 25
ROLE OF CDS IN SUBPRIME
CRISIS............................................................................................................................ 41
CDS AUCTION.................................................................................................................. 52
CDS DATA SOURCES........................................................................................................................ 57
CENTRAL COUNTERPARTY SETTLEMENT.................................................................................. 61
CREDIT DERIVATIVES MARKET IN INDIA.................................................................................... 72
CDS & ITS SETTLEMENT IN
INDIA.............................................................................................................................. 78
CONCLUSION..................................................................................................................... 81
DRAWBACKS/LIMITATIONS ...................................................................................................................
................... 82
APPENDIX A: CDS
PRICING............................................................................................................................ 83
APPENDIX B: SUBPRIME
CRISIS ...................................................................................................................................... 87
APPENDIX C: CDS
AUCTION ....................................................................................................................................... 92
REFERENCES &

BIBLIOGRAPHY.......................................................................................................................................

95

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 DERIVATIVES

Derivatives have become increasingly important in financial markets. We have observed exciting
developments in the last 25 years: the most successful innovations in capital markets. By far the most
significant event in finance during the past decade has been the extraordinary development and expansion
of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those
investors most able and willing to take it - a process that has undoubtedly improved national productivity
growth and standards of living -- Alan Greenspan, (former) chairman, Board of Governors of the US
Federal Reserve System. But again early falls of Baring bank, LTCM (Long-Term Capital Management),
Asian Financial Crisis and the most recent financial crisis posed a big question mark on the rapid
development of Derivatives. Even Warren Buffet said in Berkshire Hathaway annual report for 2002 that
derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are
potentially lethal. Now with these conflicting views lets understand what exactly are derivative and why
it posses a potential threats or potential opportunities in financial markets?

Derivatives are financial contracts, or financial instruments, whose prices are derived from the price of
something else (known as the underlying). The underlying price on which a derivative is based can be that
of an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans,
bonds), an index (e.g., interest rates, exchange rates, stock market indices), or other items. Credit
derivatives are based on loans, bonds or other forms of credit.

The derivative contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date
of commencement of the contract. The value of the contract depends on the expiry period and also on the
price of the underlying asset. Usually, derivatives are contracts to buy or sell the underlying asset at a
future time, with the price, quantity and other specifications defined today. Contracts can be binding for
both parties or for one party only, with the other party reserving the option to exercise or not. If the
underlying asset is not traded, for example if the underlying is an index, some kind of cash settlement has
to take place. Derivatives are traded in organized exchanges as well as over the counter.

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 USES OF DERIVATIVES

Hedging: Derivatives can be used to mitigate the risk of economic loss arising from changes in the
value of the underlying. This activity is known as hedging. For example, a wheat farmer and a
miller could sign a futures contract to exchange a specified amount of cash for a specified amount
of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty
of the price, and for the miller, the availability of wheat

Speculation: Derivatives can be used by investors to increase the profit arising if the value of the
underlying moves in the direction they expect. This activity is known as speculation. Speculators
will want to be able to buy an asset in the future at a low price according to a derivative contract
when the future market price is high, or to sell an asset in the future at a high price according to a
derivative contract when the future market price is low

Arbitrage: Individuals and institutions may also look for arbitrage opportunities, as when the
current buying price of an asset falls below the price specified in a futures contract to sell the asset.

TYPES OF DERIVATIVES
Over-the-counter (OTC) derivatives: OTC derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through an exchange or other intermediary.
Products such as swaps, forward rate agreements, and exotic options are almost always traded in
this way. The OTC derivatives market is huge. According to the Bank for International
Settlements, the total outstanding notional amount is USD 592 trillion (as of December 2008).

7
 Because OTC derivatives are not traded on an exchange, they are subject to counter party risk as
each counter party relies on the other to perform.

Exchange-traded derivatives (ETD): ETDs are those derivatives products that are traded via
specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an
intermediary to all related transactions, and takes Initial margin from both sides of the trade to act
as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the
Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of
European products such as interest rate & index products), and CME Group (made up of the 2007
merger of the Chicago Mercantile Exchange and the Chicago Board of Trade (CBOT) and the
2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover
in the world's derivatives exchanges totaled USD 367 trillion during Q1 2009. Some types of
derivative instruments also may trade on traditional exchanges.

COMMON DERIVATIVE CONTRACT TYPES

Forward and Future: Forward contracts are agreements by two parties to engage in a financial
transaction at a future point in time. A forward contract is traded in the OTC market. Future
contracts are similar to forward contract but they normally are traded on an exchange and are
standardized. To make sure that the clearinghouse is financially sound and does not run into
financial difficulties that might jeopardize its contracts, buyers or sellers of futures contracts must
put an initial deposit, called a margin requirement. Futures contracts are then marked to market
every day. What this means is that at the end of every trading day, the change in the value of the
futures contract is added to or subtracted from the margin account. A final advantage that futures
markets have over forward markets is that most futures contracts do not result in delivery of the
underlying asset on the expiration date, whereas forward contracts do.

8
 Options: An option is a contract between a buyer and a seller that gives the buyer the right, but not
the obligation, to buy or to sell a particular asset (the underlying asset) at a later day at an agreed
price. In return for granting the option, the seller collects a payment (the premium) from the buyer.
A call option gives the buyer the right to buy the underlying asset; a put option gives the buyer of
the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller
is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the
right and let it expire.

TYPES OF OPTIONS: American options can be exercised at any time up to the expiration date
of the contract, and European options can be exercised only on the expiration date.

Swaps: Swaps are financial contracts that obligate each party to the contract to exchange
(swap) a set of payments (not assets) it owns for another set of payments owned by another
party. There are two basic kinds of swaps. Currency swaps involve the exchange of a set of
payments in one currency for a set of payments in another currency. Interest-rate swaps involve
the exchange of one set of interest payments for another set of interest payments, all
denominated in the same currency. Most swaps are traded OTC, tailor-made for the
counterparties.

9
Risks with Financial Derivatives:
The use of derivatives can result in large losses due to the use of leverage, or borrowing.
Derivatives (especially swaps) expose investors to counter-party risk.
Derivatives control an increasingly larger notional amount of assets and this may lead to
distortions in the real capital and equities markets.
Derivatives massively leverage the debt in an economy, making it ever more difficult for the
underlying real economy to service its debt obligations and curtailing real economic activity,
which can cause a recession or even depression.
New innovations on financial derivatives are too complicated that even some financial managers
are not sophisticated enough to use them.

OTC Derivatives growth:

Derivatives market was already a very big in 1998, but it has exploded since then. The amounts
outstanding of OTC derivatives since 1998 are broken down into their various types as shown below.

As can be seen from above figure the total OTC derivative market was almost $600 trillion. Thus, in 10
years it has gown 826%. Some of the subcategories have grown even more than simple average (of 826%)

10
like, commodity contracts increased over 2000%, interest rate contracts (which make up the largest
portion, 66% of OTC market) increased over 900% in last 10 years and CDS (Credit Default Swap)
contracts increased over 905% in just three and half years (more about CDS is explained in later chapters).

Factors generally attributed as the major driving force behind growth of financial derivatives are:
1. Increased Volatility in asset prices in financial markets
2. Increased integration of national financial markets with the international markets
3. Marked improvement in communication facilities and sharp decline in their costs
4. Development of more sophisticated risk management tools, providing economic agents a wider choice
of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large
number of financial assets, leading to higher returns, reduced risk as well as transaction costs as compared
to individual financial assets.

Although there are risks associated with derivatives there are number of advantages too. So derivatives
can be considered as necessary evils.
The world seems to be dividend into two camps: those who embrace financial derivatives as the Holy
Grail of the new investment area, and those who denigrate derivatives as the financial Antichrist.
-David Edington
But still many believes derivatives are just a bet on a bet. Around 2002, soon after the effects of the
dotcom collapse ebbed away and Alan Greenspan flooded the world with cheap credit, another form of
betting became possible. This was the credit derivative. These credit derivatives played a vital role in
growing the subprime crisis all the more and still continuing to do the same with CDS being a frontrunner
along with TRS, credit options, CLN, etc.

11
Credit Derivatives
The development of credit derivatives is a logical extension of the ever-growing array of derivatives
trading in the market. The concept of a derivative is to create a contract that transfers some risk or some
volatility. Credit derivatives apply the same notion to a credit asset. Credit asset is the asset that a provider
of credit creates, such as a loan given by a bank, or a bond held by a capital market participant. A credit
derivative enables the stripping of the loan or the bond, from the risk of default, such that the loan or the
bond can continue to be held by the originator or holder thereof, but the risk gets transferred to the
counterparty. The counterparty buys the risk obviously for a premium, and the premium represents the
rewards of the counterparty. Thus, credit derivatives essentially use the derivatives format to acquire or
shift risks and rewards in credit assets, viz., loans or bonds, to other financial market participants.

Definition of Credit Derivative:

Credit derivatives can be defined as arrangements that allow one party (protection buyer or originator) to
transfer, for a premium, the defined credit risk, or all the credit risk, computed with reference to a notional
value, of a reference asset or assets, which it may or may not own, to one or more other parties (the
protection sellers).
So here the protection buyer continues to hold the reference asset (loan or bond) and protection seller
holds the risk associated with the asset (loan or bond) also called as holding synthetic asset. The protection
seller holds the risk of default, losses, foreclosure, delinquency, prepayment, etc. and the reward of
premium.
There could be two possible ways of settlement in case of credit event. In first case, physical settlement,
protection seller gives the par value of asset to the protection buyer and protection buyer hands over the
asset to the protection seller. Whereas in second case, cash settlement the difference between the par value
of the asset and the market value of the asset is given by protection seller to the protection buyer

12
TYPES OF CREDIT DERIVATIVES
Some of the fundamental types of credit derivatives are credit default swap, total return swap, credit
linked notes, and credit spread options.

Credit
Default Swaps: A credit default swap (CDS) is a credit derivative contract between two
counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an
underlying financial instrument defaults.

Credit default swaps are the most important type of credit derivatives in use in the market. Credit default
swaps are explained in detail in next chapter.

Total
Return Swaps: As the name implies, a total return swap is a swap of the total return out of a
credit asset swapped against a contracted prefixed return. The total return out of a credit asset is reflected
by the actual stream of cash-flows from the reference asset as also the actual appreciation/depreciation in
its price over time, and can be affected by various factors, some of which may be quite extraneous to the
asset in question, such as interest rate movements. Nevertheless, the protection seller here guarantees a
prefixed spread to the protection buyer, who in turn, agrees to pass on the actual collections and actual
variations in prices on the credit asset to the protection seller. Total Return Swap is also known as Total
Rate of Return Swap (TRORS).

Credit
Linked Notes: It is a security with an embedded credit default swap allowing the issuer
(protection buyer) to transfer a specific credit risk to credit investors.

CLNs are created through a Special Purpose Vehicle (SPV), or trust, which is collateralized with
securities. Investors buy securities from a trust that pays a fixed or floating coupon during the life of the
note. At maturity, the investors receive par unless the referenced credit defaults or declares bankruptcy, in
which case they receive an amount equal to the recovery rate. The trust enters into a default swap with a
deal arranger.

13
Credit
Spread Options: A financial derivative contract that transfers credit risk from one party to
another. A premium is paid by the buyer in exchange for potential cash flows if a given credit spread
changes from its current level.

The buyer of credit spread put option hopes that credit spread will widen and credit spread call buyer
hopes for narrowing of credit spread. It can be viewed as similar to that of credit default swaps but it
hedges also against credit deterioration along with default.
Consider the buyer of credit spread put: he/she pays a premium for the put. If the bond (the reference
entity) deteriorates, the spread on the bond will increase and the buyer will profit. But if the bond quality
increases, the credit spread will narrow, bond price will decrease, and the put will be worthless (i.e., put
buyer has lost the premium). In summary, the credit spread put buyer wants to hedge against price
deterioration and/or default risk of the obligation.

The pay off is duration (D) x notional (N) x [ credit spread minus (-) the strike spread ; CS-K ] Minus the
recover rate in exchange for an annual fee which is oases on to the investors inn the form of a higher yield
on the notes.

Credit Spread Options: A financial derivative contract that transfers credit risk from one party to
another. A premium is paid by the buyer in exchange for potential cash flows if a given credit spread
changes from its current level.

The buyer of credit spread put option hopes that credit spread will widen and credit spread call buyer
hopes for narrowing of credit spread. It can be viewed as similar to that of credit default swaps but it
hedges also against credit deterioration along with default.

14
Consider the buyer of credit spread put: he/she pays a premium for the put. If the bond (the reference
entity) deteriorates, the spread on the bond will increase and the buyer will profit. But if the bond quality
increases, the credit spread will narrow, bond price will decrease, and the put will be worthless (i.e., put
buyer has lost the premium). In summary, the credit spread put buyer wants to hedge against price
deterioration and/or default risk of the obligation.
The payoff is duration (D) x notional (N) x [credit spread minus (-) the strike spread; CS - K].

RISK OF CREDIT DERIVATIVES

Credit risk-The protection seller is having a credit risk related to underlying reference asset
because protection seller synthetically holds the asset and needs to do tdue diligence to counter this
risk. Another risk is associated is counterparty risk against protection seller if he fails to make good
of his obligations.

Market risk- Market rish is associated with credit derivatives traders as the prices of the
instruments are a function of interest rates, the shape of the yield curve, and credit spread. Other
types of risks involved are marking to market risk, margin call risks, etc.

Legal risk- Lack of standard documentation and agreement as to the definitions of credit event
leads to legal risks. Usage of master agreements though has simplified and homogenized the
trading of credit derivatives. More efforts are being taken recently to counter this risk with
International Swaps and Derivatives Association (ISDA) taking active role in it. The most
important legal issues still revolves around the nature of credit event and the nature of obligations.

GROWTH OF CREDIT DERIVATIVES:

Within no time credit derivatives have grown to a great extent to be a big part of derivatives segment after
interest rate contracts (82% Q408) and foreign exchange contracts (8.4% Q408) as per notional amounts
outstanding . Securitization, index products and structured credit trading.
Much of the significance credit derivatives enjoy today is because of the marketability imparted by
securitization. A securitized credit derivative, or synthetic securitization, is a device of embedding a credit
derivative feature into a capital market security so as to transfer the credit risk into the capital markets.
The synthesis of credit derivatives with securitization methodology has complimented each other. This had

15
allowed keeping the portfolio of assets on the books but transferring the credit risk associated with it. The
index products have also contributed to the increasing popularity of credit derivatives. The third important
factor contributing to the growth of credit derivatives is structured credit trading or tranching. Here the
portfolio of assets is divided into various subclasses known as tranches (means slice in French) to fulfill
the risk appetite of various investors. The tranches are divided into various levels like senior tranche,
mezzanine tranche, subordinate tranche, and equity tranche with the risk of default rising in a sequence for

these Tranches. The composition of credit

derivatives is shown in the figure. As can be seen credit default swaps dominates the composition of credit
derivatives followed by total return swaps. The composition of credit default swaps sometimes makes
people believe that credit derivatives are nothing but

credit default swaps. Considering the importance of Credit Default Swaps we will discuss about CDS in
detail in next chapter.

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Credit Default Swaps

Origin of CDS:
By the mid-'90s, JPMorgan's books were loaded with billions of dollars in loans to corporations and
foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of
them went bad. But what if JPMorgan could create a device that would protect it if those loans defaulted,
and free up that capital? And the solution they come up with is nothing but the origin of Credit Default
Swap.
Credit Default Swap (CDS) is some sort of insurance policy where the third party assumes the risk of debt
going sour and in exchange will receive regular payments from the bank who issues debt, similar to
insurance premiums. Although the idea was floating for a while JP Morgan was the first bank to make a
bet on CDS. They opened up a Swap desk in mid-90s and formally brought the idea of CDS into reality.

Definition:
A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes
periodic payments to the seller, and in return receives a payoff if an underlying financial instrument
defaults.
There are three parties involved in a typical CDS contract
1. Protection Buyer (Risk Hedger)

2. Protection Seller

3. Reference Entity

Protection buyer is the one who pays a premium (CDS spread, generally a quarterly premium) to the
protection seller for taking credit risk to a reference entity and if the credit event happens then protection
seller will have to payoff. Typical credit events include material default, bankruptcy, and debt
restructuring. The size of the payment is usually linked to the decline in the reference assets market value
following the credit event.

17
The interesting thing about CDS market is you dont need to own the underlying reference entity to get
into the contract. Such contract is know as naked CDS. Just like any derivatives market CDS can be used
for speculation, hedging and arbitrage purpose

Significance of Credit Default Swaps:

CDS
creates Liquidity: The CDS adds depth to the secondary market of underlying credit instruments
which may not be liquid for many reasons.
Risk
Management: Credit derivatives makes risk management more efficient and flexible by allocation
of credit risk to most efficient manager of that risk.
Risk Separation: Credit derivatives allows for separation of credit risk from other risks of the
asset.

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 Reliable funding source: Credit derivatives help exploit a funding advantage or avoiding a
funding disadvantage. Since there is no up-front principal outlay required for most Protection
Sellers when assuming a Credit Swap position, these provide an opportunity to take on credit
exposure in off balance-sheet positions that do not need to be funded.
.
CDS Premium:
Premium prices also known as fees or credit default spreads are quoted in basis point per annum of the
contracts notional value. In case of highly distressed credits in which CDS market remains open upfront
premium payment is a common thing. The CDS spread is inversely related to the credit worthiness of the
underlying reference entity.

CDS Size & Price:

There are no predetermined limits on the size or maturity of CDS contracts, which have ranged in size
from a few million to several billions of dollars. In general the contracts are concentrated in the $10
million to $20 million range with maturities of between one and 10 years, although 5 years maturities are
the most common.
Inevitably, the maturity of a CDS will depend on the credit quality of the reference entity, with longer-
dated contracts of five years and more only written on the best-rated names. Although there are differences
in the quotes given by banks on CDS prices due to some technical reasons rather than financial reasons,
but the CDS premium price more or less remains the same. Over and above a valuation of credit risk,
probability of default, actual loss incurred, and recovery rate, the various factors in determination of CDS
premium are liquidity, regulatory capital requirements, market sentiments and perceived volatility, etc.

Trigger Events:
The market participants view the following three to be the most important trigger events:
Bankruptcy
Failure to Pay
Restructuring

Bankruptcy, the clearest concept of all, is the reference entitys insolvency or inability to repay its debt.
Failure-to-Pay occurs when the reference entity, after a certain grace period, fails to make payment of

19
principal or interest. Restructuring refers to a change in the terms of debt obligations that are adverse to
the creditors.

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Growth of CDS Market: Since the inception of the CDS market its growth has been astounding. The
growth of CDS market over the period has been shown in the figure. As the market matured, CDSs came
to be used less by banks seeking to hedge against default and more by investors wishing to bet for or
against the likelihood that particular companies or portfolios would suffer financial difficulties as well as
those seeking to profit from perceived mispricing; the rapid growth of index compared with single name
CDS after 2003 reflected this change.

21
The market size for Credit Default Swaps began to grow rapidly from 2003; by the end of 2007, the CDS
market had a notional value of $62 trillion (as seen in the above figure). But notional amount began to fall
during 2008 as a result of dealer "portfolio compression" efforts, and by the end of 2008 notional amount
outstanding had fallen 38 percent to $38.6 trillion. It is important to note that since default is a relatively
rare occurrence (historically around 0.2% of investment grade companies would default in any one year)
in most CDS contracts the only payments are the spread payments from buyer to seller. Thus, although the
above figures for outstanding notional amount sound very large, the net cash flows will generally only be
a small fraction of this total.
Currently CDS dominates the credit derivatives market with its unprecedented growth. Although after the
subprime crisis (which will be discussed later) the credit derivatives market, in the 4th quarter of 2008,
reported credit derivatives notionals declined 2%, $252 billion, to $15.9 trillion, reflecting the industrys
efforts to eliminate many offsetting trades.

As shown in the chart above CDS represent the dominant product at 98% of all credit derivatives
notionals. As we can see from the other chart although majority of the CDSs composition is dominated by
the investment grade CDSs sub-investment grade CDSs also forms a significant part of CDSs (34%)
which is considered to be one of prime cause for subprime crisis. Considering the global OTC market
CDS accounts for about 8%.

22
Types of Credit Default Swaps:
The CDSs can be classified as Single-name CDSs or Multi-name CDSs.
Single-name CDS: These are credit derivatives where the reference entity is a single name.
Multi-name CDS: CDS contracts where the reference entity is more than one name as in portfolio or
basket credit default swaps or credit default swap indices. A basket credit default swap is a CDS where the
credit event is the default of some combination of the credits in a specified basket of credits. In the
particular case of an nth-to-default basket it is the nth credit in the basket of reference credits whose
default triggers payments Another common form of multi-name CDS is that of the tranched credit
default swap. Variations operate under specifically tailored loss limits these may include a first loss
tranched CDS, a mezzanine tranched CDS, and a senior (also known as a super-senior) tranched CDS.

THE SETTLEMENT FOR CDS

The settlement for CDSs can be done in either of two ways: Physical Settlement or Cash Settlement.
Physical Settlement:
The seller of the protection will buy back the distressed reference entity at par. Clearly given that the
credit event will have reduced the secondary market value of the underlying reference entity, this will
result in protection seller (CDS seller) incurring a loss. This was the most common means for the
settlement in CDSs and will generally take place no later than 30 days after the credit event. Till 2006
ISDA2 allowed settlement only in the form of physical settlement. But due to increased amount of naked
CDSs in the credit market ISDA has now allowed the choice between cash and physical settlement.
2 International Swaps and Derivatives Association, Inc. (ISDA), which represents participants in the
privately negotiated derivatives industry, is among the worlds largest global financial trade associations as
measured by number of member firms.
Cash Settlement: The seller of the protection will pay the buyer the difference between the notional of
the default swap and a final value for the same notional of the reference obligation. Cash settlement is less

23
prevalent because obtaining precise quotes can be difficult when the reference credit is distressed. After
the Auction process being started for the settlement of CDSs as per ISDA, this problem has been resolved.

Uses of Credit Default Swaps:

As mentioned already CDSs can be used for speculation, hedging or arbitrage. Out of which we will be
considering hedging and speculation in detail.
CDSs for Hedging:
When JP Morgan invented the credit instrument named CDS they meant it to be for hedging there credit
risk. Although market has changed a lot since then but still the use of CDSs for hedging purpose remains
to be a primary reason.
Credit default swaps are often used to manage the credit risk (i.e. the risk of default) which arises from
holding debt. Typically, the holder of, for example, a corporate bond may hedge their exposure by entering

24
into a CDS contract as the buyer of protection the bond goes into default, the proceeds from the CDS
contract will cancel out the losses on the underlying bond.
For example: if you own a bond of Apple worth $10 million maturing after 5 years and you are worried
about its future then you can create a CDS contract with an insurance company like AIG which will charge
a premium of say 200bps annually for insuring your bond. In this way you are hedging the risk of losing
$10 million in case Apple goes bankrupt. Here you will be paying $200000 to AIG for insuring your bond.
If Apple goes bankrupt you will receive the par value of bond from AIG and even if does not, you will
lose premium value at the most which is worth transferring the risk to AIG.

Counterparty Risks: When entering into a CDS, both the buyer and seller of credit protection take on
counterparty risk. Examples of counter party risks:
The buyer takes the risk that the seller will default. If reference entity and seller default simultaneously
("double default"), the buyer loses its protection against default by the reference entity. If seller defaults
but reference entity does not, the buyer might need to replace the defaulted CDS at a higher cost.
The seller takes the risk that the buyer will default on the contract, depriving the seller of the expected
revenue stream. More important, a seller normally limits its risk by buying offsetting protection from
another party - that is, it hedges its exposure. If the original buyer drops out, the seller squares its position
by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market
conditions, that may be at a lower price than the original CDS and may therefore involve a loss to the
seller. As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk. If one
or both parties to a CDS contract must post collateral (which is common), there can be margin calls
requiring the posting of additional collateral. The required collateral is agreed on by the parties when the
CDS is first issued.
This margin amount may vary over the life of the CDS contract, if the market price of the CDS contracts
changes, or the credit rating of one of the partys changes.

CDSs for Speculation:

Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market
indexes such as the North American CDX index3 or the European iTraxx index4. An investor might
speculate on an entity's credit quality, since generally CDS spreads will increase as credit-worthiness
declines and decline as credit-worthiness increases. The investor might therefore buy CDS protection on a

25
company in order to speculate that the company is about to default. Alternatively, the investor might sell
protection if they think that the company's creditworthiness might improve. As there is no need to own an
underlying entity to enter into a CDS contract it can be viewed as a betting or gambling tool.
CDX indices are credit default swap indices. CDX indices contain North American and Emerging Market
companies and are administered by CDS Index Company (CDSIndexCo) and marketed by Markit Group
Limited
iTraxx indices are credit default swap indices. iTraxx indices contain companies from the rest of the world
other than CDX indices and are managed by the International Index Company (IIC), and owned by
Markit.
For example if you feel that Microsoft is not performing well and may go bankrupt in near future then you
might enter into a CDS contract with AIG for a notional value of $10 million for 5 years even if you dont
own a single share of Microsoft. This kind of CDS is known as Naked CDS.

Changing Nature of CDS Market towards Speculation:

CDS was originally meant for hedging but as market matured the market has moved more towards using it
for speculation purpose. 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. Project by Praveen P. Mishall Welingkar Institute CDS | Credit Default Swaps MMS 2008-10 22
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.

26
[Actually CDS can be viewed as short in bond and buying a put option. Because in the case of default
protection buyer will have to give the underlying reference entity (bond) to the protection seller (in case of
physical settlement) so shorting the bond. While protection seller will have to pay the par amount to
protection buyer in case of default hence can be viewed to be a put option. The payout to credit protection
buyer can be described as
Asset value at the time of swap Asset market value;
Payout to investor = if default
0; if no default
So above expression can be viewed as binary put option based on two states of the world: default and no
default.]
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 that a "weak 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. Actually CDS can be viewed as short in bond and
buying a put option. Because in the case of default protection buyer will have to give the underlying
reference entity (bond) to the protection seller (in case of physical settlement) so shorting the bond. While
protection seller will have to pay the par amount to protection buyer in case of default hence can be
viewed to be a put option. The payout to credit protection buyer can be described as
Asset value at the time of swap Asset market value;
Payout to investor = if default
0; if no default

27
So above expression can be viewed as binary put option based on two states of the world: default and no
default.] 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. The reasons for such developments in the
secondary market will be discussed later while dealing with the role CDSs played in in the subprime
crisis. 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.

CDS is not insurance:

In many terms CDS is like an insurance policy where there is a regular premium to be paid, there is a
reference entity and in case of default a pay-off will be paid. But CDS differs in many aspects from
insurance like
The seller need not be a regulated entity
The seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are
subject to bank capital requirements (because CDS dealers are generally banks).
Insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while
dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and
transactions in underlying bond markets.
In the United States CDS contracts are generally subject to mark to market accounting, introducing
income statement and balance sheet volatility that would not be present in an insurance contract.
The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact
the buyer does not even have to suffer a loss from the default event. By contrast, to purchase insurance the
insured is generally expected to have an insurable interest such as owning a debt.

CDS PRICING
The main aim of CDS pricing is to calculate the amount of premium to be paid by protection buyer to the
protection seller. For calculating the CDS premium we need to know the Recovery Rate and Probability of
Default. Simple explanation of calculating CDS premium (spread) for a 1-year CDS contract (with yearly
premium) is shown below.

28
Let S = CDS premium (spread), p = probability of default, R = recovery rate.
The protection buyer expects to pay S. And his expected payoff is (1-R) p.
When the two parties enter a CDS contract, S is set so that the value of swap transaction is zero. That is,
S = (1-R) p
The pricing for the complicated contracts (with quarterly premium, longer maturities, etc.) is explained in
Appendix A.
Now after understanding the basics of CDS, lets look at the role played by it in the subprime crisis
by understanding first about subprime crisis and securitization process.

Credit Derivative Indices (CDX/ iTraxx):

The introduction of credit derivative indices has been a milestone for the credit markets. Credit derivative
indices provide building blocks for structuring portfolio products such as index linked tranches and index
swaptions. They have made the credit markets more transparent and liquid, but also potentially more
volatile.
Benefits:
Tradability:
Credit indices can be traded and priced more easily
Liquidity:
Significant liquidity is available in indices and has also driven more liquidity in the single
name market
Operational
Efficiency: Standardized terms, legal documentation, electronic straight-through processing
Transaction
Costs: Cost efficient means to trade portions of the market
Industry
Support: Credit indices are supported by all major dealer banks, buy-side investment firms,
and third parties
Transparency:
Rules, constituents, fixed coupon, daily prices are all available publicly

29
There are currently two main families of CDS indices: CDX and iTraxx. CDX indices contain North
American and Emerging Market companies and are administered by CDS Index Company (CDSIndexCo)
and marketed by Markit Group Limited, and iTraxx contain companies from the rest of the world and are
managed by the International Index Company (IIC), also owned by Markit. The current set of CDX/
iTraxx indices can be divided into north.

America Investment Main Index Name Main Index Composition

Grade, North America
High Yield and Crossover,
Emerging Markets, Europe
and Asia. Geographic
Concentration
North American
investment grade
North American high yield
Europe
Japan
Asia ex-Japan
Australia
Emerging Market
Emerging market
diversified
Dow Jones CDX NA IG 125 corporate names
Dow Jones CDX NA HY 100 corporate names
Dow Jones iTraxx Europe 125 corporate names
Dow Jones iTraxx CJ 50 corporate names
Japan
Dow Jones iTraxx Asia ex- 50 corporate and sovereign
Japan names
Dow Jones iTraxx 25 corporate names
Australia
Dow Jones CDX EM 15 sovereign names
Dow Jones CDX EM 40 sovereign and corporate
Diversified names

BIS Recommendations for OTC

Derivatives Settlements:
The Bank for International
Settlements (BIS) is an international
organization which fosters
international monetary and financial
cooperation and serves as a bank for
central banks. The BIS carries out
research and analysis to contribute
to the understanding of issues of

30
core interest to the central bank
community. The BIS also comments
on global economic and financial
developments and identifies issues
that are of common interest to
central banks. In such efforts,
Committee on Payment and
Settlement Systems (CPSS) and the
Eurocurrency Standing Committee
(ECSC) conducted a comprehensive
survey and analysis on the practices
and procedures for documenting,
processing and settling

Overview of CDS Auction Process:

In the event that a large reference entity is the subject of the credit event, ISDA in conjunction with Markit
Group Limited (Markit) and Creditex Securities Corp (Creditex) will generally administer an auction
to determine a market price by which the types of credit default swaps specified in the protocol written on
the reference entity can be settled. The auction is a voluntary process by which market participants agree
to be governed by a protocol issued by ISDA (separate protocol for each reference entity).
The auction is comprised of 2 parts.

CDS Auction Stage 1:

The inputs into the first part of the auction are:
1. A 2-way market supplied by dealers for the defaulted assets, of a pre-defined maximum spread, and
with a pre-defined quotation size associated with it. The spread and quotation sizes are subject to
specification prior to each auction and may vary for each auction depending on the liquidity of the
defaulted assets.

2. Physical Settlement Requests: These are the requests to buy or sell bonds/loans (at the final price),
which as described when combined with the cash settlement of their CDS trade adds up to be equivalent to
physical settlement.

31
The dealer markets submitted are used to create an inside market midpoint (IMM) which is used in the
second stage of the auction to constrain the final price. The inside market midpoint is set by discarding
crossing/touching markets, and taking the best half of the bids and offers and calculating the average.
The best half would be, respectively, the highest bids, and the lowest offers.
The second step in this section is to sum the buy and sell physical settlement requests, and tally the
difference to determine the open interest (difference between the aggregate buy and sell requests). This
open interest to buy or sell bonds/loans is carried into the second stage of the auction.
There is also a possible penalty in place for submissions that are off-market. If a dealer supplies a bid or
offer that is the wrong side of the inside market midpoint (e.g. a bid that is higher than the IMM), and the
open interest suggests it shouldnt be (e.g. if a bid is higher than the IMM, and the open interest is to sell
suggesting the price should go down so they shouldnt be bidding high), then the dealer in question has to
pay the quotation amount times the amount that their price differed from the IMM. This amount is termed
an Adjustment Amount. This is not paid if the bid or offer in question did not cross with any other offer
or bid respectively. Adjustment amount is used to cover the costs associated with the auction process and
the remaining amount is distributed pro-rata to the participating bidders.
Following this process:
1. The inside market midpoint

2. The size and direction of the open interest

3. Any Adjustment Amounts.

CDS Auction Stage 2:

The second stage of the process is to match the open interest and create a final price. This is achieved by
participating bidders submitting limit orders with respect to open interest and matching of limit orders
or inside bids/offers against the open interest.
If the open interest is to buy, we review the lowest sell limit order submitted and match it to the amount
of open interest that is equivalent to the size associated with the limit order. If the open interest was to sell,
we use buy limit orders and start at the highest. As the open interest direction is published prior to the
second stage, only limit orders of the relevant type are gathered and submitted for the second part of the
auction.

32
We then take the next lowest order (in the case of buy open interest) and match that. We continue to run
through this process until we have matched all the open interest, or run out of limit orders. In the case of
the former, the last limit order used to match against the open interest is the final price.
At this point the inside market midpoint is reviewed and checked against the price of the last limit order
used to match the open interest. If the final limit order is more than the cap amount (typically 1% of par)
higher (in case of sell open interest) or lower (in the case of buy open interest) than the inside market
midpoint, the final price will be set to be the inside market midpoint plus or minus the cap respectively.
This is to avoid a large limit order being submitted off-market to try and manipulate the results,
particularly in the case of a small open interest.

33
 CDS Data Sources
There are various international organizations which monitors the activities in the CDS market. Various
organizations and their role in CDS are as follows:

International Swaps and Derivatives Association (ISDA):

ISDA, which represents participants in the privately negotiated derivatives industry, is the largest global
financial trade association, by number of member firms. ISDA Master Agreements are ingrained into the
fabric of the derivatives market worldwide. According to its mission statement, ISDAs primary purpose is
to encourage the prudent and efficient development of the privately negotiated derivatives business by:
Promoting practices conducive to the efficient conduct of the business, including the development and
maintenance of derivatives documentation

Promoting the development of sound risk management practices

Fostering high standards of commercial conduct

Advancing international public understanding of the business

Educating members and others on legislative regulatory, legal, documentation, accounting, tax,
operational, technological and other issues affecting them and

Creating a forum for the analysis and discussion of, and representing the common interest of its
members on, these issues and developments.12

Adherence to ISDA policies is voluntary among the contracting parties; however, there is
an understanding among the financial markets that ISDA continuously stays on top of all derivative issues
and attempts to incorporate these issues into policy and advice for structuring agreements. Hence, most
derivative deals utilize ISDA Master Agreements and Definitions.

34
Role of ISDA in CDS:
Establish a secure framework of robust documentation and legal certainty by enforcing such
documentation (Master Agreement) and attendant mechanisms as collateralization and netting.

ISDA in conjunction with Markit and Creditex generally administer an auction to determine a market
price by which the types of credit default swaps specified in the protocol written on the reference entity
can be settled.

ISDA Determination Committee decides if and when credit events and succession events had
occurred and which bonds could be delivered into an auction.

From 2001, ISDA began surveying outstanding (notional amount) of credit default swaps, which consist
of single-name credit default swaps, default swaps on baskets of up to ten credits, and portfolio
transactions of ten or more credits, displaying reports (of survey) semiannually.

Bank for International Settlements (BIS):

The Bank for International Settlements (BIS) is an international organization which fosters international
monetary and financial cooperation and serves as a bank for central banks. Established on 17 May 1930,
the BIS is the world's oldest international financial organization.

35
Role of BIS in CDS:
From December 2004 BIS releases semiannual data on credit default swaps (CDS) including notional
amounts outstanding and gross market values for single-name and multi-name instruments.

36
The Office of the Comptroller of the Currency (OCC):
The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises all national
banks. It also supervises the federal branches and agencies of foreign banks. The objectives of OCC are
To ensure the safety and soundness of the national banking system.

To foster competition by allowing banks to offer new products and services.

To improve the efficiency and effectiveness of OCC supervision, including reducing regulatory burden.

To ensure fair and equal access to financial services for all Americans.

Role of OCC in CDS:

To generate quarterly report on bank derivatives activities in US indicating CDS activities (notionals by
counterparty and maturity, composition of CDSs, etc.)

OCC acts as a leading source of regulatory knowledge sharing for the financial services industry (for
example OCC shared the information on CDS after its introduction to market).

37
The Depository Trust and Clearing Corporation (DTCC):
DTCC, through its subsidiaries, provides clearing, settlement and information services for equities,
corporate and municipal bonds, government and mortgage-backed securities, money market instruments
and over-the-counter derivatives. DTCC Deriv/SERV (a subsidiary of DTCC) is the leading provider of
automation solutions for the global, over-the-counter (OTC) derivatives market. It offers a family of
services that brings greater efficiency and reduces the risk of processing a wide range of credit, equity and
interest rate derivatives products.
Role of DTCC in CDS:
DTCC provides much wider role than just acting as a data source by providing services like Trade
Information Warehouse (TIW), Matching and Confirmation service, Novation Consent, etc.

The Trade Information Warehouse (a service offering of DTCC Deriv/SERV LLC, a wholly-owned
subsidiary of DTCC) is the markets first and only comprehensive trade database and centralized
electronic infrastructure for post-trade processing of OTC derivatives contracts over their multi-year
lifecycles, from confirmation to payment calculation and netting to final settlement.

TIW reports provide weekly information regarding credit derivative products, transaction types (single-
name, index/index tranches), etc.

TIW reports can be accessed at

38
 Credit Derivatives Market in India
Banks are major players in the credit market and are, therefore, exposed to credit risk. Credit market is
considered to be an inefficient market with market players like banks and financial institutions mostly
have loans and little of bonds in their portfolios while mutual funds, insurance companies, pension funds
and hedge funds have mostly bonds in their portfolios, with little access to loans, depriving them of high
returns of loans portfolios. The market in the past did not provide the necessary credit risk protection to
banks and financial institutions. Neither did it provide any mechanism to the mutual funds, insurance
companies, pension funds and hedge funds to have an access to loan market to diversify their risks and
earn better return. Credit derivatives were, therefore, developed to provide a solution to the inefficiencies
in the credit market. Internationally, banks are able to protect themselves from the credit risk through the
mechanism of credit derivatives. However, credit derivative has not yet been used by banks and financial
institutions in India in a formal way.

Benefits from Credit Derivatives:

Banks and Financial Institutions currently require a mechanism that would allow them to provide long
term financing without taking the credit risk if they so desire. Currently banks and financial institutions
need to hold their portfolios on books depriving them of diversifying the portfolio as well as making them
forgo some of the opportunities. Also non-banking institutions looses on some of the opportunities of
holding high yielding portfolios like loans.
Credit derivatives would help resolve these issues. Banks and the financial institutions derive four main
benefits from credit derivatives, namely:
Credit derivatives allow banks to transfer credit risk and hence free up capital, which can be used in
productive opportunities.

39
Banks can conduct business on existing client relationships in excess of exposure norms and transfer
away the risks.
Banks can construct and manage a credit risk portfolio of their own choice and risk appetite unconstrained
by funds, distribution and sales effort. Banks can acquire exposure to, and returns on, an asset or a
portfolio of assets by simply writing a credit protection.
Credit risk would be diversified from banks/FIs alone to other players in the financial markets and
lead to financial stability.

Participants in the Indian Market

In order to ensure that the credit market functions efficiently, it is important to maximize the number of
participants in the market to encompass banks, financial institutions, NBFCs (all regulated by RBI),
mutual funds, insurance companies and corporates.
Minimum Conditions:
As per Report of the Working Group on Introduction of Credit Derivatives in India by Department of
Banking Operations and Development the bank should fulfill minimum conditions relating to risk
management processes and that the credit derivative should be direct, explicit, irrevocable and
unconditional. These conditions are explained below.
Direct:
The credit protection must represent a direct claim on the protection provider.

40
Explicit:
The credit protection must be linked to specific exposures, so that the extent of the cover is
clearly defined and incontrovertible.
Irrevocable:
Other than a protection purchasers non-payment of money due in respect of the credit
protection contract, there must be no clause in the contract that would allow the protection provider
unilaterally to cancel the credit cover.
Unconditional: There should be no clause in the protection contract that could prevent the
protection provider from being obliged to pay out in a timely manner in the event that the original
obligor fails to make the payment(s) due

Draft CDS Guidelines:

Reserve Bank of India (RBI) has come out with draft guidelines on Credit Default Swap (CDS) per
notification dated May 2007. The details of which are as follows:

41
Participants allowed:
Protection Buyers:
Commercial banks and Primary dealers
A protection buyer shall have an underlying credit risk exposure in the form of permissible underlying
asset / obligation

Protection Sellers:
Commercial banks and Primary dealers

RBI will consider allowing insurance companies and mutual funds as protection buyer or protection seller
as and when their respective regulators permit them to transact in credit default swaps.

Product Requirements:
Structure: A CDS may be used
By the eligible protection buyers, for buying protection on specified loans and advances, or investments
where the protection buyer has a credit risk exposure.
By the eligible protection sellers, for selling protection on specified loans and advances, or investments
on which the protection buyer has a credit risk exposure.

Settlement Methods:
Physical Settlement
Cash Settlement

42
Documentation:
1992 or 2002 ISDA Master Agreement compliance.
2003 ISDA Credit Derivatives Definitions and subsequent supplements to definitions compliance.
Documenting the establishment of the legal enforceability of the contracts in all relevant jurisdictions
before undertaking CDS transactions.

Credit Events:
Bankruptcy
Obligation Acceleration
Obligation Default
Failure to pay
Repudiation/ Moratorium
Restructuring

Minimum Requirements:
A CDS contract must represent a direct claim on the protection seller and must be explicitly referenced
to specific exposures of the protection buyer, so that the extent of the cover is clearly defined and
indisputable. It must be irrevocable.
The CDS contract shall not have any clause that could prevent the protection seller from making the
credit event payment in a timely manner after occurrence of the credit event and completion of necessary
formalities in terms of the contract.
The protection seller shall have no recourse to the protection buyer for losses.
The credit events specified in the CDS contract shall contain as wide a range of triggers as possible with
a view to adequately cover the credit risk in the underlying / reference asset and, at a minimum, cover o
Failure to pay
o Bankruptcy, insolvency or inability of the obligor to pay its debts
o Restructuring of the underlying obligation involving forgiveness or postponement of principal, interest
or fees that results in a credit loss event.
CDS contracts must have a clearly specified period for obtaining post-credit-event valuations of the
reference asset, typically no more than 30 days
The credit protection must be legally enforceable in all relevant jurisdictions

43
The underlying asset/ obligation shall have equal seniority with, or greater seniority than, the reference
asset/ obligation.
The protection buyer must have the right/ability to transfer the reference/ deliverable asset/ obligation to
the protection seller, if required for settlement (in case of physical settlement).
The credit risk transfer should not contravene any terms and conditions relating to the reference /
deliverable / underlying asset / obligation and where necessary all consents should have been obtained.
The credit derivative shall not terminate prior to expiration of any grace period required for a default on
the underlying obligation to occur as a result of a failure to pay. The grace period in the credit derivative
contract must not be longer than the grace period agreed upon under the loan agreement.
The identity of the parties responsible for determining whether a credit event has occurred must be
clearly defined. This determination must not be the sole responsibility of the protection seller. The
protection buyer must have the right/ability to inform the protection seller of the occurrence of a credit
event.
Where there is an asset mismatch between the underlying asset/ obligation and the reference asset/
obligation then: o The reference and underlying assets/ obligations must be issued by the same obligor (i.e.
the same legal entity)
o The reference asset must rank pari passu or more junior than the underlying asset/ obligation; and
o There are legally effective cross-reference clauses between the reference asset and the underlying asset.

Risk Management:
Banks should consider carefully all related risks and rewards before entering the credit derivatives
market. They should not enter into such transaction unless their management has the ability to understand
and manage properly the credit and other risks associated with these instruments. They should establish
sound risk management policy and procedures integrated into their overall risk management.
Banks which are protection buyers should periodically assess the ability of the protection sellers to
make the credit event payment as and when they may fall due. The results of such assessments
should be used to review the counterparty limits.
Banks should be aware of the potential legal risk arising from an unenforceable contract, e.g. due
to inadequate documentation, lack of authority for a counterparty to enter into the contract, etc.

44
 The credit derivatives activity to be undertaken by bank should be under the adequate oversight of
its Board of Directors and senior management (via a copy of a resolution passed by their Board of
Directors or via adequate MIS).

Procedures: The bank should have adequate procedures for:

Measuring, monitoring, reviewing, reporting and managing the associated risks.
Full analysis of all credit risks to which the banks will be exposed, the minimization and management
of such risks.
Ensuring that the credit risk of a reference asset is captured in the banks normal credit approval and
monitoring regime.
Management of market risk associated with credit derivatives held by banks in their trading books by
measuring portfolio exposures at least daily using robust market accepted methodology.
Management of the potential legal risk arising from unenforceable contracts and uncertain payment
procedures.
Determination of an appropriate liquidity reserve to be held against uncertainty in valuation.

Now after understanding the need for credit derivatives and the draft guidelines provided by RBI we will
now understand the possible settlement procedures to be adopted for CDS contracts.

45
 CDS AND ITS SETTLEMENT IN INDIA
The Reserve Bank of India (RBI) has taken the first step towards introducing credit default swaps (CDS)
to Indias 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.

CDS Settlement in India:

X 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.

X 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.

X Once the market matures one can think of having an electronic order matching platform with
central counterparty settlement (like CCIL).

46
47
 Role of 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 role of CCIL is unique as it provides settlement of three different
products under one umbrella. It has been instrumental in setting up and running electronic trading
platforms like NDS-OM, NDS-Call and NDS-Auction system for the central bank that had helped the
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 ClearCorp14 Repo 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, and Rs.20433 billion respectively.
Clearcorp Dealing Systems (India) Limited (Clearcorp), a wholly owned subsidiary of CCIL, was
incorporated in June, 2003 to facilitate, set up and carry on the business of providing dealing
systems/platform in Collateralized Borrowing and Lending Obligation (CBLO), Repos and all money
market instruments of any kind and also in foreign exchange, foreign currencies of all kinds.
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 a credit 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 incontrovertible.

48
Although CDS has helped in perforation of subprime crisis which has created negative vibes 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.

49
 Conclusion
When JPMorgan created CDS they never must have thought that the same will bring them the write downs
worth $5.5 billions. When CDS were launched they were meant to separate the risk and providing new
avenues of generating business/profit. But during the evolution of CDS it turned to many complex
products which were difficult to understand even for those dealing in it. Being an OTC market many
problems did not came to fore. Once the market reached a huge volume the problems became eminent.
The efforts are being taken to bring in more regulation to CDS market and to preserve its credibility. After
all the products were never bad its just that the users were incompetent. Many of the auctions are
conducted by ISDA, the determination committee has resolved the legal conflicts to a great deal, the
central counterparties have already started their operations and gaining good response. With many other
CCPs to follow the transparency, price discovery, liquidity will improve.
With the feedback being asked for by RBI on the launch of CDS to the banks, India is all poised to
introduce CDS. The lessons learnt from the west will allow India to do away with the drawbacks or the
product and to exploit the advantages. So with Basel II norms adopted by India and clearing house/
regulations to be in place, India will be launching the CDS soon

50
 DRAWBACKS AND LIMITATIONS
The research included in this project may not be reflecting true picture as it is a secondary data and it may
have contradictory opinions or so.

Data collected and included in this research is taken from various available sources and may not be up to
date. Particularly considering the severity of the situation after subprime crisis and the role played by CDS
contracts in perforating the subprime crisis, rapid changes are happening to bring more regulation,
transparency, standardization, soundness to the CDS market making the data used stale.

51
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