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CDS is in operation in India since October 2011 – launched in only corporate bonds. The eligible participants are commercial banks, primary dealers, NBFCs, insurance companies and mutual funds.
CDS is a credit derivative transaction in which two parties enter into an agreement, whereby one party (called as the ‘protection buyer’) pays the other party (called as the ‘protection seller’) periodic payments for the specified life of the agreement. The protection seller makes no payment unless a credit event relating to a pre-determined reference asset occurs. If such an event occurs, it triggers the Protection Seller’s settlement obligation, which can be either cash or physical (India follows physical settlement). It means, CDS is a credit derivative that can be used to transfer credit risk from the investor exposed to the risk (called protection buyer) to an investor willing to take risk (called protection seller).
It operates like an insurance policy. In an insurance policy, the insurance firm pays the loss amount to the insured party. Similarly, the buyer of the CDS—the bank or institution that has invested in a corporate bond issue— seeks to mitigate the losses it may suffer on account of a default by the bond issuer. Credit default swaps allow one party to ‘buy’ protection from another party for losses that might be incurred as a result of default by a specified reference instrument (a bond issue in India). The ‘buyer’ of protection pays a premium to the seller, and the ‘seller’ of protection agrees to compensate the buyer for losses incurred upon the occurrence of any one of the several specified ‘credit events’. Thus CDS offers the buyer a chance to transfer the credit risk of financial assets to the seller without actually transferring ownership of the assets themselves.
Let us try to understand it by an example. Suppose Punjab National Bank (PNB) invests in Rs. 150 crore bond issued by TISCO. If PNB wishes to hedge losses that may arise from a default of TISCO, then PNB may buy a credit default swap from a financial institute, suppose, Templeton. PNB will pay fixed periodic payments to Templeton, in exchange for default protection
(just like premium of an insurance policy).
CDS can be used for different purposes in a financial system, viz.,
(i) Protection buyers can use it to hedge their credit exposure while protection sellers can use it to participate in credit markets, without actually owning assets.
(ii) The protection buyer can transfer credit risk on an entity without transferring the under lying instrument, reap regular benefit in terms of lower capital charge, seek reduction of specific concentrations in credit portfolio and go short on credit risk.
(iii) The protection seller will be able to diversify his portfolio, create exposure to a particular credit, have access to an asset which may not otherwise be available, and increase the yield on his portfolio.
(iv) Banks can use it to transfer risk to other risk takers, create capital for more lending.
(v) Distribute risk widely throughout the system and prevent concentrations of risk.
Some analysts have serious apprehensions about CDS. George Akerlof, Nobel prize-winning economist, in 1993, predicted that the next meltdown will be caused by CDS. In 2003 investment legend Warren Buffet called them as ‘weapons of mass destruction’. The former US Federal Reserve Chairman Alan Greenspan, who betted big on CDS said after the ‘sub prime’ crisis that ‘CDS are dangerous’. A leading US weekly the Newsweek described CDS, ‘the monster that ate Wall Street’. Many Indian experts had the opinion that ‘CDS will not stabilise the economy rather could lead to destabilisation’.
CDS contract are dangerous because they can be manipulated for mischief. It’s all about the insurable interest which is never there as it is used for speculation. A derivative that amounts to an insurance contract with no insurable interest is bad. But do the speculators have insurable interest? No they don’t have any. The US ‘sub prime’ crisis was a fallout of such CDS contracts—one defaulting and another claiming the ‘protection’ finally resulting into the defaulter of the insuring company—overnight the biggest US insurance giant, AIG went bankrupt. So happened with many US banks
also.
The most damaging aspect of CDS is that the credit risk of one country/region gets exported to another country/region very smoothly and silently. Thus There is a serious chance of ‘contagion effect’ suppose there are defaulters there, the thing which happened during the US ‘sub prime’ crisis.