IMPORTANCE OF CREDIT DEFAULT SWAPS IN OVER-THE-COUNTER DERIVATIVE MARKET

Transcription

1 IMPORTANCE OF CREDIT DEFAULT SWAPS IN OVER-THE-COUNTER DERIVATIVE MARKET Mrs. RINTU ANTHONY Guest Lecturer, Government Law College, Trichur ABSTRACT CDS or credit default swaps are contracts where a protection buyer purchases protection (for a premium) or cover against credit risk of a specific asset or bond sold by a reference entity and if the protection buyer suffers any loss on the asset, the protection seller will make payment to the protection buyer. Global OTC derivative market consists of Foreign exchange contracts, Interest rate contracts, Equity-linked contracts, Commodity contracts and Credit default swaps, and we make an attempt to analyse the role played by CDS. The objective of this paper is to study the relevance of CDS in our financial system and especially its relevance in credit derivative market. Gross notional value of CDS contracts are used to study its growth and effectiveness in derivative especially credit derivative markets. KEYWORDS Credit default swaps, CDS spreads, Gross notional value, CCP, Systematic Risk, Accrued Payment, Premium, Market Sensitivity, Community Governance,

2 1. Introduction In late 1994, Blythe Masters, a member of the J. P. Morgan swaps team, coined the idea of selling the credit risk to the European Bank of Reconstruction and Development, since J. P. Morgan was very particular not to decline the loan demand by Exxon, which was an old client, but the deal would tie up a lot of reserve cash to provide for the risk of the loans going bad. So, if Exxon defaulted, the E.B.R.D. would be ultimately responsible and, in return for taking on the risk, would receive a fee from J. P. Morgan. The deal was so new that it didn t even have a name: eventually, the one settled on was credit-default swap. The story doesn t have a happy ending for the American economy, of course, but things turned out all right for ExxonMobil because critics put the entire blame of 2008 global financial crisis on CDS 2. Theoretical framework A CDS contract establishes a relationship between protection buyer and protection seller and in the event of credit default the settlement i.e. the credit seller will have to reimburse the credit buyer his loss on the terms and conditions of CDS contract they entered and can be made two modes i.e. cash settlement or physical settlement. Eg Suppose a protection buyer purchases 5-year protection on a company at a default swap spread of 300bp. The face value of the protection is $10 million. The protection buyer therefore makes quarterly payments approximately equal to $10 million = $75,000. Assume that after a short period the reference entity suffers a credit event and that the CDS asset of the reference entity has a recovery price of $45 per $100 of face value. The payments are as follows: The protection seller compensates the protection buyer for the loss on the face value of the asset received by the protection buyer. This is equal to $10 million (100% 45%) = $5.5 million. The protection buyer pays the accrued premium from the previous premium payment date to time of the credit event. For example, if the credit event occurs after a month then the protection buyer pays approximately $10 million /12 = $18,750 of premium accrued. Federal Reserve bailout of AIG and the culprit CDS Pre-crisis, the US financial market was experiencing bullish times and it almost seemed impossible for bond issuers to go bankrupt. Consequently, selling CDS became perceived as a lucrative business of collecting premiums, and almost without having to pay anything at all As of the end of 2007, CDS contracts had grown to roughly $60 trillion in global business. When the housing market crashed and subprime mortgage borrowers defaulted, the value of MBS fell drastically. At that point in time, AIG insured more than $440 billion of fixed income investments held by the world s leading financial institutions, including $57.8 billion in paper related to subprime mortgages. These events, coupled with increased collateral requirements due to Namex International Journal of Management Research 78 Vol. 3, Issue No. 2, July Dec ISSN

3 the downgrade of its credit ratings by major rating agencies, eventually caused AIG to suffer a liquidity crunch. It did not have enough cash and other liquid assets to meet its current obligations. By November 2008, the company was almost entirely dependent on the Federal Reserve and the Treasury for funding. According to Federal Reserve data, AIG had borrowed a total of almost $128 billion by the end of the year. Systematic Risk and Relevance of Clearing Houses/CCP (Centralized Counterparties) in CDS markets CDS contracts have to be settled on credit event or default of a specific borrower, and thus CDS are especially sensitive to the state of the overall economy, and also Counterparty risk, which arises when one party to a contract may not be able to fulfill its commitment to the other, is also a systemic concern. The failure of one important participant in the CDS market could destabilize the financial system by inflicting significant losses on many trading partners simultaneously, if the economy moves toward a recession. For example, the likelihood of defaults increases and the expected payoff on credit default swaps can rise quickly. The Depository Trust and Clearing Corporation (DTCC) estimates that in April 2009, the notional amount of credit default swaps outstanding was about $28 trillion. As a result of the overall size of the CDS market and the sensitivity of CDS payoffs to economic conditions, large exposures to credit default swaps can create substantial systemic risk. Because of this potential for systemic risk, and also the incidents of disastrous impact of CDS on global economy, some have argued that credit default swaps should be cleared through central clearing counterparties, or clearinghouses. A CCP interposes itself between the parties to a transaction so that each party contracts only with the CCP and not with the other market participant. In other words, the CCP becomes the buyer to every seller and seller to every buyer. Eg Party A pays periodic premiums to the CCP, which in turn furnishes periodic premiums to Party B. If Party Z were to experience a credit event, Party B would fulfill its contract with the CCP by paying the notional amount to the clearinghouse. Since the CCP s primary risk arises from its counterparties credit quality, the CCP assumes the risk management duties that the counterparties previously undertook in the bilateral market and thus a prerequisite for central clearing include both sufficient contract standardization and reliable, tradable prices. First, a CCP imposes access restrictions to ensure that it trades only with creditworthy partners. Each clearing house has to get approval to clear CDS by their respective regulators which involve satisfying strict criteria mentioned by them, and each serves to transfer and mutualize counterparty credit risk. CDS in India India s fledgling credit default swap (CDS) market kicked-off on Dec 6, 2011 with two deals covering 100 million rupees ($1.9 million) worth of bonds. The deals, both 1-year trades were between ICICI Bank and IDBI Bank (underwriter), at 90 basis points and Namex International Journal of Management Research 79 Vol. 3, Issue No. 2, July Dec ISSN

4 covered 50 million rupees each of 10- year bonds issued by Rural Electrification Corp (REC) and India Railway Finance Corp, according to details on the Clearing Corp of India Ltd s website. The RBI has since then allowed banks to begin hedging their banking and trading books using CDS, signaling that the infrastructure is finally in place for the launch of the instruments in Asia s fourth biggest bond market. The launch of the CDS market in India will encourage foreign institutional investors to invest in domestic corporate bonds. This will provide much needed funding for the projects, including infrastructure sector. However the operations of CDS in India are subject to strict guidelines of RBI which may be termed an effort to prevent replicas of 2008 subprime crises. 3. Literature Review Mark J. Flannery, Joel. Houston & Frank (2010) stated that CDS spreads are more viable than credit ratings. Thus, CDS spreads are a promising market based tool for regulatory and private purposes, and they may serve as a viable substitute for credit ratings. Jeffrey L. Callen, Joshua Livnat and Dan Segal (2008) found that the earnings (cash flows, accruals) of reference firms are negatively and significantly correlated with the level of CDS premia, consistent with earnings (cash flows, accruals). Johnson (2013) advocates the adoption of a community governance model which addresses the most disconcerting conflicts in the credit default swap industry, and incorporates important normative considerations and oversight by an external authority. The Squam Lake Working Group (2008) studies and explains the concepts of clearing houses and studies its relevance in CDS market in the wake of 2008 global meltdown. 4. Objectives of the study To study the working and growth of CDS over the years. To study the relevance CDS has in OTC derivative markets. To study the relevance of clearing houses in CDS markets. To study Indian CDS markets. 5. Methodological framework The data used in this paper is secondary data collected from websites of BIS(bank for international settlements), CDS pricing agencies, research publication, journal etc and notional value of CDS is collected for a time period ranging from 2004 to The data regarding clearing of CDS contracts is collected from U.S. Commodities Futures Trading Commission (CFTC). It was on November 14, 2012, the Commission began the weekly publication of a proposed version of the CFTC Swaps Report, a Commission transparency initiative to aggregate and publish swaps market data. Thus data is collected from 2012 end to 2014 on quarterly basis. Namex International Journal of Management Research 80 Vol. 3, Issue No. 2, July Dec ISSN

5 Tools used Simple percentage analysis and mean percentages are used to understand the importance of CDS in OTC market. Also compounded annual growth rate method is used to denote the growth of CDS over the years. Limitations of the Study transperancy and availing the complete data is not possible. Collection of data for Indian CDS market is a tough process because of absence of a central regulating organization. The main sources of data for CDS are BIS and DTCC, which differ from each other mainly because of difference in their sampling techniques. Since almost all the CDS are traded OTC, it suffers from lack of 6. Data analysis and findings TABLE No. 1 - Gross Notional Value Amounts Outstanding, In Billions Of US dollars of CDS Contract and Trend Analysis from 2004 To 2013 Year End Notional Amount Percent Of Growth Of CDS For Every Year As Outstanding Compared To Previous Year , , % , % , % , % ,693-22% , % ,626-4% , % ,020 Source :BIS (Bank for International settlement ) TABLE No. 2 - CAGR (Compounded Annual Growth Rate) Of Different Components of OTC Derivative Market Components of OTC Market Percent of CAGR Foreign exchange contracts 9.15% Interest rate contracts 11.86% Equity-linked contracts 4.11% Commodity contracts 4.33% Credit default swaps 12.63% Thus we find that CAGR is highest for credit default swaps Namex International Journal of Management Research 81 Vol. 3, Issue No. 2, July Dec ISSN

6 FIGURE No. 1 - Gross Notional Value Of CDS Contract From 2004 To 2013 From the table and figure given above, we find that the gross notional value of CDS is at its peak in 2007 and then starts to decline from thereon. However till 2007, the percentage increase in value as compared to the previous year is very high, more than 100%, and after 2007 there is a step decline with 28% but after 2009, even though there is a decline, the percentage fall as compared to previous year are very small. Year TABLE No. 3 - Components of Global OTC Derivatives Market, Amounts in Billions of US Dollars from 2004 To 2013 Foreign Exchange Interest Rate Equity- Linked Commodity Credit Default Swaps Unallocated Total , , , , , , , , , , , , , , , , , , , ,182 Source : BIS TABLE No. 4 - Percentage of Each Components of Global OTC Derivatives Market, Amounts In Billions of US Dollars from 2004 to 2013 and Their Mean Percent Year Foreign Exchange Interest Rate Equity- Linked Commodity Credit Default Swaps % 73.87% 1.70% 0.56% 2.48% % 71.21% 1.95% 1.83% 4.67% % 70.29% 1.81% 1.72% 6.91% % 66.04% 1.42% 1.42% 9.72% % 70.50% 1.13% 0.70% 7.65% % 74.49% 0.98% 0.49% 5.41% Namex International Journal of Management Research 82 Vol. 3, Issue No. 2, July Dec ISSN

7 % 77.41% 0.94% 0.49% 4.97% % 77.82% 0.92% 0.48% 4.42% % 77.41% 0.49% 0.41% 3.96% % 82.28% 0.92% 0.31% 2.96% Mean percentage 9.72% 74.13% 1.23% 0.84% 5.32% The above percentages and mean percentage in the table shows that highest representation of OTC derivative market is made by Interest rate derivates followed by foreign exchange derivates followed by credit default swaps, followed by equity liked and commodity derivatives. TABLE No. 5 - Gross Notional Value Of CDS Which Are Cleared Through CCP And Not Cleared And Their Percentages, Amounts In Billions Of US Dollars From 2012 To 2014 On Quarterly Basis. Year Cleared Percentage Uncleared Percentage Dec '12 2, , March '13 2, , June '13 2, , Sept '13 3, , Dec '13 2, , March '14 2, , June '14 1, , Mean Percent Source: CFTC From the above table we find that even after the introduction of clearinghouses majority of the clearing houses are not cleared through CCPs. (Due to a technical coding error there is a wide deal of difference in values from December 2013 ). TABLE No. 6 - Credit default swaps by rating category Notional amounts outstanding at end December 2013 (In millions of US dollars). Instruments And Counterparties Total Investment Grade AAA/AA Investment Grade A/BBB Investment Grade <BB Non- Rated Total CDS contracts 21,019,859 1,682,804 11,522,299 4,866,907 2,947,849 Reporting dealers 11,052,822 1,174, ,486,343 1,559,149 Other financial institutions 9,779, , ,311,958 1,356,279 Central counterparties 5,518,173 81, ,363, ,001 Banks and security firms 1,724, , , ,186 Insurance and financial guaranty firms 209,103 23,121 78,586 43,969 63,427 SPVs, SPCs and SPEs 362,931 42, ,202 42, ,361 TABLE No. 7- Credit rated instruments as a percentage of total amounts outstanding at end December Instruments And Counterparties % Of Grade AAA/AA Debts % Of Grade A/BBB Debts % Of Less Than BB Debts % Of Non Rated Debts Total CDS Namex International Journal of Management Research 83 Vol. 3, Issue No. 2, July Dec ISSN

8 Reporting Dealers Other Financial Institutions Central Counterparties Banks And Security Firms Insurance And Financial Guaranty Firms Table shows that approximately 50% of CDS contracts are bought for instruments with grade A/BBB and lesser for less than BB grade debts and again lesser for non rated debts. CDS contracts are significantly least for AAA/AA debts. TABLE No. 8 - Showing Percentage of Indian CDS Market to the Global CDS Market Date Total Gross Notional Value Of Important Indian Players Total Gross Notional Value Of Global CDS Single Reference Entity Percent Of Indian CDS Market To Global CDS Market 06/29/ ,503, /28/ ,347, /28/ ,469, /27/ ,731, /27/ ,009, Source: DTCC The above table shows that the maximum representation of India in global CDS market is in the year 2012 with 0.21% and minimum representation is in the year 2014 with 0.16%. 7. Findings and suggestions From 2004 onwards the CDS markets keep on increasing till 2007 and after 2008, the CDS market halves itself with a 38% decline as a result of trade compression. After 2008, the markets keep declining but the rate of decline is almost stagnant as compared to rate of growth before While studying OTC derivative market, we find that CDS is an important segment because it has the highest growth with respect to CAGR and also it stands at third position with respect to its representation in OTC derivative market after Interest rate derivates and foreign exchange derivates. Even after the introduction of clearing houses to safeguard against systematic risk and avoid repetition of 2008 financial crunch majority of the clearing houses are not cleared through CCPs. The reason could be that derivative players don t want to undertrake another procedural delay or would not be able to get their contracts cleared because of strict conditions laid down by clearing houses. Volume of CDS are higher on debts with a higher credit rating especially grade A/BBB debts and CDS are lowest for debts which are not rated. A significant finding we made here is that debts with grade AAA/AA are traded least the default probability being nil, protection is least required. The Indian CDS markets are insignificant with an approximate Namex International Journal of Management Research 84 Vol. 3, Issue No. 2, July Dec ISSN

9 percentage of 0.20 in the global CDS markets.. In Indian market the major players in CDS market are SBI, ICICI bank, Reliance industries, IDBI bank, Bank of India with SBI leading with highest volume of notional value. Suggestions Eventhough CDS is a very useful credit derivative to hedge risk and distribute the credit risk, risk perception and fear of counterparty risk cannot be done away with unless a strong regulating mechanism to govern and control the CDS market is introduced. Such regulating mechanism should also be capable of enhancing transparency and liquidity in CDS markets. Function of clearing houses should be enhanced and its role in CDS markets should be improved. Since CDS transfer the risk associated with credit, Indian loans can be secured by the use of CDS and funds could beraised from foreign institutional investors which could serve as an important milestone to improve the economy of India. Conclusion Thus by enhancing liquidity and transparency in CDS market, CDS due to its immense benefits could be converted to strengthen the financial system and boost the economy. Also by RBI and excessive fear in the minds of investors have deterred the growth of CDS in India. and hence liberalizing the rules and opening the markets to overseas player can contribute in reforming this sector. REFERENCES Joe Romm May 26,2010. RMS - Risk Management Society,18 th May 2013 ISDA - International Swaps and Derivatives Association (November 2009): AIG and Credit Default Swaps ICE Global credit derivatives markets overview: Evolution, Standardization and Clearing' March dated Dec RBI Draft Report of the Internal Group on Introduction of Credit Default Swaps for Corporate Bonds, available at iondraftreports. Mark j. Flannery, Joel f. Houston & Frank partnoy(2010) credit default swap spreads as viable Substitutes for credit ratings university of pennsylvania law review [vol. 158: 2085]. Jeffrey L. Callen, Joshua Livnat and Dan Segal(2008) The Impact of Earnings on the Pricing of Credit Default Swaps Kristin N. Johnson (2010) Things fall apart: regulating the credit default swap commons University of Colorado Law Review [vol. 82]. U.S. Commodity Futures Trading Commission. Depository trust and clearing corporation (DTCC). Namex International Journal of Management Research 85 Vol. 3, Issue No. 2, July Dec ISSN