Credit Default Swaps – Financial Weapons of mass destruction or effective way to mitigate credit risks?

In October 2009, the Reserve Bank of India (RBI) had announced in the second quarter review of monetary policy that it plans to introduce over-the-counter Credit Default Swaps (CDS) for resident entities and appointed an internal working group to finalise the operational framework in consultation with the market participants. Finally in May, 2011 the final guidelines on the same were published in the RBI website and the guidelines were made operational from December 1, 2011. Any person having advanced level knowledge of what happened in 2008 U.S. recession would have shivers down his spine whenever the names like CDS or CDOs (collateralized debt obligations) are mentioned. CDS and CDO are arguably, regarded as “exotic” derivative contracts that let the 2008 economic downturn to assume such massive proportions. Then why did the ever conservative and careful RBI introduce such a financial instrument in the Indian capital markets?

The above answer and the answer to the question mentioned in the topic can only be given if we analyse and understand few basic terminologies. Firstly, what is a derivative? A derivative is a financial instrument that derives its value from the value of the underlying instrument. Eg. A future contract is a derivative of the underlying equity share or commodity and would derive its value (that is, trade at a premium or discount) based on the value of share or commodity. Similarly, CDS is also a derivative. It is a credit derivative contract in which one party (protection buyer) pays a periodic fee to another party (protection seller) in return for compensation for default (or similar credit event) by a reference entity. CDS contract acts in the nature of an insurance contract (credit insurance). The entity or company or bond or share or asset on which CDS contract is made is referred to as “reference entity”. It can act as a great hedging tool in case the underlying asset tends to show drastic fall in price due to some events (credit events like failure to pay, restructuring and bankruptcy, etc.). In further simpler terms, CDS on a company that has filed for bankruptcy would trigger a credit event and entail payment as per CDS contract.  

Just by the above definition, it is crystal clear that a properly regulated and well structured CDS contract can create economic balance and financial discipline among the parties to the contract. However, it is not very hard to imagine the repercussions of a badly structured CDS contract. It can create economic havoc in banks and other financial institutions. In India, RBI has come out with regulations for CDS contracts for Indian banks and other financial institutions that allow CDS contracts to be pure hedging instruments. In other words, parties are not allowed to take “naked” positions in the CDS contracts or positions without having exposure to the underlying asset. Eg. A CDS on XYZ Ltd. 9% Bonds (maturity 10 years) can only be bought if one has bought the above mentioned bonds as then CDS would act as a hedge. Banks and few specified financial institutions would act as market makers in the above transaction. These regulations ensure the CDS market to act in its true spirit – insuring the credit risks but do not allow scope for widening the credit derivatives market.

These regulations are in stark contrast to the unregulated CDS market in the USA and Europe which exists even now. There, CDS can be used as a speculative as well as a hedging tool. Financial institutions can enter into sell or buy transactions in CDS regardless of any exposure to the underlying asset. When the market player enters into a CDS contract without having any exposure to the underlying asset, it is referred to as “naked” position. These “naked” positions which are speculative in nature are expected to account for 80 percent of the overall CDS market (which had outstanding contracts worth $62.2 trillion by 2007 end and falling to $26.3 trillion by mid-year 2010 but reportedly $25.5 trillion in early 2012). It is these positions that had created a financial bubble that ultimately burst in 2008. No doubt it was the default on subprime real estate loans (loans given to borrowers for buying houses who do not have credit worthiness) that was the base of the financial crises but CDS contracts on them actually sparked the massive economic fire. Some financial experts have described these “naked” positions being in the nature of buying fire insurance on your neighbour’s house. It creates a huge incentive to burn down the neighbour’s house as there is no insurable interest in that house. Similarly, a buyer of a CDS contract who does not hold any position in the reference entity would want the reference entity to “fail” or go bankrupt and thus, collect huge gains on the CDS contract.

Furthermore, the CDS market in the USA and Europe has few more interesting points. The reference entity is not a party to the overall contract of CDS (This is the same for Indian regulations also). The company’s bonds are traded on the stock exchange while CDS contracts that act as insurance against the exposure to the reference entity are traded over the counter between two contracting parties (having or not having exposure to the reference entity). However, an interesting point arises that the outstanding value of the bonds issued by the reference entity has no relation to the outstanding amount of CDS contracts traded against those bonds. Eg. The outstanding amount of bonds of a company may be $500 million. However, the outstanding contracts of CDS can be worth as much as or even greater than $5billion (10 times against value of those bonds).

There are arguments both in favour and against the overcapitalisation. Those against it would argue as to how can “protection” exceed the value of the “protected”. It is immoral and unethical and defies common sense. It promotes trading sans any substance to back them except for a contract paper. Wealth is generated in the most artificial fashion. Money flows and liabilities are assumed without any asset being purchased except bits of paper changing hands.

However, those favouring the overcapitalisation may argue that these contracts are totally independent to the reference entity and would be negotiated over the table (over the counter or OTC) between two parties – one who is willing to give protection and another party who is willing to buy that protection against any possible or hypothetical exposure to the reference entity. The fact that the outstanding CDS contracts are much more in value than the outstanding bonds stands pointless so long as there is a market and an appetite for a financial instrument (that is, there is a buyer and a seller for the contract). However, sometimes it so happens that the financial risks are so intertwined that these huge naked positions, rather than acting as any usual financial transaction have the power to create a financial “tsunami”. This is what happened when the investment bank Lehman Brothers’ got bankrupt in September 2008. Lehman Brothers’ had approximately $155 billion of outstanding debt but around $400 billion notional value of CDS contracts had been written that referenced this debt. Thus, not only lenders of Lehman Brothers’ were on tenterhooks after bankruptcy, but also those who had sold protection on such debt (that is, held a sell position on CDS contracts) were in deep financial trouble. Accordingly, even though marketability argument is fine, the collateral damage due to creation of these huge outstanding “naked” positions is a greater concern.

There are many more intricacies involved in CDS contracts and the even more complex CDOs (collateralised debt obligations) that caused the great financial trouble in 2008 and are still unregulated. No doubt, nobody wants regulation for regulation’s sake. Unregulated businesses in the private sector, throughout the world, have the potential to reach new heights, encourage innovation and lead to greater economic gain for the country and the world as a whole. However, sometimes regulations by the legislature are necessary if the businesses do not regulate themselves. CDS contracts need not be over regulated as is the case with India or unregulated as is the case with USA and Europe. The legislature should give enough room to widen the market but not let it attain monstrous proportions. In this way they would not be financial weapons of mass destruction but instead effective financial instruments to trade in and mitigate credit risk.