Like any other financial derivative, credit derivatives provide payoff to the investor that depends upon the underlying default risk associated with any financial instrument, especially bank loans.
Of late, the growth in credit derivatives market has been phenomenal, especially in the United States and in European countries.
Going by the British Bankers' Association Survey the global credit derivatives market comprised nearly $1 trillion as of year 2000. Probably the greatest motivation behind such a growth has been due to the gap between commercial banks and other financial institutions such as insurance companies, mutual funds and other non-banking financial institutions so far as conventional bank loan market is concerned.
Traditionally, the loan market -- which offers higher rate of return than many other assets available elsewhere in the market -- is not accessible to other financial institutions. Yet at the same time banks may be interested to trade default risk as a separate exposure and this requires the takers (read financial institutions) who can provide this kind of protection.
Credit derivatives, in this regards, are a noteworthy step which could not only bridge this gap but also develop a much more efficient market for bank loans.
Typically, a credit derivative instrument involves stripping the credit or default risk embodied with a bank loan or a corporate bond or a portfolio of such assets, thereby creating a separate financial instrument altogether.
This not only provides protection to banks against 'bad assets' but also makes the credit risk amenable for trading as a separate derivative instrument. This is probably the most noteworthy feature of credit derivatives, i.e., instead of having derivatives written on the asset itself (as in case of equity derivatives), only the credit or default risk aspect of the loan (asset) is transformed into another hybrid and tradable instrument.
In banking parlance, banks can seek protection against credit risk yet retain the loans intact in their books. Thus, it sharply contrasts with the ongoing securitisation process which requires the bank to sell the bad debt/loan in the market.
What does the market offer?
Markets in credit derivatives broadly provide two types of products, viz. 'Replication Products' and 'Credit Default Products.'
Replication products, as the name suggests, provide a comprehensive coverage against the credit risk in terms of protection against either the interest payment associated with a loan or the required spread over and above a benchmark risk-free rate of interest such as yield on government securities.
The most pronounced product in this category is Total Return Swap (TRS) in which the central concept is the replication of the total performance of a credit asset (either a bond or a loan). In a TRS, an investor (total return receiver) enters into a derivative contract whereby he will receive all the cash flows associated with a loan without owning the same.
In turn, the investor makes periodic payments to the total return payer, conventionally linked to LIBOR (London Inter Bank Offer Rate) in international market. Total return, in this case might be the sum of interest payment plus capital appreciation, if any at maturity.
Usually this transaction involves certain amount of fee to be paid by the party (bank) seeking protection to another bank or a financial institution extending the protection.
Another instrument within the category of replication products is 'Credit Spread Transactions' where protection is sought for the credit spread associated with a particular loan, that represents the margin relative to a benchmark risk free rate to compensate the investor for the risk of default on the underlying security and is calculated as the difference between the rate of interest on that security or loan and the that of corresponding risk free security.
The transaction involves the exchange of spreads on two loans, spreads being measured as discussed.
The market in credit derivative, however, is largely identified synonymously with 'Credit Default Products' and the most widely traded instrument in this category is 'Credit Default Swaps' (CDS).
This is a bilateral contract in which a periodic fixed fee or premium is paid to a protection seller, in return for which the protection seller agrees to make a payment on the occurrence of a default events.
A CDS may be compared with a guarantee or credit insurance policy to the extent that the protection seller receives an up-front fee for agreeing to compensate the protection buyer in a future date. Being a derivative product, however, CDS makes a difference.
The contract under CDS depends upon the default event and the cash flow transaction is triggered only when the default occurs and not otherwise. This not only helps market participants to seek protection but also motivates them to buy and sell positions for reasons of speculation and arbitrage, without having the direct exposure to the underlying security.
And it is worthwhile to mention here that the maturity of the default swap does not have to match with the maturity of reference (underlying loan) asset.
In a similar fashion as credit risk is stripped out from the individual loan and standardized into CDS, debt securities can also be issued by a special purpose vehicle (SPV) backed by a diversified loan portfolio. These are popularly known as Collateralized Debt Obligations (CDOs) where the cash flows on a diversified portfolio have a lower variability than the cash flows on individual loans in that basket.
However, unlike CDS these are structured products and hence do not enjoy the standardised features though they have gained wide popularity among the structured products.
In recent years another popular product has emerged in the market known as 'Credit Linked Notes', which are regular debt obligations with an embedded credit derivative. They can be issued either directly by a corporation or bank or by a special purpose vehicle. The coupon payments made by a CLN effectively transfers the cash flow of a credit derivative transaction to individual investors.
But all these are not at ZERO risk!
Globally the credit derivatives market has grown spectacularly in recent years but it has yet to reach matured derivative markets in terms of liquidity, transparency and standardisation.
Credit derivative transactions are negotiated over the counter and thus involve high degree of counterparty risk. Failed or delayed payments by sellers of protection could leave the buyers exposed to unexpected credit risk on loans and bonds. The same problem is also coupled with the issue of willingness to pay.
The most pronounced problem involves issues relating to legal and documentation risks. In particular, the market participants and legal experts have raised doubts upon the ability of a protection buyer to enforce payment following a defined default event.
Some of the prominent cases such as 1998 Russian Default, Conseco Debt Restructuring in the USA (2000), National Power Demerger in UK (2000) have sparked off a debate on documentation and legal issues involved in credit derivative transactions.
What about the Indian market?
India has yet to realise the power of the credit derivative market. Of late, Reserve Bank of India has come out with a draft proposal in this regard which has recognised that though banks are dominant players in the loan market and thus are substantially exposed to credit risk, the market has not provided provide adequate protection against the credit risk to commercial banks.
This gap, as observed by RBI, can substantially be bridged through the introduction of credit derivatives which can involve other dominant market players such as insurance companies, mutual funds and corporate sector in these transactions.
Credit derivatives, if introduced, can not only supplement the ongoing process of securitisation but also help reduce the inefficiencies in the existing loan market.
This, however, presupposes the existence of a sound regulatory setup to address the legal and documentation issues involving credit derivative transactions.
Prabir Mohanty is Member of Faculty, International Management Institute, New Delhi.
