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Credit Default Swap- Basics
May 29 , 2013

The Credit Default Swap is an enormous subject and we don't claim we can do justice to it in this article. Indeed, the US sub-prime crisis has shown even professional Economists (some of them Nobel Laureates) how little they understood the complications behind this product! Rather, we look very briefly into theory and more into what it can mean for the Indian market and for you as an investor.

What is Credit Default Swap (CDS)?

Say you are an investor wanting to put money in debt. You lack the time and resources to identify 'safe' investment avenues. So (unless you are taken for a ride by your agent!), you will and should rush to the security of the Government of India or Nationalised Banks. Your investment options are then limited to PPF, Post-office schemes or bank deposits. If a company like Infosys were to try and borrow money, you would have no idea how to evaluate the risks and benefits. A similar problem confronts institutional investors such as mutual funds and insurance companies too- they have money, but lack the ability to carry out detailed assessment of companies whose bonds they may invest in. The result is that corporate bond market in India is comatose; well over 90% of borrowing in India is done only by the Government of India or the state and local governments. 

Banks and credit institutions, on the other hand, may have detailed information about some of these borrowers. They may be able to understand, and hence price the risk their bonds hold. They may, however, lack the resources to lend to these companies themselves. The CDS, in its simplest Avtaar, brings these two people together. 

Examples of CDS

A mutual fund can lend, while a Bank can take on the risk. In return, the fund pays the bank a fee, similar to a Bank guarantee. The fund continues to get interest on the bonds it holds; but if the bond defaults, the Bank makes up to the fund. You can say the fund has taken insurance on the bonds it holds.

The person taking the insurance is called 'buying' or 'taking' a CDS, while the Bank is said to 'write' the CDS. The buyer benefits if the bond goes down, the writer benefits if the bond does well and pays interest on schedule.

This may look novel of complicated, but some form of this has been existent in India for quite some time. Remember the days when a home loan had to have two guarantors? Even today an education loan for a student going abroad often needs guarantors. This is nothing but the Bank taking a CDS from the guarantor (albeit free of charge!). The guarantor stays out till the borrower can repay. If he cannot, the guarantor needs to step in and pay off the Bank.

CDS in India

The Reserve Bank (RBI) now proposes to allow the CDS on various types of borrowing. To avoid mistakes of the US, one proposal is to allow only holders of a bond to take insurance on it. In the US, just about anyone could take a CDS on any bond they believed was going down, and this led to chaos. Also, insurance is obviously useless if the insurance company itself has no money to pay up! To prevent this situation in a CDS, Banks writing a CDS need to have good capital adequacy.

The biggest potential benefit of CDS is likely to be expansion of the corporate bond market. Banks would lose their monopoly as the only lender to business. In theory, the CDS can also create a liquid market, where people get credit at interest rates that vary as per the risk of the business they are undertaking. This is obviously a dream scenario to ensure efficient deployment of money in a credit-starved economy like India. Capital heavy sectors like infrastructure, real estate and heavy industry should benefit. Of course the product needs to be closely regulated to prevent blow-ups, and we can trust the RBI to do the best possible job of it.

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