Credit derivatives are a specific class of financial instruments whose value is derived from an underlying market instrument driven primarily by the credit risk. Credit derivatives are similar to other derivatives that transfer risk between parties; the difference is that credit derivatives transfer credit risk rather than price or interest rate risk.
Credit derivatives are financial contracts that allow one party (the beneficiary) to transfer to another party (the guarantor) the credit risk of a particular asset or portfolio of assets that the beneficiary actually owns. Such a transfer enables the guarantor to assume the credit risk of those specific asset(s) without directly purchasing them. Risk can be transferred directly between risk shedder (Seller) and risk taker (Purchaser) or indirectly through a Special Purpose Vehicle / Trust / Fund etc.
Reasons for development of Credit Derivatives are many and vary according to the motivations of different institutions involved.
Banks naturally develop expertise in particular target markets and, therefore, do not always have the ability to originate a truly diversified mix of assets. The resulting concentrations leave many banks overexposed to particular economic sectors. In order to mitigate this, Commercial banks use credit derivatives to swap loan portfolios to diversify loan exposures at both the individual and portfolio level. They agree to swap with each other payments received on a basket of each bank’s exposures, thereby diversifying the industry concentration risk and optimizing the return / volatility matrix of their respective loan portfolios.
Loan portfolio swaps effectively trade risks and returns from one basket of credits against the risks and returns from another basket of credits. They also serve the dual purpose of reducing required regulatory capital and lowering funding costs.
Other exposure purchasers are non-bank institutions, investment funds, and some insurance companies who act as counterparties to credit derivative transactions with banks. These institutions either do not lend, are unwilling to absorb ancillary costs, or lack the means to administer loan portfolios. As a result, these investors gain access to traditional loan markets previously unavailable.
Consequently, credit derivatives have become significant risk-reduction and investment products as they facilitate the trading of credit risk with the purpose of replicating, transferring and hedging credit risk
At an elementary level, the CD is a transaction between two parties. The Protection Seller also called the Credit Risk Buyer, is one who offers the protection against the credit risk (i.e. assumes the credit risk) for an agreed premium or fee, and the Protection Buyer also known as the Credit Risk Seller is the one who is protected against the credit risk (i.e. he transfers the credit risk to the Protection Seller) for which he has to pay a certain fee or premium.
The advantages of credit derivatives (CD) over a loan sales for Financial Institutions / Banks are many :
a) A CD is an off-balance sheet item and is therefore, considered less visible than a loan sale and imposes fewer administrative obligations.
b) As the exposure, but not the asset itself is sold, CDs help banks to manage internal limits and lower exposures to particular industries or segment concentrations or to large borrowers as they offer an alternative to consortiums / participations etc. without undermining client relationships. Some customers are sensitive to having their loan sold off.
c) CDs allow banks to generate income where direct lending opportunities / skills are not available.
d) Being off-balance sheet items they offer considerable flexibility in terms of leverage by allowing a reduction in regulatory capital usage, thereby achieving a better return on capital.
e) They can be structured in any manner acceptable to both parties.
On the flip side, the disadvantages of CDs are similar to any other risk management product. The efficacy of the tool depends entirely on the skill of the user and the circumstances in which it has been used. The financial world rebounds with apprehensions about CDs e.g. they are purely speculative in nature, they are unsafe and therefore unsound and highly risky, they enhance the moral hazard involved in maintaining loan discipline, etc. etc.
The risks inherent in the CD products, as in any credit product are often enhanced, primarily due to lack of adequate knowledge of how the product is to be leveraged / used and the larger volumes involved. CDs are used by Banks principally to hedge the risks inherent in their loan portfolios. The chances of another financial bank / institution (counterparty) defaulting, although not ruled out, are substantially less than that of an individual loan default.
This is not meant in any manner, to undermine the genuine apprehensions of financial analysts, bankers and regulators (a notoriously cautious tribe). There is a very real fear that because the credit risks are spread out throughout the financial markets, failure at a single bank could trigger a domino effect. However, it is precisely this spreading of risk, which provides a safeguard for the system. Because financial derivatives allow different risk components to be isolated and passed around the financial system, those who are willing and able to bear each risk component at the least cost will become the risk holders. This reduces the overall cost of risk bearing and enhances economic efficiency.
The principal credit derivative products widely available in the market comprise three main categories, namely :
Total return swaps (also known as loan swaps)
i) Credit default products take the form of put options on credit-risky assets that guarantee payoffs contingent on the occurrence of specific default events. To put it simply, this is a refined form of a traditional financial guarantee or stand-by line of credit, except that compensation is not limited to actual default but can cover credit events such as downgrading, fall in market value etc.
Credit default swap covers only the credit risk inherent in the asset, while risks on account of other factors such as interest rate movements remain with the originator of the risk. It provides protection against specific credit events only.
For instance, as illustrated in the following example, the beneficiary (Bank A) agrees to pay to the guarantor (Bank B) a fee on the specific asset(s). In return, the guarantor agrees to pay the beneficiary an agreed upon, market based, post default amount or percentage if there is a default, which is clearly defined in the contract. The guarantor makes no payment until a default actually occurs.
This is fairly similar to the kind of credit protection offered by ECGC (or erstwhile DICGC). However, the principal difference is that while settlement of an guarantee claim is subject to verification, fulfillment of various preset conditions etc. the Credit Default swap is simply a commercial transaction, which takes place on the occurrence of a pre-determined credit event e.g. default, full or partial loss, or down-gradation of rating, etc.
ii) Credit spread products or Credit-Linked Notes as they are frequently called, are generally forwards or options on the margins of credit-sensitive assets. This device transfers merely the credit risk and not other risks involved with the credit asset.
The seller identifies a particular asset or set of assets in exchange for which, the buyer issues notes and the total return of the notes is linked to the market value of the underlying pool of debt securities. From the issuer’s perspectives, credit-linked notes are used to reduce regulatory capital and additionally provide an efficient way to adjust quickly the credit risk profile of the loan portfolio.
From the investor’s perspective, credit-linked notes provide access to a pool of securities, often on a leveraged basis, without the need for the investor to buy or sell derivatives directly.
CLNs are generally created through a Special Purpose Vehicle (SPV) or a trust / hedge fund, which in turn, is collateralised with highly rated securities.
iii) Total return swaps are off-balance sheet item, that synthetically embed the returns of credit-risky assets into traditional swap structures. The key characteristic is that, being an off-balance sheet transaction, a total-return swap obviates the need to arrange a loan or purchase a bond.
As the name implies, a total return swap is a swap of the total return out of a credit asset i.e. coupons plus capital gains or losses to the seller against a contracted prefixed return to the buyer. The total return swap provides protection against loss of value irrespective of cause e.g. default, widening of credit spreads, change in valuations / ratings etc.
For example, the beneficiary (Bank A) agrees to pay the guarantor (Bank B) the total return on a specific asset(s) which consist of all contractual payments, as well as any appreciation in the market value of these asset(s). In return, the guarantor (Bank B) agrees to pay interest at an agreed rate (LIBOR / PLR) plus a spread and any depreciation to the beneficiary. The protection seller not only assumes the credit risk, but also receives a risk premium for bearing the risk. The greater the credit risk, the higher the risk premium.
The Credit derivatives are generally structured so that a payout only occurs when a predefined event of default or credit downgrade takes place, or a predetermined loss threshold is breached. Credit derivative transactions are structured and documented with master agreements similar to those governing traditional swaps or options. The International Swaps and Derivatives Association (ISDA) has been instrumental in developing credit derivative agreements, which are now used internationally.
In India, the Credit Derivative market is a nascent market warranting a cautious approach. RBI has recently issued draft guidelines restricting speculative trading of credit derivatives. Banks are initially being permitted to use credit derivatives as an additional tool, only for managing their credit risks and not for trading, with the sole exception of credit linked notes, which can be held as investments in the trading book. RBI also is restricting transactions between related parties.
Moreover, a healthy credit derivatives market presupposes the existence of protection sellers, which in the Indian context are practically absent. For this segment to develop, the sellers need to be able to hedge their risks, enabling them to quote competitive pricing for the protection they are selling, thereby providing a depth to the market.
Securitisation of portfolios is also gradually gaining acceptance in the Indian market. ICICI Bank being the frontrunner in this area has reportedly put through approx. Rs.8,000 cr. worth of securitisation deals during 2002-03 alone. Coupling of credit derivatives with securitisation deals would give an impetus to the CD market.
With the implementation of BIS II guidelines, Banks would be required to attach risk weightage to their loan portfolios commensurate with the credit ratings of the individual loans. This may prompt them to seek protection for lower rated loans to reduce the amount of regulatory capital as they can replace the risk weight of the underlying asset with that of the Protection Selling Bank to the extent of protection received. In case any of these assets turn into NPA, the Protection Buyer would also not need to make any corresponding provision in its books.
The Protection Selling Bank on the other hand, would be acquiring the credit exposure to that particular asset, and would therefore, be required to assign an appropriate risk weight to that asset (similar to the manner of non-fund based limits), and also make any provision which may be required in the interim. In case some Banks consider issuing CLNs themselves instead of through a SPV or Fund, they would be required to maintain CRR & SLR as required.
This in turn brings us to the topic of disclosure. Prudent accounting principles require that derivatives create assets and liabilities which should be captured on the balance sheet at fair economic value based on current market prices taking into account credit and market risk characteristics arising from these positions. Banks are therefore required to disclose fairly comprehensive details of their credit derivative transactions in the Notes on Account of their annual accounts.