What Exactly Constitutes A Credit Default Swap (CDS)?

India’s small and medium-sized enterprises (SMEs) drive economic growth, innovation, and employment. But, the lack of good credit history and collateral makes it difficult for SMEs to secure business loan for business operations and expansion purposes. 

Credit Default Swaps (CDS) have become famous as a global risk management tool for lenders and investors to transfer and reduce the risk associated with debt instruments. In this blog, we will understand CDS, its mechanics, and its importance in the financial landscape for SMEs and lenders in India.

Understanding Credit Default Swaps (CDS)

Definition of CDS: 

A Credit Default Swap (CDS) is a financial derivative whose value is derived from an underlying asset. The underlying asset is typically a business loan or bond issued by a company, government, or other entity. You do not own an underlying asset by owning a CDS, rather it serves as a tool to manage the risk. Simply put, a CDS acts as an insurance policy in case of non-payment of a business loan.

Purpose of CDS: 

CDS acts as a tool to manage risk for lenders and investors who issue debt/business loan to a particular company. By purchasing a CDS, they can transfer the risk associated with that debt to the CDS seller. Hence, mitigating losses in non-payment of business loan.

Mechanics of CDS

A Credit Default Swap is a financial contract between two parties. Like any other contract, this contract also involves multiple terminologies. Let’s understand these terms in detail.

Parties Involved

The buyer of the CDS: 

The buyer of a CDS is a party that has issued the debt/business loan to a company (reference entity). This could be a bank, an institutional investor, or any other fintech that may suffer losses in case of non-payment of business loan.

The seller of the CDS: 

The seller of a CDS is the party that agrees to bear potential losses in exchange for periodic premium payments from the buyer. Sellers can be banks, insurance companies, or other financial institutions willing to take on this risk.

The reference entity: 

The reference entity is the company, government, or any other organization that has taken the debt or business loan. The risk associated with this company’s ability to make timely payments on its business loan obligations is the risk being transferred through the CDS contract.

Key Component of CDS contract

A CDS contract has certain terms and conditions for the protection. These terms and conditions are mutually agreed upon by the two parties. Let us briefly understand the components of the terms and conditions of a CDS contract.

Premium payments by the buyer: 

The buyer of the CDS agrees to make periodic premium payments to the seller. You can pay premiums quarterly or semi-annually. These premium payments represent the cost of the credit protection provided by the CDS.

Trigger events of default: 

The CDS contract defines what events constitute a default by the reference entity. These trigger events include bankruptcy, failure to make scheduled business loan payments, etc. In case of default, the CDS seller must compensate the CDS buyer. 

Settlement of CDS: 

In a physical settlement, the CDS buyer delivers the defaulted debt instrument to the seller and receives the notional amount in return. The notional amount is the amount of business loan taken by the reference entity. In a cash settlement, the seller pays the buyer the market value of the defaulted debt instrument.

How a CDS contract works

Let us understand the CDS contract with an example:

Suppose  Mohit & Co. has taken a ₹10 Lakh business loan from a fintech Argus & Co. Argus & Co is concerned about the possibility of Mohit & Co. not being able to pay the business loan. Hence, it decides to buy credit protection in the form of a CDS contract from a financial institution Amigo & Co.

The CDS contract consists of the following terms: 

Reference Entity: Mohit & Co.

CDS Buyer: Argus & Co.

CDS Seller: Amigo & Co.

Notional Amount: ₹10 Lakh (the amount of the business loan)

Maturity Date: The date when the CDS contract expires

Premium: The periodic payments (e.g., quarterly or annual) that the fintech (the CDS buyer) pays to the CDS seller for credit protection.

Now, let’s consider two scenarios:

Scenario 1: Mohit & Co. pays the business loan

Argus & Co. continues to make periodic premium payments to Amigo & Co. until the maturity date of the CDS contract.

If Mohit & Co. pays the business loan during the term of the CDS contract, Amigo & Co. keeps the premium payments as compensation for providing credit protection.

Scenario 2: Mohit & Co. doesn’t pay the business loan

If Mohit & Co. doesn’t pay the business loan before the maturity date of the CDS contract, Argus & Co. (the CDS buyer) has the right to deliver the defaulted loan to Amigo & Co.

Amigo & Co. then pays Argus & Co. the notional amount of the CDS contract (₹10 Lakh), compensating Argus & Co. for the defaulted business loan.

The role of CDS in the financial market

Risk Transfer and Management: 

CDS plays an important role in the financial market by transferring credit risk from one party to another. This tool enhances the risk management capabilities of financial institutions and investors. For example, by observing the irregular payment from a particular borrower of a business loan, you can purchase a CDS contract to reduce and transfer the risk of default. Though the premium in such cases might be higher given the higher rate of default from the borrower side. 

Market Dynamics: 

The CDS market has a huge impact on the overall credit markets. The parties trade the contracts directly, instead of on a centralized exchange. CDS prices can serve as indicators of the creditworthiness of a reference entity, market sentiment, and supply and demand. This influences the pricing and availability of debt instruments issued by that entity.

Importance of CDS for SMEs and Lenders

Enhanced access to capital: 

The risk transfer mechanism through a CDS contract can make lenders more willing to provide you msme loan, as they are better prepared for cases of non-payment of business loan.  

Improved loan terms: 

Lenders offer favorable terms like longer repayment periods, lower interest rates, or collateral free business loan because the CDS reduces their overall risk. FlexiLoans offers term loan upto ₹1 crore with various flexibility in terms of payment schedule, interest rates, and collateral requirements

Enhanced credit ratings: 

The availability of CDS on msme loan can also have a positive impact on the credit ratings of your business. Credit rating agencies take into consideration the risk mitigation provided by CDS when assessing the creditworthiness of your business, as this reduces the overall default risk for lenders.

Regulatory Environment Of CDS

The Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) are the primary regulatory bodies governing the CDS market. The RBI has established guidelines and regulations for the use of CDS by banks, NBFCs, and other financial institutions. SEBI oversees the CDS market for corporate bonds and other securities.

The RBI’s guidelines include eligibility criteria for CDS participants, risk management practices, and reporting requirements. SEBI, on the other hand, has established rules for the issuance and trading of CDS contracts on corporate bonds, that ensure transparency and investor protection.

Risk and Concerns of CDS

One of the major concerns around CDS is the potential for counterparty risk, where the CDS seller may fail to pay the agreed-upon amount to the buyer if the reference entity defaults. This exposes the buyer to the risk they were trying to mitigate

This systemic risk was highlighted during the 2008 financial crisis. AIG Insurance, a major seller of CDS, collapsed when the mortgage-backed securities it had insured defaulted. AIG could not pay the agreed amount to the CDS buyer.

In India, traders trade CDS over-the-counter rather than on exchanges. The lack of transparency makes it difficult for regulators to monitor exposures and risks. Market participants find it difficult to accurately price CDS instruments due to the absence of a central exchange.

The idea of CDS is to hedge against default. There can be instances where CDS buyers push companies into default to collect on their swaps. This leads to moral hazards among CDS participants.

CDS are complex instruments that even sophisticated investors can find hard to value correctly. In a market like India, where CDS products are relatively new, there’s a risk of mispricing. This could lead to substantial losses to both buyers and sellers.

Conclusion

Credit Default Swaps (CDS) have emerged as a powerful risk management tool in the global financial market. By transferring the risk of loan defaults from lenders to third-party sellers, you get greater access to a line of credit for your business expansion plan.

The mechanics of CDS are straightforward: a lender (the buyer) pays regular premiums to a financial institution (the seller) in exchange for protection against a borrower’s (the reference entity) default. If the borrower defaults, the seller compensates the lender, effectively insuring the loan. 

However, the benefits of CDS come with significant cautions. The 2008 financial crisis illustrates the systemic risks due to CDS when major sellers like AIG collapsed. In India, the over-the-counter nature of CDS trading leads to transparency issues, making it difficult for regulators like RBI and SEBI to monitor risks effectively. 

Despite these risks, CDS remains a valuable tool in the credit market. They can enhance SMEs’ credit ratings, benefits in favorable business loan terms, longer repayment periods, and even collateral free business loan. 

As India’s financial markets evolve, the role of CDS will likely grow. But this growth must be managed carefully, learning from past global missteps, to ensure that CDS serves its primary purpose of credit flow to vital sectors like SMEs while maintaining financial stability.

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