Credit Default Swaps

Credit Default Swaps

Context: RBI releases draft norms for Credit Default Swaps

Concept:

draft guidelines on credit default swaps (CDS) by RBI:

• Retail users will be allowed to undertake transactions in permitted credit derivatives for hedging their underlying credit risk.
• non-retail users will be allowed to undertake transactions in credit derivatives for both hedging and other purposes.
• A person resident in India and a non-resident — to the extent specified in the RBI directions – can participate in the market.
• Exchanges may offer standardised single-name CDS contracts with guaranteed cash settlement.
• Retail users shall undertake transactions in exchange-traded CDS only for hedging their underlying credit risk.
• The central bank said commercial papers, certificates of deposit and non-convertible debentures of original maturity up to 1-year, rated rupee corporate bonds (listed and unlisted) and unrated rupee bonds issued by the special purpose vehicles set up by infrastructure companies will be eligible to be a reference or deliverable obligation in a CDS contract.

Credit Default Swap (CDS)

• Credit default swap is a financial derivative or contract that allows an investor to “swap” or offset his or her credit risk with that of another investor.
• In this the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Just like an insurance policy CDS needs to be maintained through regular premium.
• It is an example of Over-the-Counter derivative (OTC).
• An over the counter (OTC) derivative is a financial contract that does not trade on an asset exchange, and which can be tailored to each party’s needs.

What are derivatives?

A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. Its value is determined by fluctuations in the underlying asset.

Concerns with CDS

CDS played a big role in the global financial crisis as Lehman Brothers, the biggest casualty, owed $600 billion in debt, out of which $ 400 billion was covered by CDS.