Credit Default Swaps-Exordium
There’s no denying the fact that coronavirus is wreaking havoc in the economy and sending markets into a tizzy.
But if I say that someone made around $2.6bn, by investing only $27mn, from that very market in the month of March 2020, would you believe it?
Well, yes, Hedge Fund chief Bill Ackman achieved that feat and made an exorbitant windfall during this time of crisis.
But how? By speculating and trading strategies, which many hedge funds use?
No, by “hedging” using an instrument named Credit Default Swap.
What are these, one might ask?
Understanding Credit Default Swaps
These are nothing but like an insurance product which helps an investor in protecting his portfolio from the market downside.
Technically, a credit default swap (CDS) is a financial derivative or contract that allows an investor to “swap” or offset his/ her credit risk with that of another investor.
Imagine that HDFC Bank has given a loan to Maruti and the bank is a little bit concerned about the repayment of its loan in the future. They want to protect their loan exposure in case things go wrong some years down the line.
They enter into a Credit Default Swap agreement with ICICI Bank (who is pretty much confident about the ability and willingness of Maruti to repay the loan). HDFC Bank (CDS Buyer) would have to pay periodic premium to ICICI Bank (CDS Seller), who in turn agrees to make good any loss, on account of non-repayment of loan by Maruti (Reference Obligation) in the future, to HDFC Bank.
In case any credit event (which includes Bankruptcy, Defaulting on payment, and Restructuring of debt, to name a few) happens in the future, ICICI will have to step in to repay the loan amount, excluding any recovery if made from Maruti by HDFC, to HDFC.
The deal is struck and everyone is happy!
We have seen how CDS acts as a hedge in giving protection to the borrower.
Bill Ackman built up CDS exposure on $50bn of US investment grade debt, $18.5bn position in the equivalent European index, and $2.5bn notional exposure to Europe’s high-yield debt, according to sources. His hedge fund merely hedged their investment exposure by buying CDS and once the market started falling and things started getting gloomy, he slowly started liquidating his CDS positions to realize the gains.
Now when the market sentiment starts getting jittery, the price of a CDS contract (called CDS spread) starts rising because now most people would want to hedge their exposure and won’t mind getting some protection. A CDS buyer which entered at lower spread can now square off his/ her position by selling CDS at higher spread thereby monetizing the trade.
You might say that CDS is sounding a pretty decent instrument, then what’s the flip side?
Speculative nature of CDS: Naked CDS
Because of its speculative nature which has been a negative force for the markets in the past. Let’s go back to Global Financial Crisis (GFC) that unfolded around the year 2008.
CDS became so popular in the West in the run-up to the GFC. Banks and hedge funds started entering into CDS contract without any reference obligation!
Wait, how’s that possible?
A bank forming an opinion on the credit worthiness of a certain company started betting about that company’s prospects in the future without having any loan exposure whatsoever. Two people started betting on the credit worthiness of a company without any one having any position in that company. Mere speculation!
Such a CDS contract is known as Naked CDS (without reference obligation).
Mayhem during Global Financial Crisis
Things started getting out of hands given the huge degree of speculation in the market.
By 2007, the outstanding credit default swaps value stood at $62.2 trillion. During the financial crisis of 2008, the value of CDS was hit hard, and it dropped to $26.3 trillion by 2010 and $25.5 trillion in 2012. There was no legal framework to regulate swaps, and the lack of transparency in the market became a concern among regulators.
Many investment banks were involved, but the biggest casualty was Lehman Brothers investment bank, which owed $600 billion in debt, out of which $400 billion was covered by CDS. The bank’s insurer, American Insurance Group, lacked sufficient funds to clear the debt, and the Federal Reserve of the United States needed to intervene to bail it out.
Companies that traded in swaps were battered during the financial crisis. Since the market was unregulated, banks used swaps to insure complex financial products. Investors were no longer interested in buying swaps and banks began holding more capital and becoming risk-averse in granting loans.
The Dodd-Frank Wall Street Report Act of 2009 was introduced to regulate the credit default swap market. It phased out the riskiest swaps and prohibited banks from using customer deposits to invest in swaps and other derivatives. The act also required the setting up of a clearinghouse to trade and price swaps.
CDS market started becoming more matured in the West.
Current penetration and India’s standing
Look at the current penetration of CDS in the world:
Asian countries account for less than 2% exposure to CDS.
India embraced CDS, with RBI issuing guidelines, way back in 2011, however not much has gained traction till now. Only handful of CDS exchanged hands like, ICICI Bank bought insurance from IDBI Bank to protect its lending to Rural Electrification Corp.
Deep study of the market coupled with strict regulatory apparatus and awareness about the hedging property of CDS can help in the flight of this instrument. Credit Default Swaps can come a long way to further deepen India’s debt market.
Discussion on deepening the debt market can elongate this article more; let’s keep it for some other day.
Stay safe till then:)
P.S.: Derivatives can be over the counter and exchange traded. Click the links to read more.
Sources:
https://www.investopedia.com/terms/c/creditdefaultswap.asp
https://www.ft.com/content/70a5566c-5c02-4dcd-9360-c2b0001f2f29
https://corporatefinanceinstitute.com/resources/knowledge/finance/credit-default-swap-cds/
