Group 7

Rahul Tiwari 27NMP64

Sumit Aggarwal 27NMP73
Vikas Jain 27NMP35
Amit Jain 27NMP44
Amit Gujjewar 27NMP43
Credit Derivatives in India Issues and Challenges
The Credit derivatives market originated through securitization of mortgage
backed market of 1980s. Securitization hedged the credit risk by completely
eliminating the credit product from the books of credit provider. It was Merill
Lynch which introduced the world to credit derivatives in 1991 through a $368
Million deal.
Still the market did not grow much till 1997 but the market has evolved now with a
size of over $ 1 trillion. London is said to be concentrated heavily with credit
derivatives market. Even though the market has grown but World over this market
still has very few active players and also the secondary market is majorly illiquid.
The global financial crisis in 2008 highlighted the need to reduce dependence on
the banking system. And with the lesson learnt from the world India introduced
credit derivatives in India in 2011.It started with a small credit default swap
transaction when ICICI Bank bought insurance from IDBI Bank to protect its
lending to Rural Electrification Corp. The deal came soon after the Reserve Bank
of India gave the final green signal at the end of November 2011 for these credit
derivative products.
Credit Derivative Instruments are bilateral agreements in which one counter party
pays a fee (typically semi-annually or otherwise contracted) and has the right in
case of default of a reference entity, to collect from the other counterparty a
stipulated notional amount in exchange for a bond issued by the reference entity.
The stipulated notional amount is generally the face value of the bond and the
reference entity may be a corporate entity or a sovereign entity. Thus it acts as a
protection against losses incurred by the holder of the bond in case of the default of
the reference entity.
Credit derivatives help in diversifying credit risk, improve earning and lower the
risk profile of the institution. However, improper use of credit derivatives may
result in an imprudent risk profile. Credit derivatives expose participants to risks

familiar to commercial banks, like credit, liquidity, price, legal (compliance),

foreign exchange and reputation risks. Regulators, therefore, require banks to
address these issues before dealing in credit derivatives.
Some of the issues pertaining to regulation of the CDS market are described below.
1. Frequent innovation in the features of Credit Derivatives segment has made
difficult for the Regulator to come up with effective regulation for such products.
2. Being the OTC products, effective regulation is extremely difficult to put in
place because of their non-standardized nature.
3. Whatever the policies were developed to curb the speculative activities in the
CDS market, majority of them aimed to arrest the activities of banks preventing
them from making speculation in the CDS market, considering them as the only
participants. This has been criticized on the ground that policies were inadequate to
bring the insurance companies under their scanners, who are equally responsible
for selling default protection in the CDS market. For instance Basel III was
developed in response to the deficiencies in financial regulation unfolded during
the crisis to tighten the standards of banks on three fronts: capital requirement,
leverage ratio, and liquidity requirements, without considering the regulations for
the insurers such as AIG.
4. Absence of tight monitoring and regulation on the credit ratings institutions has
caused a severe understatement of risk, which in turn led some insurers to cash in
on selling CDS contracts to the investors. This has caused investors felt assured of
buying triple A rated securities, assigned by the credit rating institutions, from the
insurance companies. According to Harrington (2009), because of little supervisory
activities on AIGFP, the subsidiary of AIG, selling the CDS contracts, AIGFP
consequently became an unregulated hedge fund, leveraging on the credit rating of
the holding company to place huge bets with little reserves.