Thursday, 30 August 2012

Infrastructure Development: Credit Default Swap

Extract from Economic Survey 2012, Chapter 5 "Financial Intermediation and Markets" pg. 119, 129

Infrastructure development is the key to longterm sustainable growth of the economy. However, infrastructure finance remains a constraining factor with heavy dependence on bank financing.

Development of the corporate bond market therefore is the key to infrastructure development. While, the introduction of CDS is expected to help in the process, innovative steps are needed to bring the corporate bond market centre stage of infrastructure financing.

Credit Default Swaps (CDS) for Corporate Bonds

CDS are contracts where an investor in bonds gets a cover against default, by the bond issuer, from a third party-the protection provider-by investing in a credit default swap. Bankers say that this will enable a banker who is comfortable with a client's credit profile, but without adequate funds, to facilitate a loan by providing credit protection through CDS. 2 Thus CDS is a risk management product which offers the participants:
(a) the opportunity to hive off (separate from a parent entity) credit risk, and also 
(b) to assume credit risk which otherwise may not be possible. 
Thus it benefits the bond buyer as well as the entity which is seeking to raise capital by issuing bonds. Thus the latter party can assume a credit risk which would have been otherwise not possible. The objective of introducing CDS for corporate bonds is to provide market participants a tool to transfer and manage credit risk in an effective manner through redistribution of risk. 

To  understand the process through a video Click here  .

Benefits of CDS

  1. enhancing investment and borrowing opportunities 
  2. reducing transaction costs while allowing risk transfers, 
  3. would increase investors’ interest in corporate bonds and would be beneficial to the development of the corporate bond market in India.

Guidelines on Credit Default Swaps for Corporate Bonds were issued by the RBI on 23 May 2011, outlining broad norms including the eligible participants and other requirements:

  • Market participants would have to follow the capital adequacy guidelines for CDS issued by their respective regulators. 
  • NBFCs shall participate in CDS market only as users. 
    • As users, they are permitted to buy credit protection only to hedge their credit risk on the corporate bonds they hold. 
    • They are not permitted to sell protection and hence not permitted to enter into short positions in the CDS contracts. 
    • They are permitted to exit their bought CDS positions by unwinding them with the original counterparty or by assigning them in favour of the buyer of the underlying bond.

Infrastructure Debt Funds (IDFs) are being encouraged to facilitate flow of funds into infrastructure .

1. Economic Survey 2012

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