Credit Derivatives: CDS and CDO current scenario and future prospects in India

Abstract

The financial derivatives market has grown significantly in the past in terms of trading volume, availability of exotic financial products and their complex nature. Financial derivatives are used for hedging the risk in the underlying assets, obtaining exposure to the underlying and making huge profits through speculations. Globally, the credit derivatives are a major part of the financial derivatives market and have played a significant role especially coming into prominence after the financial crisis of 2008 when CDOs and CDS gathered huge popularity. Despite that, they are small when compared to other derivatives but the growth has been phenomenal in the last decade. Not only do they play a very important role in managing credit risk but also, they assist in the development of the corporate debt market. It is very surprising to note that a country like India with a projected growth rate of 8-10 % has had very insignificant development in financial instruments like credit derivatives. The credit derivatives market is still in its infancy but definitely is in an emerging stage. India is on its fast economic growth lane and it needs adequate financial supply to maintain this growth. Traditionally, Indian organizations have been dependent on banks for any kind of credit requirements. There is a growing need for a liquid corporate debt market that can help even the smaller firms to avail the credit when required and help in growing the economy. Recent initiatives of Reserve Bank of India (RBI) and the introduction of credit default swap (CDS) in the Indian market are encouraging moves towards building a more efficient corporate debt market and improving liquidity. Hence, there arises a need to analyze the needs and obstacles for the introduction of credit derivatives in India. Moreover, recently the Reserve Bank of India has come out with the CDS guidelines to allow corporate entities to hedge against their bonds. Given the popularity of CDS and CDOs after 2008 crisis, several issues and concerns have been raised regarding these products. The development of credit derivatives market will help to increase the financial stability by transfer of credit risks to a pool of investors and also help the financial institutions to separate the credit risks from other risks. Moreover, there is a great responsibility on regulators to ensure that bearers of credit risk have the appropriate risk management tools to manage such risk exposures. But in the emerging Indian debt market with concerns of institutional inadequacies like bankruptcy codes, creditor rights, clearing and settlement agencies can slow down the growth of credit derivative market. RBI guidelines on guarantees and co-acceptances presently preclude banks from issuing guarantees favouring other lending agencies, banks or FIs for loans extended by them. This project aims to understand the significance of the credit derivatives like credit default swaps in the Indian corporate debt market and analyzes how the present problems in the corporate debt market can be overcome. This has been achieved by analyzing the evolution and growth of the credit derivatives market globally and the study of the current scenario of the credit derivative products such as CDS and CDO in India. Based on this, suitable recommendations have been proposed to improve the liquidity in the debt market and steps have been suggested to make the debt market as effective as the equity market.