— Arnav Maru†
Credit derivatives, and credit default swaps (“CDS”) took a major part of the blame for the 2008 sub-prime crises that took down the global economy. Introduced by Morgan Stanley in 1994, they were originally created to transfer credit exposure and free up regulatory capital in commercial banks. By 2008, in the absence of any effective regulation, they became instruments of immense speculation and ultimately led to the market crash. According to an ISDA report, after an initial revival and peak in Q2 of 2014, the international CDS market has been consistently losing transaction count. The CDS market in India is close to non-existent, owing to stringent regulation by the Reserve Bank of India (“RBI”).
This post seeks to build an argument for the revival of an over the counter (“OTC”) CDS market which would be backed by the government. This measure is proposed as an alternative to disbursement of COVID stimuli packages proposed by the Government of India.
India’s economic woes of the last two years have been gravely accentuated by the onset of the CoVID-19 pandemic, as India likely stares at its fifth economic recession. While India dodged the 2008 recession due to weak interlinkages with the global banking system, and stringent regulatory involvement in markets among other factors, this recession has been occasioned by domestic rather than international factors. Industries of all sizes face fund shortage, with workers facing retrenchments and pay cuts, creating a vicious cycle of low capital expenditure by corporates, feeding a weakening consumer demand. Banks have raised borrowing rates despite a lowered repo rate, owing to a bad loan ratio and the moratorium on loan repayments introduced by the government to combat the financial stress faced by borrowers in these testing times. Companies have thus turned to raising debt from markets, which has proven to be cheaper and more efficient. 2020 has seen 91 companies list debt securities on open markets, compared to only 61 new entrants in 2019. However, according to estimates, only around 5% of outstanding corporate bonds are traded actively, leading to issues in liquidity as well as price discovery.
2. The Model
The United Kingdom (“UK”) recently guaranteed £10 Billion of trade credit insurance. Trade credit insurance protects goods and service providers against losses occurring on account of non-payment of a commercial trade debt. This insurance is provided by companies such as Euler Hermes, Coface, and Morgan Stanley, in the UK. The government has in turn opened an option for these insurers to buy cover for themselves from the government. This has provided the necessary liquidity to markets and has prevented a possible domino effect that payment defaults have a capacity to cause.
In India, despite promises and daunting targets of privatization of the public sector in the financial services space, banking as well as insurance remain to be dominated by government-controlled agencies. State owned banks control 70% of all assets controlled by the various banks in India, while state-owned insurance companies have a market share of nearly 50%. It is proposed that the government of India, through these PSUs, can offer OTC CDS on publicly traded bonds in India. Credit insurance and CDS share many similarities, however, one significant difference arises in the fact that an insurer cannot obtain an insurance unless he has an insurable interest, whereas, no such requirement arises in a CDS. Insurance contracts also bring with them superior disclosure obligations, while CDS can rely on easily computable and available credit ratings. These two conditions, coupled with the fact that India’s corporate bond market has deepened in 2020, are the reasons why I propose that the Government should prefer CDS over a simple credit insurance guarantee.
3. Current regulation of CDS
The regulation of CDS in India falls with the RBI, and its prescribed guidelines. The guidelines demarcate ‘users’ of CDS as entities permitted to buy credit protection to hedge underlying risk on corporate bonds. Holding the underlying bond is a necessary precondition to buy CDS protection. Furthermore, the protection can neither be sold, nor shorted by users. ‘Market makers’, on the other hand can buy or sell CDS without having the underlying corporate bond. This leeway comes with stringent preconditions in the form of strong financials being required, for being eligible as a market maker. CDS are only allowed on listed corporate bonds and unlisted, rated, bonds of infrastructure companies. All the terms of individual CDS contracts have to be agreed between the parties, and, lastly, physical settlement is mandatory for all transactions involving users.
The rigorous regulation, as well as mandatory reporting requirements, make the CDS a ripe instrument for introducing structured liquidity into the markets. The prohibition on their use as instruments of speculation also hedges the markets against abuse as well as possible downsides. While government owned commercial banks can qualify as market makers as per existing guidelines, insurance companies would need a nod from the RBI to perform market-making functions.
4. The need for this model
The government, in the early days of the pandemic, suspended the initiation of fresh corporate insolvency resolution processes under the Insolvency and Bankruptcy Code, 2016 for a period of six months. This move was undertaken to help preserve the small and medium enterprises from going insolvent due to the CoVID imposed lockdown and economic inactivity. The suspension is still in place and has been a massive hurdle for creditors trying to recover their dues. It has also acted as a disincentive for creditors from handing out debt, as recourse against defaults remains limited. Introduction of a government backed default swap would counteract the apprehensiveness induced by the suspension of the IBC. It will also give an easier and quicker recourse to lenders, incentivising them to buy debt from the markets.
Even in the absence of the insolvency process, secured creditors prefer cashing out on the security interest. However, economic inactivity and slowdown has turned the Indian market into a ‘buyer’s’ market’. Not only will a creditor not receive full value on the security interest, but selling certain asset classes might also prove to be more expensive than before, resulting in an avoidable drain on the creditor’s as well as the debtor’s resources.
The government has seen some of the lowest levels of tax collection in the past quarter, and now faces the additional burden of providing stimulus to the contracting economy. The benefit of introducing the stimulus as CDS, thus, would be two-fold. First, the disbursement will not involve a lump sum handout to any stakeholder: only a default on a bond by a corporate would lead to the invocation of the swap. Second, the government would instead collect money in the form of the premium paid on the swaps. Theoretically, the move could end up with a positive contribution to the government treasury.
CDS also eliminate the problem of moral hazard that goes with direct disbursement of stimulus funds. While directly aiding the liquidity problems being faced by corporates, swaps eliminate the need to ensure the scrutiny and diligence on proper utilisation of funds. Since CDS are only permitted on listed debt securities, the markets, along with credit rating agencies will be sufficient indicators of the creditworthiness of the corporate debtors, as well as effective determinants of the price as well as premiums payable on the CDS.
Lastly, small and medium enterprises (“SME”) will immensely benefit due to long term effects of these swaps. When banks transfer the credit risk to the government, the risk would not remain primary concern of the banks. Resultantly, banks might be willing to infuse more funds in the SME sector. Prompted by the ease with which debt can be raised from primary and secondary markets, more firms will be incentivized to prefer debt as a viable option for financing. Investors will also benefit from a widening and diversified asset portfolio.
Former prime minister of India, Dr. Manmohan Singh, recently pointed out that the government “should make adequate capital available for businesses through government-backed credit guarantee programmes”. A number of European countries have already taken similar steps as a response to the economic slowdown and liquidity crunches, and have benefitted from them. Introducing CDS through state owned banks and insurance agencies will be a novel step that will benefit the slowing economy in a number of ways. With minimum capital infusion on an already stressed government wallet, the move will instill confidence in market participants. The possible benefits of the introduction of such swaps outweigh the risks and costs that accompany the any novel form of economic rescue missions.
†Arnav Maru is a V year student at MNLU, Mumbai. He can be reached at email@example.com.