Explained: Will AIFs trading in CDS deepen corporate bonds market?

So what is a CDS?

Firstly, it is a derivative. But here’s more.

A CDS is basically a financial instrument bought to hedge against a credit risk. That is, if a lender believes that its debtor could be slack in servicing a loan—for example, taken through bonds and securitised loans—then the lender can protect itself from a default risk by buying a CDS. Then, if the debtor defaults in any of his/her/its payments, the CDS seller will compensate the CDS buyer. The CDS seller will be someone who is willing to take the default risk, but for a price, aka premium.

Usually, CDS aren’t bought with one-time payments, like a raincoat. They are maintained through regular payments, like a Netflix subscription; and these payments are made for a fixed period. The period of time could either be till the maturity of the CDS contract or till a credit event, which causes a settlement to be done like the borrower filing for bankruptcy.

SEBI has now allowed AIFs to buy the swaps mostly to hedge against risk but category II and III funds have been allowed a deeper interaction.

What more can Cat II and Cat III funds do?

Cat III funds can sell CDS contracts provided that the leverage undertaken through this way does not exceed limits set under the norms set for AIF-III funds.

If Cat II and Cat III funds sell CDS contracts, after setting aside unencumbered government bonds or treasury bills that add up in value to the CDS exposure, then it won’t be considered as leverage.

What is the size of the CDS market in India?

According to Venkatakrishnan Srinivasan, founder and manager of Rockfort Fincap, who has worked in the debt capital market for decades, it is difficult to estimate the size of the CDS market in India because it has never really taken off.

“The CDS market has not developed here. Though initially there was some interest in it from a few big banks (to sell CDS), that seems to have fizzled out,” he said.

“CDS isn’t very useful for high-quality credit, such as triple AAA-rated or sovereign-backed ones. They can be useful to insure against low-quality credit. But there isn’t an appetite for low-quality credit in the Indian market; even in the bond market, the liquidity for the corporate bond market below AA-rated credit is very, very low. Most of the low-quality credit is extended through loan-like products from private funds, they don’t come to the listed markets, and CDS sellers may not be comfortable buying from such unlisted markets,” he said.

So there may be enough buyers for CDS in the domestic market but there aren’t any sellers, who will have to take on the low-quality credit risk, according to him. Also, CDS buyers themselves may be put off by premiums that could be on the higher side. This in turn will affect the returns generated by these private funds and put these funds off.

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Who have been the market makers for CDS so far?

The market makers in the credit derivatives market are scheduled commercial banks, with some exceptions such as small finance banks and regional rural banks, non-banking financial companies including standalone primary dealers and housing finance companies (HFCs), and some of the development banks in India.

Will AIFs’ participation make much change?

According to Srinivasan, there may be some interest initially, when the products are launched. But whether that interest will sustain will need to be seen.