Basics of Credit Derivatives

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Credit Derivatives news from April 2009




News items are indexed chronologically, latest on top

RBI revised CDS guidelines: Feeble effort to a start a non-starting product

It is like trying to press the ignition button of a vehicle that does not have fuel!  The RBI has done some bit of widening of the CDS market, hoping that this time the ignition will work.

The RBI brought out the CDS guidelines, after a long wait of 4 years, in 23rd May, 2011[1]. The operational guidelines were announced in 30th November, 2011[2]. Post this, till August, 2012 there have only been 3 CDS transactions, adding upto a total transaction volume of only Rs 15 crores (less than USD 3 million). Compare this to the whopping USD 30 trillion international volume – the data speaks for itself.

The 2011 guidelines proved to be a non-starter for several reasons:

  • First, the RBI has started with a notion that users in India can enter into CDS contracts only for the purpose of hedging. Most of the international trades are for trading motive, not for hedging motive. However, one may regard this as the usual feature of all OTS derivatives in India – most derivatives are allowed only for hedging.

  • Even within the hedging motive, the RBI limited CDS only for bonds. Most international CDS contracts are referenced to loans or bonds, not merely to bonds. In fact, one may understand international CDS contracts being linked with bonds, as there is a huge bond market internationally. However, in India, the bond market itself is toddling. 

  • Even within bonds, the RBI limited it to listed bonds. Arguably, if one of the primary purposes of a CDS trade is to take advantage of pricing inefficiencies in corporate bonds, this is not possible in case of listed bonds, where pricing is presumably transparent.

Therefore, little wonder that there was hardly any CDS activity in the country.

The RBI has now relaxed the Guidelines a bit. A comparative of the existing guidelines and the revised guidelines is provided for in annexure below. Among the major changes are:

  1. CDS permitted on unlisted but rated corporate bonds for issues other than infrastructure companies also -- It is difficult to understand why would the CDS market be kept limited to rated bonds, particularly when there is no rating minima specified. Rating itself assists in price discovery. To an extent, even a CDS contract leads to price discovery.

  2. Unwinding CDS bought position with original protection seller at mutually agreeable or FIMMDA price – The revised guidelines do not permit offsetting of the contract however novation is permissible.

  3. CDS permitted in case of short term instruments such as Commercial Papers, Certificates of Deposit and Non Convertible Debentures -- In case of short term instruments, including short term bonds, it seems that the requirement of rating is not applicable. Once again, linking CDS contract for short-term instruments does not jell will the nature of CDS instruments. Globally, most CDS trades are for 3 years and above tenure. If one has a short term instrument, the probability of default, which is what a CDS instrument tries to mitigate, is itself low for most entities. Hence, an issuer or a holder may not even need a CDS protection.

In our view, the linkage with the bond market will still continue to keep the CDS market in shackles. It is a chicken-egg story – we do not have an active bond market, due to several inhibiting factors. And we will not have a CDS market because we do not have an active bond market.

In short, the new CDS guidelines still retain several inefficiencies, and may not lead to the market picking up any substantially.

Annexure: A Comparative on the CDS Guidelines issued and revised by RBI




Former CDS Guidelines[3]


Revised CDS Guidelines[4]


Para 2: CDS for Indian Markets – Product Design

Sub-Paras and Headings




2.1 Eligible Participants

Users: Commercial Banks, PDs, NBFCs, Mutual Funds, Insurance Companies, Housing Finance Companies, Provident Funds, Listed Corporates, Foreign Institutional Investors (FIIs) and any other institution specifically permitted by the Reserve Bank.


Additions in the list of entities in the eligible user category:


All India Financial Institutions namely, Export Import Bank of India (EXIM), National Bank for Agriculture and Rural Development (NABARD), National Housing Bank (NHB) and Small Industries Development Bank of India (SIDBI)


2.4 Reference obligation (eligible underlying for CDS) - eligibility criteria

CDS will be allowed only on listed corporate bonds as reference obligations

The scope has been widened to include:


Reference/deliverable obligations shall be listed and unlisted but rated corporate bonds.


Securities with original maturity up to one year e.g., Commercial Papers, Certificates of Deposit and Non-Convertible Debentures shall also be permitted as reference / deliverable obligations.

2.6 Exiting CDS transactions by users


New Insertion:


Users shall be allowed to unwind their CDS bought position with original protection seller at mutually agreeable or FIMMDA price. If no agreement is reached, then unwinding has to be done with the original protection seller at FIMMDA price.


2.8 Other Requirements

CDS shall not be written on securities with original maturity up to one year e.g., Commercial Papers (CPs), Certificate of Deposits (CDs) and Non-Convertible Debentures (NCDs) with original maturity up to one year






[2] Guidelines on Capital Adequacy and Exposure Norms for Credit Default Swaps (CDS) --

Credit Default Swaps (CDS) for Corporate Bonds-Reporting Platform --

Prudential Guidelines on Credit Default Swaps (CDS) --



Credit Derivatives market shrinks in the first half of 2009 – BIS report 

Being termed as the worst financial crisis after the Second World War, credit derivatives volumes aren’t voluminous anymore. After the collapse of Lehman Brothers investors had shunned the credit derivatives market, with apprehensions and concerns on counterparties not being able to honor trades.  

According to the BIS OTC Derivatives Market Activity Report in the first half of 2009, the market for OTC derivatives grew by 10% after a decline in the second half of 2008 largely contributed by Interest Rate Derivatives. 

As per the BIS report the notional amount outstanding of CDS contracts protecting investors against losses on bonds and loans continued to shrink. After a reduction of 27% in the second half of 2008 there is a decline of 14% in the first half of 2009, to cover a notional $36 trillion of debt in the six months to June 2009. Part of the reduction is due to major credit events in 2008 and 2009, leading to massive settlement of trades.

[Reported by: Nidhi Bothra]

CDS are legalized homicide: Soros 

CDS continue to take the battering. George Soros, hedge fund investor, writer and Chairman of Soros Fund Management, said that CDS should be banned and that and the instrument was ‘toxic’. As reported by Reuters, during a banking conference in Southern England, George Soros termed the CDS market as a legalized homicide, he then added It's like selling insurance to someone other than the person you are insuring and giving them a license to shoot that person." He said that there is a need for greater regulatory oversight for the derivatives market. 

Over the last 2 years, there have been plenty of angry voices against complex structured finance products and derivatives, which have been blamed due to their complexity, inherent leverage or opaqueness. Some years ago, when Warren Buffet called them “weapons of mass destruction”, it was a lonely voice; now there is a complete orchestra singing the same tune

[Reported by: Nidhi Bothra]

Consensus on OTC derivatives regulations

7 December, 2009: Several authorities over the past few months have been framing regulations to tame the OTC derivatives market.  The House of Agriculture Committee, the House Financial Service Committee had presented bills for regulating the OTC derivatives market and the Banking Subcommittee on Securities, Insurance and Investment, introduced the Comprehensive Derivatives Regulation Act of 2009 (See our report here). Now the House of Agriculture Committee and the House Financial Service Committee have reached an agreement on a bill to impose federal regulation for the first time on the over-the-counter derivatives market.  The OTC derivatives helps corporations, hedge against operational risks but post financial crisis the lawmakers have been wanting to tighten the regulatory noose to curb the speculative activities.

However there are two issues that are yet to be decided whether to limit ownership in swaps clearinghouses, and whether regulators would have the power to set margin and capital requirements on swaps traded by non-financial end users. The compromise bill includes that the standardized swaps will be traded on the exchange whereas there would be higher margin and capital requirement for customized swaps but registration of dealers and major market participants would be required to ensure transparency and record keeping in trading.

The bill is expected to come up for a vote on the House floor next week as part of financial regulation reform proposals. See the press release here.

[Reported by: Nidhi Bothra]


 Derivative Regulatory legislations continue to proliferate

This is what lawmakers will do if they have to tame a tiger – propose a comprehensive bill, complete with a regulatory authority, licensing requirements, and so on. This is what they are doing now, to put curbs on the unbridled greed that fueled derivatives.

Regulation of derivatives continues to be focal point of regulatory activity. Currently, there are at least 3 legislative proposals on regulation of OTC derivatives that would probably form the basis of a regulatory legislation.

The House Financial Services Committee on 13th October began work on a draft of the OTC Derivatives Markets Act. The proposal outlines an extensive regulatory system complete with registration of swap dealers and major swap participants, capital and margin requirements, mandatory exchange trading, etc. Prudential regulators for derivatives transactions are the Federal Reserve Board in case of banks that are under regulatory supervision of the FRB, and FIDC in case of other financial institutions. This proposal lays extensive regulations for security-based derivatives. Full text of the Bill is here and a section-wise summary is here.

On Sept 22, 2009, Senator Jack Reed, Chairman of the Banking Subcommittee on Securities, Insurance and Investment, introduced the Comprehensive Derivatives Regulation Act of 2009 (the “CDRA”). Reed’s Bill broadly classifies derivatives into two sets – commodity derivatives and security derivatives, the former to be regulated by CFTC and the latter by SEC. Hence, the meaning of the word “security” becomes critical. The definition in the Securities Act is being widened by including “any agreement, contract, or transaction that is associated with a financial, economic, or commercial occurrence, extent of an occurrence, contingency, or consequence that is related to or based on a security, an interest in a security, an issuer of a security, or group or index of securities, or interests in securities or issuers of securities, or based on the value of any of the foregoing or any security”. 

A third draft is the Derivatives Markets Transparency and Accountability Act of 2009, H.R. 977. This has been passed by the House Agriculture Committee.  The text of this bill is here.

[Reported by: Vinod Kothari]


 Stiglitz shuns banks from derivative trading

While US and European regulators are looking for tougher regulations to be enforced for the over the counter derivatives market and are calling for the establishment of global rules to prevent financial institutions from exploiting jurisdictional differences in regulation; Nobel Prize winner, economist, Joseph Stiglitz shuns banks from trading in derivatives including credit default swaps. In a press conference in Brussels, Stiglitz commented that CDS position held by the banks pose higher risks to the financial system which results in the faltering and a bail out recourse as witnessed, it was derivative trading and excessive risk taking that led to the financial crisis. Stiglitz also suggested that the financial markets should be subject to taxes to discourage “dysfunctional” trading.

[Reported by: Nidhi Bothra] 

 CDO investors continue to crowd courts: UBS charged for selling "crap" to Connecticut Hedge Funds

This is only one of the several rulings either already out of the legal press, or under publication. Law courts all over the US and some even in Europe are currently considering CDO/ MBS/ ABS investors’ claims as to fraud, mis-selling, misrepresentations and so on. In a ruling dated 8th Sept 2009, Justice Blawie of the Stamford’s  Superior Court ordered UBS to set aside money for pre-judgment damages, or face garnishee orders for recovery. 

In this case  brought by Pursuit Partners, a Connecticut-based hedge fund, UBS was charged for selling CDO tranches that were described in internal emails as “crap” and “vomit”, and were sold shortly before Moody’s downgraded the securities. All the CDOs were so-called bespoke CDOs structured to meet Pursuit’s needs of a triggerless, investment-grade piece that could be available at significant discount on face value. 

Moody’s and S&P have also been charged in the case, as there were allegations that UBS was privy to forthcoming changes in the rating methodology of Moody’s whereby the notes that were sold to Pursuit would cease to be investment grade. The change in methodology was the correlation assumption in CDO pools. 

The offer document, as is quite usual with transactions, said the transaction will be governed by New York law. However, the Connecticut court still assumed jurisdiction, ignoring the choice of law clause, on the ground that a choice of law by parties can  be ignored on ground of public policy. The Judge said: “To allow securities to be marketed, offered and sold in any or all of the 49 states outside of New York, and hold that no other jurisdiction’s laws can be enforced or invoked, or that Connecticut law must be ignored, even if a plaintiff can establish, as it has here, probable cause to support a cause of action under Connecticut law, the state where the solicitation was made, simply because of this choice of law provision, is not a proposition this court will or may accept, both as a matter of statute and public policy”. If this ruling is finally accepted at higher forums, then CDO marketers would have a real tough time defending suits all over the country. 

The notes were sold to Pursuit between 26th July 2007 and Oct 1, 2007. This was the beginning of the avalanche of CDO downgrades. Obvious enough, UBS would have sensed the impending downgrades, and therefore, internal emails of UBS indicated the need to clear the inventory of CDO tranches that UBS was carrying. This evidence led the court to find “probable cause to sustain the claim that UBS sold the Notes to Pursuit without disclosing the following material non-public information: (1) that the Notes would soon no longer carry an investment grade rating, as the ratings agencies intended to withdraw these ratings as a result of a change in methodology; and (2) that once the investment grade rating was withdrawn, the CDO Notes sold by UBS to Pursuit, being valued in the tens of millions of dollars, would thereby become worthless”. 

The court on analysis of facts, primarily emails of the CDO marketing team of UBS, that UBS was in superior knowledge of the facts, which were concealed from the buyer, which the buyer relied upon and was thus unduly affected by the representations of the seller.  Internal emails of UBS said they had sold more “crap” to Pursuit, etc., which led the court to apply the “superior knowledge” doctrine. The court noted that risk is something that attaches to all such investments. However, (t)hat is the difference between a risk that something might happen to change the value of an investment, which is both a fact of life and a risk shared by all parties to any securities transaction, and the undisclosed knowledge that something will happen. That type of nondisclosure, whether it is on the part of a seller or a buyer, can cross the line into actionable securities fraud, and the court finds probable cause to sustain a finding that it this instance, it did”. 

Vinod Kothari comments: The ruling above is a flavor of the times. Judges, like the financial press, common people and others, have been affected by the wave of sentiment that goes against people who marketed and sold CDOs. On objective analysis of the ruling above, the question to be asked is – if UBS sold crap to Pursuit, what else do you sell to someone who comes to buy crap? Pursuit wanted to buy investment grade, being sold at steep discount on face value. Which investment grade notes would sell at steep discount on face value, given the high return on face value itself that they carry? The notes in question were bought between July and October, 2007 when the subprime crisis had already started surfacing. Bear Stearns’ hedge funds had already imploded by then. Rating agencies had also started downgrading several CDOs. On our website here, on June 20, 2007, we had reported that securitisation market was looking like a sinking ship, and there was fire everywhere. The purchases were made by Pursuit in tranches upto 1 October, 2007, by which time the subprime story, and the impact of that on CDOs was spread all over the financial press. So, can Pursuit really contend that there was a “superior knowledge” that UBS had, which Pursuit could have had? Pursuit, as a matter of investment strategy, might have projected that that was the right time to buy CDOs at deep discount, as its investment team might have projected that the crsis will not last long. 

Offer documents contained a detailed description of what were the assets of the pools, and what risks they carried. The impending change in rating methodology of Moody’s was  in public domain as rating agencies had come up with public statements on the same. Pursuit has affirmed before the court that it had read the offer documents and understood the same. A hedge fund is not a lay investor – its sole USP lies in being able to make money by taking risks that lay investors do not or cannot take.  

If this ruling leads UBS to pay damages for the losses that Pursuit faced, almost every seller who sold bonds that went bad would, sooner or later.

[Reported by: Vinod Kothari]


  IOSCO recommends securitization & CDS regulations

The International Organisation of Securities Commissions’ (IOSCO) has published the ‘Unregulated Financial Markets and Products – Final Report’ prepared by the Task Force on Unregulated Financial Markets and Products  on the 4th of September, 2009. The Task Force had earlier, in May published its consultative report on the issue (see our news here)

The Final Report recommends the regulatory actions to improve the transparency and oversight of the securitization and credit default swaps (CDS) markets.

As regards securitisation, IOSCO’s recommendations are not lot different from what regulations in the EU and US have proposed - alignment of incentive in the securitization value chain, essentially implying retention of originator stakes in securitized pools. CDS issues relate to counterparty risk, operational risk and market transparency.

The main securitisation-related recommendations are:

1.       Consider requiring originators and/or sponsors to retain a long-term economic exposure to the securitisation in order to appropriately align interests in the securitisation value chain;

2.       Require enhanced transparency through disclosure by issuers to investors of all verification and risk assurance practices that have been performed or undertaken by the underwriter, sponsor, and/or originator;

3.       Require independence of service providers engaged by, or on behalf of, an issuer, where an opinion or service provided by a service provider may influence an investor's decision to acquire a securitised product; and

4.       Require service providers and/or issuers to maintain the currency of reports, where appropriate, over the life of the securitised product.

The main CDS recommendations are:

1.      Provide sufficient regulatory structure, where relevant, for the establishment of CCPs to clear standardised CDS, including requirements to ensure:

a.       appropriate financial resources and risk management practices to minimise risk of CCP failure;

b.      CCPs make available transaction and market information that would inform the market and regulators; and

c.       cooperation with regulators;

2.      Encourage financial institutions and market participants to work on standardising CDS contracts to facilitate CCP clearing;

3.      The CPSS-IOSCO Recommendations for Central Counterparties should be updated and take into account issues arising from the central clearing of CDS;

4.      Facilitate appropriate and timely disclosure of CDS data relating to price, volume and open-interest by market participants, electronic trading platforms, data providers and data warehouses;

5.      Support efforts to facilitate information sharing and regulatory cooperation between IOSCO members and other supervisory bodies in relation to CDS market information and regulation; and

6.      Encourage market participants' engagement in industry initiatives for operational efficiencies.

links: for text of the IOSCO report, see here

(Reported by: Nidhi Bothra)


  Department of Treasury proposes regulations for securitization & CDS transactions

It is always like this – things go wrong because of natural process of sheer over-exuberance, and we react with more rules and more regulations, as if it was lack of rules that caused the problem. Not unexpected at all, the Department of Treasury issued an 89 page report proposing several new regulations in the financial market. 

As for securitization transactions, it proposes originators to be mandated to keep at least 5% risk in the securitized portfolios – similar to what European counterparts have already imposed. Recognition of upfront gain on sale should be eliminated, and off balance sheet treatment should be ruled out (see FASB’s new standards).  Originators should have fees or incentives based on actual performance of the pool. Originators should give representations and warranties as to performance of the pool – something which is today seen as violating the true sale condition. In short, the true sale business is clearly frowned upon in the report.  

SEC should continue its effort to regulate credit rating agencies. Ratings to structured products should be distinguished from other products – something which technically takes away the very comparability of ratings. Surprisingly, the report also says the regulators should reduce dependence on ratings for risk weights, and should think of different risk weights for structured and unstructured products. 

On credit derivatives, the Report has comprehensive regulation on all OTC derivatives, including credit derivatives. Clearing of all standard OTC derivatives should be required through centralized counterparties. [Reported by : Vinod Kothari] 

For full text of report, see here.


     IOSCO recommends regulations of securitisation and credit derivatives

The International Organisation for Securities Commissions’ (IOSCO) Technical Committee published a report on ‘Unregulated Financial Markets and Products - Consultation Report prepared by its task force.

Thankfully, in a period when lot of commentators are spitting venom at securitization as being the source of the present crisis, the Report recognizes the significance of securitization. “The absence of a well-functioning securitisation market will impact consumers, banks, issuers and investors. The price of credit is likely to be higher for the consumer and the availability scarcer. Banks will no longer have a tool to reduce risk and diversify their financing sources”, says the Report.  Credit default swaps, too, can serve as an excellent instrument for risk hedging and price discovery, but also have a potential to proliferate as a tool of speculative trading in credit.

Thus, the interim recommendations are aimed towards restoring transparency and investors’ confidence, promoting fairness and bringing about stability in the international financial markets. The interim recommendations on securitization include:

  • The originators or the sponsors to have longer term economic interest in the securitization transaction
  • Disclosures and the transparency norms to be made stringent to ensure that appropriate checks and assessments are done and the originator, issuer and underwriters have duly performed their duties.
  • Improving disclosure norms for the issuers on initial and continuing basis, giving out data on the underlying asset pool’s performance and so on.
  • Independence of experts used by issuers

In the CDS market, the task force recommended the formation of central counterparties to handle clearing of CDS contracts and for market participants to support the clearing process by developing a standardised CDS contract. The report is open for comments till the 15th June, 2009. See the full text of the report here.

Links: See news updates on securitisation here

Reported by: Nidhi Bothra  


US OCC data reports huge decline in credit derivatives revenue of US banks; volumes fall too

The US Comptroller of Currency came out with the usual quarterly report on derivatives held by US banks.


Unsurprisingly, while there has been a rise in the notional volumes of derivatives contracts in general held by the US commercial banks, growing by 14%, to $200.4 trillion, the notional value of the credit derivatives contracts decreased by 2% during the quarter to $15.9 trillion.

The report also indicated that the credit derivative trading revenue dipped steeply,  by (-) 452% from Q3 2008 to Q4 2008, whereas the total fall in the revenue of all the derivative contracts was -253% only.

Credit derivatives still remain a relatively small segment of the total OTC derivatives business. However, they have been dubbed as being responsible for much of the turmoil in the banking system, and much of the losses that banks are currently passing through. The credit derivative contracts in the US formed only 7.9% of the total derivative contracts.

There were series of incidents that took place in the fag end of 2008. The fallout of the various investment banks resulted in the shifting of the derivative business into the hands of the commercial banks which clearly reflected in the figures. There were several reasons that made the markets look innate and the liquidity crunch further worsened the scenario.

Note: other sources of credit derivatives data include BIS Derivatives report, and DTCC’s credit derivatives data warehouse.