It is a form of insurance against debt default. When an investor buys corporate (or government) bonds he/she faces the risks of default on part of the issuing agent. The investor can insure its investment in such bonds against default through a third party. The investor pays a premium to the party providing insurance. In the event of default by the bond issuer, the insurer would step in and pay the investor. A CDS is just that insurance, which is bought by those who fear default and sold by those who believe it won't.
• What is the economic benefit of CDS?
It is a derivative instrument that transfers risk from investors to those willing to bear it for a fee. By insuring against risks of default, credit default swaps allow riskier companies to raise funds. Also, it improves investment and borrowing opportunities by redistributing risk. Therefore, overall it helps increase credit flow and boost liquidity.
• What are the key concerns?
The third party insurer issuing credit default swaps must have the capital to pay-up in case of debt default. Therefore, the issuers of CDS must be well capitalized and have stringent regulations on their exposure or else in case of a default they will not be able to honour their commitment.
• What role did credit default swaps play in the financial meltdown?
Speculators started buying CDS on even the bonds they did not hold, hoping to make good gains in the case of a default. This kind of CDS is known as naked CDS wherein the buyer doesn't hold the underlying debt. In many cases, such investors were holding CDSs worth much more than underlying debt, betting on the defaults in the US subprime market. And when those defaults did happen, CDSs compounded the problem as the underwriters did not have the capital to honour their commitment.
• How is RBI safeguarding against CDS ills?
CDSs will be subject to strict capital requirements, ensuring that the business is within prudent limits. Second, naked CDS will not allowed in India. Third, CDS buyers cannot buy insurance higher than the value of the underlying debt. These steps are expected to control speculation on default of bonds, restricting them to their proper use.
