Credit Default Swaps & its benefits - Explained by Surety007

Lending and borrowing is an age-old activity. Also, India in its 75 years of Independence has come a long way in providing access to working capital to Individuals and businesses. Legacy banks, NBFCs & Fintech companies have given a boost to the Indian lending market and  made India’s total lending market size stand at ₹156.9 lakh crore, recording a 100% growth between FY2017 and FY2021. However, the access to working capital through borrowing is still not accessible to the majority of Indian SME businesses. 

Insurance product that solve these problems are Credit Default Swaps.

What are Credit Default Swaps? 

A Credit Default Swap / Credit Default Guarantee is, in simplified terms, an insurance on loans taken by the lending party. 

Now, Imagine a large bank gives a loan to Tata Power. The bank expects to receive a steady stream of payments from Tata Power over the years. But the bank figures that there’s a chance that Tata Power might go bankrupt. It’s a very small chance, but not zero, and if it happens, the bank doesn’t get any more of those payments.

Emphatically, the bank might decide to buy a CDS, a kind of insurance policy. CDS contracts are maintained via an ongoing premium payment similar to the regular premiums due on an insurance policy. If  Tata Power never goes bankrupt, the bank is out whatever premium it paid for the CDS. If  Tata Power goes bankrupt and stops paying the bank, it gets money from the CDS.

Why is CDS an effective tool to hedge the Credit Default Risk?

Risk financing, underwriting & actuarial sciences are forte of the Insurance companies.

A properly backed Credit Default Guarantee helps effectively hedge the Credit Default Risk. A Credit Default Guarantee protects the lender from the borrower’s inability to repay the loan or debt.  This Credit Default Guarantee provides the lender an assurance of repayment. Such an assurance enables lenders to carry on the lending activity with relative ease. This ensures easier access of capital to a borrower. In a capital starved country like ours, CDS can be a boost if used effectively.

Further, In India, where non-collateralized lending is almost non-existent, Credit Default Guarantees will allow for such borrowing. This kind of borrowing is required by budding businesses and startups. They are at the heart of the developing Indian economy.

What happens in case of non payment of loans due to insolvency or credit dealing capability of a borrower ? 

No insurance product, in India, at present addresses this very legitimate risk. 

Credit Default Guarantee  is used by the banks/loan companies as a risk management tool. Under this policy, the Credit Insurer will cover the portfolio of borrowers in exchange of a regular premium payment and pay loan amounts that remain unpaid as a result of insolvency, bankruptcy or protracted default. 

What are the most common credit events that trigger a payment from the risk “buyer” to the risk “seller” in a CDS?

Read Reserve Bank of India (Credit Derivatives) Directions, 2022

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