The origin of credit derivatives can be traced back to the securitisation of mortgaged-back market of 1980s. In securitisation, the credit risk was hedged only by eliminating the credit product from the books of credit provider altogether. The credit derivative, in the present form, was formally launched by Merrill Lynch in 1991 (with USD 368 million). However, the market did not grow much till 1997. The size of the market was USD 40 and 50 billions respectively in 1996 and 1997. The market has now acquired a critical mass of over USD one trillion, half of which is concentrated at London. The average transaction size is between USD 10 to 25 million and the average tenor, which was less than two years, has now gone up to five years. However, there are only a few active players in the market and the secondary market is still illiquid.

Credit derivatives are over the counter financial contracts. They are usually defined as "off-balance sheet financial instruments that permit one party (beneficiary) to transfer credit risk of a reference asset, which it owns, to another party (guarantor) without actually selling the asset". It, therefore, "unbundles" credit risk from the credit instrument and trades it separately. Credit Linked Notes (CLNs), another form of credit derivative product, also achieves the same purpose, though CLNs are on-balance sheet products.

Another way of describing credit derivative is that it is a financial contract outlining potential exchange of payments in which at least one leg of the cash flow is linked to the "performance" of a specified underlying credit sensitive asset.

The characteristic features of credit derivative are as under:

1. Credit derivative is a contract between two counterparties. One is the credit risk protection buyer or beneficiary and the other is the credit risk protection seller or guarantor.

2. The protection buyer or beneficiary pays a fee, called premium as in insurance business, to protection seller or guarantor.

3. The reference asset for which credit risk protection is bought and sold is pre-defined. It could be a bank loan, corporate bond / debenture, trade receivable, emerging market debt, municipal debt, etc. It could also be a portfolio of credit products.

4. The credit event for which protection is bought or sold is also pre-defined. It could be bankruptcy, insolvency, payment default, delinquency, price decline or rating downgrade of the underlying asset / issuer.

5. The settlement between the protection buyer and protection seller on the credit event can be cash settled. It could also be settled in terms of the physical financial asset (loan or bond, etc.). If the protection seller is not satisfied with the pricing or valuation of the asset in the credit event, it has the right to ask for physical settlement.

6. Credit derivatives use the International Swaps and Derivatives Association (ISDA) master agreement and the legal format of a derivative contract.

Credit derivatives can be divided into two broad categories:

1. Transactions where credit protection is bought and sold; and

2. Total return swaps.

Characteristics of different types of Credit Derivatives are discussed in the next page

Credit derivatives are an evolution of conventional banking products for the transfer of credit risk such as Guarantees, Letters of Credit and Unfunded Sub-Participation. A credit default swap is akin to these products. The guarantee, letter of credit or unfunded sub-participation are manners in which the credit risk on a third party can be transferred between two parties; under which if the underlying credit i.e. the borrower defaults, then the guarantor has to make good the obligation to the lender; thus the guarantor takes the risk of the borrower defaulting on the obligation. In a credit default swap, the buyer of protection ("buyer") gets an assurance from the seller of protection ("seller"), that if the underlying credit defaults, the seller will compensate the buyer for the loss that it suffers due to the default of the underlying credit.

A credit linked deposit / note enables the buyer to take on credit risk of a certain credit by subscribing to the deposit/ note of the issuer. It is similar to a funded sub-participation in a loan or bond, except that the borrower is not the same as the entity whose credit risk the investor takes. Thus, the buyer is exposed to the credit risk of the underlying asset as well as the note issuer. The basic elements of credit derivatives, thus, are the same as normal commercial banking products.

Apart from the above, the credit derivatives have the following benefits/ advantages over other products:

• Other instruments / mechanisms would be less efficient.

• Insurance, guarantees and securitisation are less liquid mechanisms in the first place.

• Credit insurance also leads to increase in intermediation because only insurance companies can write this. Due to this banks cannot directly participate in exposures of other banks for managing their own portfolio exposure and diversification attributes.

• Guarantees are limited by the current prohibition on banks from offering guarantees in favour of other banks or financial institutions.

• Classical securitisation transactions involve substantial transaction costs.

• Financial intermediaries also stand to gain through indirect participation in credit-linked returns.

• Currently, intermediaries like insurance companies and mutual funds are not permitted to take certain kinds of direct exposure like lending. However, they would be able to write credit protection and earn returns on assets to which they have no access today. Also, intermediaries that lack the selling relationships would be able to participate in exposures and returns that are otherwise not available to them.

• Non banking participants gain from credit derivatives primarily through hedging of credit risk exposure.

• Vendors and suppliers can hedge credit risk without recourse to funding, especially if funded limits are being used fully. Sovereign risk can also be hedged away by use of credit derivatives.

• The financial system would primarily benefit due to increased usage of capital and more efficient pricing of exposures.

• With credit exposures being transferred across institutions, capital is likely to be used more efficiently as players having excess capital can take up credit risks, allowing capital-scarce players to generate more business. This leads to an overall gain to the system.

• Since credit risk can be transferred, credit spreads may narrow as illiquidity is no longer a significant risk.

Though initially the scheme is to start in a limited phase, as experience gains it is to be made more comprehensive and diversified. In order to ensure that the credit market functions efficiently, it is important to maximise the number of participants in the market to encompass banks, financial institutions, NBFCs, mutual funds, insurance companies and corporates.

Banks would typically be both buyers and sellers of credit risk in the market. There may be cases where a bank believes that it is overexposed to a particular credit or industry. In such case, the bank will wish to buy protection. Conversely, there may be sectors or highly rated companies or fast growing companies to which a bank has little or no exposure. Entering the consortium may be a time consuming exercise. In such case, the bank will wish to sell protection. Buying and selling of participation in the priority sector is one example where credit derivatives, albeit in a different form, has been practiced for several years.

Financial Institutions and NBFCs may also find themselves in a similar position to the banks and are thus likely to be both buyers and sellers in the market.

Mutual funds and insurance companies that have an investment where they anticipate spread widening would typically be buyers of protection. Similarly, mutual funds and insurance companies that are looking for yield enhancement and believe that spreads of a given company are expected to narrow would typically be sellers of protection. Mutual funds and insurance companies may also sell protection as a means to diversify their portfolio and broaden their asset base.

Companies may participate in the credit derivatives market to either buy or sell protection. One instance where a company would wish to buy protection is when it is overexposed to one or more buyers. Conversely, parent companies sometimes provide guarantees to banks on behalf of subsidiaries and these could easily be structured as credit derivatives.