Two friends got together and decided to watch The Big Short movie. As the movie got engaging in the scene where Lehman Brothers goes belly up and the prices of credit default swaps (CDS) zoomed, they got into an interesting conversation.

Ram: I am still not able to clearly understand how these CDS function. How can someone profit from another person defaulting? I also heard last week how the increase in CDS prices of Credit Suisse and Deutsche Bank debt spooked markets

Veena: Well CDS is either like an insurance product or a speculative derivative depending on who is buying/selling it.

Ram: What makes the difference?

Veena: At a basic level, a CDS is a contract between two parties  wherein the seller of the CDS agrees to indemnify a bond holder (who buys the CDS), if there is a default on the bonds. So it is like protection a bond investor can take against heavy losses in case of default by the bond issuer, by paying an annual premium to the seller of the CDS. The CDS seller makes profits by raking in the annual premium and may have to incur losses in case a situation to indemnify arises. So, if you read about the spike in CDS prices of the European banks last week, that was likely because some investors may have got concerned on default risk and there may have been a rush for protection against defaults. Higher the risk, higher the CDS premium.

Ram: Ok, so when does it become a speculative product?

Veena: The CDS instruments are available for trading not just between bond holders and ‘bond insurers’, but also between speculators who have a view on the quality of a credit instrument. For example, if you have a positive view on the fundamentals of a company and are confident that it will never default, you can sell a CDS and profit from the premium. To the contrary, if you have a negative view, you can buy the CDS and profit in case there is default. Think of it as selling and buying of put options in the stock markets, even though you may not own the underlying. So, whether it is like an insurance product or speculative product, it depends on this factor. The Big Short movie focuses on speculators who understood the fundamentals clearly and profited from unwinding of the reckless credit boom that preceded the Global Financial Crisis.

Ram: Interesting. So is there a market in India too for CDS?

Veena: It is gradually evolving, but still in very early stages and hence the product is not as developed as in the western markets.

Ram: Ok, another doubt I have is, why were Indian markets down one day last week over concerns surrounding two European banks?

Veena: That was because of what could happen to global liquidity flows in case there indeed is a default by a major European bank. For example, in 2008, as the financial crisis deepened, the severity of it was understood by the US Treasury Secretary – Hank Paulson (similar to Finance Minister in India) and he proceeded to bail out the banks, when the CEO of a company like General Electric (which had the highest credit rating) called him and informed him that they were not able to access the credit markets. However, I need to mention  here that this version, as given by  Hank Paulson, is contested by GE.

Ram: And what happens when liquidity flows are impacted?

Veena: Asset prices will fall. Smooth functioning of global markets requires sufficient flows of liquidity. Equity markets get buoyed by cross border capital flows. However, when market participants get worried about safety of their capital and just stay in cash, cross border flows of capital into India can be impacted. This, in turn, can also make Indian investors nervous and can have a domino effect on asset prices like equities. This is actually what happened during 2008 and in 2020 and central banks addressed it by pumping liquidity into the system via quantitative easing to address fears of market participants.

Veena: Ok, finally what do these spikes in CDS of European banks indicate for our markets?

Ram: It’s an amber signal, suggesting ‘stay alert’!