Credit default swap

Indian Economy glossary

Also called: CDS · Topic: Financial Markets, Instruments, Insurance and Pensions · NCERT: Beyond NCERT

Meaning

A credit default swap (CDS) is an over-the-counter credit derivative. In it, the protection buyer pays regular premiums to the protection seller. In return, the seller promises to pay compensation if a named borrower (the reference entity) defaults or suffers a similar credit event.

  • It works like insurance on a loan or bond. It lets a lender pass on the risk of the borrower not repaying, without selling the loan or bond itself.
  • It matters because it can help a corporate bond market grow. It also matters because careless use helped cause the 2008 global financial crisis (AIG).
  • Payout on a credit event = face value of the protected debt − amount recovered from the borrower

Explanation

How a CDS works

  • Three parties are involved:
  • Protection buyer: usually a lender, such as a bank that holds a company's bonds.
  • Protection seller: a bank or financial firm that takes on the default risk in return for a fee.

  • Reference entity: the borrower whose default is being covered. It is not a party to the contract.

  • Premium: the buyer pays a fixed percentage of the notional principal (the amount the payments are calculated on) every year.

  • Credit event: a default or a similar trigger named in the contract. The seller pays only when a credit event happens.
  • If no credit event happens: the seller simply keeps the premiums. The buyer's cost is like an insurance premium.
  • CDS is a derivative. Its value comes from an underlying asset, here the credit quality of the borrower.
  • The borrower becomes riskier → protection becomes more valuable → the premium for new protection goes up.
  • The borrower becomes safer → the premium for new protection goes down.
  • So the CDS premium works like a market signal of how risky the borrower is.

Worked example

  • A bank holds ₹100 crore of Company X bonds.
  • It buys CDS protection at 2% a year, so it pays ₹2 crore every year to the seller.
  • Case 1: X keeps paying. The bank pays ₹2 crore a year and gets nothing back. This is the cost of its "insurance".
  • Case 2: X defaults. The bonds recover only ₹40 crore.
  • The CDS seller pays 100 − 40 = ₹60 crore.
  • The bank gets back its full ₹100 crore (₹40 crore recovery + ₹60 crore CDS payout). Its default risk has moved to the seller.

Settlement and risks

  • Physical settlement: the buyer hands over the defaulted bond to the seller and receives its face value.
  • Cash settlement: the seller pays only the loss (face value − recovery value) in cash.
  • Counterparty risk is high (the risk that the other side cannot pay):
  • A CDS is an OTC contract (a private deal between two parties, not made on an exchange).

  • There is no clearing corporation that promises payment. If the seller itself fails, the buyer's "insurance" is worth nothing.

  • Systemic risk: the AIG case (2008)

  • AIG had sold huge amounts of CDS protection on mortgage-linked securities.
  • Those securities collapsed, so many claims came due at the same time.
  • AIG could not pay and nearly failed. Every firm that had bought protection from it was now at risk too.

  • Lesson: OTC derivatives can hide risk and spread it across the whole system.

  • Hedging vs speculation

  • Hedging = a lender that holds the bond buys a CDS to reduce its risk.
  • Speculation = someone buys or sells a CDS only to bet on whether the borrower will default, without holding the bond.

In India

  • Regulator: the Reserve Bank of India (RBI) regulates CDS. CDS is a credit derivative on debt, so it falls under RBI and not SEBI.
  • RBI's definition: a credit derivative in which the protection seller "commits to pay to the other counterparty (protection buyer) in the case of a credit event", in return for periodic premium payments. [1]
  • Timeline:
  • 2011: RBI issued the first CDS guidelines.
  • 10 February 2022: RBI widened the framework through the Master Direction – Reserve Bank of India (Credit Derivatives) Directions, 2022. It was updated as on 1 January 2025. [1]

  • 2026: RBI released a draft revised Master Direction and invited comments till 27 February 2026. [2]

  • Who can do what under the 2022 Directions [1]:

  • Market-makers (firms that stand ready to both buy and sell protection):
    • Scheduled commercial banks, except small finance, payment, local area and regional rural banks.
    • NBFCs, SPDs and HFCs with net owned funds of at least ₹500 crore, with RBI approval.
    • EXIM Bank, NABARD, NHB, SIDBI and NaBFID.
  • Non-retail users: NBFCs, insurers, pension funds, mutual funds, AIFs, FPIs, and resident companies with a net worth of ₹500 crore or more.

  • Retail users (all other users):

    • They may use CDS only for hedging, so they must first hold the underlying exposure.
    • Their protection cannot exceed the face value of that exposure.
    • Settlement must be physical.

  • What can be protected [1]:

  • Reference entities: resident entities that issue eligible debt.

  • Permitted debt: money market instruments, rated rupee corporate bonds, and unrated bonds of infrastructure SPVs (special purpose vehicles, i.e. separate companies set up for one project).

  • Why it matters for India: if investors can buy protection against default, they may be more willing to buy lower-rated corporate bonds. This can help companies, especially infrastructure projects, borrow directly from the bond market instead of only from banks.

Don't confuse with

  • Interest rate swap (IRS): an IRS exchanges fixed and floating interest payments to manage interest-rate risk. A CDS pays out only on a credit event and manages default risk.
  • Insurance contract: a CDS works like insurance, but it is a derivative contract regulated by the RBI, not an insurance policy regulated by IRDAI. Globally, a buyer may not even own the underlying bond. In India, retail users must hold it [1].
  • Put option: a put pays when the market price of an asset falls below the strike price. A CDS pays only when a named credit event (default) happens, however far the price falls before that.
  • Futures: futures are exchange-traded, marked to market daily and backed by a clearing corporation, so counterparty risk is low. A CDS is OTC, and counterparty risk is high.

Prelims Hooks

  • In a CDS, the protection buyer pays the premium and the protection seller pays compensation on a credit event. The borrower (reference entity) is not a party to the contract.
  • CDS in India is regulated by the RBI, not SEBI, through the Master Direction – Reserve Bank of India (Credit Derivatives) Directions, 2022, issued on 10 February 2022. [1]
  • Retail users may use CDS only for hedging. They must hold the underlying exposure, protection cannot exceed its face value, and settlement must be physical. [1]
  • Trap: small finance banks, payment banks, local area banks and RRBs cannot be CDS market-makers. Only other scheduled commercial banks can. [1]
  • Eligible debt includes rated rupee corporate bonds, money market instruments and unrated bonds of infrastructure SPVs. [1]
  • Trap: CDS is an OTC derivative with high counterparty risk. The AIG near-collapse in 2008 came from selling CDS protection on mortgage-linked securities.

Mains Points

  • Deepening the corporate bond market vs financial stability:
  • CDS lets investors pass on default risk, so they may buy lower-rated bonds and infrastructure bonds more readily. This lowers companies' dependence on bank loans.
  • But the AIG case in 2008 showed that CDS can hide and spread risk across the system.

  • India's cautious design allows retail users only to hedge and requires physical settlement [1]. The trade-off is that the market stays safer but grows more slowly.

  • Hedging vs speculation:

  • A CDS bought by a lender that holds the bond reduces risk. A CDS used only to bet on default can add risk and can even push a weak borrower's funding costs higher.

  • RBI's rules let only market-makers and non-retail users go beyond pure hedging [1]. The framework is still being revised through the draft Master Direction of 2026 [2].

  • Counterparty and systemic risk in OTC markets (GS-III, financial stability):

  • A CDS is only as good as the seller's ability to pay. The risk is highest in a crisis, when many borrowers default together.
  • Policy link: RBI's strict limits on who can be a market-maker (for example, the ₹500 crore net owned funds rule for NBFCs, SPDs and HFCs [1]) aim to make sure sellers are strong. This fits with RBI's wider role in managing systemic risk.

Related concepts

Read more

Sources

  1. 1RBI, "Master Direction – Reserve Bank of India (Credit Derivatives) Directions, 2022"rbi.org.in · tier 1
  2. 2RBI Press Release, draft revised Master Direction on Credit Derivatives (comments till 27 February 2026)rbi.org.in · tier 1