This article is written by Anuraag Bukkapatnam, pursuing a Certificate Course in Capital Markets, Securities Laws, Insider Trading and SEBI Litigation from Lawsikho.com.
The Indian economy has been struggling for the past couple of years, with the GDP growth rate slowing down in the year 2019.[i] An already fragile economy was further devastated by the impact of Covid-19 crisis in the Financial Year. Estimates indicate that the GDP growth rate for FY 2020-21 would be around -6.1%,[ii] with approximately 122 million people losing their jobs.[iii] These setbacks have made it an incredibly difficult task for the government to bounce back and repair the economic health of the country. This would not just require major reforms to improve ease of business, but also ensuring that businesses are able to secure access to much needed finances in order to sustain their operations and expand. The latter, however, is an extremely difficult task. With banks already burdened with heavy bad loans and having not received interest payments during the crisis, they might not have the capacity to aggressively provide finance to Indian entrepreneurs. While government intervention can help Banks in lending more, we must start looking at alternate sources for financing our businesses, namely the corporate bond market.
A well-developed and efficient corporate bond market complements a sound banking system in providing an alternative source of finance to the economy.[iv] Developing such a market increases the ease of obtaining finance while at the same time helps in the diversification of risks in the financial system.[v] In comparison to other major emerging economies, however, the Indian Bond Market fares poorly in being able to raise funds for companies.[vi] While there are a number of reasons why the Indian Bond Market is not as developed as other countries, one of the primary reasons is the aversion towards debt. Institutional Debt investors in India have largely confined their investments to the bonds of companies which have a very high credit rating, as a result of which a large number of companies are not able to secure debt finance.[vii] In order to increase access to finance to these companies we must solve this problem of risk aversion. One potential solution to the same is developing the credit default swap market in India.
A Credit Default Swap is a financial derivative which is used to hedge the risk of its underlying security (a bond). With this instrument, 2 parties can enter into a contract wherein one party (the insurer) insures the other party (bond holder) from the risk of default of the underlying bond. In exchange for providing such protection against default, the insurer charges the bond holder premiums on a periodical basis, the value of which is determined based on the credit rating of the underlying bond. When the insurer enters into several such swap agreements, it can use the premiums from other parties to off-set the loss caused by default to any one particular party. As a result, more participants are encouraged to invest in the Corporate Bond market and provide finance to slightly riskier companies. The development of a CDS market can facilitate the development of the Bond market. The same was also recognized by the working group on the development of the Corporate Bond market in India, which referred to the introduction of the CDS market as an “intended outcome yet to be achieved”.[viii]
Despite the benefits, however, there are many limitations to these instruments too. This article confines itself to a key limitation of these agreements, which is the presence of counterparty risk.[ix] This refers to an instance where the insurer does not fulfil its obligation of indemnifying the insured from the loss upon default, as a result of which the insured suffers a loss. This can be seen as one of the crucial factors which led to the 2007-08 global financial crisis.[x] For years preceding the financial crisis, major financial institutions such as the Federal National Mortgage Association (popularly known as ‘Fannie Mae’) and Federal Home Loan Mortgage Corporation (popularly known as ‘Freddie Mac’) began entering into credit default swaps for Mortgage Backed Securities, which derived their value from the mortgage payments being made by the public which took home loans. A lack of regulatory oversight led to the creation of a system wherein home loans were approved without necessary due diligence, thereby increasing the default potential drastically. Despite this, Fannie Mae and Freddie Mac entered into numerous Credit Default Swap agreements with numerous other financial institutions in order to provide them with insurance on these securities (which were ultimately worthless). When the market crashed, Fannie Mae and Freddie Mac were not in a position to honour their obligations towards all the entities with whom they had entered into the CDS agreement, which ultimately required a governmental intervention to save the economy. In order to avoid such a scenario again and encourage a market for CDS, regulators must solve the problem of counterparty risk. One such solution to the same is the introduction of smart contracts.
‘Smart Contract’ refers to a blockchain based computer code, which enables automatic execution of a particular agreement.[xi] For example, two parties entering into a contract would set out the terms based on which the contract would be executed. In the absence of a smart contract, one of the parties could unilaterally refuse to fulfil its obligations when it arises, and the other parties would have no option but to seek relief from the courts of law. By using smart contracts, however, such a problem is less likely to arise. Once the terms of the contract are entered into the code, the contract gets executed automatically when the conditions required are fulfilled. This is particularly useful in agreements which involve the payment of money, as the money is automatically transferred to the other party once the conditions are fulfilled. The application of this technology can prove to be extremely useful in the CDS market.
When two parties enter into a CDS agreement with a smart contract, they are better off with respect to counterparty risk.[xii] For starters, the code can prescribe maintaining adequate collateral as a pre-condition for entering into the contract. In the event that the collateral offered is lesser than what is prescribed, the contract would not be entered into, thus avoiding any repetition of the 2007 meltdown. If the collateral is decreased subsequently, the contract would be automatically terminated.[xiii] The contract can be designed in a way that money is transferred from the insurer as and when the underlying bond defaults. This way, the bond holder is guaranteed of indemnification without having to go through the hassle of approaching the courts of law.
Efforts to use blockchain based platforms to enter into swap agreements have already begun. Citibank and Goldman Sachs made news by becoming the first banks to enter into an equity swap agreement on an Ethereum based blockchain platform.[xiv] It is claimed that by using a smart contract, both parties saved millions of dollars and days of work hours which would otherwise have been spent in the event that either party defaulted or there arose any discrepancies which could arise later.[xv]
Despite the benefits of a blockchain based approach, there exist multiple issues which must be sufficiently researched before any such model can be introduced. One such limitation is the lack of scope for ambiguity in the contract. Once smart contracts are entered into, amending/altering the terms of the contract is an extremely tedious process, and can involve significant costs.[xvi] This is unlike traditional contracts, wherein parties can mutually decide to amend the terms of the contract and change their conduct after reaching a consensus. Furthermore, the nature of a smart contract is such that it executes automatically. Hence, all the terms which can have an impact on execution must be agreed upon by the parties in advance. This, however, can increase the transaction costs while negotiating, as parties would have to provide for every single scenario which can affect the contract.[xvii] This is in contrast to a traditional contract where they could avoid these costs by including a provision which enabled the parties to decide the matter if it ever arose by the means of negotiation/mediation/arbitration and so on. However, it could also be argued that CDS agreements are largely standardized in nature, and that the nature of the contracts is such that there is very little scope for complex legal issues to emerge subsequently. A solution to this problem could be ensuring that organizations like the International Swaps and Derivatives Association (ISDA) work out standard templates which cover all the material terms necessary in a smart CDS contract, which can then become an industry norm. This would cut down on any potential negotiation costs.
Nevertheless, there still exists multiple grey areas which must be researched upon before taking any steps to introduce such a model. The rewards of a successful implementation of such a model make this an extremely interesting area to research on.
References
[i] Press Trust of India, “Covid-19 Impact: India’s GDP to Contract 6.1% in FY21, Says Nomura.” Business Standard India, July 22, 2020. https://www.business-standard.com/article/economic-revival/covid-19-impact-india-s-gdp-to-contract-6-1-in-fy21-says-nomura-120072200025_1.html
[ii] Id.
[iii] Jayanta Roy Chowdhury, “The Great COVID Job Crisis: 122 Million Went out of Work in April in India, Says Data” The New Indian Express, 28th May, 2020. https://www.newindianexpress.com/business/2020/may/28/the-great-covid-job-crisis-122-million-went-out-of-work-in-april-in-india-says-data-2149239.html.
[iv] Report of the Working Group on Development of Corporate Bond Market in India, August 2016. https://www.sebi.gov.in/reports/reports/aug-2016/report-of-the-working-group-on-development-of-corporate-bond-market-in-india_33004.html
[v] Id.
[vi] Saikta Das, “How India stands among peers or bond raising” The Economic Times, July 29, 2020. https://economictimes.indiatimes.com/markets/bonds/how-india-stands-among-peers-for-bond-raising/articleshow/77243745.cms
[vii] Id.
[viii] Supra note. 4
[ix] Arora, Navneet, Priyank Gandhi, and Francis A. Longstaff. “Counterparty Credit Risk and the Credit Default Swap Market.” SSRN Scholarly Paper. Rochester, NY: Social Science Research Network, March 1, 2011. https://doi.org/10.2139/ssrn.1830321.
[x] Id.
[xi] Lipton, Alex, and Stuart Levi. “An Introduction to Smart Contracts and Their Potential and Inherent Limitations.” The Harvard Law School Forum on Corporate Governance (blog), May 26, 2018. https://corpgov.law.harvard.edu/2018/05/26/an-introduction-to-smart-contracts-and-their-potential-and-inherent-limitations/.
[xii] Oxford Law Faculty. “A ‘Smart Derivative Contract’: Constructing a Digital Financial Derivative,” December 19, 2018. https://www.law.ox.ac.uk/business-law-blog/blog/2018/12/smart-derivative-contract-constructing-digital-financial-derivative.
[xiii] Id.
[xiv] Castillo, Michael del. “Citi, Goldman Sachs Conduct First Blockchain Equity Swap On Ethereum-Inspired Platform.” Forbes, January 28, 2020. https://www.forbes.com/sites/michaeldelcastillo/2020/02/06/citi-goldman-sachs-conduct-first-blockchain-equity-swap-on-ethereum-inspired-platform/.
[xv] Id.
[xvi] Supra note. 11
[xvii] Id.
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