As part of their overall risk management strategy, banks are using innovative products like credit derivatives. These derivatives pose risks due to failure of counterparty. This credit risk can be managed by using tools like master netting exposure and structure finance solutions.

Banks in many countries are using exotic derivative instruments to manage or mitigate the credit risk of their credit portfolio. They are also acting as intermediary to the counterparties. Most commonly used credit derivatives are credit default swap, total return swap, asset backed credit linked notes, spread options, credit intermediation swaps etc. These instruments of credit enhancement are totally different from traditional credit enhancement tools. Traditional credit enhancement tools are collateral, termination or reassignment, marking to market, bond insurance, guarantees, letter of credit etc.

Counterparty risk is very important in OTC derivatives. Loss to the bank, which acts as intermediary, occurs only when the counterparty defaults and positive market value to the bank of defaulting counterparty.

CDS provides protection to banks against default from the borrower. If the borrower defaults, the protection seller pays the amount based on the swap's notional amount. It also helps free up capital for other loans. Suppose a bank X gives the loan of Rs. 200 cr to bank Y and enters into a credit default swap with counterparty Z. When the bank enters CDS with counterparty Z, he will provide protection to X that in case of default he (Z) will make default payments.

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