RBI set to introduce credit default swaps

The Reserve bank of India (RBI) on Wednesday proposed to
introduce credit default swaps, or CDS, in Indian markets, enabling
firms to hedge against any possible default by a bond issuer.

CDS is a derivative used to offset risks in debt markets. It allows
creditors to insure themselves against the possibility that a borrower
might default.

The draft guidelines were put up on RBI’s website late Wednesday. It
did not say when the instrument would come in play but invited public
comments to the report—titled “Draft Report of the Internal Group on
Introduction of Credit Default Swaps for Corporate Bonds”—till 4
October.

This is the third time RBI has come out with a draft report on CDS. The
first was in 2003 and second in 2007.

The introduction of CDS got stalled after a credit crunch hit the
global financial system in the wake of the collapse of US investment
bank Lehman Brothers Holdings Inc. in 2008.

CDS was blamed for the crisis and the near collapse of largest
insurance firm in the world, American International Group Inc.
Investors were trading CDS as stand-alone instruments and the trade
proliferated exponentially.

RBI has already introduced instruments such as repo, or repurchase, in
corporate bonds or interest rate futures, but CDS is possibly the most
sophisticated financial instrument the Indian market could be seeing.

Like all derivatives that reflect the value of an underlying
instrument, CDS reflects the value of a bond or a loan. If an investor
in a company’s bond wants to buy an insurance against a possible
default by the issuer, the investor could buy CDS for a price,
technically called CDS spread. The CDS seller, in turn, guarantees to
pay the buyer a predetermined amount if the bond issuer defaults on
repayment.

To avoid inherent risks, the draft report on CDS says users cannot
purchase CDS without having an underlying exposure and the protection
can be bought only to the extent (both in terms of quantum and tenure)
of such underlying risk.

“Since the users are envisaged to use the CDS only for hedging their
credit risks, the group recommended that the users shall not, at any
point of time, maintain naked CDS protection,” the draft report said.

This means CDS cannot be used as a pure trading instrument. “This
instrument ensures that banks take position on companies from an arms
length even when not directly lending to them. After some time, it
could be possible that international CDS of Indian companies could be
brought back to India for trading,” said a banker who did not want to
be identified.

To restrict users from holding naked CDS positions—CDS bought without
underlying exposure—physical delivery is mandated in case of credit
events, the report said, adding users are prohibited from selling CDS.
It also proposed “rigorous audit” to ensure that buyers of CDS have
underlying exposure, and to make “physical settlement” mandatory for
CDS buyers.

Market-makers of these instruments, which include commercial banks,
primary dealers and non-banking financial companies (NBFCs), insurance
companies and mutual funds, have other options to settle their
positions.

Users category would consist of commercial banks, primary dealers,
NBFCs, mutual funds, insurance companies, housing finance companies,
provident funds and listed corporations.

“All CDS trades shall have a RBI-regulated entity at least on one
side,” the draft said.

At the initial stage, related parties or banks and their subsidiaries
cannot enter into CDS transactions between themselves, since “it would
be difficult to have an objective and transparent price discovery
mechanism at the initial stages and, therefore, it would be difficult
to determine whether an ‘arms’ length relationship exists or not”.
Market-makers should have sound financial fundamentals, the report
said.

Market-makers cannot enter into CDS transactions without obtaining from
the counterparty a copy of a resolution passed by their boards
authorising it to transact in CDS.

RBI said a centralized CDS repository with reporting platform could be
set up for transactions in CDS and it may be made mandatory for all CDS
market-makers to report their trades on the platform within 30 minutes
from the deal time. A separate reporting platform for CDS transactions
would be developed and housed along with the reporting platform for
over the counter derivatives.

In the interim, clearing houses such as Clearing Corporation of India
Ltd can be given the responsibility on a non-guaranteed basis, it said