Mumbai: The Reserve Bank of India (RBI) on Tuesday announced norms for credit default swaps (CDS) enabling foreign funds, banks, mutual funds, insurance companies, provident funds and listed 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.
Five months down the line, from 24 October, creditors will be allowed to buy CDS to insure themselves against such defaults. RBI expects the market infrastructure to be created in the next five months.
Also see | Hedging Tool (PDF)
RBI had first released draft guidelines for CDS in 2003 and followed it up in 2007, 2010 and February this year, but in none of the earlier draft guidelines were foreign funds allowed to trade in the derivative instrument.
The initial plan was to introduce CDS in Indian market in 2008, but it got stalled after an unprecedented credit crunch hit the global financial system in the wake of the collapse of US investment bank Lehman Brothers Holdings Inc. in September 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.
In an introduction to the guidelines on Tuesday, RBI said CDS would help market participants hive off credit risk. “Since CDS have benefits like enhancing investment and borrowing opportunities and reducing transaction costs while allowing risk-transfers, such products would increase investors’ interest in corporate bonds and would be beneficial to the development of the corporate bond market in India,” RBI said.
RBI has divided CDS users into two groups.
The first is the market-makers—namely banks, primary dealers and non-banking financial companies (NBFCs) which are permitted to both buy and/or sell CDS spreads, even without having the underlying bond.
The second group is made up of “users”—banks, primary dealers, NBFCs, mutual funds, provident funds, insurance firms, housing finance firms, listed companies and foreign institutional investors (FIIs).
Users are permitted to buy credit protection only to hedge their underlying credit risk on corporate bonds, but they are not permitted to hold credit protection without having the eligible underlying asset as a hedged item.
Users are also not permitted to sell protection and not permitted to hold short positions in CDS contracts. However, they are permitted to exit their bought CDS positions by unwinding them with the original counterparty or by assigning them in favour of the buyer of the underlying bond, RBI said.
Mohan Shenoi, treasurer at Kotak Mahindra Bank Ltd, said it was too early to expect trades to pick up in the CDS market.
“Already we have seen instruments like when-issued and interest-rate futures introduced, but trades have not really picked up. Similarly, it will also take time in this market. But the regulator must be willing to tweak the guidelines if trade is slow,” he said.
In the past few years, the banking regulator has introduced products such as strips (separate trading of registered interest and principal of securities), repurchase or repo in corporate bonds, a so-called when-issued facility and short-selling of bonds to deepen the market.
However, trades have been thin, reflecting the underlying trades in the bond market.
Ashish Ghiya, managing director at Derivium Capital and Securities Pvt. Ltd, a corporate bond broker, said pick-up may take time because CDS is a complex derivative instrument. “It is more complex than interest rate or currency futures because besides the counterparties and the underlying entity, the market is also illiquid,” he said.
Trades in the corporate bond market have been thin with the secondary market seeing daily volumes of Rs 200-300 crore, though primary issuances are at Rs 2.5-3 trillion every year.
The Fixed Income Money Market and Derivatives Association of India, an industry body, will devise a master agreement for CDS. “There would be two sets of documentation: one set covering transactions between user and market-maker and the other set covering transactions between two market-makers,” RBI said.
Banks, NBFCs and primary dealers have to report their CDS trades on the reporting platform of the CDS trade repository within 30 minutes from deal time.
Users, including FIIs, insurance companies, provident funds and listed corporations, will be required to affirm or reject their trade already reported by the market-maker by the end of the day, RBI said.