Stage set for total return swaps as RBI floats new credit derivatives framework

The Reserve Bank of India (RBI) on Friday set the stage for the debut of so-called total return swaps (TRS) proposed in the Union budget, by revising the definition of credit derivatives to include corporate bond indices as well.

The RBI proposed an updated framework expanding the definition of credit derivatives to mean a contract whose value is derived not just from the credit risk of an underlying debt instrument, but also from an index of underlying debt instruments. This clears the way for TRS, where an investor gets economic exposure to a bond, including coupon payments and price movements, without owning the bond itself.

An active derivatives market can facilitate the sale of corporate bonds of all ratings, the central bank said. Such a market could help investors manage credit risk more efficiently, improve liquidity and pricing efficiency. Once the norms are finalized, market-makers and users will get to transact in TRS, besides existing credit default swaps (CDS).

Framework

An index comprising solely of eligible debt instruments can be the underlying reference obligation for a CDS, a reference asset for a TRS, a credit index for an exchange-traded CDS contract, and for futures contracts on credit indices, RBI said, adding that this will be subject to the index being published by a financial benchmark administrator authorised by the regulator. Further, any floating interest rate used in a TRS will also need to be linked to a benchmark published by a financial benchmark administrator.

The central bank also proposed expanding the definition of eligible users of such derivative contracts from the existing minimum net worth criteria of ₹500 crore to also include entities with a minimum turnover of ₹1,000 crore.

Market makers can offer TRS to any resident entity, other than an individual, without any restriction in terms of purpose. A TRS contract can be offered to a person resident outside India only for the purpose of hedging.

The central bank has sought comments and feedback on the draft norms by 27 February, based on which the final norms will be issued thereafter.

Settlement

The settlement basis and market conventions for credit derivative contracts will be specified by the Fixed Income Money Market and Derivatives Association of India (Fimmda), in consultation with market participants and based on international best practices. Fimmda may also prescribe standard documentation procedures for credit derivative transactions, but market participants may, alternatively, use a standard master agreement for credit derivative contracts.

Foreign Portfolio Investors (FPIs) will only be allowed to participate in futures on credit indices if their aggregate long position on credit indices falls under the investment limits for corporate debt securities; and if their total gross short (sold) position does not exceed the consolidated long position in corporate bonds, debentures and future contracts on credit indices. Further, they will not be allowed to invest in future contracts where the underlying credit index includes money market debt instruments.

Credit views

Treasury officials said the introduction of TRS could mark a shift in how investors access corporate credit, allowing them to take short-term or directional views on bond yields and prices without deploying large balance-sheet capital. Market participants also said TRS is less about earning carry (net profit earned from holding an asset) and more about expressing tactical credit views.

While similar structures are widely used in overseas government bond markets and selectively by offshore investors in Indian debt, officials cautioned that TRS may not generate long-term, stable demand for corporate bonds. Still, the RBI’s move is seen as a step towards boosting secondary-market activity, improving price discovery and expanding participation in India’s relatively shallow corporate bond market.