Money & Banking

RBI releases guidelines on credit default swaps

Our Bureau Mumbai | Updated on February 16, 2021

File photo   -  PAUL NORONHa

The Reserve Bank of India (RBI) plans to allow retail users undertake transactions in permitted credit derivatives for hedging their underlying credit risk, according to its Draft guidelines on Credit Default Swaps (CDS).

Non-retail users shall be allowed to undertake transactions in credit derivatives for both hedging and other purposes.

The RBI has come up with ‘Reserve Bank of India (Credit Derivatives) Directions, 2021 – Draft’ as development of CDS market is sine qua non for the development of a liquid market for corporate bonds, especially for the bonds of lower rated issuers.

CDS is a credit derivative contract in which one counterparty (protection seller) commits to compensate the other counterparty (protection buyer) for the loss in the value of an underlying debt instrument resulting from a credit event with respect to a reference entity.

The protection buyer makes periodic payments (premium) to the protection seller until the maturity of the contract or the credit event, whichever is earlier.

CDS is a tool to transfer and manage credit risk in an effective manner through redistribution of risk. The RBI will allow only single-name CDS contracts.

According to the draft Directions, Exchanges may offer standardised single-name CDS contracts with guaranteed cash settlement. Retail users shall undertake transactions in exchange-traded CDS only for hedging their underlying credit risk.

User classification

Any user who is not eligible to be classified as a non-retail user will be classified as a retail user.

Non-retail users will include insurance companies, pension funds, mutual funds, alternate investment funds, foreign portfolio investors. These entities will also be eligible to act as protection seller in CDS.

Standalone primary dealers (SPDs) and non-banking finance companies (NBFCs), including housing finance companies (with minimum net owned funds of ₹500 crore) and resident companies (with minimum networth of ₹500 crore), too, will be classified as non-retail users.

Eligible debt instruments

Debt instruments which will be eligible to be a reference / deliverable obligation in a CDS contract include Commercial Papers, Certificates of Deposit and Non-Convertible Debentures of original maturity up to one year; Rated Indian Rupee (INR) denominated corporate bonds (listed and unlisted); and Unrated INR bonds issued by the Special Purpose Vehicles set up by infrastructure companies.

The RBI said the reference/deliverable obligations shall be in dematerialised form only.

Asset-backed securities/mortgage-backed securities and structured obligations such as credit enhanced/guaranteed bonds, convertible bonds, bonds with call/put options etc. shall not be permitted as reference and deliverable obligations.

Market-makers – entities which can buy and sell protection from/to users and other market-makers in order to provide liquidity to the market – will include Scheduled Commercial Banks (except Small Finance Banks, Payment Banks, Local Area Banks and Regional Rural Banks) and NBFCs, including HFCs, and SPDs with minimum net owned funds of ₹500 crore.

They will also include Export-Import Bank of India, National Bank of Agriculture and Rural Development, National Housing Bank and Small Industries Development Bank of India.

Restrictions

The RBI said market-makers and users shall not enter into CDS transactions if the counterparty is a related party or where the reference entity is a related party to either of the contracting parties.

Further, market-makers and users shall not buy/sell protection on reference entities if there are regulatory restrictions on assuming similar exposures in the cash market or in violation of any other regulatory restriction, as may be applicable.

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Published on February 16, 2021
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