RBI Sets Stiff Rules Ahead of Credit Default Swaps Debut

Instrument to debut in India in October, move to help develop local bond market credit default swaps, an insurance instrument partly blamed for the credit crisis and the near sinking of US insurer AIG, will be permitted in India from October with banks, primary dealers and non-banking financial companies’ participation and some strict rules to prevent abuse. 

The instrument, popularly known as CDS, which promises the holder payment of money to the insured amount of bond holding in case of a default, is aimed at developing the domestic corporate bond market. 

The new guidelines that will come to force from October 24, is framed with safeguards to prevent abuse of position by financial intermediarie to boost their revenues as it happened with currency derivatives that sank many small companies. 

“The objective of introducing credit default swaps on corporate bonds is to provide market participants a tool to transfer and manage credit risk in an effective manner through redistribution of risk,” the Reserve Bank of India said in a statement. 

Legal hassles and procedural delays due to unique rollover of loan repayments in the name of ‘corporate debt restructuring’ will also qualify as a credit event that will help the holder get insurance claim since it will be treated as default. 

“A key demand of the market to incorporate restructuring a credit event has been incorporated,” said B Prasanna, chief executive at I-sec Primary Dealership. “This would increase the efficiency of the product as a hedging tool and hence increase acceptability among users.” 

Along with commercial banks and primary dealers, with netowned funds up to . 500 crore and a minimum capital adequacy ratio of 15%, NBFCs with strong financials, net-owned funds worth . 500 crore or more and capital adequacy ratio of 15% will be allowed to be market makers. 

Only the market makers or commercial banks will be allowed to buy and sell credit default swaps while the ‘users’ can only buy credit protection, but will not be allowed to sell them. Users may be insurance companies, housing finance companies, provident funds, listed corporates and foreign institutional investors. RBI, which received comments from public, has built-in protection for naive and put the onus on the sellers of CDS to ensure that they educate the buyer on what they are getting into. 

“Market makers may ensure adherence to suitability and appropriateness criteria while dealing with users,” the RBI guideline said. “CDS transactions shall be undertaken only on obtaining from the counterparty, a copy of a resolution passed by their board of directors. The product terms are transparent and clearly explained to the counterparties along with the risks involved.” The users cannot hold these contracts without having eligible underlying bonds, though the market makers can buy protection without having the underlying bond. The users cannot buy CDS for amounts higher than the face value of the corporate bonds held by them. 

Though credit default swaps is only allowed on listed corporate bonds, the central bank has made an exception for rated but unlisted bonds of infrastructure companies.

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