RBI places draft report of Internal Group on Introduction of Credit Default Swaps (CDS) for Corporate Bonds

11 August, 2010: Reserve Bank of India has placed its draft report of the Internal Group on Introduction of Credit Default Swaps (CDS) for Corporate Bonds on 4^th August, 2010. RBI has published draft guidelines on the introduction to CDS in 2003 and in 2007 and these were again introduced in the Second Quarter Review of Monetary Policy of 2009-10 wherein RBI proposed the introduction of plain vanilla OTC single-name CDS for corporate bonds for resident entities subject to appropriate safeguards.

To provide liquidity to the corporate debt market and to provide complete and efficient markets and enable price discovery, recently, Reserve Bank of India set up an Internal Group comprising officials from its various departments to finalise the operational framework for introduction of CDS in India. The recommendations of the report are as follows:

• Reference Obligations: CDS shall be permitted only on corporate bonds as reference obligations and the reference entities shall be single legal resident entities and direct obligor for the reference asset/ obligation and deliverable asset/ obligation. The RBI has also laid down requirement for rating of the corporate bonds to be eligible as underlying for CDS, however there is no minimum rating prescribed. Only in case of infrastructure companies, CDS may also be written for corporate bonds issued by unrated special purpose vehicles.
• Participants: There are two categories of participants;
  • Market Makers: The market makers, uch as, commercial banks, non-banking financial companies, primary dealers, insurance companies and mutual funds, complying with the eligibility criteria and subject to the approval of their respective regulators can buy and sell protection.
  • Users: Users such as commercial banks, primary dealers, non-banking financial companies, mutual funds, insurance companies, housing finance companies, provident funds and listed corporate, can only hedge their underlying exposures. and are not allowed to sell CDS or do short selling. The users can buy CDS for amounts not higher than the face value of credit risk held by them and for periods not longer than the tenor of credit risk held by them.

All CDS trades should have an RBI regulated entity on one side of the transaction. Participants shall put in place a written policy on CDS which should be approved by their respective Boards of Directors. The policy may be reviewed periodically.

• Settlement Methodologies: For users, physical settlement is mandatory. Market-makers can opt for any of the three settlement methods (physical, cash and auction), provided the CDS documentation envisages such settlement.
• Other recommendations
  • The accounting norms applicable to CDS contracts shall be on the lines indicated in the ‘Accounting Standard (AS) 30 – Financial Instruments: Recognition and Measurement’, approved by the Institute of Chartered Accountants of India (ICAI).
  • Participants are required to build robust and appropriate risk management system to manage risk of sudden increases in credit spreads resulting in mark-to-market losses, high incidence of credit events, jump-to-default risk, basis risk, counterparty risks, etc., which are difficult to anticipate or measure accurately.
  • A centralised CDS repository with reporting platform on the lines of the DTCC’s Trade Information Warehouse (TIW) would be set up for capturing transactions in CDS and it may be made mandatory for all CDS market-makers to report their CDS trades on the reporting platform within 30 minutes from the deal time.
  • Fixed Income Money Markets and Derivatives Association of India (FIMMDA) may coordinate with service providers/ISDA to come out with a daily CDS curve, day count convention, setting up of determination committees and in the matters relating to documentation. However, if a proprietary model results in a more conservative valuation, the market participant can use that proprietary model.
  • The report proposes standardization of contracts

Key Highlight of the Report: 

The central highlight of the Report is that the users are not allowed to enter into synthetic transactions, that is, users can only use CDS for hedging purposes and only if they have an actual exposure in the underlying, can the users buy protection and cannot maintain naked CDS protection. The relevant extract of the text of the report is reproduced below: 

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 users can, however, unwind their bought protection by terminating the position with the original counterparty. The original counterparty (protection seller) may ensure that the protection buyer has the underlying at the time of unwinding. Users are not permitted to unwind the protection by entering into an offsetting contract.  

In order to restrict the users from holding naked CDS positions i.e. CDS is not bought without underlying; physical delivery is mandated in case of credit events. Further, users are prohibited from selling CDS. Proper caveat may be included in the agreement that the protection seller, while entering into CDS contract / unwinding, needs to ensure that the protection buyer has exposure in the underlying. This may also be subject to rigorous audit discipline.  

The draft report has been placed for public comments till 4^th October, 2010. See the text of the report here

[Reported by: Nidhi Bothra]

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