February 17, 2021 12:59:24 am
Pushing for the development of the credit derivatives market, the Reserve Bank of India on Tuesday said retail users will be allowed to undertake transactions in permitted credit derivatives for hedging their underlying credit risk.
Unveiling draft guidelines on credit default swaps (CDS), the RBI said non-retail users will be allowed to undertake transactions in credit derivatives for both hedging and other purposes.
A person resident in India and a non-resident — to the extent specified in the RBI directions – can participate in the market, it said. 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,” it said.
Played a role in 2008-09 global financial crisis
The RBI, which was planning to introduce credit default swaps 10 years ago, deferred the move in 2011 in the wake of global financial crisis in 2008-09. CDS played a big role in the global financial crisis as Lehman Brothers, the biggest casualty, owed $600 billion in debt, out of which $ 400 billion was covered by CDS. Insurance firm AIG lacked enough funds to clear the debt, forcing the US Federal Reserve to arrange a bailout. Considering the risks involved, the RBI seems to be cautious now as the CDS buyer may default on the contract, thereby denying the seller the expected revenue.
Bonds and other debt securities have risk that the borrower will not repay the debt or its interest. CDS is a derivative or contract that allows an investor to swap or offset his credit risk with that of another investor.
If a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in case the borrower defaults.
The central bank said commercial papers, certificates of deposit and non-convertible debentures of original maturity up to 1 year, rated rupee corporate bonds (listed and unlisted) and unrated rupee bonds issued by the special purpose vehicles set up by infrastructure companies will be eligible to be a reference or deliverable obligation in a CDS contract.
As per the central bank, retail users should exit their CDS position within one month from the date they cease to have underlying exposure. “Market participants can exit their CDS contract by unwinding the contract with the original counterparty or assigning the contract to any other eligible market participant,” it said.
CDS contracts should be denominated and settled in Indian rupees. “CDS contracts can be cash settled or physically settled. However, CDS contracts involving retail users should be mandatorily physical,” it said.
The Fixed Income Money Market and Derivatives Association of India, in consultation with market participants and based on international best practices, should devise standard master agreement/s for the Indian CDS market, which should include credit event definitions and settlement procedures. Credit derivative is a contract whose value is derived from the credit risk of an underlying debt instrument.
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