Different types of SWAP derivatives and RBI guidelines on CDS contract

[The most popular swaps are Commodity Swaps, Currency Swaps, Interest rate Swaps, and Credit Default Swap (CDS)]

In simple words, a Swap is an act of exchanging one thing for another. A financial derivative swap is an agreement between two counterparties (a buyer is a counterparty to a seller) to exchange financial instruments, cash flows, or payments for a specific time.  Often, swap trading is based on loans or bonds, otherwise known as a notional principal amount.

Financial derivatives are used for several purposes including risk management, hedging, arbitrage between markets, and speculation. Unlike futures and options, swaps are not traded on exchanges but over-the-counter. Introduced in the late 1980s, swaps are a relatively new type of derivative. Even though relatively new, their simplicity, coupled with their extensive applications, makes them one of the most frequently traded financial contracts.

Commodity Swap:

These derivatives are designed to exchange floating cash flows that are based on a commodity’s spot price for fixed cash flows determined by a pre-agreed price of a commodity. Despite its name, commodity swaps do not involve the exchange of the actual commodity.

Currency Swap:

When buying and selling a foreign currency with different delivery dates simultaneously takes place, it is called a SWAP transaction. Currency swaps are used to hedge interest rate risk and exchange rate risk. As per RBI notification, effective from April 5, 2024, there is no restriction to ADs to offer deliverable and non-deliverable foreign exchange derivative contracts not involving INR to users. They may offer foreign currency interest rate derivatives to users without any restriction in terms of purpose. Further, there is no restriction to offer currency swaps to resident users, other than individuals, to convert their INR liability into a foreign currency liability. However, in the case of resident retail users, such conversion shall be subject to the existence of a natural hedge.

Interest Rate swaps:

An interest rate swap is a contractual arrangement between two parties, often referred to as “counterparties”. In an interest rate swap, the principal amount is not exchanged between the counterparties, rather, interest payments are exchanged based on a “notional amount” or “notional principal.” Interest rate swaps do not generate new sources of funding themselves; rather, they convert one interest rate basis to a different rate basis (e.g., from a floating or variable interest rate basis to a fixed interest rate basis, or vice versa). These “plain vanilla” swaps are by far the most common type of interest rate swaps.

Fixed v/s Floating swaps: Where one side pays the other a fixed interest rate and the other pays a floating rate determined by some benchmark and reset at fixed time intervals.

Overnight interest rate swaps:

Overnight interest rate swaps are currently prevalent to the largest extent. They are swaps where the floating rate is an overnight rate (such as NSE MIBOR) and the fixed rate is paid in exchange for the compounded floating rate over a certain period.

Credit default swaps (CDS):

Credit default swap (CDS) is an over-the-counter (OTC) agreement between two parties to transfer the credit exposure of fixed-income securities. A CDS provides insurance from the default of a debt instrument. The buyer of a swap transfers to the seller the premium payments. In case the asset defaults, the seller will reimburse the buyer the face value of the defaulted asset, while the asset will be transferred from the buyer to the seller.

Eligible debt instruments for CDS:

Debt instruments that are 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 reference/deliverable obligations shall be in dematerialized form only.

Not eligible instruments for CDS:

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 a reference and deliverable obligation.

To learn more Read: Credit Default Swap

RBI guidelines on CDS contract:

As per RBI guidelines, only single-name CDS contracts are allowed. Exchanges may offer standardized single-name CDS contracts with guaranteed cash settlement. Retail users are allowed to undertake transactions in exchange-traded CDS only to hedge their underlying credit risk. The users cannot buy CDS for amounts higher than the face value of corporate bonds held by them and for periods longer than the tenor of corporate bonds held by them. A proper caveat may be included in the agreement that the market-maker while entering into a CDS contract, needs to ensure that the user has exposure to the underlying. Further, the users are required to submit an auditor’s certificate to the protection sellers, of having the underlying bond while entering into/unwinding the CDS contract.

ISDA Agreement:

Most of the derivatives in the global derivatives market are documented under the International Swaps and Derivatives Association (ISDA) documentation. The ISDA Master Agreement is an internationally agreed document published by the International Swaps and Derivatives Association, Inc. (“ISDA”) which is used to provide certain legal and credit protection for parties who enter into over-the-counter or “OTC” derivatives transactions. Read: ISDA MASTER AGREEMENT: SALIENT FEATURES

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