RBI guidance on Credit Default Swap

A credit default swap (CDS) is a contract between two parties in which one party purchases protection from another party against losses from the default of a borrower for a defined time. The protection buyer makes periodic payments (premium) to the protection seller until the maturity of the contract or the credit event, whichever is earlier.

Credit default swap under a credit derivative contract, the 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 of a reference entity.

The objective of introducing Credit Default Swaps (CDS) on corporate bonds is to provide market participants a tool to transfer and manage credit risk in an effective manner through redistribution of risk. CDS as a risk management product offers the participants the ability to hive off credit risk and also to assume credit risk which otherwise may not be possible. Since CDS have benefits like enhancing investment and borrowing opportunities and reducing transaction costs while allowing risk-transfers, such products would increase investors’ interest in corporate bonds and would be beneficial to the development of the corporate bond market in India.

Users of buy credit protection:

Entities permitted to buy credit protection (buy CDS contracts) only to hedge their underlying credit risk on corporate bonds.  Therefore, they are not permitted to hold credit protection without having eligible underlying as a hedged item. Users are also not permitted to sell protection and are not permitted to hold net short positions in the CDS contracts. However, they are permitted to exit their bought CDS positions by unwinding them with the original counterparty or by assigning them in favour of buyer of the underlying bond.

Non-retail users:

Non-retail users include insurance companies, pension funds, mutual funds, alternate investment funds, and foreign portfolio investors. 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 net worth of ₹500 crore), too, will be classified as non-retail users.  These entities are eligible to act as protection sellers in CDS. Foreign Portfolio Investors (FPIs) are eligible to be categorised as non-retail users and have been allowed to buy and sell CDS protection under the Credit Derivatives Directions. Non-retail users shall be allowed to undertake transactions in credit derivatives for both hedging and other purposes.

Retail user:

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

RBI guidelines on CDS contract:

Eligible debt instruments:

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 dematerialised form only.

Not eligible instruments:

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 obligations.

As per RBI guidelines, only single-name CDS contracts are allowed. Exchanges may offer standardised 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.

*Market Maker:

A market maker participates in the market at all times, buying securities from sellers and selling securities to buyers. Market makers provide a ‘two-way quote’ to the market, which means they are willing to both buy and sell a security in a tradable asset hoping to make a profit on the bid–ask spread.

Market makers include Scheduled Commercial Banks (except Small Finance Banks, Payment Banks, Local Area Banks, and Regional Rural Banks), EXIM bank, NABARD, NHB, SIDBI, and NBFCs, including HFCs, and SPDs with minimum net owned funds of ₹500 crore.

Restrictions on related Parties:

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 violation of any other regulatory restriction, as may be applicable. Related parties for these guidelines will be as defined in ‘Accounting Standard 18 – Related Party Disclosures’. In the case of foreign banks operating in India, the term ‘related parties’ shall include an entity that is a related party of the foreign bank, its parent, or group entity.

Settlement:

For users, physical settlement is mandatory. In the case of auction-based settlement, physical settlement for users would take place at a price decided through auction. Market-makers can opt for any of the three settlement methods (physical, cash, and auction), provided the CDS documentation envisages such settlement. The notional amount of protection sold by FPIs, and the debt instruments received as deliverable obligation as well as debt instruments purchased for meeting deliverable obligation by FPIs in physical settlement of CDS contracts shall not be subject to minimum residual maturity requirement / short-term limit, concentration limit or single/group investor-wise limits applicable to FPI investment in corporate bonds.

Limit for selling CDS protection by FPI:

Selling of CDS protection by all FPIs shall be subject to a limit specified by the Reserve Bank from time to time (hereinafter, aggregate limit). The aggregate limit of the notional amount of CDS sold by FPIs shall be 5% of the outstanding stock of corporate bonds. FPIs shall not sell any CDS protection once the aggregate limit is utilised. The limit utilised for CDS protection sold by the FPI shall be released upon the exit of the CDS position by the FPIs. The usage of aggregate limit is decimated by CCIL based on reporting by the market makers to the OTC market and stock exchange.

Deliverable obligation:

Debt instruments received by FPIs as deliverable obligation and debt instruments purchased by FPIs for meeting deliverable obligation in physical settlement of CDS contracts shall be reckoned under the investment limits for corporate bonds as specified in A.P. (DIR Series) Circular No. 05 dated May 31, 2021, as amended from time to time. In case of non-availability of investment limit at the time of physical settlement, such debt instruments shall be adjusted against the revised limits in the subsequent review of investment limits.

Exiting CDS transactions by users:

Users are not permitted to sell protection and they cannot exit their bought positions by entering into an offsetting sale contract. In the case of unwinding, the original counterparty (protection seller) is required to ensure that the protection buyer has the underlying at the time of unwinding. While unwinding, the protection seller may also ensure that the transaction is done at a transparent market price and this must be subject to rigorous audit discipline. Further, they can exit from a bought position by unwinding the contract with the original counterparty or by assigning (novating) the CDS protection to the purchaser of the underlying bond (the “transferee”) subject to consent from the original protection seller (the “remaining party”). After the assignment, the “transferor” will end his involvement in the transaction, and credit risk will continue to lie with the original protection seller. The new user (the “transferee”) will pay the premium to the original protection seller. Market participants may adopt the standard Novation Agreement and Novation Confirmation given in the 2003 ISDA Credit Derivatives Definitions in this regard. [The 2003 ISDA Credit Derivatives Definitions (the “2003 Definitions”) are intended for use in confirmations of individual transactions governed by agreements such as the 2002 ISDA Master Agreement]. The users would be given a grace period of five business days from the date of sale of the underlying to unwind the CDS position.

Other requirements:

1. The CDS contract shall be denominated and settled in Indian Rupees;
2.  CDS cannot be written on interest receivables;
3. CDS cannot be written on interest receivables;
4.  CDS shall not be written on securities like CP (commercial paper), CD (certificate of deposit), and NCD (negotiable certificate of deposit) with an original maturity of up to one year.
5. CDS contract must represent a direct claim on the protection seller;
6.  CDS contract must be irrevocable; there must be no clause in the contract that would allow the protection seller to unilaterally cancel the contract. However, if the protection buyer defaults under the terms of a contract, the protection seller can cancel/revoke the contract;
7. the protection seller shall have no recourse to the protection buyer for credit-event losses;

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