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India has allowed Credit Default Swaps (CDS) from October with banks, primary dealers and non-banking financial companies' participation subjected to certain strict rules so as to prevent abuse of position by financial intermediaries to boost their revenues. According the Reserve Bank of India (RBI), the objective of introducing 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, an insurance instrument, promises the holder payment of money to the insured amount of bond holding in case of a default. The instrument helped at developing the domestic corporate bond market. However, the instrument was partly blamed for the credit crisis and the near sinking of US insurer AIG that happened in 2008.
The new guidelines will come to force from October 24 2011.
Commercial banks having minimum capital adequacy ratio (CRAR) of 11% with core CRAR (Tier I) requirement to 7 % and primary dealers will be the market makers. Also, non- banking financial companies having net owned funds up to Rs. 500 crore and CRAR of 15% will be allowed to be the market makers. Only the market makers or commercial banks will be allowed to buy and sell credit default swaps.
Users may be insurance companies, housing finance companies, provident funds, listed corporate and foreign institutional investors. They can only buy credit protection. But, they are neither being allowed to sell them nor permitted to hold net short positions in the CDS contracts. However, they can exit their bought CDS positions by unwinding them with the original counterparty or by assigning them in favor of buyer of the underlying bond. Users will have a grace period of 10 business days from the sale of the underlying bond to unwind the CDS position, or double the time.
The central bank also included restructuring under credit events for CDS, which are as per international standards.
The CDS transactions will be take place only after obtaining a copy of a resolution passed by the board of directors from the counterparty. RBI 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.
Apart from these, some of the rules are as follows:
- 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.
- Along with listed corporate bonds, CDS is also allowed on rated but unlisted bonds of infrastructure companies.
- 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. This will increase the efficiency of the product as a hedging tool and hence increase acceptability among users.
Article on Credit Default Swaps