The Reserve Bank of India (RBI) has placed the draft guidelines on credit default swaps (CDS) for corporate bonds on its website and invited comments from the public. It has also published the report of the internal working group on the introduction of credit default swaps for corporate bonds.
The report defines a CDS contract as a bilateral derivative contract on one or more reference assets. As part of it the protection buyer, who pays a premium during the life of the contract, receives a credit event payment from the protection seller following a credit event of the reference entities.
Following the global financial crisis, the RBI appears cautious about the introduction of CDS and so allows only listed corporate bonds as the reference obligation. However the infrastructure sector has been granted some latitude. As such, unlisted rated bonds of infrastructure companies and unlisted unrated bonds issued by the special purpose vehicles (SPVs) setup by infrastructure companies can also be reference obligations.
Participants have been clearly demarcated as market makers or users, the former defined as entities that can quote both buy and/or sell CDS spreads without necessarily having an “underlying” i.e. an underlying credit risk, provided they meet certain specified criteria. These include commercial banks, standalone primary dealers and non-banking financial companies with sound financials and good track record and any other institution specifically permitted by the RBI. Insurance companies and mutual funds will also be included as market makers as and when the Insurance Regulatory and Development Authority and the Securities and Exchange Board of India permit them to do so.
Users are defined as entities permitted to buy CDS protection only to hedge risks arising out of corporate bonds they hold. These include housing finance companies, provident funds, listed corporate and foreign institutional investors in addition to the entities mentioned above.
Reference against who?
The draft guidelines state that the reference entity against whose default the protection is bought and sold, will be a single legal resident entity and the direct obligor for the reference asset or obligation and the deliverable asset or obligation. In line with section 45V of the Reserve Bank of India Act, 1934, the guidelines require all CDS transactions to have an RBI regulated entity at least on one side.
Limits on protection
The draft guidelines make it mandatory for users to have an underlying at all times during the life of a CDS transaction. The user can exit its bought position by unwinding the CDS transaction with the original counterparty or novating the CDS transaction in favour of a new party who buys the underlying corporate bond.
The draft guidelines specify that CDS transactions cannot be entered into either between related parties or where the reference entity is a related party to either of the contracting parties. For foreign banks operating in India the term “related parties” include an entity that is a related party of the foreign bank, its parent or any other group entity.
Creating paper trails
The Fixed Income Money Market and Derivatives Association of India (FIMMDA) is responsible for standardizing and devising appropriate documentation for CDS transactions. The draft guidelines have made it mandatory that the master agreement to be drafted by FIMMDA in association with the International Swaps and Derivative Association (ISDA) should ensure that the CDS transactions envisaged therein are intra vires and any re-characterization risks are reduced to the minimum. The FIMMDA has also been given the task of standardizing CDS contracts in terms of coupon, coupon payment dates, etc in consultation with market participants.
The draft guidelines also suggest that a determination committee be formed jointly by the market participants and the FIMMDA to resolve issues such as credit events, CDS auctions, succession events etc. Although the credit events for CDS transactions are to be as provided in the 2003 ISDA Credit Derivative Definitions, restructuring is not one of them.
While settling CDS transactions, users must undertake physical settlement, whereas market makers have other options. The draft guidelines have stipulated that the individual market participants have to maintain margin in either cash or government securities and that the positions should be marked-to-market daily and re-margined on a weekly basis. Moreover to ensure there is no mis-selling and market abuse, market makers have to ensure that a CDS transaction is undertaken only upon obtaining a copy of the resolution passed by the counterparty’s board of directors that authorizes the transaction.
Ameya Khandge is a partner at Trilegal in Mumbai where Anoop Vasu is an associate. Trilegal is a full service law firm with offices in Delhi, Mumbai, Bangalore and Hyderabad and has over 120 lawyers.
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