Mumbai, Feb. 23: The Reserve Bank of India (RBI) today suggested that foreign institutional investors also be allowed to participate in credit default swaps (CDS) for corporate bonds when they are introduced in India.
CDS is a derivative used to manage risks in debt markets.
It allows creditors or investors of a bond to insure themselves against the possibility that the issuer may default. Therefore, if an investor of a bond issue wants to buy an insurance to hedge risk in the event of a default by the issuer, he can do so by purchasing it for a price (he makes regular premium payments) called the CDS spread. The buyer will be paid a set amount if the issuer indeed defaults by the seller of the CDS.
While the RBI has been contemplating to introduce CDS in the country for around eight years now, its launch got delayed on account of the global credit crisis. CDS was faulted for the crisis with observers pointing towards the huge trading in these instruments.
Last August, the central bank had placed a draft report prepared by an internal working group on the introduction of CDS for corporate bonds. Based on the feedback that it received, the RBI today placed draft guidelines for the introduction of CDS on corporate bonds.
Besides the FIIs, the guidelines said the other entities who would be permitted to buy credit protection (users) include commercial banks, primary dealers, non banking finance companies, mutual funds, insurance companies, housing finance companies, provident funds and listed companies.
On the other hand, the entities who are permitted to buy and/or sell CDS spreads include banks, NBFCs, stand-alone primary dealers or any other institution specifically permitted by the RBI.
It is felt that the addition of the FIIs to the list of users will help to widen the CDS market. The central bank is proposing that banks which intend to sell CDS protection should have a minimum capital adequacy ratio of 12 per cent and net non performing assets (NPAs) of less than 3 per cent. Similarly, NBFCs should have minimum net-owned funds of Rs 500 crore and minimum CRAR of 15 per cent.
The RBI has also said that the CDS can be written only on listed corporate bonds apart from unlisted but rated bonds of infrastructure companies.
It has also stipulated that the users can maintain CDS protection only if they have an underlying exposure (they have invested in that bond). The investors can also buy CDS only to extent of their underlying risk in terms of quantum and tenure.