Reserve Bank of India releases draft report proposal on introducing CDS to the country

It has been a few years in the making but India’s central bank, the Reserve Bank of India (RBI), today issued its updated draft report covering the introduction of onshore CDS. The public document clarifies the country’s goals and expectations for the orderly management and functioning of its own credit derivative market and took India a step ahead of China which is also trying to introduce its own onshore CDS market.

The summary press release is available for download here.

The full draft report is available for download here.

CreditLime’s previous report on the introduction of rupee credit default swaps to India is also available in three parts: Part 1, Part 2 and Part 3.

The summary of the findings and recommendations by the internal working group commissioned to conduct this report are:

- Only corporate bonds should be allowed as reference obligations (i.e. no other CDS sectors such as asset-backed, convertible bonds or municipal will be allowed … so the short answer to all those speculators looking to buy CDS on Jammu & Kashmir are out of luck)

- Only single legal resident entities should be allowed as reference entities (i.e. no cross-border companies will be traded onshore nor will foreign companies issuing debt in Indian markets be covered. So for example, a company like Hindustan Unilver which is a separately-traded subsidiary of the parent company in India, will be allowed to have its own CDS contracts but debt tied to cross-border parent companies Unilever PLC/Unilever NV will not be traded in India nor can be used to qualify for buying CDS to hedge in India).

- CDS must cover debt that is over 1 year to maturity (i.e. no short-term debt like commercial paper will be covered).

- CDS should be standardised (i.e. on things like payment dates and coupons)

- Users  must have their underlying bonds being hedged in de-materialised (demat, similar to the common form of public equity traded in India) form so that sellers can verify buyer holdings.

- A recognized credit rating will be required, but there is no minimum rating necessary.

- 2 sets of permitted CDS market participants:

• Market Makers: allowed to buy and sell CDS. Need to meet eligibility requirements to qualify. Specifically, banks, dealers and non-bank finance companies (NBFCs) that offer borrower credit facilities. RBI, also states that insurers and mutual funds may also qualify subject to approval either implicit or explicit approval from their regulators (IRDA & SEBI)
• End-users: only allowed to hedge long risk by buying CDS (therefore they need to have an underlying exposure and would only allowed to hedge up to that amount, both in size and time).

- The end goal is to have an RBI-regulated entity on at least one side of every CDS trade.

- Restructuring will not be a credit event in Indian CDS (although a different view may be considered as the market develops).

- Users must physically settle their CDS contracts. Market makers can settle in any of 3 ways (physical, cash or auction).

- Only market makers will be required to report all their CDS trades to a central data repository within 30 minutes of trade completion.

- Users and market-makers would not be permitted to enter into CDS transactions having their ‘related parties’ either as counterparties or as reference entities (this includes foreign bank subsidiaries with their parent or other international subsidiaries – much to the disappointment of transfer pricing professionals).

- Protection sellers (CDS sellers) must account for their risk to the underlying reference entity. Protection buyers (CDS buyers), however, must account for their risk to counterparty.

- Fixed Income Money Markets and Derivatives Association of India  (FIMMDA) will be the local governing body to setup things like the Determination Committee (DC) to officially declare credit events that require the settlement of CDS.

- 2 sets of documentation: one for user-market maker trades and another one for market-maker trades amongst themselves.

- No need for a central counterparty yet (although they may decide to move to one at a later time).

- A sampling of the eligibility norms for market makers:

• minimum capital to risk-weighted assets ratio (CRAR) of 12% & core CRAR (Tier 1 capital) of 8% for banks,
• non-performing assets (NPAs) less than 3% for banks and NBFCs
• minimum CRAR of 15% for NBFCs and dealers.
• minimum new owned funds of Rs. 500 crore (~US$108 million) for NBFCs and dealers.
• “robust risk management systems” (this is the requirement that critics worldwide laugh at since everyone already knows how the well even the best and most robust risk management systems at American banks performed in 2008 and 2009).

Though unreported by the major western publications including the FT, WSJ and Bloomberg so far (though they are still in overnight markets),  interested readers may want to have a look at the many Indian news outlets that have also covered the report release  for more information or opinions including The Indian Express,  The Economic Times, The Hindu BusinessLine, The Financial Express, Moneycontrol (CNBC-TV18),  Business Standard, and Livemint (twice).