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Note on RBI Places Draft Report on Introduction of Credit Default Swaps (CDS) for Corporate Bonds

Note on RBI Places Draft Report on Introduction of Credit Default Swaps (CDS) for Corporate Bonds

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Published by Nidhi Bothra
RBI places draft report of Internal Group on Introduction of Credit Default Swaps (CDS) for Corporate Bonds By Nidhi Bothra nidhi@vinodkothari.com Reserve Bank of India has placed its draft report of the Internal Group on Introduction of Credit Default Swaps (CDS) for Corporate Bonds on 4th August, 2010. RBI has published draft guidelines on the introduction to CDS in 2003 and in 2007 and these were again introduced in the Second Quarter Review of Monetary Policy of 2009-10 wherein RBI proposed
RBI places draft report of Internal Group on Introduction of Credit Default Swaps (CDS) for Corporate Bonds By Nidhi Bothra nidhi@vinodkothari.com Reserve Bank of India has placed its draft report of the Internal Group on Introduction of Credit Default Swaps (CDS) for Corporate Bonds on 4th August, 2010. RBI has published draft guidelines on the introduction to CDS in 2003 and in 2007 and these were again introduced in the Second Quarter Review of Monetary Policy of 2009-10 wherein RBI proposed

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Categories:Business/Law, Finance
Published by: Nidhi Bothra on Aug 12, 2010
Copyright:Attribution Non-commercial

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10/25/2012

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RBI places draft report of Internal Group on Introduction of Credit Default Swaps (CDS)for Corporate BondsBy Nidhi Bothranidhi@vinodkothari.com 
Reserve Bank of India has placed its draft report of the Internal Group on Introduction of CreditDefault Swaps (CDS) for Corporate Bonds on 4
th
August, 2010. RBI has published draftguidelines on the introduction to CDS in 2003 and in 2007 and these were again introduced inthe Second Quarter Review of Monetary Policy of 2009-10 wherein RBI proposed theintroduction of plain vanilla OTC single-name CDS for corporate bonds for resident entitiessubject to appropriate safeguards.To provide liquidity to the corporate debt market and to provide complete and efficient marketsand enable price discovery, recently, Reserve Bank of India set up an Internal Group comprisingofficials from its various departments to finalise the operational framework for introduction of CDS in India. The recommendations of the report are as follows:
 
Reference Obligations:
CDS shall be permitted only on corporate bonds as referenceobligations and the reference entities shall be single legal resident entities and directobligor for the reference asset/ obligation and deliverable asset/ obligation. The RBI hasalso laid down requirement for rating of the corporate bonds to be eligible as underlyingfor CDS, however there is no minimum rating prescribed. Only in case of infrastructurecompanies, CDS may also be written for corporate bonds issued by unrated specialpurpose vehicles.
 
Participants:
There are two categories of participants;
o
 
Market Makers
: The market makers, uch as, commercial banks, non-bankingfinancial companies, primary dealers, insurance companies and mutual funds,complying with the eligibility criteria and subject to the approval of theirrespective regulators can buy and sell protection.
o
 
Users
: Users such as commercial banks, primary dealers, non-banking financialcompanies, mutual funds, insurance companies, housing finance companies,provident funds and listed corporate, can only hedge their underlying exposures.and are not allowed to sell CDS or do short selling. The users can buy CDS foramounts not higher than the face value of credit risk held by them and for periodsnot longer than the tenor of credit risk held by them.All CDS trades should have an RBI regulated entity on one side of the transaction.Participants shall put in place a written policy on CDS which should be approved by theirrespective Boards of Directors. The policy may be reviewed periodically.
 
 
Settlement Methodologies
: For
users
, physical settlement is mandatory.
 Market-makers
can opt for any of the three settlement methods (physical, cash and auction), provided theCDS documentation envisages such settlement.
 
Other recommendations
o
 
The accounting norms applicable to CDS contracts shall be on the lines indicatedin the ‘Accounting Standard (AS) 30 – Financial Instruments: Recognition andMeasurement’, approved by the Institute of Chartered Accountants of India(ICAI).
o
 
Participants are required to build robust and appropriate risk management systemto manage risk of sudden increases in credit spreads resulting in mark-to-marketlosses, high incidence of credit events, jump-to-default risk, basis risk,counterparty risks, etc., which are difficult to anticipate or measure accurately.
o
 
A centralised CDS repository with reporting platform on the lines of the DTCC’sTrade Information Warehouse (TIW) would be set up for capturing transactions inCDS and it may be made mandatory for all CDS
market-makers
to report theirCDS trades on the reporting platform within 30 minutes from the deal time.
o
 
Fixed Income Money Markets and Derivatives Association of India (FIMMDA)may coordinate with service providers/ISDA to come out with a daily CDS curve,day count convention, setting up of determination committees and in the mattersrelating to documentation. However, if a proprietary model results in a moreconservative valuation, the market participant can use that proprietary model.
o
 
The report proposes standardization of contracts
Key Highlight of the Report
:The central highlight of the Report is that the users are not allowed to enter into synthetictransactions, that is, users can only use CDS for hedging purposes and only if they have an actualexposure in the underlying, can the users buy protection and cannot maintain
naked 
CDSprotection. The relevant extract of the text of the report is reproduced below:
The
users
are envisaged to use the CDS only for hedging their credit risks, theGroup recommended that the
users
shall not, at any point of time, maintain nakedCDS protection. The
users
can, however, unwind their bought protection byterminating the position with the original counterparty. The original counterparty(protection seller) may ensure that the protection buyer has the underlying at thetime of unwinding.
Users
are not permitted to unwind the protection by enteringinto an offsetting contract.In order to restrict the
users
from holding naked CDS positions i.e. CDS is notbought without underlying; physical delivery is mandated in case of credit events.Further,
users
are prohibited from selling CDS. Proper caveat may be included inthe agreement that the protection seller, while entering into CDS contract / unwinding, needs to ensure that the protection buyer has exposure in theunderlying. This may also be subject to rigorous audit discipline.

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