A (single name) credit default swap (CDS) allows the contracting partners to trade or hedge

the risk that an underlying entity defaults – either a corporate or a sovereign borrower

In effect, a CDS contract resembles an insurance policy, where one side assumes the risk and
the other pays an (insurance) premium

In addition to the CDS "spot market" there is also a market for options and forwards written
on CDSs. Options on CDSs, so called Credit Swaptions, give the buyer the right but not the
obligation to receive or sell protection for a predetermined premium, whereas CDS forwards
oblige the parties to buy or sell CDS protection in future at a certain price.

Importance to emerging markets

CDS as a product had its repercussion’s in increasing the financial complexity of the market,
Credit Default Swap (CDS) can help market participants a tool to transfer and manage credit
risk in an effective manner through redistribution of risk
Specially funding of SMEs (Small and Medium Enterprise) may be supported by credit
derivatives, a systematic structure can be formed in the following manner: Banks can transfer
the credit risk to a third party, which in turn can transfer that risk to a pool of investors, since
the credit risk would not remain primary concern of the banks, banks might be willing to
infuse more funds in the SME sector. The investors will also be benefitted as new asset class
would be available to them,which can be incorporated as a part of their portfolio.

Such products would also increase investors’ interest in corporate bonds and would be
beneficial to the development of the corporate bond market in a country like India.
The objective of RBI for introducing Credit Default Swaps (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 as a risk management product offers the participants the
opportunity to hive off credit risk and also to assume credit risk which otherwise may not be
possible. Since CDS have benefits like enhancing investment and borrowing opportunities
and reducing transaction costs while allowing risk-transfers, such products would increase
investors’ interest in corporate bonds and would be beneficial to the development of the
corporate bond market in India.

In US
The fact that a party A can buy a CDS without actually owning the reference entity, in
essence allows for speculative betting on the reference entity. Before 2007 the CDS
market was several times bigger than the market sizes of the reference entities being
ensured.

CDS spreads are widely regarded as a market consensus on the creditworthiness of

the underlying – corporate or sovereign-entity. This is especially useful for markets
where the underlying debt is less liquid.
speculative CDS raises the cost of debt on risk securities, it can also reduce the cost
of hedging for less risky securities by increasing liquidity in the market. This positive
aspect of CDS was seen in the Asian bond market, where “CDS trading has had
positive impacts on bond market development in terms of lowering average spreads
and enhancing the market liquidity.”
For Banks

 Minimum CRAR of 12 percent with core CRAR (Tier I) of at least 8 percent;

 Net NPAs of less than 3 percent.
For NBFCs
 Minimum Net Owned Funds of Rs. 500 crore;
 Minimum CRAR of 15 per;
 Net NPAs of less than 3 percent;
 Have robust risk management systems in place to deal with various risks.

To eliminate the risk of Asset-Backed Securities that was seen when CDOs where
the reference entities of CDS contracts, Indian regulation mandates that only rated
corporate bonds can act as reference entities of CDSs.
 Standardizing CDS contracts
 Mandating pricing and pricing methodologies of CDSs be regularly validated
by external validators
 Requiring all CDS trades be reported on the trade reporting platform, where
any updates and changes to the contract are reported to RBI on a fortnightly
basis.
but India has placed more regulations that devoid the CDS of what
differentiates it from a simple insurance contract, removing many of the
perceived benefits that come with a CDS.

Indian Regulation mandates that CDSs for a certain reference entity can only be
bought by a User who actually owns the reference entity and can only ensure the
amount that is owned by the reference entity.
It also mandates that CDS contracts cannot be traded in and out of like other
securities. Instead, if the User wants to exit a contract he must discuss it with the
seller and unwind the contract. He may not offset or sell the CDS contract.
These two pieces of regulation solve the issue of excessive speculation, and its
effects (rise in the price of debt and the increase in the spread of credit risk), but by
doing so, they single-handedly limit liquidity and usability of CDSs. 
It is the speculative/ naked CDSs that provide liquidity to the market, and it is this
liquidity that allows for an accurately priced CDS that reflects the true credit risk of a
reference entity
With these regulations, the only use of a CDS is to hedge one’s own credit risk, and
without much market activity, the CDS spreads often will be higher or equal to the
spread between the corporate bond and government bonds, removing any incentive
for the investor to invest in corporate bonds in the first place.

2021
The RBI’s latest draft guidelines state that retail investors can take part in CDS but
only for hedging purposes. However, non-retail investors can use CDS for “other”
purposes as well.

Though, the draft does not clearly mention what these “other” purposes could be,
the RBI has made sure that the CDS is defanged before it hits the market. A trade
has to be reported within 30 minutes, clearly mentioning if it is to a retail or non-
retail investor, and whether it is for hedging or for other purposes. Importantly, the
central bank can ask for details of the trades any time and even publish those for
public dissemination.

In India, CDS has to be priced based on a methodology set by the Fixed Income
Money Market and Derivatives Association (FIMMDA). If the CDS contract uses a
proprietary methodology, the writer of the CDS has to justify why it did not follow
the FIMMDA model in note to accounts. In short, the RBI wants a standardised
product and no experimentation whatsoever when it comes to CDS

The International Financial Services Centre (IFSC), set up to channelise the offshore
derivative trading, changes the game. To bring offshore investors onshore, RBI has
to offer various kinds of standard derivatives instruments that are widely used in
the global markets. CDS is the most common derivatives contract globally.

In the domestic market, however, first the corporate bond market has to develop
for the CDS to take off. And, acceptance of CDS among Indian firms can, in turn,
increase the depth of the corporate bond market as investors gain confidence in
exposure to lower rated bonds.

Corporate Bond Market

The real problem in Indian context is the loans to large businesses can have huge
ramifications on the economy. Large companies accounted to Rs. 65.47 Trillion
(58%) of the total Bank Credit till March 2016 when the NPAs (Non-Performing
assets or Bad Loans) stood at roughly the Rs. 6 Trillion mark. By this estimate if 10%
of the loans to the large-scale companies were to become NPAs, then the lending
banks will soon be out of business.  That’s a huge setback to the economy and
would sabotage it.
Growth and development of the corporate bond market would also foster economic
development.  In countries with a developed bond market, the contribution of
corporate bonds to the GDP is much more than that in India. For instance, in the US,
the corporate bond market accounts for about 120% of GDP, with investors investing
across the spectrum, including in junk bonds. The figure for India is 16% of GDP