A mature corporate bond market boosts the economy by allowing businesses to seek alternative financing, creating a holistic banking environment. To tap into the full potential of the corporate bonds and derivatives markets, the Reserve Bank of India (RBI) in one of its policy statements in 2020 had stated that the development of the market for credit default swaps (CDS) is ‘sine qua non for the development of a liquid market for corporate bonds, especially for the bonds of lower rated issuers’. In this regard, RBI recently introduced a revised framework with a focus on CDS - the Master Direction – RBI (Credit Derivatives) Directions, 2022 dated 10 February 2022 (CDS Directions), which came into effect from 9 May 2022.
What is CDS?
In simple words, a swap allows the exchange of cash flows or liabilities with an objective to either reduce costs or generate profits. Swaps could be in relation to interest rates, currencies, commodities or credit defaults.
As the name suggests, CDS derives its value from the credit risk of the issuer of an underlying debt instrument. Under CDS, a party (referred to as a ‘protection seller’) commits to pay the counterparty (referred to as a ‘protection buyer’) in the event a credit event occurs1 with respect to the issuer of the underlying debt instrument (referred to as the ‘reference entity’).
CDS is commonly understood as a derivative product akin to an insurance, where a protection buyer gets protection against the occurrence of a credit event in exchange for payment of a premium. The commercial objective for the protection buyer to enter such a transaction is to transfer the credit risk concerning the underlying debt instrument to the protection seller while retaining the title to such debt instrument.
History of CDS
The concept of CDS was first introduced in the early 1990s with the objective of tapping into the potential of derivatives dealing with credit risks. Soon after its introduction, CDS became increasingly popular in the global financial markets. However, with the onset of the financial crisis of 2008 (which many argue was partly a result of unregulated CDS trades), the value of CDS hit rock bottom. As a result, most leading financial markets such as the United States and the United Kingdom framed guidelines to regulate CDS transactions to bring overall transparency for the market participants entering into derivative trades of this nature.
In India, while a rigid framework for credit derivatives for corporate bonds framed by the RBI (being the primary regulator for credit derivatives transactions) had been in place since 2011 (revised in 2013) (Erstwhile CDS Framework), CDS arrangements were not common. In fact, in the earlier years, there was just one CDS product written by the State Bank of India that was later withdrawn. It is apparent that the CDS Directions have been introduced in response to market participants’ need for an expansive regime and resolving other ‘operational constraints’.
Key features of the CDS Directions
List of debt instruments that may be hedged
The list of debt instruments that are eligible to be hedged under the CDS Directions remains largely the same as the Erstwhile CDS Framework. It includes various instruments issued in dematerialised form by Indian entities in the over-the-counter (OTC) market and on exchanges, as follows:
Money market debt instruments, namely:
- commercial papers,
- certificates of deposits, and
- non-convertible debentures with maturity of up to one year.
Corporate bonds and debentures, namely:2
- rated non-convertible securities, and
- unrated non-convertible securities issued by special purpose vehicles of infrastructure companies (excluding security receipts, securitised debt instruments and bonds issued by the government/entities identified by RBI).
Loans and other forms of advances representing financial indebtedness are currently not eligible for CDS arrangements. Further, the CDS Directions expressly prohibit asset-backed securities and structured obligations including credit enhanced bonds and convertible bonds from CDS arrangements.
Role of market-makers modified
Market-makers are responsible for overseeing credit derivative transactions, including determination of price and settlement of transactions. Currently, the CDS Directions define market-makers as entities that ‘provide prices to users and other market-makers’. Under the Erstwhile CDS Framework, in addition to quoting CDS spread, market-makers were expressly permitted to buy and/or sell protection. However, the CDS Directions do not provide clarity on whether market-makers can buy and/or sell protection.
Entities eligible to participate as market-makers
Scheduled commercial banks, non-banking financial companies (NBFCs) meeting quantitative thresholds subject to RBI approval including housing finance companies (HFCs) and certain governmental financial institutions are identified as eligible market-makers in CDS transactions. The rationale of the RBI for the inclusion of HFCs (which are specialised home financing lenders) as market-makers and their potential contribution to the CDS market is unclear, especially given the learnings from the insolvency of Dewan Housing Finance Limited (DHFL) and the stressed assets of some of the HFCs. Also, the CDS Directions are unclear on the mechanism for NBFCs and HFCs to obtain approval from RBI to act as a market-maker.
Other CDS Market Participants
The table below depicts the various users in the OTC Market, classified as retail and non-retail users and their role in the CDS market. Both retail and non-retail users may buy protection, but only non-retail users are eligible to sell protection.
Users CDS MARKET PARTICIPANTS NON-RETAIL USERS RETAIL USERS Regulated non-retail users - insurance companies, pension funds, mutual funds, alternate investment funds and foreign portfolio investors. Unregulated non-retail users - Resident companies with net owned funds of INR 500 Crores (USD 62,873,300 approximately). Any entity that is not eligible to be a non-retail user. ELIGIBLE PROTECTION BUYERS Regulated non-retail users may buy protection for hedging or otherwise. Unregulated non-retail users may buy protection for hedging or otherwise. Retail users may buy protection only for hedging. ELIGIBLE PROTECTION SELLERS Regulated non-retail users may sell protection. Unregulated non-retail users cannot sell protection. Retail users cannot sell protection.
Participation of retail investors
In offshore markets where CDS transactions are common the participation of retail investors is usually limited owing to the need for ‘significant capital requirements’ to buy protection, as available with institutional investors. Given this, it is unclear as to how the RBI intends to promote eligible users to sell protection to retail protection buyers. In the interest of investor protection, the RBI may in consultation with the Securities and Exchange Board of India consider incentivising debtor-issuers to issue securities with embedded CDS in compliance with CDS Directions.
Concept of naked CDS introduced for non-retail users
Under the CDS Directions, retail users may buy protection only for hedging, whereas non-retail users may buy protection for hedging or ‘otherwise’. The provisions imply that non-retail users may buy protection for speculation purposes as well. Protection bought by speculators are commonly known as ‘naked CDS’ and do not require the buyers to hold the debt instrument or have any insurable interest/hedging motive. Globally, naked CDS are viewed as arrangements that ‘amplify exposure and create systemic risk, incentivise moral hazard, and play no meaningful role besides gambling’.3 In light of the European Debt Crisis, the European Union banned naked CDS in sovereign debt owing to many European States accusing hedge funds of using CDS contracts to bet on the Greek default. However, others have countered that naked CDS complete markets, allow for aggregation of information and increase bond market liquidity, making it easier for debt to be issued by distressed borrowers. Naked CDS arrangements are essentially controversial as they allow users to sell debt short. While these arrangements may seem to work better in evolved and sophisticated financial markets, it may be prudent for the RBI to re-consider if permitting ‘naked CDS’ in a less mature CDS market like ours would be appropriate or productive.
Role of Fixed Income Money Market and Derivatives Association of India
Under the CDS Directions, the Fixed Income Money Market and Derivatives Association of India (FIMMDA) is proposed to play a crucial part. Its role and responsibilities include recommending benchmark rates for the valuation of CDS contracts, establishing a credit derivatives determination committee (comprising of market-makers and users) and settlement procedures for the use of CDS in the Indian market.
FIMMDA has also been entrusted with the responsibility of finalising drafts of standard master agreements for Indian CDS contracts. Credit derivative transactions and, more importantly, CDS transactions are quite complex and could significantly influence financial markets. Hence, it is imperative that the concerned draft agreements are nuanced, comprehensive, financially sound and impartial. FIMMDA’s role in preparing drafts of the agreements is crucial for protecting the interests of the stakeholders and the market.
Further, for achieving the objectives chalked out for CDS in the Indian derivatives market by the RBI, the valuation of CDS contracts will be one of the most important factors. Since FIMMDA has been entrusted with the role akin to a regulatory authority under the CDS Directions, it will be interesting to watch how FIMMDA meets these expectations.
Credit risks arising due to defaults by protection sellers
CDS Directions are currently silent on aspects relating to a default by a protection seller. Defaults by protection sellers may result in a systemic failure in the CDS market. Hence, it is critical for the RBI to provide for adequate risk management measures for market-makers and protection sellers to mitigate counterparty default risk.
Over the last two decades, we have seen that the collapse of financial services entities is overarching and it carries systematic risks for the economy. The 2008 financial crisis, primarily owing to rampant speculation in the deregulated CDS market, triggered the deepest recession in the world. Similarly in India, the recent crisis surrounding the failure of IL&FS and DHFL impacted the debt market, led to the breakdown of infrastructure and automobile sectors (debtors) and caused a liquidity crunch. Hence, it is important that there are stringent regulations along with a strong central regulator in place to ensure that there is no systemic collapse of the market/key market participants due to the CDS market.
While the robustness of the CDS Directions will be tested in the debt markets in the times to come, the need for a central regulator is imperative under the new regime. Further, given the volatility of derivative transactions in financial markets, a non-RBI regulator’s involvement may not necessarily be aligned with RBI’s objectives for the CDS regime’s implementation.
Therefore, in the interest of healthy growth of CDS arrangements and better risk management in the financial market, it may be efficient for all users to be primarily regulated by the RBI for CDS transactions undertaken by them.
Globally, CDS have seen strong growth since the 2008 collapse, however, the market is currently in a nascent stage in India. These CDS Directions are certainly a first step to bolster the existing framework, to address the operational constraints faced by market participants and to bring transparency, creditability and enhancement of liquidity in the Indian derivatives market.
The CDS Directions have been introduced in response to market participants’ need for an expansive regime and resolving other ‘operational constraints’.
In the interest of healthy growth of CDS arrangements and better risk management in the financial market, it may be efficient for all users to be primarily regulated by the RBI for CDS transactions undertaken by them.
 In the Indian context, credit events may include bankruptcy, payment default, and debt restructuring among other events.
 Including bonds with call/put options.
 Wenda Jiang, In Defense of Naked Credit Default Swaps, The FinReg Blog, Duke University.