RBI issues draft guidelines for CDS, derivative contracts

Insurance companies, mutual funds, foreign portfolio investors, select companies, pension and alternative investment funds are among others that will be permitted buy protection against any possible default on select debt securities, the Reserve Bank of India said in a draft guidelines issued Tuesday for Credit Default Swap (CDS), a derivative instrument gaining ground globally after the great economic recession in 2009.

A protection buyer will pay a premium to the protection seller, which will take care of any loss arising in the event of any default. This continues until the maturity of the contract or a credit event, whichever is earlier.

Banks, non-banking finance companies including home financiers, bond houses along with Exim Bank, NABARD and National Housing Bank will help the proposed product to become liquid as they will buy and sell such derivative contracts frequently adding to daily trading volumes. They are known as market makers in the market parlance.

Both NBFCs and bond houses called as primary dealers should have a net owned funds of Rs 500 crore at least. Net owned fund is generally the sum total of equity capital and free reserves.

CDS is a credit derivative contract in which one participant known as a protection seller, commits to compensate the other one, marked as protection buyer for any loss in the value of an underlying debt instrument.

Commercial papers, a short-term debt instrument issued by any company, certificates of deposit that are issued by banks and local corporate bonds are among others that can be part of any CDS contract.

The debt instruments shall be eligible to be a reference / deliverable obligation in a CDS contract, RBI said in a release.

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“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,” RBI had said in its December bi-monthly monetary policy.

The CDS guidelines were last issued in January 2013. But it did not gain momentum due to the need for expanding the base of protection sellers and certain other operational constraints. Accordingly, the central bank had decided to review the guidelines for CDS.



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