Decoded: Understanding the draft guidelines on credit default swaps

The Reserve Bank of India (RBI) has unveiled draft guidelines on credit default swaps (CDS). In the past too, the RBI has tried to launch a comprehensive CDS product but it never really took off. Here’s a look at why that was the case and what has changed now.

What is a credit default swap (CDS)?  

It is a form of insurance that a bond investor buys against potential defaults by a corporation. The seller of the CDS is not necessarily an insurance company and the contract can be written (issued) by any permitted regulated financial entity, mainly banks. If the underlying bond defaults, the writer of the CDS pays for the default. A premium is charged for the risk.

What is the status of the CDS market in India?  

It is almost non-existent. The lone CDS instrument written by the country's largest lender, the State Bank of India, is no longer there in the market.

Why doesn't India trade in CDS?

CDS is seen as being responsible for the 2008 global financial crisis, and is, therefore, a feared instrument in Indian psyche. For the RBI, which believes in regulation ahead of innovation, CDS was a forbidden word for a very long time.

In its original form, CDS was a bilateral instrument, and more often than not, written in an opaque and non-transparent manner. Later, when D Subbarao, as RBI governor, tried to introduce it, the central bank proposed to make it strictly a hedging instrument with several conditionalities attached. Bond dealers and banks were not interested in the product.

The last draft guidelines on CDS were issued in 2013. The new draft norms replace those. In 2010, too, there was an effort to introduce CDS, but it didn't get enough support. The main reason is that 90 per cent of the corporate debt market is dependent on private placement. All the risks are concluded in the pricing negotiation and buyers know what they are getting into. CDS is not needed in this environment when there is no corporate paper to deal with in the secondary market.  

CDS is needed only for corporate bonds. Government bonds are sovereign instruments, the safest form of investment possible in a country. For government bonds, there is no need for CDS as it covers primarily the default risk or 'credit events'. However, there are other instruments for G-secs to hedge the interest risk and even currency risk for foreign investors.

How did CDS cause the 2008 financial crisis?  

CDS is just a financial instrument, but the way it used to be traded was what caused the problem. Investors sliced and diced the CDS; made derivatives of CDS, which itself is a derivative product; and ended up speculating on CDS and also on its derivatives (CDS-Cube), treating them as a standalone financial product. In short, CDS became a tool for clever financial engineering – and it backfired.

So, what has changed now?  

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.  

Does this include for speculative purposes?  

Unlikely. 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.  

What could the ‘other’ purposes then be?  

It seems the RBI is keeping the field open in response to a long-standing criticism that the Indian version of CDS is nothing more than a hedging instrument. At the same time, the RBI has clearly mentioned that the CDS itself cannot be part of a structured product as underlying. This simply means one cannot make derivatives of a CDS, or create the destructive “CDS cube”. So, the RBI is safeguarding the system from a potential minefield, and at the same time placating its critics.

This still sounds like a risky instrument; so what’s the need for it?

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.

Retail participation, though, would take a long time as retail investors are not even invested in government bonds much – something the RBI hopes will change once retail investors get to participate directly in government bond auctions.