Over-the-counter credit default swaps are here

Banks can finally hedge their loan portfolio, now that the Reserve Bank of India (RBI) has decided to introduce credit default swaps (CDSs).

A CDS is a derivative contract based on a loan or a bond of a financial institution and helps it hedge the default risk if the credit extended goes bad in case the company undergoes restructuring, bankruptcy or a downgrade.

Just as a currency swap or an interest rate swap helps hedge currency or interest rate risks in a bank’s portfolio, CDS helps in minimising the credit default risk.

In 2007, RBI had issued draft guidelines for introduction of CDSs. However, issuance of final guidelines was kept in abeyance, given the role of credit derivatives in the ongoing financial crisis.

The second-quarter monetary policy 2009-10 said RBI had then considered it appropriate to proceed with caution.

To start with, RBI proposes to introduce a basic, over-the-counter, single-name CDS for corporate bonds for resident entities, subject to safeguards. These will not be exchange-traded instruments such as a rupee-dollar forward contract. The underlying will initially be only corporate bonds.

All CDS trades will come to a centralised reporting platform and in due course will be brought on a central clearing platform.

Meanwhile, RBI has decided to widen the scope of the currency basket for the newly-introduced derivative-currency futures. In its policy statement, it said recognised stock exchanges would now be permitted to offer currency futures contracts in currency pairs of euro-rupee, yen-rupee and pound-rupee, in addition to the already-permitted dollar-rupee contracts.

Currency futures are exchange-traded derivative contracts used by portfolio managers of banks and other financial institutions to hedge currency risks from the business’s foreign exchange exposure.

These futures , introduced on August 29, 2008, commenced trading on the National Stock Exchange and thereafter on the Multi-Commodity Exchange (MCX) and United Stock Exchange (promoted by the Bombay Stock Exchange).

The combined average daily volume of currency futures since January 2009 stood at Rs 7,129 crore in a cash market where daily spot rupee-dollar trades clock a volume of $12.52 billion on an average.

The currency futures volumes have shot up in the past three months due to the volatile rupee-dollar exchange rate. The monthly average since August 2009 stood at Rs 11,993 crore.