Go-ahead to banks, PDs to enter credit default swap mart

In its draft guidelines issued today, the Reserve Bank of India has allowed banks and primary dealers (PD) to act as market makers of credit default swaps (CDS).

Banks and PDs, as market makers, will buy and sell CDS as a protection on specified loans, advances or investments. It is a derivative with the underlying of loans or advances.

Various credit events eligible for being covered under CDS include bankruptcy, obligation default, failure to pay, moratorium and restructuring. In its draft, the RBI has stated that insurance companies and mutual funds may be allowed as buyers and sellers of the products as and when their respective regulators permit them to transact in CDS.

Regarding exposure norms, while the banks' exposure to such products will be guided by their counterparty's credit exposure, primary dealers will have to maintain an exposure limit of 15 per cent of their capital funds or existing counterparty limits, whichever is less.

While the central bank has enlisted a series of requirements under which CDS will be valid, significant of them are that CDS contract should represent direct claim of the buyer of the product on the seller.

The seller and buyer of the product will be banks and primary dealers in government securities. The seller of the product shall have no recourse to the buyer for losses. The product should not terminate before the grace period required for a default on the underlying obligation. A seller will sell the swap as a hedge to the buyer against the risk on its credit portfolio.

As a prudential measure the banks should have clear guidelines for exposure in such products from their respective boards. It will be included in the trading book of the bank, is eligible for mark to market for valuation purpose and will not qualify as guarantee.

A bank can buy credit protection with CDS to the extent of the loan covered under this and not the full amount of the loan. Credit derivatives shall be denominated and settled in Indian rupees and banks are not permitted to enter into credit derivative transactions where their 'related parties' are the counterparties or where the related parties are reference entities.