RBI to allow FIIs to use credit default swaps, but under tight norms

In a move that will help deepen the corporate bond market, the Reserve Bank of India (RBI) has ruled in favour of allowing FIIs to use credit default swaps. In its draft guidelines on introduction of credit default swaps (CDS) for corporate bonds, released on Wednesday, the central bank has allowed corporates and financial institutions, including foreign institutional investors (FIIs), to buy protection against default on their debt investments.

Credit Default Swaps (CDS) - derivatives which got a bad name during the global financial crisis for the role they played in bringing down large institutions like AIG - are all set to be launched in India. However, these Indian instruments will be vastly different from those that precipitated the global crisis.

The norms, however, are very different from those in developed economies. High capital requirements, restricting the participation to a few in financial services, a tight transaction norm and limiting it to just vanilla corporate bonds will ensure there is no trading risk on credit default swaps, or CDS.

In India, FIIs will be allowed to participate in CDS only as users. In other words, they can participate in CDS only to the extent of buying protection they need in terms of their debt investment. Second, they are not allowed to sell protection or to hold short positions. If FIIs want to exit from a CDS, they can only do it by unwinding the transaction with the counterparty or by passing on the CDS protection along with the bond when they sell it.

This is the third time that the central bank is publishing its draft guidelines on the subject. The RBI's earlier proposal to introduce this credit derivative was delayed because of the global crisis. However, despite the crisis, RBI said that it would allow these instruments in the market as they allow investors to hedge against credit risks.

RBI had last published its draft guidelines on credit default swaps in August 2010. One of the biggest drawbacks of the original proposal was that FIIs were kept out.

"FIIs would be one of the biggest potential buyers of credit protection, considering that unlike local banks they do not have an insight into the financial position of the companies that they are investing in," said an investment banker.

He added that with the increase in yields in Indian corporate bonds, the appetite for Indian corporate debt has increased. Domestic institutions would also find credit default swaps useful to bring down exposure to sectors where they already have a large exposure. Similarly, lenders who do not have the liquidity but a thorough understanding of an industry could participate by providing protection to company that have the cash but do not have the risk appetite.