One of the principal objectives of this effort is to boost the corporate bond market. As RBI notes:
The objective of introducing Credit Default Swaps (CDS) on corporate bonds is to provide market participants a tool to transfer and manage credit risk in an effective manner through redistribution of risk. CDS as a risk management product offers the participants the ability to hive off credit risk and also to assume credit risk which otherwise may not be possible. Since CDS have benefits like enhancing investment and borrowing opportunities and reducing transaction costs while allowing risk-transfers, such products would increase investors’ interest in corporate bonds and would be beneficial to the development of the corporate bond market in India.
However, CDSs are susceptible to great risk, as the experience from the global financial crisis bears. Cautious of this factor, the RBI has imposed a number of checks and balances on the CDS market. For example, entities that are permitted to buy CDS protection may do so only to hedge against their underlying exposure to corporate bonds. They are not permitted to hold CDSs without appropriate underlying securities. The idea is to curb speculation.
There seem to be opposing concerns regarding the introduction of CDSs as well as the regime governing them. On the one hand, it is felt that the instrument is too risky to be introduced in the markets given the current environment. India’s own experience in dealing OTC derivatives has not been satisfactory, as several transactions had been mired in litigation over the last few years. On the other hand, proponents of CDS as a risk protection mechanism feel that the introduction of such an instrument with numerous restrictions will make it non-palatable to the investing community, thereby rendering it a non-starter. RBI has adopted the path involving some tight-rope walking.
The draft guidelines include some language on risk management and mis-selling:
3.1.6 Risk Management – Role of Board and Senior Management
3.1.6.1 Participants should consider carefully all related risks and rewards before entering into CDS transactions. They should not enter into such transactions unless their management has the ability to understand and manage properly the credit and other risks associated with CDS. They should establish sound risk management policies and procedures integrated into their overall risk management.
3.1.6.2 Participants which are protection buyers should periodically assess the ability of the protection sellers to make the credit event payment as and when they may fall due. The results of such assessments should be used to review the counterparty limits.
3.1.6.3 Participants should be aware of the potential legal risk arising from an unenforceable contract, e.g., due to inadequate documentation, lack of authority for a counterparty to enter into the contract (or to transfer the asset upon occurrence of a credit event), uncertain payment procedure or inability to determine market value when required. They should consult their legal experts on these and other related legal aspects before engaging in CDS transactions.
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3.1.10 Prevention of mis-selling and market abuse
Market-makers may ensure adherence to suitability and appropriateness criteria (as stipulated in the circular RBI / 2006 – 2007 / 333 DBOD.No.BP.BC.86 / 21.04.157 / 2006-07, dated April 20, 2007) while dealing with users. From the protection buyer’s side, it would be appropriate that the senior management is involved in transactions to ensure checks and balances. In this connection, following may be ensured by the protection sellers:
a. CDS transactions shall be undertaken only on obtaining from the counterparty, a copy of a resolution passed by their Board of Directors, authorising the counterparty to transact in CDS.
b. The product terms are transparent and clearly explained to the counterparties along with risks involved.
