MUMBAI: The Reserve Bank on India issued draft guidelines on credit default swaps (CDS) to put in place a regulatory framework for their transaction.

"In view of the complexities involved, it has been decided to initially issue the proposed guidelines as a first draft for comments and feedback from various stakeholders,'' the RBI said in a notification.

The bank has decided to initially allow only plain vanilla credit default swaps, it said.

CDS means a type of credit derivative in terms of which the protection buyer pays a fee to the protection seller in exchange for a `credit event payment'.

Rationale for initiative

An event specified under a credit derivative contract that affects the `reference entity' and triggers a credit event payment, for example, bankruptcy, failure to pay, obligation acceleration, obligation default, repudiation/ moratorium of an obligation and restructuring in respect of the reference entity will lead to payment of losses to the protection buyer by the protection seller.

Making reference to CDS in its annual policy announced in April, the RBI had said, as part of the gradual process of financial sector liberalisation in India, it is considered appropriate to introduce credit derivatives in a calibrated manner at this juncture. The risk management architecture of banks has been strengthened and banks are on their way to becoming Basel II compliant, providing adequate comfort level for the introduction of such products.

Furthermore, the recent amendment to the Reserve Bank of India Act, 1934, has provided legality of OTC (over-the-counter) derivative instruments, including credit derivatives, the RBI said.

Bar on `related parties'

Banks are not permitted to enter in to credit derivative transactions where their `related parties' are the counter parties or where the related parties are reference entities. Related parties for the purpose of these guidelines will be as defined in Accounting Standard 18 — Related Party Disclosures. In the case of foreign banks operating in India, the term related parties shall include an entity which is a related party of the foreign bank, its parent, or group entity.

Banks' policy on CDS approved by the board of directors should cover their strategy — whether for hedging or for trading — appetite and limits for credit derivatives business.

Feedback/comments on the draft guidelines, available in the RBI web site (www.rbi.org.in), should be sent to the RBI Mumbai office within a month. — PTI

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