Reserve Bank of India has decided to allow banks/financial institutions to use credit derivatives to manage risks relating to lending, including buying protection on loans and investments. Banks would be barred from using these derivatives for trading and only domestic entities would be allowed to enter in credit risk contracts, RBI said in draft guidelines while seeking comments from the banks.

For enabling the banks and the financial institutions, in India, to manage their credit risk effectively it was being felt appropriate to permit them the use of credit risk hedging techniques like the credit derivatives, which are over the counter (OTC) financial contracts and can help banks and financial institutions in managing the risk arising from adverse movements in the credit quality of their loans and advances, and their investments. Banks can derive many benefits from the credit derivatives such as,

• Transfer credit risk and hence free up capital, which can be used in other opportunities,

• Diversify credit risk,

• Maintain client relationships, and

• Construct and manage a credit risk portfolio as per their risk preference and appetite unconstrained by funds, distribution and sales effort.

A Working Group on introduction of Credit Derivatives in India, comprising officers from the Reserve Bank of India and industry was set up to study the need and scope for allowing banks and financial institutions to use credit derivatives, the regulatory issues involved and make suitable recommendations in this regard. The Group has since submitted its report, which is available on the Reserve Bank of India Website. The draft guidelines detailed herein are based on the recommendations of the Working Group and have been customized keeping in view the present regulatory environment, the state of development of the market for credit derivatives and the preparedness of the banks for using the credit derivative products. Only relevant portions of the RBI guidelines are reproduced. Full text may be viewed on the website of RBI.

1. Transactions where credit protection is bought and sold; and

2. Total return swaps.

1. Credit Default Swap (CDS)

   It is a bilateral derivative contract on one or more reference assets in which the protection buyer pays a fee through the life of the contract in return for a credit event payment by the protection seller following a credit event of the reference entities. In most instances, the Protection Buyer makes quarterly payments to the Protection Seller. The periodic payment is typically expressed in annualized basis points of a transaction's notional amount. In the instance that no pre-specified credit event occurs during the life of the transaction, the Protection Seller receives the periodic payment in compensation for assuming the credit risk on the Reference Entity/Obligation. Conversely, in the instance that any one of the credit events occurs during the life of the transaction, the Protection Buyer will receive a credit event payment, which will depend upon whether the terms of a particular CDS call for a physical or cash settlement. With few exceptions, the legal framework of a CDS - that is, the documentation evidencing the transaction - is based on a confirmation document and legal definitions set forth by the International Swaps and Derivatives Association, Inc. (ISDA). If a Credit Event occurs and physical settlement applies, the transaction shall accelerate and Protection Buyer shall deliver the Deliverable Obligations to Protection Seller against payment of a pre-agreed amount. If a Credit Event occurs and cash settlement applies, the transaction shall accelerate and Protection Seller shall pay to Protection Buyer the excess of the par value of the Deliverable Obligations on start date over the prevailing market value of the Deliverable Obligations upon occurrence of the Credit Event. The procedure for determining market value of Deliverable Obligations is based on ISDA definitions or may be defined in the related confirmation and some cases a pre-determined amount agreed by both parties on inception of the transaction is paid.

2. Credit Default Option

   It is a kind of CDS where the fee is paid fully in advance.

3. Credit Linked Note (CLN)

   It is a combination of a regular note and a credit-option. Since it is a regular note with coupon, maturity and redemption, it is an on-balance sheet equivalent of a credit default swap. Under this structure, the coupon or price of the note is linked to the performance of a reference asset. It offers lenders a hedge against credit risk and investors a higher yield for buying a credit exposure synthetically rather than buying it in the publicly traded debt. CLNs are generally created through a Special Purpose Vehicle (SPV), or trust, which is collateralized with highly rated securities. CLNs can also be issued directly by a bank or financial institution. Investors buy the securities from the trust (or issuing bank) that pays a fixed or floating coupon during the life of the note. At maturity, the investors receive par unless the referenced credit defaults or declares bankruptcy, in which case they receive an amount equal to the recovery rate. Here the investor is, in fact, selling credit protection in exchange for higher yield on the note. The Credit-Linked Note allows a bank to lay off its credit exposure to a range of credits to other parties.

4. Credit Linked Deposits/ Credit Linked Certificates of Deposit

   Credit Linked Deposits (CLDs) are structured deposits with embedded default swaps. Conceptually they can be thought of as deposits along with a default swap that the investor sells to the deposit taker. The default contingency can be based on a variety of underlying assets, including a specific corporate loan or security, a portfolio of loans or securities or sovereign debt instruments, or even a portfolio of contracts which give rise to credit exposure. If necessary, the structure can include an interest rate or foreign exchange swap to create cash flows required by investor. In effect, the depositor is selling protection on the reference obligation and earning a premium in the form of a yield spread over plain deposits. If a credit event occurs during the tenure of the CLD, the deposit is paid and the investor would get the Deliverable Obligation instead of the Deposit Amount.

5. Repackaged Notes

   Repackaging involves placing securities and derivatives in a Special Purpose Vehicle (SPV) which then issues customized notes that are backed by the instruments placed. The difference between repackaged notes and CLDs (Credit Linked Deposits) is that while CLDs are default swaps embedded in deposits/notes, repackaged notes are issued against collateral - which typically would include cash collateral (bonds / loans / cash) and derivative contracts. Another feature of Repackaged Notes is that any issue by the SPV has recourse only to the collateral of that issue.

6. Collateralised Debt Obligations (CDOs)

   CDOs are specialized repackaged offerings that typically involve a large portfolio of credits. Both involve issuance of debt by a SPV based on collateral of underlying credit(s). The essential difference between a repackaging programme and a CDO is that while a simple repackaging usually delivers the entire risk inherent in the underlying collateral (securities and derivatives) to the investor, a CDO involves a horizontal splitting of that risk and categorizing investors into senior class debt, mezzanine class and a junior debt. CDOs may be further categorized, based on the structure with which funding is raised. The funding could be raised by issuing bonds, which are called Collateralised Bond Obligations (CBOs) or by raising loans, which are called Collateralised Loan Obligations (CLOs).

Total Return Swaps (TRS), also called Total Rate of Return Swaps (TROR) are bilateral financial contracts designed to synthetically replicate the economic returns of an underlying asset or a portfolio of assets for a pre-specified time. One counterparty (the TR payer) pays the other counterparty (the TR receiver) the total return of a specified asset, the reference obligation. In return, the TR receiver typically makes regular floating payments. These floating payments represent a funding cost. In effect, a TRS contract allows the TRS receiver to obtain the economic returns of an asset without having to fund the assets on its balance sheet. Should the underlying asset decline in value by more than the coupon payment, the TRS receiver must pay the negative total return, in addition to the funding cost, to the TRS payer. At the extreme, a TRS receiver can be liable for the extreme loss that a reference asset may suffer following, for instance, the issuing company's default.

As such, a TRS is a primarily off-balance sheet financing vehicle. In contrast to credit default swaps, which only transfer credit risk, a TRS transfers not only to credit risk (i.e. the improvement or deterioration in credit profile of an issuer), but also market risk (i.e. any increase or decrease in general market prices). In TRS payments are exchanged among counterparties upon changes in market valuation of the underlying, in addition to the occurrence of a credit event as is the case with CDS contracts.

Of the above types of Derivtives RBI forthe present has permitted SCBs to trade only in the first-mentioned three products i.e.Credit Default Swap (CDS), Credit Default Option and Credit Linked Note (CLN)