India publishes credit derivatives guidelines

New guidelines from the Indian central bank are intended to kick-start development of the credit derivatives market in the region. But are the restrictions too limiting to be of any use?

India's credit derivatives market took a step forward last month with the release of draft guidelines issued by the country's central bank and regulator, the Reserve Bank of India (RBI). This is not the first time that India has set out to provide a framework for the country's credit derivatives market. The RBI first issued a set of proposals in 2003 though these were never implemented due to lack of market interest. However, sentiment seems to have turned since then.

"The RBI is taking this as a first move towards the development of an onshore credit derivatives market," says S Rajaram, head of structured finance analytics at Indian rating agency Icra in Mumbai. "The RBI's rationale is that banks have improved their risk management capabilities as they migrate towards Basel II; as a result it is more comfortable introducing these products into the market."

The development of a credit default swap market should offer banks the chance to shed corporate loan risk from their books to third-party investors. Corporate loan volumes have been growing at a rapid pace in India on the back of the country's recent economic surge. According to the RBI, total issuance in corporate loans stood at around $422 billion in May 2007, an increase of approximately $87 billion from the same period last year.

But securitisations of corporate loans remain thin on the ground, says one head of securitisation at a domestic Indian bank. "Originators have thus far found it difficult to transfer this risk from their books. This rule will make banks more comfortable with using credit derivatives and help them transfer some of this risk."

The rules will also benefit the domestic corporate bond market, which remains relatively undeveloped. A 2005 report issued by the Indian Finance Ministry put annual corporate debt issuance at around $1.3 billion, a fraction of corporate loan issuance. The regulator hopes the creation of a domestic CDS market will create a more active secondary market business for corporate credit, which should encourage future issuance.

"The corporate bond market has suffered from chronic neglect, both in terms of policy and infrastructure, and has been almost entirely restricted to a set of domestic institutional investors," said the Ministry of Finance in its 2005 report. "For creating robust corporate debt markets it is desirable that appropriate policy reforms are introduced to encourage building up of necessary market infrastructures that facilitate growth of an active primary market as also a vibrant and transparent secondary market."

Restrictive regime

Yet despite the progressive nature of its announcement, the RBI has not completely cast aside its normal cautious attitude and the guidelines impose a stringent framework on the use of credit derivatives. In the initial stages only domestic Indian banks and primary dealers will be able to trade credit derivatives, which will draw on standardised documentation from the International Swaps and Derivatives Association. Furthermore CDS will only be eligible on rated single-name reference entities. Index or portfolio products will not qualify, which could make it difficult for banks to package assets into synthetic securitisations.

This last stipulation is likely to prove contentious. With only around 150 to 200 corporate entities carrying a rating, out of a total of around 120,000 according to market estimates, the number of loan names which will be eligible is limited. And with pension funds and insurance companies unable to participate in CDS, finding protection sellers could be a challenge.

On top of this, the fact that the RBI has limited involvement to domestic banks will disappoint many foreign institutions who had been targeting India as a potentially lucrative source of credit derivatives business. Several of India's largest corporates, including ICICI Bank, Reliance Industries and Tata Motors, are already traded as part of the iTraxx Asia Pacific index. The RBI has given the market a one-month window to comment on the guidelines. Judging by past experience, however, participants do not expect any major changes in the rules when they are finalised later this year.

Sarfraz Thind.