India paves way for credit derivatives

India's central bank has taken a small first step towards creating an onshore credit derivatives market. A set of draft guidelines released on Wednesday evening propose a framework that will allow the buying and selling of credit protection.

The Reserve Bank of India could not be accused of rushing the rules through. It set up a working group to consider its approach to credit derivatives back in 2003, but nothing much happened between then and April this year, when the central bank finally announced that it was finally ready to issue some guidelines.

The end product is largely in line with what the market had expected: single-name credit default swaps (CDS) that can be traded between primary dealers and banks. Insurers and mutual funds are eventually expected to be able to participate in the market as well, subject to the approval of their own industry regulators û Sebi and the Insurance Regulatory and Development Authority.

Under the proposed rules, primary dealers will be able to buy over-the-counter protection against corporate bonds and banks will be able to protect against any rated credit risk they hold. All CDS will reference rupee-denominated assets.

The central bank is now asking market participants to comment, though few changes are expected û most banks and dealers are just pleased to get any kind of framework in place. "I think overall this is a great first step," says Neeraj Gambhir, head of structured products at ICICI Bank. "The reality of the derivatives market in India is that the state-owned banks do not participate much, but they are the biggest part of the banking system, so the central bank has to allow time for them to bring their risk management and systems up to speed."

Once the central bank is satisfied that the big banks are comfortable with valuing, accounting and managing credit derivatives it will move beyond the plain vanilla CDS market to include total return swaps, credit-linked notes and credit spread options.

"The risk management architecture of banks has strengthened and banks are on the way to becoming Basel II-compliant, providing adequate comfort level for the introduction of such products," says the central bank in its guidelines.

However, there are still some obstacles to overcome before the CDS market can get underway. For example, Indian accounting standards don't yet include guidelines on how to treat CDS, but a draft modelled on IAS39 is in the process of being adopted.

"The building blocks are being put in place," says Gambhir. "It's hard to comment on when the market will open, but it shouldn't take too long now."

Some Indian CDS are already traded in the offshore market û the iTraxx Asia ex-Japan index includes CDS of India's biggest borrowers: CNOOC, ICICI Bank, Reliance Industries, State Bank of India, Tata Motors and Vedanta Resources.

India's central bank has made a late start, and a slow one, but it is at last moving in a direction that could give India's capital markets a much-needed boost û in particular, CDS should have a significant effect on price discovery in the country's illiquid bond market, which could help lower rated borrowers come to the market.