What changed
RBI issued guidelines allowing NBFCs to participate in the credit default swap market only as users, not as sellers. They can buy CDS to hedge credit risk on corporate bonds they hold, but cannot sell protection or take short positions. Exiting is permitted through unwinding with the original counterparty or assigning to the buyer of the underlying bond.
What it means for you
NBFCs can now use CDS as a risk management tool to protect against defaults on corporate bonds in their portfolio, but cannot speculate or generate income by selling protection. This limits their exposure and aligns with conservative regulatory oversight. Banks lending to NBFCs may see reduced credit risk if NBFCs hedge effectively.
What you must do
- Ensure NBFC clients comply with CDS user-only status and do not sell protection.
- Verify that NBFCs hold the underlying corporate bonds before buying CDS for hedging.
- Monitor NBFCs' CDS positions to confirm they are not taking short positions.
- Advise NBFCs on proper documentation for unwinding or assigning CDS contracts.
Who it affects
All NBFCs (excluding primary dealers), Corporate bond issuers, Banks dealing with NBFCs
Can NBFCs sell credit protection using CDS?
No, NBFCs are only permitted to buy credit protection as users to hedge credit risk on corporate bonds they hold. Selling protection or taking short positions is not allowed.
How can NBFCs exit a CDS position?
NBFCs can exit by unwinding the CDS contract with the original counterparty or by assigning it to the buyer of the underlying bond.
What guidelines must NBFCs follow for CDS?
NBFCs must comply with all provisions in the circular, including operational requirements detailed in the annex, and follow capital adequacy guidelines from their regulator.