Indian equity markets have made remarkable progress since liberalisation. In contrast, progress in bond markets has been modest. This disparity arises from the fact that equity contracts do not promise returns or repayment of capital. They can function even at low levels of financial development.

On the other hand, debt contracts promise returns, repayment of capital, and, in the case of bonds, traceability. Bond markets, therefore, require what equity markets need and more. Specifically, the corporate bond market benefits from a liquid government bond market across all maturities, interest rate derivatives, credit derivatives (such as CDS) and an effective corporate insolvency framework. It is for this reason that Indian policymakers have shown keen interest in developing the CDS market for more than a decade now.

A 2010 RBI report, ‘Introduction of Credit Default Swaps for Corporate Bonds’, recommended that MFs be permitted as market makers, that is, act as both protection sellers and buyers. Subsequently, RBI issued the first regulations on CDSs in 2011. This allowed MFs to be market markers subject to strong financial and risk management capabilities prescribed by Sebi. RBI reiterated this in 2013.

The 2022 Master Direction on Credit Derivatives allows MFs and AIFs to act as CDS sellers subject to approval by Sebi. This has prompted Sebi to initiate the recent consultations. The CDS market in India is almost non-existent. Reportedly, the first CDS deal, worth only ₹25 cr, was recently closed between two banks.

The basic challenge in developing a CDS market is well known. The current policy has resulted in only highly rated bonds being owned and traded. Highly rated bonds have the least credit risk, reducing the need for CDS. CDS becomes useful only when there is a market in lower-rated bonds with high credit risk. While Sebi’s proposal to enable MFs to invest in below-investment-grade bonds with CDS protection may help, there are two additional issues to consider:

Review Section 45V of RBI Act 1934 It invalidates any transaction in OTC (over the counter) derivatives unless at least one of the parties to the transaction is RBI, a scheduled bank or ‘such other agency falling under the regulatory purview’ of the RBI. Therefore, an OTC CDS transaction between two MFs or between MF and AIF may be invalid because MFs and AIFs are regulated by Sebi. For OTC CDS market to take off, this legal provision must be suitably amended.

Rules on valuation This is critical for development of the CDS market. A trade in any instrument takes place only when the buyer and seller have different views on its future cash flows. Regulators do not provide a uniform method of valuing equity shares. Each investment manager takes her own call and decides to buy or sell the equity share.

In contrast, bond investors’ decisions become secondary to ratings given by CRAs. Even when valuing the portfolio, an external valuation agency takes over, which applies a spread over the risk-free return for the given rating. In such a scenario, it is more likely than not that everyone in the market has more or less the same view on the future cash flows of a bond, reducing the scope for developing a CDS market on such a bond. Unless and until the viewpoints of buyers and sellers of protection differ, likelihood of trade in the CDS market is minimal.

While policy changes are certainly needed to increase the number of players by removing unnecessary entry barriers to the CDS market, policymakers must also review the straitjacket in which bond valuation has been placed, discouraging diversity in trading views.

This article was originally published in The Economic Times on 18 August 2024 Co-written by: Prashant Saran, Sr. Consultant; Pratik Datta, Associate Director.  Click here for original article

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