Credit Derivative (India)
A financial contract whose value is derived from the credit risk of an underlying reference entity — typically a corporate or sovereign borrower — with the credit default swap (CDS) being the primary instrument, subject to a restrictive regulatory framework established by RBI and SEBI in the Indian context.
Credit derivatives allow market participants to transfer credit risk — the risk that a borrower will default — without physically transferring the underlying debt obligation. The most common instrument is the credit default swap (CDS), in which the protection buyer pays a periodic premium (the CDS spread, expressed in basis points per annum) to the protection seller. In return, if a defined credit event occurs — default, restructuring, or failure to pay — the protection seller compensates the buyer for the loss on the reference obligation.
India's CDS market has had a chequered history. RBI introduced guidelines for CDS in 2011 with a highly conservative framework: only listed corporate bonds could be used as reference obligations, only certain eligible participants (scheduled commercial banks, primary dealers, NBFCs, mutual funds, and insurance companies) could transact, and naked CDS positions (protection buying without underlying exposure to the reference entity) were prohibited for most participant categories. This restriction dramatically limited market activity, as much of the price discovery and liquidity in international CDS markets comes from participants who take directional views on credit quality without holding the underlying bonds.
The resulting market was thin and illiquid. Bid-ask spreads were wide, tenors were limited, and the absence of standardised documentation equivalent to the ISDA Credit Derivatives Definitions used internationally created legal uncertainty about the enforceability of contracts. Foreign banks with global CDS books were reluctant to participate in the domestic market on such different terms from their standard international practice.
RBI and SEBI made incremental revisions over the years, but the Indian CDS market remained a fraction of the size that the underlying bond market suggested it should be. The constraint was not just regulatory; India's corporate bond market itself was underdeveloped relative to bank credit, meaning the natural hedging demand that drives CDS activity in other markets — bondholders seeking to hedge default risk in their fixed income portfolios — was limited.
CCIL explored the introduction of central counterparty clearing for CDS, which would reduce bilateral credit risk and standardise settlement, potentially improving market confidence. International experience suggested that CCP-cleared CDS markets attracted more participants and displayed better liquidity than bilateral OTC markets.
The relevance of credit derivatives became particularly acute during periods of stress in the Indian banking sector — the NPA (non-performing asset) crisis of 2015–2018 and the IL&FS default in 2018. In each case, market participants reflected that a functioning CDS market might have provided earlier price signals of credit deterioration and allowed better risk distribution across the financial system.