On September 15, 2008, Lehman Brothers filed for bankruptcy. On September 16, the United States government seized control of American International Group — AIG — to prevent its collapse. AIG had not made bad mortgage loans. AIG had sold credit default swaps — insurance contracts promising to pay if mortgage-backed securities defaulted — to every major bank on Wall Street. When the mortgage market crashed, AIG owed more than it could pay. The U.S. Treasury injected $182 billion to prevent AIG's failure from cascading through the global financial system. In Mumbai, the Reserve Bank of India watched this unfold and drew a conclusion that would shape Indian financial regulation for the next decade: credit derivatives are powerful instruments for transferring risk, but unregulated CDS markets can create the very systemic risk they claim to mitigate. India's 2013 CDS guidelines were deliberately restrictive. The 2022 Credit Derivatives Directions (RBI_MD_12226) represent the careful reopening — a framework built on the wreckage of AIG, calibrated for a corporate bond market that has matured enough to support it.
See also: Forex Derivatives: Hedging, Product Framework & User Categories | What Basel III Actually Changed | Government Securities & Money Market: Complete Timeline
What is a Credit Default Swap, and why does it exist?
A Credit Default Swap is a contract between two parties. The protection buyer pays a periodic premium — like an insurance premium — to the protection seller. In return, the protection seller agrees to compensate the protection buyer if a credit event occurs with respect to a reference entity. A credit event is typically a default: the reference entity fails to pay on a bond or loan, or enters bankruptcy, or undergoes a debt restructuring.
The Credit Derivatives Directions 2022 (RBI_MD_12226) define the instrument:
"'Credit Default Swap (CDS)' means a credit derivative contract in which one counterparty (protection seller) commits to pay to the other counterparty (protection buyer) in the case of a credit event with respect to a reference entity and in return, the protection buyer makes periodic payments (premium) to the protection seller until the maturity of the contract or the credit event, whichever is earlier."
Why does CDS matter? Because it separates credit risk from the loan itself. A bank that has lent Rs 500 crore to a steel company can buy CDS protection on that company. If the steel company defaults, the bank receives compensation from the CDS seller. The bank still holds the loan, still earns interest, still maintains the client relationship — but has transferred the risk of default to someone else. This separation of risk from ownership is the fundamental innovation of credit derivatives, and it is both their power and their danger.
The danger is that CDS can be used to speculate. A hedge fund that has never lent a rupee to the steel company can buy CDS protection anyway — a "naked" CDS position that functions as a bet that the company will default. If enough speculators buy CDS on a single reference entity, the CDS premium rises, signalling distress to the market, potentially triggering the very default the speculators are betting on. This self-fulfilling prophecy dynamic was at the heart of the European sovereign debt crisis, and the RBI was determined to prevent it in India.
Why did the RBI restrict CDS in the first place?
India's journey with credit derivatives began cautiously. The RBI constituted a Working Group on Credit Derivatives in 2002 and released draft guidelines in March 2003 (Draft guidelines for introduction of Credit Deriva):
"A Working Group on Credit Derivatives was constituted in Reserve Bank of India drawing experts from select banks and Financial Institutions and Reserve Bank. The Working Group studied the need and scope for allowing banks to use credit derivatives."
The 2003 draft was never implemented. The global financial landscape changed dramatically over the next five years — the explosion of structured credit products, the growth of the CDS market to over $60 trillion in notional value globally, and finally the 2008 crisis — and the RBI chose to wait. In August 2010, the RBI released a draft report on CDS for corporate bonds (RBI places the draft report of the Internal Group) for public comments, and in November 2011, the CDS guidelines for corporate bonds went live (Introduction of Credit Default Swaps (CDS) for Cor):
"The Reserve Bank of India has decided to implement the guidelines relating to introduction of CDS for Corporate Bonds effective December 1, 2011."
The 2011-2013 framework was deliberately narrow. Only scheduled commercial banks could act as market makers. Users could only buy protection for hedging — no naked CDS. The reference entities were limited to corporate bonds only (no sovereign CDS). Documentation had to follow ISDA standards, and all trades had to be reported. The result was a market so restricted that barely any trades occurred. By 2020, CDS volumes in India were negligible.
Why was the RBI so cautious? Three reasons. First, the AIG lesson: an unregulated CDS market can create systemic risk through interconnected counterparty exposures. The RBI was not willing to allow India's banking system to accumulate the kind of hidden CDS exposures that nearly destroyed the American financial system. Second, India's corporate bond market was underdeveloped — without a liquid underlying bond market, CDS pricing would be unreliable and subject to manipulation. Third, the supervisory infrastructure was not ready — the RBI did not have the systems to monitor bilateral OTC derivative exposures in real time.
What changed in 2022?
The Credit Derivatives Directions 2022 (RBI_MD_12226), issued on February 10, 2022, and updated as of January 1, 2025, represent a comprehensive reopening. The directions superseded the restrictive 2013 circular (IDMD.PCD.No.10/14.03.04/2012-13) and built a new framework from the ground up.
The draft was released in February 2021 for public comments, as announced in the Statement on Developmental and Regulatory Policies (RBI releases Draft Reserve Bank of India (Credit D):
"In pursuance of the announcement made in the Statement on Developmental and Regulatory Policies regarding the review of Credit Default Swaps (CDS) Guidelines, the Reserve Bank of India has released today the Draft Reserve Bank of India (Credit Derivatives) Directions, 2021."
The key expansions fall into four categories.
Expanded market-makers. The 2022 framework allows three categories of market-makers: Scheduled Commercial Banks (except Small Finance Banks, Payment Banks, Local Area Banks, and Regional Rural Banks), NBFCs with minimum net owned funds of Rs 500 crore (including Standalone Primary Dealers and Housing Finance Companies, subject to Department of Regulation approval), and All India Financial Institutions (EXIM Bank, NABARD, NHB, SIDBI, and NaBFID).
A user classification framework. Users are classified as either retail or non-retail. Non-retail users include NBFCs, insurance companies, pension funds, mutual funds, alternative investment funds, resident companies with minimum net worth of Rs 500 crore, and Foreign Portfolio Investors registered with SEBI. The distinction matters because retail users can only buy protection for hedging, while non-retail users can buy protection for hedging or otherwise — meaning non-retail users can take positions that are not backed by an underlying exposure.
Expanded protection sellers. Under the 2013 framework, only banks could sell protection. The 2022 directions allow insurance companies, pension funds, mutual funds, alternative investment funds, and FPIs to act as protection sellers. This is a fundamental expansion — it means non-bank institutional investors can earn premium income by assuming credit risk, and banks can distribute their credit risk to a wider base of protection sellers.
FPI participation. The Operational Instructions for FPIs in CDS RBI/2021-22/155 issued alongside the main directions, and the periodic limits for FPI investment in debt and CDS RBI/2025-26/20, open the Indian CDS market to foreign capital for the first time. FPIs can both buy and sell CDS protection on Indian corporate bonds, bringing global risk transfer into the domestic market.
Why now? India's corporate bond market had finally grown large enough to support CDS. Outstanding corporate bonds crossed Rs 40 lakh crore. Trading platforms improved. CCIL's infrastructure for reporting and settlement matured. And the RBI's supervisory systems — enhanced after a decade of post-crisis reforms — were capable of monitoring bilateral OTC exposures. The conditions that justified extreme caution in 2013 had changed.
How settlement works: physical delivery vs. cash settlement
When a credit event occurs, the CDS contract must be settled. The 2022 directions provide for three settlement methods.
Physical settlement means the protection buyer delivers a deliverable obligation (a bond issued by the reference entity that meets the contract specifications) to the protection seller and receives the notional amount of the CDS contract. The protection seller is left holding a defaulted bond — and whatever recovery value it can extract from the resolution process.
Cash settlement means the protection seller pays the protection buyer the notional amount less the recovery value of the reference obligation. The recovery value is determined by market pricing of the defaulted bond.
Auction settlement means the recovery value is determined through an auction mechanism — typically organised by ISDA — which establishes a single clearing price for the defaulted obligation. This is the globally preferred method because it eliminates disputes about recovery value.
"'Auction settlement' of CDS means a settlement process in which the price of the reference/deliverable obligation at which the settlement will happen is determined through an auction mechanism."
The choice of settlement method matters because it determines who bears the residual risk after a credit event. In physical settlement, the protection seller holds a defaulted bond and must manage the recovery process. In cash settlement, the protection buyer retains the defaulted bond and manages recovery. The auction mechanism avoids this asymmetry by establishing a single market-clearing price.
Variation margin: reducing counterparty risk in bilateral trades
CDS contracts traded over-the-counter create bilateral counterparty credit risk. If Bank A buys CDS protection from Bank B, Bank A faces the risk that Bank B will not be able to pay when a credit event occurs. Conversely, Bank B faces the risk that Bank A will stop paying premiums. This bilateral exposure is exactly the type of interconnected risk that brought down AIG — a single entity concentrated so much CDS risk that its failure threatened the entire system.
The Variation Margin Directions 2022 (RBI_MD_12328) address this risk by mandating margin exchange for non-centrally cleared OTC derivatives, including credit derivatives. The core requirement: variation margin must be calculated daily and exchanged no later than three business days after the transaction date or margin recalculation date.
The directions define variation margin as:
"Collateral that is collected or paid to reflect the current mark-to-market exposure resulting from changes in the market value of a derivative contract."
The entity scope is calibrated by size. Domestic entities regulated by a financial sector regulator with an Average Aggregate Notional Amount (AANA) of outstanding non-centrally cleared derivatives of Rs 25,000 crore or more must exchange variation margin. Other resident entities face a higher threshold: Rs 60,000 crore. Non-resident financial entities must have an AANA of USD 3 billion or more. Other non-residents: USD 8 billion.
Why the size thresholds? Because variation margin exchange imposes operational costs — daily valuation, collateral transfer, dispute resolution. Smaller entities with minimal derivative exposures would bear disproportionate compliance costs. The thresholds ensure that margin requirements target systemically relevant exposures without burdening smaller participants.
Two approaches to margin are permitted. Collateralise to market treats the exchanged margin as collateral securing the current exposure — the margin provider retains title to the collateral. Settle to market treats the exchanged margin as an actual settlement of the current exposure — the mark-to-market exposure resets to zero after each margin exchange. The distinction matters for accounting and capital treatment but the risk-reduction effect is the same.
Certain transactions are exempt. CDS between entities within the same consolidated group do not require margin exchange. Transactions with sovereign governments, central banks, the BIS, and specified multilateral development banks are exempt. Physically-settled foreign exchange forwards and swaps are also exempt, though covered entities must manage their risks appropriately.
How CDS connects to the NPA framework
When a bank buys CDS protection on a loan it has originated, the economics change but the regulatory treatment creates complexity. The bank still holds the loan on its books. It still reports the loan in its advances. If the borrower misses payments for 90 days, the loan becomes an NPA under the RBI's asset classification norms. But the bank has transferred the credit risk to the protection seller — so does the bank still need to provision for the NPA?
The answer depends on the specific regulatory treatment that the RBI prescribes for credit risk mitigation through CDS. Under the Basel III capital framework, a bank that has bought CDS protection can reduce the risk weight on the protected exposure — effectively reducing the capital it must hold against that loan. But the provisioning question is separate: even if the capital charge is reduced, the RBI may still require the bank to classify the asset based on the borrower's actual payment behaviour, not the CDS protection.
This creates a paradox. A bank that has fully hedged a loan through CDS must still classify that loan as NPA if the borrower defaults, potentially requiring provisioning even though the bank will be made whole by the CDS settlement. The February 2026 draft revised Credit Derivatives Directions (RBI releases draft revised Master Direction – Rese) indicate that the RBI is continuing to refine the framework:
"The Reserve Bank of India has released today the draft revised Master Direction -- Reserve Bank of India (Credit Derivatives) Directions, 2022."
The interaction between CDS protection and NPA classification is one of the areas likely being addressed in this revision. Getting it right matters because incorrect treatment could either discourage banks from using CDS (if they must still provision fully despite having protection) or create moral hazard (if CDS protection eliminates provisioning requirements and banks use it to avoid recognising problem loans).
The regulatory chain
The credit derivatives regulatory chain reflects India's characteristic caution. The 2003 draft guidelines (Draft guidelines for introduction of Credit Deriva) initiated the discussion. The 2010 internal group report (RBI places the draft report of the Internal Group) revived it after the global financial crisis. The 2011 CDS launch (Introduction of Credit Default Swaps (CDS) for Cor) introduced a deliberately restrictive framework. The 2021 draft revised directions (RBI releases Draft Reserve Bank of India (Credit D) proposed the expansion. The 2022 Credit Derivatives Directions (RBI_MD_12226) implemented the new framework. The 2022 Variation Margin Directions (RBI_MD_12328) addressed counterparty risk for all non-centrally cleared OTC derivatives including CDS. The FPI CDS operational instructions RBI/2021-22/155 opened the market to foreign capital. And the February 2026 draft revision (RBI releases draft revised Master Direction – Rese) signals the next round of refinement.
Each link in the chain widened participation while maintaining supervisory control. The RBI's approach to credit derivatives is the regulatory equivalent of a controlled experiment: introduce the instrument in a narrow form, observe its behaviour, expand if conditions permit, and always maintain the ability to restrict if risks emerge. It took India 23 years to move from the first draft guidelines to a functional CDS market. The caution was deliberate, and given what happened to AIG, arguably justified.