Credit default swaps
A contract that transfers the risk of a borrower defaulting, for a fee, and what India now allows
Rules as on 16 October 2026
Verified 16 October 2026
For training and education only. Not investment advice.
Trainer notes
Ask the room: if you lend money and worry the borrower may not repay, can you pass that worry to someone else for a fee? That is what a credit default swap does. This deck explains the contract and the Indian rules that govern it.
A credit default swap moves the risk that a borrower fails to pay from one party to another, for a price.
The borrower is not part of the deal. Two other parties agree: one pays a regular fee, the other promises to pay up if the borrower defaults.
Trainer notes
Keep the picture simple: it is protection against a borrower's default, bought and sold like a policy. The borrower (the 'reference entity') need not even know the contract exists.
Four words to know first
Protection buyer
Pays a regular fee; gets paid if the borrower defaults. Often holds the borrower's bonds, but not always.
Protection seller
Takes the fee and the risk. Must pay the buyer if the borrower defaults. Takes on the credit risk for income.
Reference entity
The borrower whose default is covered. Its debt, such as a bond, is the 'reference obligation'. Not a party to the swap.
Credit event
The trigger: typically the borrower failing to pay, going bankrupt or restructuring its debt. It sets off the payout.
Take-away: The fee is the CDS premium, quoted per year as a percentage (or in basis points) of the amount covered.
Source: RBI (Credit Derivatives) Directions, 2026, definitions in paragraph 2.
Trainer notes
A basis point is one hundredth of one per cent, so 100 basis points = 1%. RBI leaves exact credit-event wording to the standard master agreement used (ISDA's 2023 Indian-credits template uses the 2014 ISDA definitions).
The fee and the payout, with arithmetic
THE SET-UP
A lender holds ₹10 crore of one company's bonds.
It buys CDS protection on that ₹10 crore. The agreed premium is 2% a year (200 basis points).
- Premium: 2% of ₹10 crore = ₹20 lakh a year, paid by the buyer to the seller while the contract runs.
- No default: the seller pays nothing. Over two years the buyer has paid ₹40 lakh for the cover and still holds its bonds.
- Default happens: say the bonds are then worth 40% of face value. The loss is 60% of ₹10 crore = ₹6 crore.
- The seller pays that ₹6 crore to the buyer and the premiums stop. The buyer's loss on the bonds is made good.
Result: The buyer swapped an uncertain big loss for a known yearly fee; the seller took on that risk.
Illustration with assumed, round figures. Recovery rates vary and are not known in advance.
Trainer notes
The amount recovered after a default (here 40%) is called the recovery rate; the payout covers the rest. Settlement can be in cash (as shown) or by delivering the bond. Do not present 2% or 40% as typical; they are chosen for clean arithmetic.
How a single-name CDS works
Agree the terms
The two parties fix the reference entity, the amount covered, the premium, the maturity and what counts as a credit event.
Pay the premium
The buyer pays the premium at set dates. This continues until the contract matures or a credit event occurs, whichever comes first.
A committee decides
If a default is claimed, a Credit Derivatives Determinations Committee set up by FIMMDA decides whether a credit event has in fact occurred.
Settle, or run to maturity
On a credit event the seller pays the buyer and the contract ends. With no credit event, it simply ends at maturity.
Source: RBI (Credit Derivatives) Directions, 2026, paragraphs 4 and 5.
Trainer notes
The committee's determinations are binding on the participants, which keeps disputes out of each individual contract. Over-the-counter trades must be reported to the Clearing Corporation of India (CCIL) within 30 minutes.
What Indian rules now allow
The RBI (Credit Derivatives) Directions, 2026 widened the products beyond plain CDS.
| Product | What it is | Where traded |
|---|---|---|
| Single-name CDS | Protection against the default of one named borrower. | OTC and exchange |
| Index CDS | Protection on a basket of borrowers tracked by a credit index. | OTC and exchange |
| Total return swap | Swaps the full return of a bond (income plus price change) for a set payment. | OTC only |
| Credit index futures | A standardised, exchange-traded futures contract on a credit index. | Exchange |
Source: RBI (Credit Derivatives) Directions, 2026, paragraphs 4 and 6.
Trainer notes
OTC means over-the-counter: negotiated directly between two parties rather than on an exchange. The 2022 rules permitted only single-name CDS; the 2026 directions added index CDS, total return swaps and credit index futures.
How a debt mutual fund may use CDS
SEBI set the conditions for mutual funds in a circular dated 20 September 2024.
Buying protection
A scheme may buy CDS only to hedge the credit risk of debt securities it already holds. The CDS cannot cover more than that holding, and must be closed within 15 working days if the bond is sold.
Selling protection
A scheme may also sell CDS, backed by cash, government securities or Treasury bills set aside as cover. Overnight and liquid schemes may not sell CDS.
Take-away: Before this circular, a fund could only buy CDS, and only in fixed maturity plans of over one year.
Source: SEBI Master Circular for Mutual Funds, 20 Mar 2026, para 13.17.
Trainer notes
Selling protection carries the reference borrower's credit risk, so SEBI requires cover (notional plus a buffer), allows only investment-grade references, bars overnight and liquid schemes, and caps a scheme's total CDS exposure at 10% of AUM.
Where things stand
Regulatory position as on 16 October 2026. These are rules, not market prices.
- CURRENT RULEBOOK
- 2026RBI Directions 2026: in force 25 Jun 2026, replacing the 2022 ones.
- OTC REPORTING
- 30 minA market-maker must report each OTC trade to CCIL within 30 minutes.
- FPI SELL CAP
- 5%All FPIs' protection sold is capped at 5% of corporate bonds outstanding.
- WHO MAY SELL
- 5Sellers: only insurers, pension funds, mutual funds, AIFs and FPIs.
Sources: RBI (Credit Derivatives) Directions, 2026, paragraphs 1, 4 and 5.
Trainer notes
Market-makers (the dealers) include scheduled commercial banks, standalone primary dealers, Upper and Middle Layer NBFCs and specified development finance institutions. Market-makers may not offer CDS to individuals.
If you learnt this from older material
Older explanations of CDS often pre-date India's current rules.
What older material says
- A CDS is an overseas idea, explained with two friends lending money.
- No Indian rulebook is mentioned; it is for banks abroad.
- Only plain, single-name CDS exists.
What holds now
- RBI rules since 2011-13; replaced in 2022, then by the 2026 directions.
- RBI sets who may trade, the products and the reporting.
- Mutual funds, insurers and others may take part; more products are allowed.
Take-away: The idea is old; the Indian market and its rulebook are recent and still developing.
Sources: RBI (Credit Derivatives) Directions, 2022 and 2026; SEBI circular of 20 September 2024.
Trainer notes
An earlier RBI attempt at CDS guidelines dates to 2011-13, but the current framework rests on the 2022 directions, now replaced by the 2026 directions.
Four things people get wrong
Misconception'A CDS is the same as insurance.'
What is trueIt works like insurance, but is a derivative under RBI rules, not an insurance policy. Retail users and mutual funds may buy only to hedge.
Misconception'The premium is the most I can lose.'
What is trueFor the buyer, the contract cost is the premium, plus the risk the seller cannot pay. The seller can owe a payout far above the premium received.
Misconception'CDS pays out if the bond price falls.'
What is trueNo. It pays only on a defined credit event, such as a default, not on day-to-day price moves.
Misconception'Only banks can use CDS in India.'
What is trueBanks are the main dealers, but mutual funds, insurers, pension funds, AIFs and FPIs may also take part, within limits.
Check yourself
Question 1: Name the two parties to a credit default swap and say which one pays a regular fee.
Answer: The protection buyer and the protection seller. The protection buyer pays the regular fee (the premium); the seller pays out if a credit event occurs on the reference entity.Question 2: A buyer pays 2% a year on ₹20 crore of protection. How much is the yearly premium, and when does the seller have to pay?
Answer: 2% of ₹20 crore = ₹40 lakh a year. The seller pays only if a defined credit event (such as the borrower defaulting) occurs on the reference entity.Question 3: Under SEBI's rules, when may a debt mutual fund scheme buy a CDS?
Answer: Only to hedge the credit risk of debt securities it already holds, with cover no larger than that holding, and it must close the CDS within 15 working days if it sells the bond.
Sources and disclaimer
Sources for the figures in this explainer
- CDS and credit event definitions, products, participants, 30-min CCIL reporting, FPI 5% cap, Determinations Committee: RBI (Credit Derivatives) Directions, 2026 (in force 25 Jun 2026).
- Earlier framework permitting single-name CDS: RBI (Credit Derivatives) Directions, 2022 (in force 9 May 2022), superseded by the 2026 directions.
- MF CDS rules (buy only to hedge; sell with cover, investment-grade, 10% cap; 15-working-day unwind): SEBI/HO/IMD/PoD2/P/CIR/2024/125, 20 Sep 2024; Master Circular 20 Mar 2026, 13.17.
- The credit-event wording (failure to pay, bankruptcy, restructuring) sits in the standard master agreement, e.g. ISDA's 2023 Indian-credits template (2014 ISDA definitions).
- All rupee amounts, the 2% premium and the 40% recovery rate in the worked example are invented for illustration and are not market figures.
This material is for training and investor education only. It is not investment, tax or legal advice and is not a recommendation to buy, sell or hold any security or scheme. Examples use assumed figures unless a source and date are shown. Mutual fund investments are subject to market risks; read all scheme related documents carefully. Trustner Asset Services Pvt. Ltd. is an AMFI-registered Mutual Fund Distributor (ARN-286886).