‘High value’ debt listed entities under full scale corporate governance requirements

SEBI move nullifies MCA exemption; bond issuers face disproportional compliances

Vinod Kothari & Vinita Nair  | Vinod Kothari & Company

Giving bond markets in the country a push is an admitted policy objective; so much so that “large borrowers” are mandated to move a part of their incremental funding compulsorily to the bond markets. Just when privately placed bond issuance was looking very promising, augured by low interest rates and  increasing investors’ confidence, SEBI’s recent move of notifying SEBI (Listing Obligations and Disclosure Requirements) (Fifth Amendment) Regulations, 2021 (‘2021 Amendment’)to extend corporate governance requirements, largely equivalent to that applicable to equity listed entities, comes as an enigma. These new norms, incorporated in the post-listing corporate governance requirements imbibed in SEBI ( Listing Obligations and Disclosure Requirements) Regulations, 2015  (‘Listing Regulations’) become effective immediately on a “comply or explain” basis, and become binding from 1st April, 2023.

What is surprising is that the capital market regulator has thought of equating a debt listed entity with an equity listed one; potentially disregarding the essential difference between equity listing and bond listing. Equity listing is achieved by a public offer, which underlies widely dispersed retail investors’ interest. Bond listing, to the extent of 98%, is by way of private placement, which definitely means that bonds are placed with knowledgeable qualified institutional buyers. Also, it is a known fact that a large number of listed bond issuers are private limited companies, which are close corporations, with strictly private holding of capital. In light of these facts, extension of substantially the same regime for debt listed entities as that applicable to equity listing creates several irreconcilable compliance requirements, some of which are detailed out in this article. At a time when the need to push the country’s bond markets to new heights, ahead of a potential inclusion of India in global bond indices, is unquestionable, this regulatory move is both surprising as prejudicial. Surprising, because many of SEBI’s regulatory exercises, there was no public comments for these amendments.

The key to the potential prejudice that the regulatory move may cause to bond markets is the definition of “high value debt listed entities”, picking up a threshold of Rs. 500 crores. If the total value of listed bonds outstanding, purely from the corporate sector, is over Rs. 36 lakh crores[1], the amount of Rs. 500 crores is infinitesimal, less than 0.014% of the bond market, and therefore, the basis for taking this value as “high value” is seriously flawed.

Let us start with some facts. India’s bond market is largely a private placement, comprised of bespoke bond issues with limited number investors, majority of them being Qualified Institutional Buyers (QIBs). While technically, these bonds may be sourced through an electronic platform, the avowed fact is that bond issues by even the most frequent bond issuers are negotiated over the counter. Public issue of bonds is activity rarity. This is evident from Table 1: Listed debt issuance, by way of private placement vis-à-vis public issuance during last 3 years.

Regulatory regime before:

Regulation is always proportional to the regulatory concern: the regulatory concern in this case, obviously, is investor protection. Securities regulator is neither the prudential regulator for the bond issuers, nor does it lay the operational safeguards in working of companies. The key objective of the securities regulator is to ensure that the corporate governance does not entail risks to investors’ interest.

Further, the regulatory regime that existed hitherto is as follows: Once the debt securities are listed, companies were required to comply with Listing Regulations mainly Chapter II (dealing with principles relating to disclosures), Chapter III (dealing with common obligations for all listed entities and Chapter V (dealing with disclosure requirements on website, to debenture trustees, stock exchanges, submission of financial results and structure and terms of debt securities). Provisions relating to corporate governance were not applicable to debt listed entities.

It is also notable that debt listed entities were earlier only required to prepare half yearly financial statements, as opposed to quarterly financial statements applicable to equity listed entities.

The rest of the labyrinth of corporate governance provisions, dealing with composition of board of directors, non-executive chairperson, independent directors, constitution of the several board committees, shareholders’ approval for  related party transactions, etc. were not applicable to debt listed entities.

Present amendment

SEBI, in its Board meeting held on August 06, 2021 approved amendments to the Listing Regulations and notified 2021 Amendment with effect from September 8, 2021[2]. The amendments may be classed into (i) those applicable to a “high value” debt listed entity and (ii) those applicable to every entity having its non-convertible securities listed[3].

The 2021 Amendment has made corporate governance related provisions applicable to a listed entity which has listed its non-convertible debt securities and has an outstanding value of listed non-convertible debt securities of Rs. 500 crore and above as on March 31, 2021 (‘HVD entity’). Further, once the provisions become applicable, it will continue to apply even if subsequently the outstanding value falls below the threshold.

Given the details of bonds issuance and present outstanding indicated above, there would be several entities that would be regarded as an HVD entity. In view of SEBI’s requirements under Large Corporate Borrower framework, entities with any of its securities listed, having an  outstanding  long  term  borrowing  of  Rs.  100  crores  or  above and with credit rating of ‘AA and above’[4], will have to mandatorily raise 25% of its incremental borrowing by ways of issuance of debt securities or pay monetary penalty/fine of 0.2% of the shortfall in the borrowed amount at the end of second year of applicability[5].

If one were to argue it is the mere size of debt funding that brings in corporate governance requirements, then even a company that borrows from banks and financial institutions to the extent of Rs. 500 crores should, a priori, have been subjected to similar requirements. If moving from loans to bonds attracts severe corporate governance requirements, not applicable otherwise, there is a clear disincentive to moving bond markets, which is conflicting directly with SEBI’s own requirement of a “large borrower framework”.

We discuss some of the new requirements imposed on HVD entities, and demonstrate how some of these are completely non-reconciling with the type of entities to which they would apply.

Complete overhaul of Board composition

The Board of an HVD entity should comprise of prescribed number of independent directors (‘IDs’) depending on the nature of office of the Chairperson. Appointment of IDs in case of private companies and wholly owned public limited companies will require inducting requisite number of external persons on its Board. In case of a promoter Chairperson, half of its Board should comprise of IDs. A private company is a private matter, in terms of its shareholding. It cannot have an “independent” shareholder. Hence, boards of private companies, as per law, may only have 2 directors. SEBI, on the contrary, mandates 6 directors. Regrettably, the very “privacy” of a private company is compromised with the mandated presence of independent directors. Indeed, there are external investors who contributed to the debt of the entity, but they did with the explicit understanding that the corporate governance of a private company is remarkably different from that of a widely held company. If a private company has to behave and be governed almost like a widely held public company, then there may be a very strong disincentive for such companies to access bond markets.

The requirement of IDs is not merely getting some guests into the boardroom: IDs are required to be independent of management, should meet the eligibility criteria and are responsible to protect the interest of the minority shareholders. In case of several HVD entities there would be no minority shareholders whatsoever: therefore, the IDs would be left wondering as to how the IDs discharge the very same obligations as applicable to an entity with a few lakh shareholders.

The procedure to be followed by a listed entity for appointment of an ID under Listing Regulations is also very elaborate. The Nomination and Remuneration Committee (‘NRC’) is required to prepare a description of the needed capabilities and skill sets after doing a gap analysis, identify candidates basis the prepare description, justify to the Board and shareholders how the proposed incumbent meets the criteria and then recommend their appointment.

The listed entities are not only required to obtain declaration of independence from the IDs but also assess the veracity of the same. Further, the provisions stipulate conducting familiarization programme periodically, obtain Directors and Officer’s insurance for the IDs (otherwise applicable only to top 500 equity listed entities w.e.f. Jan 1, 2022), and ensure that a separate meeting of IDs are carried out.

Need to constitute 4 Committees

The HVD entity, irrespective whether a private company or a closely held company, is required to have an Audit Committee, NRC, Risk Management Committee (otherwise applicable only to top 1000 listed entities based on market capitalization,  but strangely applicable to the entire population of HVD entites) and even a Stakeholder’s Relationship Committee (‘SRC’).

Section 178 of CA, 2013 also mandates constituting SRC only where there are 1000 shareholders, debenture holders, deposit-holders and any other security holders at any time during a financial year. And there are quite a few debt listed entities that have not triggered this requirement even after 8 years of enforcement of CA, 2013.

Under Listing Regulations as well, the role of SRC is mainly to resolve investor grievances, oversee steps taken by the listed entity to reduce quantum of unclaimed dividend, effective exercise of voting rights, monitoring adherence to service standards by RTA, which may not be even relevant to HVD entities that are private companies or closely held public companies. Strangely, the requirement of having SRC will be applicable to debt listed entities having a handful of debt investors, and purely in-house shareholders.

Remuneration related approvals

Requirement to seek shareholder’s approval by way of special resolution is applicable in case of continuing with directorship of a non-executive director (‘NED’) of 75 years and above, or remunerating one NED to the extent of more than 50% of annual remuneration of all NEDs in a financial year, or paying of remuneration to the promoter directors serving in executive capacity in case (i) the annual remuneration payable to such executive director exceeds Rs. 5 crore or 2.5 per cent of the net profits of the listed entity, whichever is higher; or (ii) where there is more than one such director, the aggregate annual remuneration to such directors exceeds 5 per cent of the net profits of the listed entity.

And it will not be a case of wide shareholder participation with institutional shareholders exercising voting rights basis the guidance from proxy advisors etc. as several of HVD entities could be private companies or closely held public limited companies.

Further, prior approval of public shareholders is required in case any employee including key managerial personnel or director or promoter of a listed entity enters into any agreement for himself /herself or on behalf of any other person, with any shareholder or any other third party with regard to compensation or profit sharing in connection with dealings in the securities of such listed entity.

Formulation of codes and policies

Code of conduct for Board and senior management personnel, policy for determination of material subsidiary, policy for determination of materiality of and dealing with related party transactions, archival policy for website are some of the additional codes and policies that HVD entities will have to frame.

Paradoxical regulation: Related Party Transactions (‘RPTs’) to require minority shareholder approvals

While framing a policy for determination of materiality of and dealing with RPTs and half yearly disclosure of RPTs to stock exchange might seem feasible, the 2021 Amendment also stipulates only IDs in the Audit Committee to approve RPTs. Further, in case of material RPTs, at the time of seeking shareholder’s approval all related parties are prohibited from voting to approve the RPT i.e. either they may vote against or abstain from voting altogether.

This is completely paradoxical. A debt listed entity may be a subsidiary of a holding company. The holding company, being a “related party”, will be excluded from voting. If the related parties are to be excluded from voting at the general meeting of a private company, it is quite likely that there will be no shareholders whose votes may be counted!


Subsidiary related governance

An HVD Entity will be required to ascertain material subsidiary, induct an ID on the board of super material subsidiary (that contribute 20% of consolidated income or net worth), place details of significant transactions undertaken by unlisted subsidiary before its Board, place the financials of unlisted subsidiaries before its Audit Committee and seek prior approval of shareholders in case of disposal of shares resulting in losing of control over the entity by the HVD entity or selling/leasing/ disposing 20% of the assets of such material subsidiary in a financial year.

Group governance may be more relevant for entities where the listed entity is answerable for creation of shareholder value. In case of a debt listed entity, the expectation of the investors is not creation of shareholder value but ability to timely service the debt and redeem the principal.


Will this be a deterrent for new issuers or small players from opting for the listed debenture route? Whether these enhanced corporate governance norms provide greater comfort and assurance to the investors in securing timely repayment of their monies? Will it increase trading in debt securities in the secondary market? It is assumed that SEBI must have considered these before enforcing the 2021 Amendment and only time could reveal the effectiveness of these provisions.






[1] The total corporate bond outstanding as on June, 2021[1] is about 36,27,667.18 crores represented by 26,350 outstanding instruments of 3903 issuers. The actual number of issuers, instruments and outstanding amount will be higher, if one were to include unlisted debt issuance as well.

[2] https://www.sebi.gov.in/legal/regulations/sep-2021/securities-and-exchange-board-of-india-listing-obligations-and-disclosure-requirements-fifth-amendment-regulations-2021_52488.html

[3] As per SEBI (Issue and Listing of Non-convertible Securities) Regulations, 2021 means debt securities, non-convertible redeemable preference shares, perpetual non-cumulative preference shares, perpetual debt instruments and any other securities as specified by the Board;

[4] As per para 2.2 of https://www.sebi.gov.in/legal/circulars/nov-2018/fund-raising-by-issuance-of-debt-securities-by-large-entities_41071.html

[5] a listed entity identified as a LC, as on last day of FY “T-1”, shall  have to  fulfil  the  requirement  of  incremental borrowing for FY “T”, over FY”T” and “T+1”.

Our other resources on related topics –

  1. https://vinodkothari.com/2021/09/high-value-debt-listed-entities-under-full-scale-corporate-governance-requirements/
  2. https://vinodkothari.com/2021/09/presentation-on-lodr-fifth-amendment-regulations-2021/
  3. https://vinodkothari.com/2021/09/debt-listed-entities-under-new-requirement-of-quarterly-financial-results/
  4. https://vinodkothari.com/2021/09/full-scale-corporate-governance-extended-to-debt-listed-companies/



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Our  our Book on Law and Practice Relating to Corporate Bonds and Debentures, authored by Ms. Vinita Nair Dedhia, Senior Partner and Mr. Abhirup Ghosh, Partner can be ordered though the below link:



Presentation on LODR Fifth Amendment Regulations, 2021

Our other resources on related topics –

  1. https://vinodkothari.com/2021/09/high-value-debt-listed-entities-under-full-scale-corporate-governance-requirements/
  2. https://vinodkothari.com/2021/09/corporate-governance-enforced-on-debt-listed-entities/
  3. https://vinodkothari.com/2021/09/debt-listed-entities-under-new-requirement-of-quarterly-financial-results/
  4. https://vinodkothari.com/2021/09/full-scale-corporate-governance-extended-to-debt-listed-companies/

Full scale corporate governance extended to debt listed companies


View link of the gazette notification here

Our other resources on related topics –

  1. https://vinodkothari.com/2021/09/high-value-debt-listed-entities-under-full-scale-corporate-governance-requirements/
  2. https://vinodkothari.com/2021/09/corporate-governance-enforced-on-debt-listed-entities/
  3. https://vinodkothari.com/2021/09/debt-listed-entities-under-new-requirement-of-quarterly-financial-results/
  4. https://vinodkothari.com/2021/09/presentation-on-lodr-fifth-amendment-regulations-2021/

Credit Default Swaps (Global and Indian Scenario)

Credit default swaps (what is happening in global markets and the recommendations of the working group)

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      1. https://vinodkothari.com/wp-content/uploads/RBIa%CC%82%C2%80%C2%99s-Guidelines-on-Credit-Default-Swaps-for-Corporate-Bonds.pdf
      2. https://vinodkothari.com/2021/02/rbi-issues-draft-directions-on-credit-derivatives/
      3. https://vinodkothari.com/isda_new_definition_credit-derivs_impact/
      4. https://vinodkothari.com/2013/12/secnews-110810/
      5. https://vinodkothari.com/rbi-new-cds-guidelines-feeble-effort-start-non-starting-product/

Use of dual recourse instruments for SME finance: The Making of European Secured Notes

– Vinod Kothari and Abhirup Ghosh (finserv@vinodkothari.com)

The European financial regulators are working on a new funding instrument whereby banks and primary lenders can raise refinance against their portfolio of SME loans, by issuing a bond which is directly linked with such portfolios, called European Secured Notes (ESNs). ESNs are a dual recourse instrument, following the time-tested structure of covered bonds.

Covered bonds, developed more than 250 years ago in Europe, use dual recourse structure. The first recourse, against the issuer, is prone to the risk of bankruptcy of the issuer. In that situation, the investors have recourse against the assets of the issuer, and that recourse is made immune from other bankruptcy claims or priorities. This ring-fencing is granted either by explicit legislation, or by use of contract law flexibility. Covered bonds are currently used, to an overwhelming extent, for prime residential mortgage loans. Given their bankruptcy-protected asset backing, covered bonds allow the issuer to get a rating higher than the issuer’s own default rating. This phenomenon, called “notching up”, may cause the ratings on the bonds to go up over the rating of the issues by some 6 to 9 notches.

European regulators are trying to build on the methodology of covered bonds to see if a similar instrument can be used by banks to refinance their SME loan pools.

Development of European Secured Notes:

There have been past instances, sporadically, of dual recourse bonds, on lines similar to ESNs,. A notable instance was Commerzbank’s SME-backed structured covered bond programme established in 2013 but fully repaid in 2018[1]. Besides this, there were several issuances in France, though they are no longer used.

There has been a multi-issuer platform called French “Euro secured Note issuer” (ESNI), established in 2014 and supported by the Banque de France. Though the programme was open to all French and European Banks, only four French banks opted for this. There were around 20 issuances totalling to over Euro 10 Bn. Banque de France acted as the monitor for the asset quality of the SME loans. It used its internal rating model to examine the assets and score them. The scoring, in combination with haircuts on such assets established the minimum over-collateralisation level.

The Italian regulators also proposed to come up with an enabling regulatory framework to permit domestic issuers to issue Obbligazioni Bancarie Collateralizzate (OBC);  however, this seems to have been stranded into oblivion.

Similar efforts were made by the Spanish regulators when they amended the covered bonds framework in 2015.

The work done all this while might have been the inspiration for the European Commission when it proposed the use of ESN as a financial instrument backed by SME loans and infrastructure loans, to be used by banks, as a part of the Capital Markets Union proposals in 2017[2].

Subsequently, the Commission requested a report from the European Banking Authority to set out probable structures of ESNs, which was issued in July 2018[3].

It was originally meant to be kept on the backburner until 2024, however, with the COVID 19 pandemic, the European Parliament asked the European Commission to accelerate the introduction of ESNs to help financing the recovery from the pandemic.

In April 2021, the ESN Task Force, that is, ECBC along with EMF, issued the ESN Blueprint[4]. It appears that ESNs may be rolled out ahead of the original implementation schedule.

Structure of ESNs

Originally, at the time of conceptualisation, there were two structures which were contemplated:

  1. A structure that mirrors the structure of covered bonds,
  2. A structure that mirrors the structure of ABS

However, EBA suggested the first structure in its report.

The key recommendations of the EBA on the structure are as follows:

  1. Dual recourse – The bond must grant the investor a claim on the covered bond issuer, and if it fails to pay, a priority claim on the cover pool limited to the fulfilment of the payment obligations. Further, if the cover pool turns to be insufficient to fulfil the payments, the investor shall have recourse back to the insolvency estate of the issuer, which shall rank pari passu with the claims of the unsecured creditors.
  2. Segregation of cover assets – The next important suggestion was with respect to the segregation of cover assets. The segregation of assets could be either be achieved through registration of the cover pool into a cover register or by transferring them to a special purpose vehicle (SPV). Note that registration of covered bonds is required by several European jurisdictions, as well as Canada.
  3. Bankruptcy-remoteness of the covered bond: The legal/ regulatory framework should facilitate the bankruptcy-remoteness by not requiring acceleration of payments in case of issuer default.
  4. Administration of the covered bond programme after the issuer’s insolvency or resolution: The legal/regulatory covered bond framework should provide that upon issuer’s default or resolution the covered bond programme is managed in an independent way and in the preferential interest of the covered bond investor.
  5. Composition of cover pool: The cover pool should comprise of non-defaulted SME loan and leasing exposures. Further, the pool should be dynamic. Given the high risk associated with SME loans, the EBA recommended incorporating strict eligibility criteria at both loan and pool levels in the form of:
    • selected SME exposures
    • sufficient granularity,
    • concentration limit,
    • quality standards.
  6. Coverage principles and legal/regulatory overcollateralization: The claims against the cover pool should not exceed the receivables arising out of the cover pool. Further, the EBA considered a minimum over-collateralisation must be prescribed for SME ESNs. In this regard, the EBA recommended a minimum over-collateralisation of 30%.

Use of capital market instruments for refinancing SME loans:

“SMEs are important actors in economic growth and transformation, creating positive value for the economy and contributing towards sustainable and balanced economic growth, employment and social stability”[5]. The use of capital market instruments for refinancing SME loans has been engaging the attention of policymakers and regulators alike. The extent of penetration of bank finance to SMEs is far from optimal, and additionally, there are gaping differences across geographies.

Direct access of SMEs to capital markets for debt funding is quite limited, since most of the SMEs do not have the size to be able to attract the attention of institutional investors in the capital market. An OECD-World Bank report notes that “individual SMEs issuances do not easily align with the risk appetite and prudential requirements of institutional investors.”[6] On the other hand, institutional investors may easily participate in bonds or similar instruments which refinance or repackage SME lenders’ loan portfolios. The aforesaid OECD-World Bank report envisages 4 types of capital market instruments for SME refinancing –corporate bonds issued by SME lenders, securitisation of SME loans, SME covered bonds, and SME loan & bond funds, as collective investment schemes.

Issuance of bonds by banks, for on-lending to SMEs or refinancing SME loan portfolios, is quite common in many countries. Such bonds are, however, linked with the performance and rating of the issuer bank.

As for securitisation of SME loans, the overall contribution of SME loans as an asset class in the global securitisation volumes will be in the region of 2%, which obviously dwarfs in comparison to popular asset classes such as residential mortgage loans. Post the GFC, several European jurisdictions have used securitisation of SME loans, but looking at the huge proportion of retained securitisations (see Graph below), it is quite evident that such activity was motivated by the objective of refinancing by ECB. This low volume is despite the fact that  asset backed securitisation is the most natural choice to fund SME loans through capital market, as they provide three benefits:

  1. Provide funding to the banks
  2. The assets move off the books of the originator, depending on the structure
  3. Can be tailor made to the specifications of the investor
  4. Regulatory capital relief

In the recent times, SME ABS issuances in Europe peaked in 2019, of which almost 97% were issued in retained format.

Source: Scope Ratings[7]

Outside of Europe, Korea and India have seen several securitisations of SME loan pools.

Relevance of dual recourse instrument for SME funding

Covered bonds are mostly supported by legislation to provide bankruptcy protection in European jurisdictions. In several other jurisdictions, the flexibility of the common law structure is utilised for providing bankruptcy protection. However, the essential premise in either case is the same –which is the ability of the cover pool to be a backstop for redemption of the bonds, in the event of failure of the issuer to pay them. Therefore, the pool of assets have to be liquid and robust to be able to pay off the bondholders.

There is substantial difference between mortgage pools backing up covered bonds, and SME loans. SME loans have lesser granularity, heterogeneity, and higher historical default rates. The servicing of SME loans from the viewpoint of ongoing collections is also not as easy as in case of mortgage loans. However, these will be ultimately be the factors that would have to be borne in mind by the rating agencies while sizing up the level of over-collateraliation and fixing the level of rating notch-ups for SME-loan-backed covered bonds. As a matter of principle, if there is a market for securitisation of SME loans as demonstrated by recent global transactions, a covered bond structure only tries to marry the benefits of securitisation and corporate bonds. Hence, introducing covered bonds backed by SME loans may be the right idea.

The robustness of covered bond with a history of over 250 years is explained, other than by the legislative protection, by the good quality of the cover pool. The transparency of loan-level performance data of SME loans is much lesser than mortgage loans. Even more importantly, the question is the ability and liquidity of the cover pool, given the insolvency of the issuer, to redeem the bonds. SME loans do not have as liquid secondary market, and the migration of servicing to an alternate servicer makes the liquidity of such loan pools even more difficult. The layering of a credit guarantee support by credit guarantee schemes, which exist practically in every jurisdiction in the world, could also be considered as a credit support.

Should there be a legislative bankruptcy protection, which removes these loan pools completely from the bankruptcy estate and makes the same available to covered bond investors only? This question becomes a complicated one, involving inter-creditor rights. Insolvency for other creditors becomes deeper if there are more bankruptcy-protected instruments.

The urgency for ESNs is also a part of the post-Covid worries of regulators all over the world, and clearly, SMEs are seen as a huge agent of post-Covid revival. However, the need for availability of more liquidity for SMEs has always been crucial. Therefore, the introduction of SME-loan-backed covered bonds may be an agenda items for countries outside of Europe too.

[1] https://www.scoperatings.com/ScopeRatingsApi/api/downloadstudy?id=dfa74ad6-f1ca-4860-a916-bc0638846bb1

[2] https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52017DC0292

[3] https://www.eba.europa.eu/sites/default/documents/files/documents/10180/2087449/6fe04a31-ec0b-4ea1-9508-258ad2cf72d8/EBA%20Final%20report%20on%20ESNs.pdf

[4] https://hypo.org/app/uploads/sites/3/2017/05/ECBC-ESN-Blueprint-April-2021.pdf

[5] IOSCO Report, 2015, titled SME Financing Through Capital Markets, at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD493.pdf

[6] https://www.oecd.org/g20/topics/development/WB-IMF-OECD-report-Capital-Markets-Instruments-for-Infrastructure-and-SME-Financing.pdf, page 46

[7] https://www.scoperatings.com/ScopeRatingsApi/api/downloadstudy?id=dfa74ad6-f1ca-4860-a916-bc0638846bb1

Our other resources on Covered Bonds:




Covered Bonds in India: creating a desi version of a European dish

Abhirup Ghosh | abhirup@vinodkothari.com

It is not uncommon to have Indianised version of global dishes when introduced in India, and we are very good in creating fusion food. We have a paneer pizza, and we have a Chinese bhel. As covered bonds, the European financial instrument with over 250 years of history were introduced in India, its look and taste may be quite different from how it is in European market, but that is how we introduce things in India.

It is also interesting to note that regulatory attempts to introduce covered bonds in India did not quite succeed – the National Housing Bank constituted Working Group on Securitisation and Covered Bonds in the Indian Housing Finance Sector, suggested some structures that could work in the Indian market[1]  and thereafter, the SEBI COBOSAC also had a separate agenda item on covered bonds. Several multilateral bodies have also put their reports on covered bonds[2].

However, the market did not wait for regulators’ intervention, and in the peak of the liquidity crisis of the NBFCs, covered bonds got uncovered – first slowly, and now, there seems to be a blizzard of covered bond issuances. Of course, there is no legislative bankruptcy remoteness for these covered bonds.

There are two types of covered bonds, first, the legislative covered bonds, and second, the contractual covered bonds. While the former enjoys a legislative support that makes the instrument bankruptcy remote, the latter achieves bankruptcy remoteness through contractual features.

To give a brief understanding of the instrument, a standard covered bond issuance would reflect the following:

  1. On balance sheet – In case of covered bonds, both the cover pool and the liability towards the investor remains on the balance sheet of the issuer. The investor has a recourse on the issuer. However, the cover pool remains ring fenced, and is protected even if the issuer faces bankruptcy.
  2. Dual recourse – The investor shall have two recourses – first, on the issuer, and second, on the cover pool.
  3. Dynamic or static pool – The cover pool may be dynamic or static, depending on the structure.
  4. Prepayment risk – Since, the primary exposure is on the issuer, any prepayment risk is absorbed by the issuer.
  5. Rating arbitrage – Covered bonds ratings are usually higher than the rating of the issuer. Internationally, covered bonds enjoy upto a maximum of 6-notch better rating than the rating of the issuer.

Therefore, covered bond is a half-way house, and lies mid-way between a secured corporate bond and the securitized paper. The table below gives comparison of the three instruments:

  Covered bonds Securitization Corporate Bonds
Purpose Essentially, to raise liquidity Liquidity, off balance sheet, risk management,

Monetization of excess profits, etc.

To raise liquidity
Risk transfer The borrower continues to absorb default risk as well as prepayment risk of the pool The originator does not absorb default risk above the credit support agreed; prepayment risk is usually transferred entirely to investors. The borrower continues to absorb default risk as well as prepayment risk of the pool
Legal structure A direct and unconditional obligation of the issuer, backed by creation of security interest. Assets may or may not be parked with a distinct entity; bankruptcy remoteness is achieved either due to specific law or by common law principles True sale of assets to a distinct entity; bankruptcy remoteness is achieved by isolation of assets A direct and unconditional obligation of the issuer, backed by creation of security interest. No bankruptcy remoteness is achieved.
Type of pool of assets Mostly dynamic. Borrower is allowed to manage the pool as long as the required “covers” are ensured. From a common pool of cover assets, there may be multiple issuances. Mostly static. Except in case of master trusts, the investors make investment in an identifiable pool of assets. Generally, from a single pool of assets, there is only issuance. Dynamic.
Maturity matching From out of a dynamic pool, securities may be issued over a period of time Typically, securities are matched with the cashflows from the pool. When the static pool is paid off, the securities are redeemed. From out of a dynamic pool, securities may be issued over a period of time.
Payment of interest and principal to investors Interest and principal are paid from the general cashflows of the issuer Interest and principal are paid from the asset pool Interest and principal are paid from the general cashflows of the issuer.
Prepayment risk In view of the managed nature of the pool, prepayment of loans does not affect investors Prepayment of underlying loans is passed on to investors; hence investors take prepayment risk Prepayment risk of the pool does not affect the investors, as the same is absorbed by the issuer.
Nature of credit enhancement The cover, that is, excess of the cover assets over the outstanding funding. Different forms of credit enhancement are used, such as excess spread, subordination, over-collateralization, etc. No credit enhancement. Usually, the cover is 100% of the pool principal and interest payable.
Classes of securities Usually, a single class of bonds are issued Most transactions come up with different classes of securities, with different risk and returns Single class of bonds are issued.
Independence of the ratings from the rating of the issuer Theoretically, the securities are those of the issuer, but in view of bankruptcy-proofing and the value of “cover assets”, usually AAA ratings are given AAA ratings are given usually to senior-most classes, based on adequacy of credit enhancement from the lower classes. There is no question of independent rating.
Off balance sheet treatment Not off the balance sheet Usually off the balance sheet Not applicable.
Capital relief Under standardized approaches, will be treated as on-balance sheet retail portfolio, appropriately risk weighted. Calls for regulatory capital Calls for regulatory capital only upto the retained risks of the seller Not applicable


This article would briefly talk about the issuance of Covered bonds world-wide and in India, and what are the distinctive features of the issuances in India.

Global volume of Covered Bonds

Since most volumes for covered bonds came from Europe, there has been a decline due to supply side issues. This is evident from the latest data on Euro-Denominated Covered bonds Volume. The performance in FY 2020 and FY 2021 has been subdued mainly due to COVID-19. Though, the volumes suffered significantly in the Q3 and Q4 of FY 20, but returned to moderate levels by the beginning of FY 2021.

The figure below shows Euro-Denominated Covered bond Issuances until Q2 2021.

Source: Dealogic[3]

Countries like Denmark, Germany, Sweden continues to be dominant markets for covered bond issuances. The countries in the Asia-Pacific region like Japan, Singapore, and Australia continues to report moderate level of activities. In North America, Canada represents all the whole of the issuance, with no issuances in the USA.

The tables below would show the trend of issuances in different jurisdictions in 2019 (latest available data):

Source: ECBC Factbook 2020[4]

Covered Bonds in India

In India, the struggle to introduce covered bonds started way back in 2012, when the National Housing Bank formed a working group[5] to promote RMBS and covered bonds in the Indian housing finance market. Though the outcome of the working group resulted in some securitisation activity, however, nothing was seen on covered bonds.[6]

Some leading financial institutions attempted to issue covered bonds in the Indian market, but they failed. Lastly, FY 2019 witnessed the first instance of covered bonds, which was backed by vehicle loans.

In India, issuance of covered bonds witnessed a sharp growth in FY 2021, as the numbers increased to INR 22 Bn, as against INR 4 Bn in FY 2020. Even though the volume of issuances grew, the number of issuers failed to touch the two-digit mark. The issuances in FY 2021 came from 9 issuers, whereas, the issuances in FY 2020 were from only 2 issuers. Interestingly, all were non-banking financial companies, which is a stark contrast to the situation outside India.

The figure below shows the growth trajectory of covered bonds in India:

Source: ICRA, VKC Analysis

The growth in the FY 2021 was catapulted by the improved acceptance in Indian market in the second half of the year, given the uncertainty on the collections due to the pandemic, and the additional recourse on the issuer that the instrument offers, when compared to a traditional securitisation transaction.

Almost 75% of the issuances were done by issuers have ‘A’ rating, the following could be the reasons for such:

  1. Enhanced credit rating – In the scale of credit ratings, ‘A’ stands just above the investment grade rating of ‘BBB’. Therefore, it signifies adequate degree of safety. With an earmarked cover pool, with certain degree of credit enhancements and, covered bonds issued by these entities fetched a much better credit rating, going up to AA or even AAA.
  2. AUM – FY 2021 was a year of low level of originations due to the pandemic. As a result, most of the financial sector entities stayed away from sell downs, which is evident from the low of level of activity in the securitisation market, as they did not want their AUM to drop significantly. In covered bonds, the cover pool stays on the books, hence, allowing the issuer to maintain the AUM.
  3. Better coupon rate – Improved credit ratings mean better rates. It was noticed that the covered bonds were issued 50 bps – 125 bps cheaper than normal secured bonds.

The Indian covered bonds market is however, significantly different from other jurisdictions. Traditionally, covered bonds are meant to be long term papers, however, in India, these are short to medium term papers. Traditionally covered bonds are backed by residential mortgage loans, however, in India the receivables mostly non-mortgages, gold loans and vehicle loans being the most popular asset classes.

In terms of investors too, the Indian market has shown differences. Globally, long term investors like pension funds and insurance companies are the most popular investor classes, however, in India, so far only Family Wealth Offices and High Net-worth Individuals have invested in covered bonds so far.

Another distinct feature of the Indian market is that a significant share of issuances carry market linked features, that is, the coupon rate varies with the market conditions and the issuers’ ability to meet the security cover requirements.

But the most important to note here is that unlike any other jurisdiction, covered bonds don’t have a legislative support in India. In Europe, the hotspot for covered bonds, most of the countries have legislations declaring covered bonds as a bankruptcy-remote instruments. In India, however, the bankruptcy-remoteness is achieved through product engineering by doing a legal sale of the cover pool to a separate trust, yet retaining the economic control in the hands of the issuer until happening of some pre-decided trigger events, and not with the help of any legislative support. In some cases, the legal sale is done upfront too.

Considering the importance and market acceptability of the instrument, rating agencies in India have laid down detailed rating methodologies for covered bonds[7].


Covered Bonds issued in India will not match most of the features of a traditional covered bond issued in Europe, however, the fact that finally the investors community in India has started recognizing it as an investment opportunity is very encouraging.

The real economics of covered bonds will come to the fore only when the market grows with different classes of investors, like the mutual funds, pension funds, insurance companies etc. in the demand side, which seems a bit far-fetched for now.



[1] A working group was constituted by the National Housing Bank to promote RMBS and Covered Bonds, the report of the working group can be viewed here: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf

[2] In 2014-15, the Asian Development Bank appointed Vinod Kothari Consultants to conduct a Study on Covered Bonds and Alternate Financing Instruments for the Indian Housing Finance Segment

[3] https://www.icmagroup.org/resources/market-data/Market-Data-Dealogic/#14

[4] https://hypo.org/app/uploads/sites/3/2020/10/ECBC-Fact-Book-2020.pdf

[5] A working group was constituted by the National Housing Bank to promote RMBS and Covered Bonds, the report of the working group can be viewed here: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf

[6] Vinod Kothari Consultants has been a strong advocate for a legal recognition of Covered Bonds in India. They were involved in the initiatives taken by the NHB to recognize Covered Bonds as a bankruptcy remote instrument in India.

[7] The rating methodology adopted by ICRA Ratings can be viewed here: https://www.icra.in/Rating/ShowMethodologyReport/?id=709

The rating methodology adopted by CRISIL can be viewed here: https://www.crisil.com/mnt/winshare/Ratings/SectorMethodology/MethodologyDocs/criteria/crisils%20criteria%20for%20rating%20covered%20bonds.pdf

Our Video on Covered Bonds can be viewed here <https://www.youtube.com/watch?v=XyoPcuzbys4>

Some resources on Covered Bonds can be accessed here –

Introduction to Covered Bonds by Vinod Kothari: http://vinodkothari.com/2015/01/introduction-to-covered-bonds-by-vinod-kothari/

The Name is Bond. Covered Bond. By Vinod Kothari: http://www.vinodkothari.com/wp-content/uploads/covered-bonds-article-by-vinod-kothari.pdf

NHB’s Working Paper on Covered Bonds: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf



Draft Credit Derivatives directions: Will they start a market stuck for 8 years?

Vinod Kothari (vinod@vinodkothari.com) and Abhirup Ghosh (abhirup@vinodkothari.com)

Credit derivatives, an instrument that emerged around 1993–94 and then took the market by storm with volumes nearly doubling every half year, to fall off the cliff  during the Global Financial Crisis (GFC), have been a widely used instrument for pricing of credit risk of entities, instruments, and countries. Having earned ignoble epithet as “weapons of mass destruction” from Warren Buffet, they were perceived by many to be such. However, the notional outstanding volume of CDS contracts reached a volume of upwards of USD 9 trillion in June, 2020, the latest data currently available from BIS website.

In India, CDS has been talked about almost every committee or policy recommendation that went into promoting bond markets, and yet, CDSs have been a non-starter ever since the CDS guidelines were first issued in 2013. A credit derivative allows a synthetic trade in a credit asset, and is not merely a hedging device. One of the primary limitations with the 2013 guidelines was that the RBI had taken a very conservative stand and would permit CDS trades only for hedging purposes. The 2021 draft Directions seek to open the market up, on the realisation that much of the activity in the CDS market is not a hedge against what is on the balance sheet, but a synthetic trade on the movement in credit spreads, with no underlying position on the reference bonds or loans.

What is a CDS?

Credit derivatives are derivative contracts that seek to transfer defined credit risks in a credit product or bunch of credit products to the counterparty in the derivative contract. The counterparty to the derivative contract could either be a market participant, or could be the capital market through the process of securitization. The credit product might either be exposure inherent in a credit asset such as a loan, or might be generic credit risk such as bankruptcy risk of an entity. As the risks, and rewards commensurate with the risks, are transferred to the counterparty, the counterparty assumes the position of a virtual or synthetic holder of the credit asset.

The counterparty to a credit derivative product that acquires exposure (called the Protection Seller), from the one who passes on such exposure (called the Protection Buyer), is actually going long on the generalised credit risk of the reference entity, that is, the entity whose debt is being synthetically traded between the Protection Seller and Protection Buyer. The compensation (CDS premium) which the Protection Buyer pays and the Protection Seller receives, is based on the underlying probability of default, occurring during the tenure of the contract, and the expected compensation (settlement amount) that the Protection Seller may be called to pay if the underlying default (credit event) occurs. Thus, this derivative product allows the protection buyer to receive . Thus, the credit derivative trade allows the parties to express on view on (a) whether a credit event is likely to occur with reference to the reference entity during the tenure; and if yes, (b) what will be the depth of the insolvency, on which the compensation amount will depend. As a result, the contract allows people to trade in the credit risk of the entity, without having to trade in a credit asset such as a loan or a bond.

Credit default swaps (CDSs) are the major credit derivative product, which itself falls within the bunch of over-the-counter (OTC) derivatives, the others being interest rate derivatives, exchange rate derivatives, equity derivatives, commodity derivatives, etc.  There are, of course, other credit derivative products such as indices trades, basket trades, etc.

Structure of a plain vanilla CDS contract has been illustrated in the following figure:

Fame and shame

Credit derivatives’ claim to fame before the GFC, and shame thereafter, was not merely CDS trading. It was, in fact, synthetic CDOs and their more exotic variations. A synthetic CDO will bunch together several CDS contracts, create layers, and then trade those layers, mostly leaving the manager of the CDO with a fee income and an equity profit. While it could take years to ramp up a book of actual bonds or loans, a synthetic CDS book could be ramped in a matter of hours. In the benign market conditions before the GFC, there were not too many defaults, and therefore, synthetic CDOs and structured finance CDOs would be happily created and sold to investors, with happiness all over. However, since every synthetic CDO would, by definition, be a highly leveraged structure (the lowest tranche bearing the risk of the entire edifice), and multiple sequential layers of such leverage were built by structured finance CDOs, the entire edifice came crumbling during the GFC, as modeling assumptions based on good times of the past were no more true.

RBI hesitatingly allows CDS

The RBI developed cold feet looking at the mess in the global CDS market, and rightly so, and therefore, the RBI has never been bullish on unbridled CDS activity. Hence, the 2013 Guidelines were very guarded and limited permission – only for hedging purposes. Hedging was not something that the Indian bond market needed, as India mostly had highly rated bonds, and the bondholder earning fine spreads will not pay out of these spreads to shell out the risk of a highly rated, mostly held-to-maturity bond investment. Hence, the CDS market never took off.

Nearly every committee that talked about bond markets in India talked about the need to promote CDS. In August 2019[1], the FM announced several reforms that could boost economic growth. One of the proposals was that the MOF, in consultation with the RBI and SEBI will work on the regime for CDS so that it can play an important role in deepening the bond markets in India.

Latest move of the RBI

The Reserve Bank of India (“RBI”) in the Statement of Developmental and Regulatory Policies dated 4th December, 2020[2], expressed its desire to revise the regulatory framework for Credit Default Swaps as a measure to deepen the corporate bonds market, especially the ones issued by the lower rated issuers.

Subsequently, on 16th February, 2021[3], the RBI issued draft Reserve Bank of India (Credit Derivatives) Directions, 2021 (“Draft Directions” or “Proposed Directions”) to replace the Guidelines on Credit Default Swaps (CDS) for Corporate Bonds which was last revised on 7th January, 2013[4] (“2013 Guidelines”).

This write-up attempts to provide a detailed commentary on the Draft Directions, with references to the 2013 Guidelines as and where required, however, before that let us take a note of the key highlights of the proposed revised directions.

Highlights of the Draft Directions

  1. Participants in a CDS transaction:

The major participants in the proposed transactions:

    1. Market-makers: they are financial institutions
    2. Non-retail users: they can be protection buyers as well as protection sellers, and purpose of their engagement could be for hedging their risk or otherwise. An exhaustive list of the institutions has been laid down who can be classified as non-retail users
    3. Retail users: they can be protection buyers as well as protection sellers, however, the purpose of their engaged should be for hedging their risk only. A user who fails to qualify as non-retail user, by default becomes a retail user. Additionally, the Proposed Directions also allow non-retail users to reclassify themselves as retails users.

Persons resident in India are allowed to participate freely, however, persons resident outside India are allowed to participate as per the directions issued by the RBI, which are yet to be issued.

2. Only single-name CDS contracts are permitted:

The Proposed Directions allow single-name CDS contracts only, that is, the CDS contracts should have only one reference entity. Therefore, other forms of the CDS contracts like bucket or portfolio CDS contracts are not allowed.

3. Presence of a reference obligation:

Credit derivatives could either have a reference entity or a reference obligation. The Proposed Directions however envisages the presence of a reference obligation in a CDS contract. This is coming out clearly from the definition of the CDS states that the contract should provide that the protection seller should commit to compensate the other protection buyer for the loss in the value of an underlying debt instrument resulting from a credit event with respect to a reference entity, for a premium.

4. Eligible reference obligations:

The reference obligations include money market instruments like CPs, CDs, and NCDs with maturity upto 1-year, rated rupee denominated (listed and unlisted) corporate bonds, and unrated corporate bonds issued by infrastructure companies. In this regard, it is pertinent to note that the

5. Structured finance transactions:

Neither can credit derivatives be embedded in structured finance transactions like, synthetic securitisations, nor can structured finance instruments like, ABS, MBS, credit enhanced bonds, convertible bonds etc., be reference obligations for CDS contracts.

Commentary on some of the Key Provisions of the Draft Directions


The Proposed Directions will apply on all forms of the credit derivatives transactions irrespective of whether they are undertaken in the OTC markets and or on recognised stock exchanges in India.


5. Cash settlement:

Relevant extracts:

(i) Cash settlement of CDS means a settlement process in which the protection seller pays to the protection buyer, an amount equivalent to the loss in value of the reference obligation.

Our comments:

The Proposed Directions allow cash settlement of the CDS, where the protection seller pays only the actual loss in the reference obligation to the protection buyer. There are usually two ways of computing the settlement amount in case of cash settlement – first, based on the actual value of the loss arising from the reference obligation, and second, based on a fixed default rate which is agreed between the parties to the contract at its very inception.

To understand the second situation, let us take an example of a contract where the protection seller agrees to compensate the losses of the protection buyer arising from a reference obligation. Say, the seller agrees to compensate the buyer assuming a 10% default in the buyer’s exposure in a debt instrument on happening of a credit event. In this case, if the credit event happens, the seller will compensate the buyer assuming a 10% default rate, irrespective of the whether losses are more or less than 10%.

However, in the first case, settlement amount would work out based on the assessment of actual losses arising due to happening of the credit event.

Apparently, the definition of cash settlement seems to include only the first case, as it refers to an amount equivalent to the loss in value of the reference obligation.

6. Credit default swaps

Relevant extracts:

(iii) Credit Default Swap (CDS) means a credit derivative contract in which one counterparty (protection seller) commits to compensate the other counterparty (protection buyer) for the loss in the value of an underlying debt instrument resulting from 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.

Our comments:

CDS contracts can be drawn with reference to a particular entity or to a particular obligation of an entity. In the former case, the reference is on all the obligations of the reference entity, whereas in the latter case, the reference is on a particular debt obligation of the reference entity – which could be a loan or a bond.

However, the definition of CDS in the Proposed Directions states the contract should be structured in a manner where the protection seller commits to compensate the protection buyer for the loss in the value of an underlying debt instrument. Therefore, the exposure has to be taken on a particular debt obligation, and it cannot be generally on the reference entity.

 7. Credit event:

Relevant extracts:

(iv) Credit event means a pre-defined event related to a negative change/ deterioration in the credit worthiness of the reference entity underlying a credit derivative contract, which triggers a settlement under the contract.

Our comments:

In the simplest form of a credit derivative contract, credit event is a contingent event on happening of which the protection buyer could incur a credit loss, and for which it seeks protection from the protection seller. The definition used in the Proposed Directions is a very generalised one. As per ISDA, the three most credit events include –

  1. Filing for bankruptcy of the issuer of the debt instrument;
  2. Default in payment by the issuer;
  3. Restructuring of the terms of the debt instrument with an objective to extend a credit relief to the issuer, who is otherwise under a financial distress.

8.Deliverable obligation

Relevant extracts:

(v) Deliverable obligation means a debt instrument issued by the reference entity that the protection buyer can deliver to the protection seller in a physically settled CDS contract, in case of occurrence of a credit event. The deliverable obligation may or may not be the same as the reference obligation.

Our comments:

Refer discussion on physical settlement below.

In case of physical settlements, the question arises, what is the asset that protection buyers may deliver? As discussed under physical settlement, protection buyers may exactly hold the reference asset. A default on this asset would also imply a default on other parallel obligations of the obligor: therefore, market practices allow parallel assets to be delivered to protection sellers. Essentially, a protection buyer may select out of a range of obligations of the reference entity, and logically, will select the one that is the cheapest to deliver. To ensure that the asset delivered is not completely junk, certain filters are covered in the documents, and the deliverable asset must conform to those filters. In particular, these limitations are quite relevant when the reference entity has not really defaulted on its obligations, but only undergone a restructuring credit event.

9. Physical settlement

Relevant extracts:

(xv) Physical settlement of CDS means a settlement process in which the protection buyer transfers any of the eligible deliverable obligations to the protection seller against the receipt of notional/face value of the deliverable obligation.

Our comments:

We discussed earlier that one of the ways of settling a CDS contract is the cash settlement. The other way of settling a CDS contract is the physical settlement. In case of physical settlement, protection buyers physically deliver; that is, transfer an asset of the reference entity and get paid the par value of the delivered asset, limited, of course, to the notional value of the transaction. The concept of deliverable obligation in a credit derivative is critical, as the derivative is not necessarily connected with a particular loan or bond. Being a transaction linked with generic default risk, protection buyers may deliver any of the defaulted obligations of the reference entity.

In case of physical settlement, there is a transfer of the deliverable reference obligation to protection sellers upon events of default, and thereafter, the recovery of the defaulted asset is done by protection sellers, with the hope that they might be able to cover some of their losses if the recovered amount exceeds the market value as might have been estimated in the case of a cash settlement. This expectation is quite logical since the quotes in case of cash settlement are made by potential buyers of defaulted assets, who also hope to make a profit in buying the defaulted asset. Physical settlement is more common where the counterparty is a bank or financial intermediary who can hold and take the defaulted asset through the bankruptcy process, or resolve the defaulted asset.

10. Reference entity:

Relevant extracts:

(xvi) Reference entity means a legal entity, against whose credit risk, a credit derivative contract is entered into.

Our comments:

As may be noted later on in the writeup, reference entity in the context of the Proposed Directions refers to a legal entity resident in India.

11. Reference obligation

Relevant extracts:

(xvii) Reference obligation means a debt instrument issued by the reference entity and specified in a CDS contract for the purpose of valuation of the contract and for determining the cash settlement value or the deliverable obligation in case of occurrence of a credit event.

Our comments:

Reference obligation is the underlying debt instrument, based on which the contract is drawn. In practice, this obligation could be loan, or a bond of the obligor. However, the Proposed Directions refer to certain money market instruments and corporate bonds. Discussed later.

12. Single-name CDS

Relevant extracts:

(xix) Single-name CDS means a CDS contract in which the underlying is a single reference entity.

Our comments:

Usually, CDS could be created with reference to either a single obligation, or obligations from a single reference entity, or a portfolio of obligations arising from different reference entities. The Proposed Directions completely rules out portfolio derivatives, and allows CDS contracts with reference to a single entity only.

Eligible participants

Relevant extracts:

  1. Eligible participants

The following persons shall be eligible to participate in credit derivatives market:

(i) A person resident in India;

(ii) A non-resident, to the extent specified in these Directions.

Our comments:

Any person resident in India is eligible to participate in the credit derivatives market. Even retail investors have been allowed to be a part of this, however, restrictions have been imposed on specific classes of users concerning the purpose of their participation.

Non-resident users, like FPIs, have also been allowed to participate on a restricted basis, however, specifics of their limitations will come by way of specific directions which will be issued by the RBI in due course.

Permitted products

  1. Permitted products in OTC market

(i) Market-makers and users may undertake transactions in single-name CDS contracts.

(ii) Market-makers and users shall not deal in any structured financial product with a credit derivative as one of the components or as an underlying.

As already discussed earlier, only single-name CDS contracts are allowed, bucket or portfolio CDS contracts are not permitted. One of the reasons for this could be that RBI might like to test the market before allowing the users to write contracts on exposures on multiple obligors.

Clause (ii) prohibits the use of credit derivatives in the structure finance products. Synthetic securitisation is one of the products that use embeds a credit default swap in the securitisation transaction. Presently, the Securitisation Guidelines[5] has put a bar on synthetic securitisation, in fact, the draft Guidelines on Securitisation, issued by the RBI in 2019[6], also retained the bar on synthetic securitisation.

Vinod Kothari, in his article Securitisation – Should  India be moving to the next stage of development?[7], stated:

It is notable that a synthetic securitisation uses CDS to shift a tranched risk of a pool of assets into the capital markets by embedding the same into securities, without giving any funding to the originator. Synthetic structures are intended mainly at capital relief, both economic capital as well as regulatory capital.

Synthetic securitisation may come in handy for Indian banks to gain capital relief. Synthetic securitisation structures are seen by many to have made a comeback after the GFC. In fact, the European Banking Authority has launched a consultation process for laying down a STS framework for synthetic securitisations as well[8]. A Discussion Paper of EBA says: “The 2008 financial crisis marked a crash of the securitisation market, after which, also due to stigma attached to the synthetic segment, the securitisation market has gradually emerged in particular in the traditional (and retained) form. With respect to synthetic securitisation following a few years of subdued issuance, the synthetic market has been recovering in the recent years, with both the number and volume of transactions steadily increasing. Based on the data collection conducted by IACPM, altogether 244 balance sheet synthetic securitisations have been issued since 2008 up until end 2018. In 2018, 49 transactions have been initiated with a total volume of 105 billion EUR.”[9]

In the USA as well, credit risk transfer structure has been used by Freddie Mac and Fannie Mae vide instruments labelled as Structured Agency Credit Risk (STACR) and Connecticut Avenue Securities™ (CAS) bonds. Reportedly, the total volume of risk transferred using these instruments, for traditional single family dwelling units, has crossed USD 2.77 trillion by end of 2018[10].

There may be merit in introducing balance sheet synthetic securitisations by banks and NBFCs. To begin with, high quality portfolios of home loans, consumer loans or other diversified retail pools may be the reference pools for these transactions. Gradually, as the market matures, further asset classes such as corporate loans may be tried.

Synthetic securitisations were frowned upon by financial regulators across the globe after the GFC, however, as may have been noticed in the extracts quoted above, several developed jurisdictions now allow synthetic securitisation, with the required level of precautions added to the regulatory framework dealing with it.

Reference entities and obligations for CDS

Relevant extracts:

  1. Reference Entities and Obligations for CDS

(i) The reference entity in a CDS contract shall be a resident legal entity who is eligible to issue any of the debt instruments mentioned under paragraph 5(ii).

(ii) The following debt instruments shall be eligible to be a reference / deliverable obligation in a CDS contract:

  1. Commercial Papers, Certificates of Deposit and Non-Convertible Debentures of original maturity upto one year;
  2. Rated INR corporate bonds (listed and unlisted); and
  3. Unrated INR bonds issued by the Special Purpose Vehicles set up by infrastructure companies.

(iii) The reference/deliverable obligations shall be in dematerialised form only.

(iv) Asset-backed securities/mortgage-backed securities and structured obligations such as credit enhanced/guaranteed bonds, convertible bonds, bonds with call/put options etc. shall not be permitted as reference and deliverable obligations.

Our comments:

As per Clause 5(i), only resident legal entities can be reference entities for the purpose of CDS contracts, however, the Proposed Directions are silent on the meaning of the term resident legal entity. One could argue that entities which are registered in India should be treated as resident legal entities, however, a clarification in this regard shall remove the ambiguities.

Clause (ii) allows the use of the following instruments as a reference obligations:

  1. Money market instruments like CPs, CDs and short-term NCDs
  2. Rated Rupee-denominated corporate bonds, both listed and unlisted
  3. Unrated rupee-denominated corporated bonds issued by infrastructure companies.

The 2013 Guidelines also provided for similar set of instruments. However, it is pertinent to note that the Proposed Directions provide for an express bar on usage of the following structured products as reference obligations:

  1. Asset backed securities
  2. Mortgage backed securities
  3. Credit enhanced or guranateed bonds
  4. Convertible bonds
  5. Bonds with embedded call/ put options

Loans continue to be ineligible for use as reference obligation.

Market makers and users

Relevant extracts:

6.1 Market-makers

(i) The following entities shall be eligible to act as market-makers in credit derivatives:

  1. Scheduled Commercial Banks (SCBs), except Small Finance Banks, Payment Banks, Local Area Banks and Regional Rural Banks;
  2. Non-Bank Financial Companies (NBFCs), including Housing Finance Companies (HFCs), with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet and subject to specific approval of the Department of Regulation (DoR), Reserve Bank.
  3. Standalone Primary Dealers (SPDs) with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet and subject to specific approval of the Department of Regulation (DoR), Reserve Bank.
  4. Exim Bank, National Bank of Agriculture and Rural Development (NABARD), National Housing Bank (NHB) and Small Industries Development Bank of India (SIDBI).

(ii) In case the net owned funds of an NBFC, an HFC or an SPD as per the latest audited balance sheet fall below the aforesaid threshold subsequent to the receipt of approval for acting as a market-maker, it shall cease to act as a market-maker. The NBFC, HFC or SPD shall continue to meet all its obligations under existing contracts till the maturity of such contracts.

(iii) Market-makers shall be allowed to buy protection without having the underlying debt instrument.

(iv) At least one of the parties to a CDS transaction shall be a market-maker or a central counter party authorised by the Reserve Bank as an approved counterparty for CDS transactions.

Our comments:

When compared to the 2013 Guidelines, the only addition to list of entities that are eligible to act as market makers is housing finance companies. The net-worth requirements for NBFCs and SPDs remain the same as that under 2013 Guidelines. However, here it is pertinent to note that while the banks are not required to obtain any specific approval from the RBI, NBFCs and SPDs will have to obtain specific approval from the Department of Regulation. The RBI may reconsider this position and remove the requirement of obtaining special approval for the NBFCs and SPDs and put them in a level playing field with the banks.

Relevant extracts:

6.2 User Classification Framework

(i) For the purpose of offering credit derivative contracts to a user, market-maker shall classify the user either as a retail user or as a non-retail user.

(ii) The following users shall be eligible to be classified as non-retail users:

  1. Insurance Companies regulated by Insurance Regulatory and Development Authority of India (IRDAI);
  2. Pension Funds regulated by Pension Fund Regulatory and Development Authority (PFRDA);
  3. Mutual Funds regulated by Securities and Exchange Board of India (SEBI);
  4. Alternate Investment Funds regulated by Securities and Exchange Board of India (SEBI);
  5. SPDs with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet;
  6. NBFCs, including HFCs, with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet;
  7. Resident companies with a minimum net worth of ₹500 crore as per the latest audited balance sheet; and
  8. Foreign Portfolio Investors (FPIs) registered with SEBI.

(iii) Any user who is not eligible to be classified as a non-retail user shall be classified as a retail user.

(iv) Any user who is otherwise eligible to be classified as a non-retail user shall have the option to get classified as a retail user.

(v) Retail users shall be allowed to undertake transactions in permitted credit derivatives for hedging their underlying credit risk.

(vi) Non-retail users shall be allowed to undertake transactions in credit derivatives for both hedging and other purposes.

Our comments:

As brought out earlier under the highlights section, there can be two types of users – non retail and retail users. Financial institutions, resident corporates with networth of Rs. 500 crores or above, and FPIs can become non-retail users. The non-retail users can participate in these contracts either for hedging their credit risk or any other purposes.

On the other hand, anyone who is not eligible to become a non-retail user, by default becomes a retail user. Additionally, non-retail users have been given an option to reclassify themselves as retail issuers should they want. Retail users are allowed to undertake these transactions only for the hedging their credit risk.

The provisions under the Proposed Directions differ significantly from that under the 2013 Guidelines which allowed only financial institutions and FIIs to participate as users. Further, neither did the Guidelines differentiate between retail and non-retail users, nor did it allow the use of CDS for other than hedging purposes.

The classification between retail and non retail users is welcome move where they have not put any restriction on the more serious non-retail users, who can use these even for speculative purposes, apart from hedging. This could increase the liquidity of the instruments, therefore, deepening the market.

Operations and standardisations

Relevant extracts:

7.1 Buying, Unwinding and Settlement

(i) Market-makers and users shall not enter into CDS transactions if the counterparty is a related party or where the reference entity is a related party to either of the contracting parties.

(ii) Market-makers and users shall not buy/sell protection on reference entities if there are regulatory restrictions on assuming similar exposures in the cash market or in violation of any other regulatory restriction, as may be applicable.

(iii) Market-makers shall ensure that all CDS transactions by retail users are undertaken for the purpose of hedging i.e. the retail users buying protection:

  1. shall have exposure to any of the debt instruments mentioned under paragraph 5(ii) and issued by the reference entity;
  2. shall not buy CDS for amounts higher than the face value of the underlying debt instrument held by them; and
  3. shall not buy CDS with tenor later than the maturity of the underlying debt instrument held by them or the standard CDS maturity date immediately after the maturity of the underlying debt instrument.

To ensure this, market-makers may call for any relevant information/documents from the retail user, who, in turn, shall be obliged to provide such information.

(iv) Retail users shall exit their CDS position within one month from the date they cease to have underlying exposure.

(v) Market participants can exit their CDS contract by unwinding the contract with the original counterparty or assigning the contract to any other eligible market participant.

(vi) Market participants shall settle CDS contracts bilaterally or through any clearing arrangement approved by the Reserve Bank.

(vii) CDS contracts shall be denominated and settled in Indian Rupees.

(viii) CDS contracts can be cash settled or physically settled. However, CDS contracts involving retail users shall be mandatorily physically settled.

(ix) The reference price for cash settlement shall be determined in accordance with the procedure determined by the Credit Derivatives Determinations Committee or auction conducted by the Credit Derivatives Determinations Committee, as specified under paragraph 8 of these Directions.

Our comments:

The Proposed Directions imposes restrictions on the users to enter into contracts involving their related parties.

Further, as noted earlier, contracts entered into by the retail users must be for the purpose of the hedging credit risks only, in addition to it there are some other restrictions with respect to the tenor and amount of the protection. However, the onus to ensure that these conditions are met with have been imposed on the market makers. This leads to an additional compliance on the part of the market makers.

In terms of settlement, the Proposed Directions allow both cash and physical settlement, however, for retail users only physical settlement is allowed.

Further, the Proposed Directions also provide for the manner of exiting a CDS contract. In practice, there are three ways of settling a credit derivative contract – first, by settlement in cash or physically, second, by entering into a matching contract with a third party, therefore knocking off the contract in the hands of the protection buyer, and third, by assigning the contract to third parties. The Proposed Directions allow all of these.

Relevant extracts:

7.2 Standardisation

(i) Fixed Income Money Market and Derivatives Association of India (FIMMDA), in consultation with market participants and based on international best practices, shall devise standard master agreement/s for the Indian CDS market which shall, inter-alia, include credit event definitions and settlement procedures.

(ii) FIMMDA shall, at the minimum, publish the following trading conventions for CDS contracts:

  1. Standard maturity and premium payment dates;
  2. Standard premiums;
  3. Upfront fee calculation methodology;
  4. Accrual payment for full first premium;
  5. Quoting conventions; and
  6. Lookback period for credit events.

Our comments:

FIMMDA has been authorised to standardise the documents, and conventions for CDS contracts. World-over standard CDS products are prevalent with standard maturity dates, coupon payments, rates. Standardisation of key terms of a credit derivative contract transform the product from bespoke bilateral transactions to standard marketable products.

Some of the prevalent conventions used internationally are the Standard North Amercian Corporate Convention (SNAC) or the Standard European Corporate (SEC) Convention. The aim of both these conventions is to standardize the trading mechanics of credit default swaps (the SNAC for North American corporate names and the SEC for European corporate names) and facilitate trading through a central clearing counterparty, as well as to reduce uncertainty associated with credit events. This is because in order to make trades completely fungible (i.e., so they have the quality of being capable of exchange or interchange), all trading conventions have to be fully standardized.

Both the conventions have the following trading mechanics:

  1. They have a fixed coupon and an upfront fee.
  2. The first coupon of a CDS accumulates from the date of the last coupon, regardless of the trade date.
  3. The quoted spread for a given maturity is assumed to be a flat spread, rather than representing a point in the term structure.

References from the aforesaid conventions could be drawn while standardisation of the CDS conventions for the Indian market.

Prudential norms, accounting and capital requirements

Relevant extracts:

  1. Prudential norms, accounting and capital requirements

Market participants shall follow the applicable prudential norms and capital adequacy requirements for credit derivatives issued by their respective regulators. Credit derivative transactions shall be accounted for as per the applicable accounting standards prescribed by The Institute of Chartered Accountants of India (ICAI) or other standard setting organisations or as specified by the respective regulators of participants.

Our comments:

The market participants shall have to follow prudential norms and capital adequacy requirements for credit derivatives issued by the sectoral regulators. For NBFCs, for credit protection purchased, for corporate bonds held in current category – capital charge has to be maintained on 20% of the exposure, whereas for corporate bonds held in permanent category, and where there is no mismatch between the hedged bond and the CDS, full capital protection is allowed. The exposure shall stand replaced by exposure on the protection seller, and attract risk weights at 100%.

Similar provisions apply for banks, however, for bonds held in the permanent category, where there is no mismatch between the hedged bonds and CDS, the capital charge on the corporate bonds is nil, whereas, the capital charge on the exposure on protection sellers is maintained at 20% risk weight.

In terms of accounting, for NBFCs and HFCs, Ind AS 109 will have to be followed. Banks however will have to rely on ICAI’s Guidance Notes, if any, to do the accounting.

Our other resources on the topic:

  1. Our dedicated page on Credit Derivatives: http://vinodkothari.com/cdhome/
  2. Our articles on Credit Derivatives: http://vinodkothari.com/creart/
  3. Our book, Credit Derivatives & Structured Credit Trading, by Vinod Kothari – http://vinodkothari.com/crebook/

[1] https://static.pib.gov.in/WriteReadData/userfiles/ASss%2023%20August.pdf

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50748

[3] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=51138

[4] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=7793&Mode=0

[5] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/C170RG21082012.pdf


[7] http://vinodkothari.com/2020/01/securitisation-india-and-global/

[8] https://eba.europa.eu/eba-consults-on-its-proposals-to-create-a-sts-framework-for-synthetic-securitisation

[9] https://eba.europa.eu/file/113260/download?token=RpXCSVe2,

[10] Based on https://www.fhfa.gov/AboutUs/Reports/ReportDocuments/CRT-Progress-Report-4Q18.pdf

Investment window for FPIs widened

Permitting FPIs to invest in defaulted debt securities


-Aanchal Kaur Nagpal (aanchal@vinodkothari.com)


While the Indian equity market has consistently shown a rigorous growth, the bond market in India has mostly been relatively lagging behind. The size and performance of the Indian bond market has been quite inappreciable as compared to the developed economies in the world. The COVID-19 pandemic further caused a turmoil in the market. Among the investor class, Foreign Portfolio Investors (FPI) are a major participant in the debt market contributing to approximately 10% of the total debt investment.

Source: CRISIL Yearbook on Indian Debt Market, 2018

Further, as depicted below, the investments by FPIs in debt market has not been a consistent or a straight line and has seen more downward trend than upward.

Source: NSDL

As on February 5, 2021, foreign investment in corporate bonds has only reached 25% of the total available limit[1]. Further, the proportion of FPI investment as a part of the total foreign investment in India, is constrained by various investment limits and regulatory requirements.

FPIs are allowed to invest in eligible government securities and eligible corporate bonds. In case of corporate bonds, the following restrictions are imposed –

  • Restriction on short term investment in corporate bonds

FPIs are not permitted to make short term investments of more than 20% of their total investment in corporate bonds. The above cap was increased from 20% to 30% of the total investment of the FPI providing more flexibility to FPIs in making investment decisions.

  • Issue limit

Investment by any FPI, including related FPIs, cannot exceed 50% of any issue of a corporate bond. In case an FPI, including related FPIs breaches the same and invests in more than 50% of any single issue, it cannot make further investments in that issue until the condition is met.

  • Minimum residual maturity

FPIs can only invest in corporate bonds with a minimum residual maturity of 1 years, subject to the condition that short-term investments limit in corporate bonds.

Exempted Securities –

However, there are certain securities that are exempt from the above restrictions –

  • Debt instruments issued by ARCs; and
  • Debt instruments issued by an entity under the CIRP as per the resolution plan approved by the NCLT under the Insolvency and Bankruptcy Code, 2016.

The aforesaid exemption was introduced with the intent to further widen the scope of investment by FPIs. It not only allowed FPIs to make short term investments in the above debt instruments without any limit but also bring in more options for FPIs to invest without having to consider the single/group investor-wise limits

FPIs are allowed to invest in security receipts issued by ARCs to address the NPA issue of financial institutions. Further, debt instruments issued by a corporate debtor under CIRP have also been made eligible for FPI investment. This was done with the intent to revive corporate debtors under a resolution plan. Thus, RBI has allowed FPIs to invest in such securities that are in dire need of investment, while granting various exemptions to make them more attractive.

Power of RBI to permit debt instruments or securities for FPI investment

As per SEBI (Foreign Portfolio Investors) Regulations, 2019, amongst other eligible debt instruments, FPIs are allowed to invest in any debt securities or other instruments as permitted by RBI [Regulation 20(1) (g)].

Thus, RBI has the power to prescribe eligible debt securities for FPI investment.

Foreign Portfolio Investors (FPIs) Investment in Defaulted Bonds

As discussed, investment by FPIs in debt instruments issued by ARCs or an entity under the CIRP, are exempted from the short-term limit and minimum residual maturity requirement. In order to further promote investment by FPIs in corporate bonds, RBI, in its Statement on Developmental and Regulatory Policies dated 5th February, 2021[2], has proposed to extend similar exemptions to defaulted corporate bonds. Accordingly, FPI investment in defaulted corporate bonds are proposed to be exempted from the short-term limit and the minimum residual maturity requirement. For this purpose, detailed guidelines will be issued separately by RBI.

Defaulted debt securities refer to ‘non-payment of interest or principal amount in full on the pre-agreed date and shall be recognized at the first instance of delay in servicing of any interest or principal on such debt.

At present, FPIs are permitted to invest in defaulted debt securities only against repayment of amortising bonds. Now, RBI is intending to permit FPIs to invest in defaulted corporate bonds as fresh issues as well and in all other cases as well.

Existing provision on FPI investment in corporate bonds under default –

Investments by FPIs in corporate bonds under default [Para 15 of Operating Guidelines for FPIs[3]]

  1. FPIs are permitted to acquire NCDs/bonds, which are under default, either fully or partly, in the repayment of principal on maturity or principal instalment in the case of an amortising bond.
  2. FPIs will be guided by RBI’s definition of an amortising bond in this regard.
  • The revised maturity period for such NCDs/bonds restructured based on negotiations with the issuing Indian company, should be as per the norms prescribed by RBI from time to time, for FPI investments in Corporate Debt.
  1. The FPIs shall disclose to the Debenture Trustees, the terms of their offer to the existing debenture holders/beneficial owners of such NCDs/bonds under default, from whom they propose to acquire.
  2. All investments by FPIs in such bonds shall be reckoned against the prevalent corporate debt limit. All other terms and conditions pertaining to FPI investments in corporate debt securities shall continue to apply.

SEBI also issued an operational framework[4] for transactions in defaulted debt securities post redemption date along with obligations of Issuers, Debenture Trustees, Depositories and Stock Exchanges while permitting such transaction

However, the motive for FPIs for investing in such defaulted corporate bonds is still to be understood. Since defaulted debt securities refer to securities even with one-time defaults, corporate bonds with favourable future prospects or where the security against such bonds is sufficient and promising, may attract FPI investments. RBI’s intent behind this move is to deepen the financial market, bring better liquidity in defaulted debt securities and also provide an additional investment opportunity to FPIs. The detailed guidelines are awaited to be issued by RBI.


[1] Source: NSDL- https://www.fpi.nsdl.co.in/web/Reports/ReportDetail.aspx?RepID=1

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=51078



Our articles on related topics-

Market-Linked Debentures – Real or Illusory?

Aanchal Kaur Nagpal and Shreya Masalia

Vinod Kothari and Company | corplaw@vinodkothari.com  


Market linked debentures (MLDs) are a type of debt security that provides returns based on the performance of an underlying index/security. When the underlying security does well, the return on MLDs will be high and vice-versa. While the underlying security to which the MLDs are linked is at the discretion of the issuer, the same, however, needs to be related to the market, e.g. indices such as Nifty 50, SENSEX etc., or securities like equity, debt securities, government securities etc. For an in-depth understanding of the concept and the regulatory framework of MLDs, read our article here.

The previous article touched upon the concern of MLDs being used for the purpose of regulatory arbitrage, without being truly market-linked. The regulatory arbitrage may come in the form of additional ISINs, exemption from EBP mechanism, etc. The same has been discussed in detail in the previous article.

In this article, we shall examine various case studies (picked from various information memorandum available on the stock exchange and websites of companies) to prove the point.

The case studies are tabulated below:

S. No. Underlying The basis for coupon payoff Likely/unlikely conditions
1. NIFTY 50 If final fixing level > 25% of initial level, coupon – 8.1767% (XIRR 8.000%)

Initial level (NIFTY 50) index = 11400
25% of initial level (NIFTY 50) = 2850

So, if the final fixing level is above a value of 2850, then coupon pay off will be 8%.
If the final fixing level is below 2850, the coupon will be 0%.

Conclusion –

This condition is highly unlikely to happen. Looking at past trends, the probability that NIFTY 50 would fall below the level of 2850 is very low.

2. NIFTY 50 If Final >= Initial, Principal Amount * 20.50%
If Final < Initial, Principal Amount * 19.65%
This is a likely condition. However, in all cases, the investor is going to receive coupon payoff, even if the underlying performs negatively, there is a payoff.The level of rise in Nifty is not related to the return that the investor will receive. i.e. if the initial level is 10,000 and nifty either rises to 20,000 or 10, 200, the return will be the same.

Difference between coupon payoffs in both the scenarios i.e. whether the underlying performs or not is less than 1%.

3. G-sec The initial fixing level is 105.94 (which is the price of G-sec on the initial fixing date)

If the final fixing level is >=79.455 – then the coupon will be 8%
If the final fixing level is <79.455 but >= 26.485 then the coupon will be 7.95%
If the final fixing level is <26.485 then the coupon will be 0%.


Conclusion –

The downside condition is highly unlikely to happen. The probability that the price of the G-sec on the final fixing date will fall below 26.485 from a level of 105.94 is very low. In fact, on the final fixing date, the price of the G-sec was 108.17 which is higher than the initial fixing level.

4. NIFTY 50 Initial level – an average of 6 observations
Final level – an average of 6 observations
Nifty performance- final level/initial level – 1
Fixed coupon- 26.70%
Participation rate (variable component)- 85%Coupon payoff –
If Final Level >= Initial Level, Principal + Max Fixed-Coupon, Participation rate * Nifty Performance)
Else, If Final Level < Initial Level; Principal + Fixed-Coupon.
Conclusion –

This is a likely condition. Here the coupon payoff is a combination of the fixed and variable part (Directly depending on the performance of nifty)
Even if the underlying performs negatively, the investor will still earn the fixed component along with the principal.

5. NIFTY 50 If Final Fixing Level <= 25% of Initial Fixing Level: 0.000%
If Final Fixing Level > 25% of Initial Fixing Level: 7.4273% p.a.
(XIRR 6.95% p.a.)Suppose,
Initial level (NIFTY 50) index = 9106.25
25% of initial level (NIFTY 50) = 2276.56

So, if the final fixing level is above a value of 2276.56, then coupon pay off will be 6.95%.
If the final fixing level is below 2276.56, the coupon will be 0%.

Conclusion –

This condition is highly unlikely to happen. Looking at past trends, the probability that NIFTY 50 would fall below the level of 2376.56 is very low.

6. G-sec If Final Fixing Level >=25% of the Initial Fixing level, then coupon+ principal
If Final Fixing Level < 25% of the Initial Fixing level, then only principal.
Conclusion –

This condition is highly unlikely to happen. Looking at past trends, the probability that G-sec would fall below 25% of the initial level is low.

7. 10-year G-sec Underlying performance- Final level/ Initial level * 100
Coupon payoff-
If UP >= 75% of initial level- 8.45%
If UP < 75% but >= 25% of initial level, then 8.40%
If UP < 25%, then 0.
This condition is highly unlikely to happen. Looking at past trends, the probability that G-sec would fall below 25% of the initial level is low.
Also, the difference between the two coupon rates is 0.5%
8. NIFTY 50 Reference Index-Linked Return=
Debenture Face Value* Reference Index Return FactorFactor = Max [0%, 115%* {(Observation Value of the Reference Index / Start Reference Index Value) – 100%}]

115% is the participation rate

Observation Value of the Reference Index shall Mean Closing Value of CNX Nifty on the scheduled valuation date for redemption.

This condition is likely to happen- since the return is directly dependent on the performance of the index.Here, the value of Nifty for example is 5700, if nifty falls below 5700, there will be 0% pay off, if nifty rises above 5700, then the payoff would be 115% of the performance of NIFTY,

For example, if Nifty is 5700 and it rises to 6000- rise is 5%- coupon payoff shall be 115% of 5% = 6.05%.

9. G-sec If the performance of underlying final fixing date –

greater than 50% of digital level : Coupon= 8.6819 p.a.
less than or equal to 50% of digital level: Coupon = 0%

*Digital level: 100% of the Closing price of the reference security, of 7.17 G-Sec 2028 as on Initial Fixing Date.

The condition is unlikely to happen.
E.g. The Value of G-sec on the initial date is 97. 72- The chances that the same will fall below 48.86 is very low.
10. NIFTY 50 If Final Fixing Level <= 25% of Initial Fixing Level: 0.000%
If Final Fixing Level > 25% of Initial Fixing Level: 8.70% p.a. (XIRR 8.35% p.a.)Suppose,
Initial level (NIFTY 50) index = 9106.25
25% of initial level (NIFTY 50) = 2276.56

So, if the final fixing level is above a value of 2276.56, then coupon pay off will be 6.95%.
If the final fixing level is below 2276.56, the coupon will be 0%.

Conclusion –

This condition is highly unlikely to happen. Looking at past trends, the probability that Nifty 50 would fall below the level of 2376.56 is very low.

Further, put option is given- participation rate is lower i.e. 65%.

11. NIFTY 50 Coupon amount –

A) If Final > 140% of Initial, then coupon rate =Performance% of the initial principal amount
B) If Final <= 140% of Initial, then coupon rate = 40% of the initial principal amount.

Conclusion –

This condition is highly unlikely to happen as the possibility of Nifty falling to 40% is rare.

12. NIFTY 50 Coupon = Max(Underlying Performance, Min(48.85%,Max(4.885*Underlying
Performance,0)))Underlying performance – (Final Fixing Level / Initial Fixing Level) – 1
Conclusion –

The condition is likely to happen.
Here, if the initial level is 11404.80 and Nifty is below 11404.80 (negative or 0% performance), then the coupon rate is 0%.
Here, if the Nifty rises above 11404.80 till 12431.23 (up to 9% rise), then the coupon rate shall be as per the formula.
If Nifty rises above 12545.28 till 16977.19 (above 9% up to 48.86% rise), then coupon shall be 48.86%)
If Nifty rises above 16993.15 (above 48.86% rise), then the coupon shall be equal to the underlying performance.

13. G-sec If Final Fixing Level <= 25% of Initial Fixing Level: 0.000%
If Final Fixing Level > 25% of Initial Fixing Level: 6.80% p.a.Suppose,
The initial level of g-sec is 100
25% of initial level (G Sec) = 25
So, if the final fixing level is above a value of 25 then the coupon payoff will be 6.80%.
If the final fixing level is below 25, the coupon will be 0%.
Conclusion –

The condition is highly unlikely. Looking at past trends, the probability that g-sec will fall to 25% is very low.

14. Nifty 10 YR Benchmark G-Sec (Clean Price) index 100% of Principal Amount * (Coupon A + Coupon B) Where,

“Coupon A” shall mean:
A) If Final Level >= 30% of Initial Level (i.e. 0.30 * Initial Level),
Coupon shall mean Rebate i.e. 21%


B) If Final Level < 30% of Initial Level (i.e. 0.30 * Initial Level),
Coupon shall be Nil

“Coupon B” shall mean:

(1 + Coupon A) * 10.50% * (Day-Count/365)

The initial level of g-sec is 925
30% of initial level (G Sec) = 277.5

So, if the final fixing level is above a value of 277.5 then coupon pay off will be 21%.
If the final fixing level is below 25, the coupon will be 0%.

Conclusion –

The condition is highly unlikely. Looking at past trends, the probability that g-sec will fall to 30% is very low.

15. NIFTY 50 If Final Fixing Level >=25% of the Initial Fixing level = 36.405%
If Final Fixing Level < 25% of the Initial Fixing level = 0%Suppose,
Initial level 10710.45
final below 2677.61 only then will the coupon be 0%.
Conclusion –

The condition is highly unlikely. Looking at past trends, the probability that Nifty 50 will fall to 25% is very low.

16. CNX Nifty Here, the entry NIFTY is calculated as average for 3 dates in 3 months.

For the final level- NIFTY on 11 observation dates is calculated.

Increases have been divided into levels – and for each level, there is a percentage for coupon rate.

The highest coupon rate out of all the 11 levels will be taken for the final coupon rate.

The minimum level is 115% of the entry Nifty.

Below that- no level and no coupon.

Conclusion –
The coupon is based on the performance of Nifty and hence is likely to happen.
17. 10 year Government security price (a) if IGB 5.79 05/11/30 Corp Price => 75% of *Digital Level the Coupon rate shall be at 11% p.a. (Maximum)

b) if IGB 5.79 05/11/30 Corp Price is less than 75% but equal to or greater than 25% of *Digital Level the Coupon rate shall be at 10.95% p.a. (Minimum)

(c) if IGB 5.79 05/11/30 Corp Price < 25% of *Digital Level then no Coupon shall be

*Digital Level – 100% of IGB 5.79 11/05/2020 Corp price at Initial Observation Date.

Conclusion –

As such it’s highly unlikely to receive no coupon at all as the probability of the g-sec falling to 75% is negligible looking at the past trends. Even the probability of the G-sec value falling between 25 – 75 % is unusual, but even if it does, the difference is the coupon rate is merely that of .05% which is negligible.

18. CNX Nifty If Final Fixing Level >=25% of the Initial Fixing level = 32.143%
If Final Fixing Level < 25% of the Initial Fixing level = 0%Suppose,
The initial level is 10252.10
If the final level falls below 2563.03 then the coupon rate will 0 and above that coupon rate will be 9.25%.
Conclusion –

The condition is highly unlikely. Looking at past trends, the probability that Nifty 50 will fall to 25% is very low.

Analysis of the MLD market in India

On an analysis of the cases given above, one can clearly observe that the conditions on which the performance of the underlying is based, are highly unrealistic. An instance where the value of Nifty or a G-sec would fall by 50-75% seems quite impossible where even ‘The Great Depression of 2008’ caused a fall of only 40% in stock indices. Hence in almost all conditions, the investor will always be receiving a coupon and thus the hedging shown is more of a hoax. The MLDs are, thus, not market-linked at all thereby defeating the purpose of introducing MLDs. On lifting the veil of the underlying condition used, it reveals that the MLDs are in fact equivalent to plain vanilla debentures.


The true intent and spirit of introducing the concept of MLDs can be seen missing from a lot of the issuances by the companies. Instead, MLDs, are being issued, rather in some of the most farcical avatars, to gain regulatory arbitrage otherwise not available to plain vanilla debentures. This is indicative of what the market perceives as a bottleneck or a disadvantage, and what the market desires.

This, in itself, may call for a relook at the extant regulatory framework. Relaxations or exemptions should be considered where laws are not meeting the requisite purpose or are harsher than required, except where such relaxations become unconscionable or go against the basic tenets of policy-making.