Reserve Bank of India said on Thursday that banks would be allowed to use credit derivatives to manage risks relating to lending, including buying protection on loans and investments, to reduce risk.

Banks would be barred from using these derivatives for trading and only domestic entities would be allowed to enter in credit risk contracts, RBI said in draft guidelines while seeking comments from the banks.

Banks, it said, could use two types of contracts -- Credit Default Swap and Credit Linked Note. CDS is a bilateral contract on one or more reference assets.

Under the CLN structure, the price of the note is linked to the performance of a reference asset, offering lenders a hedge against credit risk.

CLNs are generally issued by floating special purpose vehicle. But, when banks plan to issue CLN's directly, they would need to take prior approval of apex bank, it said.

Initially, banks will not be permitted to take long or short credit derivative positions. However, CLN can be held as investments in the trading book if the bank so desires, RBI said.

Banks would be required to disclose details on derivative transactions in the annual accounts, it said adding these disclosures would include kind of transactions, gains and losses -- realised/unrealised -- from various derivative deals.

RBI said, it proposes not to allow credit derivative transactions between related parties till the players gain experience and maturity.

Hence, banks would not be able to strike credit derivative contract with its subsidiaries, it said.