Sebi proposes to open credit default swap market for MF: Key factors
The Securities and Exchange Board of India (SEBI) has proposed to allow mutual funds to buy and sell credit default swaps (CDS), marking an important step to deepen the credit derivatives market in India. The proposal aims to improve the risk management tools available to fund managers and promote more liquid trading in the fixed income sector.
“MF schemes are only allowed to sell CDSs as investors in synthetic debt securities, i.e. sell CDSs on the basis of a reference obligation backed by cash/G-Sec/T-bills. Overnight and liquid schemes will not be allowed to sell CDS contracts,” Sebi said in a consultation paper released on Friday.
What are credit default swaps?
A credit default swap is a financial instrument designed to reduce the risk associated with investing in bonds. In a CDS contract, one party agrees to compensate the bond investor with a predetermined amount if the bond issuer defaults. In return, the investor pays a recurring premium. This mechanism works in the same way as an insurance policy and provides protection against possible losses due to default.
Main proposals
Sebi’s consultation paper outlines several key proposals aimed at increasing the flexibility of mutual funds in managing their risk exposure through CDS. Some of the significant changes include:
Buying CDS: Mutual funds are now allowed to buy CDS from programs rated by recognized credit rating agencies. This includes the ability to purchase CDSs for both investment-grade and under-investment-grade debt securities. The move will allow mutual funds to hedge their debt securities more effectively, especially for bonds with lower credit ratings.
Selling CDS: Mutual funds may sell CDS schemes provided they have the necessary cash, government bonds or treasury bills to support the sale. However, this permission does not apply to overnight or liquid arrangements. This new flexibility will enable investment funds to manage their risk exposure more dynamically.
Exposure limits: Total CDS positions, both bought and sold, may not exceed 10 percent of an investment fund’s assets under management (AUM). This limit ensures that investment funds do not overexpose themselves to CDS, thus maintaining a balanced risk profile.
Disclosure and valuation: investment funds will have to periodically provide information about their CDS positions. The Association of Mutual Funds in India (AMFI) will issue detailed guidelines on the valuation and accounting of these instruments.
Regulatory Compliance: Mutual funds will have to follow the norms set by the Reserve Bank of India (RBI) for buying and selling CDS. Moreover, they will be allowed to participate in CDS only through standard contracts prescribed by the Fixed Income Money Market and Derivatives Association of India (FIMMDA).
Impact on the industry
The proposed changes are expected to have a significant impact on the mutual fund industry. Allowing mutual funds to sell CDS will help them better manage their risk exposure and optimize their portfolios. This greater flexibility will also enable them to offer more diversified investment products to their clients.
First print: June 10, 2024 | 2:17 PM IST