Sebi proposes steps to open credit default swap market for mutual funds

The Securities and Exchange Board of India (Sebi) is planning steps that will increase participation and allow greater flexibility for mutual funds (MFs) in the credit default swap (CDS) market.

These include proposals to allow MFs to participate as buyers and sellers in a wider range of schemes. The market regulator has sought comments on the proposals by July 1. 

CDS allows an investor to offset their credit risk with another investor, who is willing to reimburse or pay a notional amount in case the borrower or the issuer of the bond defaults.

It facilitates risk mitigation and investments in lower-rated corporate bonds. It also facilitates the swapping of the risk of default through a derivative contract and is akin to insurance.

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For instance, if an Entity A has corporate bonds of a company and enters CDS with Entity B, then in case of a default, Entity A will transfer these bonds to Entity B on receiving a notional amount.  

While Sebi had issued some guidelines nearly a decade back for MFs to participate only as protection buyers which meant they could use it only for hedging their credit risk, it did not pick up due to the limitations.

MFs were not permitted to sell protection which restricted them from entering short positions in CDS contracts.

In a consultation paper floated on Friday, the market regulator has tried to offer flexibility to these limitations.

“MF schemes may be permitted to sell CDS only as investors in synthetic debt securities, i.e., sell CDS on a reference obligation covered with Cash/G-Sec/T-bills. Overnight and Liquid schemes may not be permitted to sell CDS contracts,” said Sebi in a consultation paper floated on Friday.

Further, CDS buying may only be permitted for the purpose of hedging their credit risk on debt securities they hold in all schemes. Any naked exposure may not be allowed as it leads to speculative positions being held by MFs.

Sebi is also mulling to allow purchase CDS for below investment grade debt securities. It has also proposed several conditions such as a shorter timeline for squaring off a CDS position and exposure in terms of single-issuer limits.

On the anvil
 

Proposal to allow MF schemes to buy CDS only to hedge their credit risk on debt securities
 

May allow CDS buying for all schemes but overnight and liquid schemes excluded from CDS selling
 

7 days’ time limit to square off instead of a prior condition to keep liquidity in check
 

CDS is akin to insurance, helps in risk mitigation through a derivative contract