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Sebi mulls fresh CDS play for MFs as it seeks to boost corporate bond mkts

Regulator sets up working group to spot lacunae in failed framework introduced over a decade ago

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File photo: PTI
Khushboo Tiwari Mumbai
3 min read Last Updated : Dec 28 2022 | 11:18 PM IST
The Securities and Exchange Board of India (Sebi) is mulling a fresh framework to allow mutual fund (MF) participation in credit default swaps (CDS), a move part of a series of actions planned by the regulator to develop the corporate bond market in the country.

The market regulator has formed a working group to identify lacunae in the framework introduced over a decade ago, which had failed to take off. The terms of reference of the committee include suggesting big-scale changes aimed at facilitating risk mitigation and investments in lower-rated corporate bonds, said people in the know.

In November 2012, Sebi had allowed MFs to participate in the CDS market but only as buyers. Also, the framework had conservative positional caps. Due to these and some other limitations, volumes in the CDS market did not pick up.

“The market regulator wants to deepen the domestic corporate bond market. Greater participation via CDS will help reduce risk and increase demand for bonds rated below AA that come with a credit-risk premium,” said a source.

Mutual funds were allowed to participate only as protection buyers, which means they could use the mechanism only to hedge their credit risk. They were not permitted to sell protection which restricted them from entering short positions in CDS contracts.

CDS allows an investor to offset its credit risk with another investor who is willing to reimburse in case the borrower or the issuer of the bond defaults. It facilitates swapping the risk of default through a derivative contract. Experts say equity as a class has a vibrant derivative market and a similar infrastructure is needed for corporate bonds.

Industry players believe a revised framework is key for the development of the market, but there will be several challenges.

“In the past, CDS volumes have been negligible for a variety of reasons vis a vis what would have been envisaged when the regulations were issued. For this market to thrive, we would need more counterparties on either side, and clarity and uniformity in valuations and settlement. The recent re-focus and announcements are encouraging in that respect,” said Amit Tripathi, CIO - Fixed Income Investments, Nippon India Mutual Fund.

Illustration: Binay Sinha
The relook at the CDS framework is being done at a time when alternate investment funds (AIFs) have been allowed to participate both as protection buyers and sellers. The decision was taken earlier this month.

“We need broader market participation from bankers, insurance companies, sovereign funds, PMS, and mutual funds. The focus of the regulator is to develop the ecosystem. In lack of a broad participation, depending only on AIFs and mutual funds may not help the CDS market to pick-up. Hopefully there will be a marketplace for entities to participate,” said Lakshmi Iyer, CEO-Investment Advisory, Kotak Investment Advisors.

According to sources, the banking regulator is also expected to come up with some framework for CDS over the next one month. Norms from other regulators will be crucial for the market to catch pace. Sources said Sebi's framework will be aligned on the changes prescribed by the RBI.

Industry experts are of the opinion that with Sebi approval, category II AIFs will see a larger participation in the CDS market. AIFs such as private equity funds or debt funds fall in this category.

Topics :SEBIMutual Fundscorporate bond marketMarket newsInvestment

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