Sebi proposes to open credit default swap market for MF: key factors

Sebi has proposed to permit participation of mutual funds in CDS buying for all schemes as well as CDS selling for all schemes except overnight and liquid

The Securities and Exchange Board of India (SEBI) has proposed allowing mutual funds to buy and sell credit default swaps (CDS), marking a significant move to deepen the credit derivatives market in India. The proposal aims to enhance risk management tools available to fund managers and promote more liquid trading in the fixed income space.
 

“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.
 

What are credit default swaps?
 

A credit default swap is a financial instrument designed to mitigate the risk associated with bond investments. In a CDS contract, one party agrees to compensate the bond investor with a predetermined sum if the bond issuer defaults. In exchange, the investor pays a recurring premium. This mechanism functions similarly to an insurance policy, providing protection against potential losses due to default.
 

Key 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 will now be permitted to buy CDS from programmes rated by recognised credit rating agencies. This includes the ability to purchase CDS for both investment-grade and below-investment-grade debt securities. This move will allow mutual funds to hedge their debt securities more effectively, particularly for bonds with lower credit ratings.
 

Selling CDS: Mutual funds will be allowed to sell CDS schemes, provided they have the necessary cash, government securities, or treasury bills to back up the sale. However, this permission does not extend to overnight or liquid schemes. This new flexibility will enable mutual funds to manage their risk exposure more dynamically.
 

Exposure limits: The total CDS holdings, both bought and sold, should not surpass 10 per cent of a mutual fund's Assets under Management (AUM). This limit ensures that mutual funds do not overexpose themselves to CDS, maintaining a balanced risk profile.
 

Disclosure and valuation: Mutual funds will be required to make periodic disclosures of their CDS positions. The Association of Mutual Funds in India (AMFI) will issue detailed guidelines on valuation and accounting for 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. Additionally, they will be required 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. By allowing mutual funds to sell CDS, they will be able to better manage their risk exposure and optimise their portfolios. This increased flexibility will also enable them to offer more diversified investment products to their customers.