SEBI Opens Doors for Mutual Funds to Trade in Credit Default Swaps
The Securities and Exchange Board of India (SEBI) has now permitted mutual funds to sell credit default swaps, in restricted circumstances, which would expand mutual funds’ role beyond mere buying of credit protection. Earlier, mutual funds were permitted to get ahead with their CDS transactions only as a buyer, using the swaps for hedging against such potential risks on corporate bonds in their portfolios is, only in the context of the fixed maturity plan schemes.
SEBI on 20 September relaxed mutual fund norms in a circular. The move is the sequel to the RBI, which in February 2022 brought amendments to expand the CDS market. Under the new dispensation, a much larger base of entities, including non-bank regulated entities such as mutual funds, can participate as sellers of credit protection. This was in keeping with suggestions from a Working Group, the Mutual Funds Advisory Committee (MFAC), and input from the Association of Mutual Funds in India (AMFI), as well as feedback received on a consultation paper on addressing this issue.
The circular noted that the mutual funds could now be offered more flexibility in terms of purchasing and selling CDS as long as they were able to adhere to proper risk management practices. Increased flexibility is thus a means to enhance options for mutual fund investments along with improving liquidity in the corporate bond market.
Under this circular, mutual funds are also allowed to sell CDS under several conditions:
1. Mutual fund schemes can sell CDS only as part of their investments in synthetic debt securities. It can do this by selling CDS on reference obligations backed by cash, government securities, or treasury bills. However, overnight and liquid schemes are barred from selling CDS contracts.
2. The notion of synthetic debt securities will be used in the calculations of single issuer, group issuer, and sectoral exposure limits. This notional amount depicts the exposure to the issuer, the group, and the sector of the underlying reference obligation.
3. Only investment grade rated or higher rated can be sold against the CDS.
4. The credit risk rating for the synthetic debt security shall be similar to that of the reference obligation. Additionally, in determining the liquidity risk, the liquidity risk value for the synthetic debt security would be the same as that of the reference obligation plus two.
5. The credit risk value of the PRC matrix should be the same as that of the reference obligation.
The new guidelines are likely to attract more investment opportunities to mutual funds and a pool of investment generally, thereby enhancing overall market liquidity.
