SEBI Allowed Participation of AIFs in Credit Default Swap

Nikhil Mogha

30 May, 2024

The credit default swap is a financial derivative which allows the investor to offset or swap their credit risk with that of other investor. To swap the risk of default, the lender buys a credit default swap from other investors who agree to reimburse them if the borrower defaults. In simple terms, the CDS is a financial swap agreement indicating that the seller of CDs will compensate the buyer if there is any event of debt default or other credit events. It means the seller insures the buyer against any asset default. The Securities and Exchange Board of India undertakes the management of CDS in the securities market. Through an amendment in SEBI (AIF) Regulation 2012, the SEBI has allowed the AIFs to participate in the CDS as a protection buyer and seller. Regulations 16 (1) (aa), 18 (ab) and 20(11) of the Alternative Investment Fund (AIF) regulations further enable the AIFs to participate in CDS in terms of the conditions specified by the SEBI from time to time. The SEBI specifies one such list of conditions on 12^th January 2023. The present article will discuss the related conditions discussed under the guidelines.

Conditions Applicable on Category I, II and III AIFs for Buying CDS

The conditions applicable to category I, II and III AIFs for buying credit default swaps are:

1. The category I and II AIFs can buy CDS only for the purpose of hedging based on underlying investment in debt securities.
2. The category III AIF can buy CDS for the purpose of hedging or otherwise within the permissible leverage as mentioned in “Circular for operational, prudential and reporting requirements for Alternative Investment Funds “dated 29^th July 2013.

Conditions Applicable to Category II and III AIFs for Selling CDS

The conditions applicable to category II and III AIFs for selling credit default swaps are:

1. The category III AIF can sell CDS provided the effective leverage undertaken is well within the permissible limits as mentioned in “Circular for operational, prudential and reporting requirements for Alternative Investment Funds” dated 29^th July 2013.
2. Category II and III AIFs can sell the CDS by setting aside the unencumbered government bonds or treasury bills equal to the amount of the said CDS exposure. Such securities that are kept aside may also be used for maintaining the applicable margin requirements for the said CDS exposure. Further, the exposure to credit default swap undertaken will not amount tantamount to leverage.
3. The total exposure to an investee company, including the exposure through CDS, should be within the applicable concentration limit norm as mentioned in the AIF regulations.

Other Conditions Applicable For Transacting Credit Default Swap

The other conditions applicable for transacting credit default swaps are:

• The AIFS are required to report details of CDS transactions to the custodian by the next working day as per the manner specified by the custodian.
• The custodian establishes a mechanism that will ensure the collection of necessary details from AIFs transacting in CDS for monitoring of compliance with the conditions.
• The obligation of the manager or AIF & custodian in case of breach of leverage limits due to transaction in credit default swap by category II AIFs should be as per the prudential requirements of under “Circular for operational, prudential and reporting requirements for Alternative Investment Funds” dated 29^th July 2013 and para 1 of “Guidelines on disclosures, reporting and clarifications under AIF Regulations” dated 19^th June 2014.
• In case if the amount of earmarked securities falls below the CDS exposure for category II and III AIFs that sell CDS by earmarking securities, the AIF is required to perform the below tasks:
  • It shall send a report to the custodian on the day of the breach.
  • It shall bring the amount of earmarked securities equal to the CDS exposure and report the rectification of the breach to the custodian by the end of the next working day. 

However, if the AIF fails to rectify the breach, the custodian must report the details of the breach to the SEBI on the next working day.

• As per Regulations 16 (1) (c) and 17 (c) of the AIF Regulations, the category I and II AIFs should not borrow funds directly or indirectly. Further, the AIF shall only engage in leverage if meeting temporary funding requirements for up to 30 days on at most 4 occasions in a year and not more than 10% of the investable funds. In this regard, the category I and Category II AIFs who transact in the CDS must maintain 30 day cooling off period between the two periods of engaging or borrowing in leverage.
• All the CDS should be on a platform regulated by SEBI or RBI for enhancing transparency and disclosure.

Conclusion

The SEBI^[1] now allows the AIFs to participate in credit default swaps as protection for buyers and sellers. The Category I, II and III AIFs are allowed to buy or sell an underlying investment in debt securities provided that the selling takes place within the permissible limits. Further, reporting requirements by AIF on CDS transactions make the whole process transparent and easy for SEBI to regulate the CDS market. 

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