SEBI Updates Credit Default Swap Rules for Mutual Funds

Vaibhav Rathi

10 Oct, 2024

Mutual funds can now purchase and sell credit default swaps (CDS) to increase liquidity in the corporate bond market, according to a move made by the capital market regulator Securities and Exchange Board of India (SEBI) on Friday.

In a circular, SEBI stated, “It has been decided to allow greater flexibility to mutual funds to both buy and sell CDS with adequate risk management.” “Having this flexibility to participate in CDS will help increase liquidity in the corporate bond market and act as an additional investment product for mutual funds,” the market watchdog stated.

What Does This Mean?

This change in regulation may significantly impact the corporate bond market in India. Previously, mutual funds could only purchase CDSs to hedge against credit risks on corporate bonds maturing in over a year. They can now sell CDSs as well, but only under certain restrictions.

According to SEBI, this increased flexibility will improve corporate bond market liquidity and provide mutual funds with an additional tool for risk management. Mutual funds that sell CDSs must keep sufficient collateral and limit their exposure to CDSs to no more than 10% of their assets under management (AUM) to preserve stability.

Join the financial revolution by registering your asset management company and leveraging the new CDS rules to enhance liquidity and transparency in your investments.

For Markets: New Tools in The Financial Toolkit

This action may result in increased market liquidity for corporate bonds, which would facilitate the issuance of bonds by businesses and the trading of such bonds by investors. Now that mutual funds can trade CDSs, a more active secondary market may develop, resulting in reduced spreads and cheaper business borrowing costs.

Bigger Picture to Enhance Market Stability

By limiting mutual funds’ purchase of CDSs to sellers who fulfil investment-grade standards, systemic risk is decreased by ensuring that participants are likely to fulfil their debt obligations. By bringing India’s financial laws into line with international norms, this move could attract more foreign investors to the Indian market.

Overview of Credit Default Swaps

Mutual fund houses can now purchase and sell Credit Default Swaps (CDS) thanks to the approval of the Securities and Exchange Board of India (SEBI). This action is intended to improve liquidity in the corporate bond market. Mutual funds could only be purchasers in past Credit Default Swap (CDS) transactions. The primary purpose of this restriction was to reduce the credit risks related to corporate bonds held in fixed maturity plans (FMPs) that are longer than a year.

In the market context, Credit Default Swaps (CDS) are insurance contracts that protect against a borrower’s default. These financial tools are essential to mutual funds’ ability to manage and reduce the risks connected to the debt securities in their portfolios. A mutual fund that secures a CDS agrees to pay a premium to the seller in exchange for financial protection if a specified bond, also known as the reference firm, cannot fulfil its financial obligations.

Sebi said in a recent circular released on September 20 that mutual funds will now be allowed to participate as sellers in CDS transactions. Mutual funds will have another way to invest thanks to this expanded participation in CDS transactions, which will diversify their strategies and portfolios.

The Reserve Bank of India said in a circular from February 2022 that the Credit Default Swap (CDS) market’s framework has been updated to encourage development, as reported by the Sebi. The base of protection sellers has been expanded to include significant non-bank regulated companies like mutual funds as part of this amendment.

Registration of mutual fund with SEBI is crucial in order to ensure that it operate in a transparent and efficient manner.

Top Points of Credit Default Swaps Scheme

Below are the important points of the credit default swaps scheme:

Mutual Fund Schemes as buyers of CDS

• Schemes are limited to purchasing CDS to hedge the credit risk associated with the debt instruments they own across many schemes. The exposure of CDS cannot be more than the exposure of the corresponding debt security, nor may it be added to the scheme’s overall exposure.
• Should the secured debt security be sold, the plans will ensure that the corresponding CDS position is closed within fifteen working days following the sale of the aforementioned secured debt security.
• Any protected debt security will be deemed exposed to either the CDS seller or the debt security issuer (reference entity), whichever has a higher credit rating (the lowest long-term rating of the seller of CDS’s instruments will be used for comparison).
• This is true for determining credit risk for various purposes, such as the Risk-o-meter and Potential Risk Class (PRC) matrix of MF schemes and for deciding single issuer, group, and sectoral limits.
• The exposure will be included in the reference entities or the seller of CDS’s overall single issuer limitations, as appropriate. When the seller of CDS and the reference entity have the same rating, the exposure is evaluated on the reference entity rather than the seller of CDS.
• Only sellers of products with the lowest long-term rating of investment grade or higher may be purchased by mutual fund schemes (MF schemes). 12.28.5. If any lower investment-grade debt assets are currently in the portfolio, schemes may purchase CDS for them.

Mutual Fund Schemes as sellers of CDS

• Under some circumstances, mutual fund schemes can sell Credit Default Swaps (CDS). More specifically, CDS sales by MF Schemes are restricted to purchases of synthetic debt securities. Accordingly, they might offer to sell CDS on a reference obligation backed by Treasury Bills, Government Securities (G-Sec), or cash. It is important to remember that selling CDS contracts is forbidden for overnight and liquid schemes.
• T-bills, G-Sec, and cash can serve as collateral. Government securities that mature within six months or less of the reference obligation’s maturity date will serve as cover, and the cover may be utilised to keep the margin requirements on the relevant CDS in place.
• The necessary coverage must be sufficient to guarantee that the notional amount is not beyond the value of the cover retained, which will be determined using the following formula: The CDS sell contract’s notional amount (+)
• A buffer maintained as a cushion against changes in the price of government securities. The buffer will be computed to account for interest rate risk on government securities.
• In the event of repo transactions on Clearing Corporation of India Limited, the buffer must be at least three times the daily haircut that applies to the G-sec above instrument. The worth of the cover preserved will be examined daily.
• The cover can be utilised to maintain margin requirements on the relevant CDS and is designated for the CDS sell position. Investments made as cover for the instruments above, however, will not be regarded as eligible for the Liquidity Ratio-Redemption at Risk (LR-RaR) or Liquidity Ratio-Conditional Redemption at Risk (LR-CRaR) programs. They cannot be sold or used for any other reason until the CDS sell position is open.
• The notional amount of synthetic debt securities exposure will be considered for the corresponding sectoral, group, and single issuer limits. This exposure to the issuer, group, and industry must match the notional sum.
• Every day, the worth of the cover preserved will be examined.
• The cover can be utilised to maintain margin requirements on the relevant CDS and should be designated for the CDS sell position. Investments made as cover for the instruments above, however, will not be regarded as eligible for the Liquidity Ratio-Redemption at Risk (LR-RaR) or Liquidity Ratio-Conditional Redemption at Risk (LR-CRaR) programs. They cannot be sold or used for any other reason until the CDS sell position is open.
• The notional amount of synthetic debt securities exposure will be considered to determine the sectoral, group, and single issuer restrictions. This exposure to the issuer, group, and industry must match the notional sum.
• The exposure resulting from an investment in synthetic debt securities will be calculated in the following manner to determine the scheme’s gross exposure: • The hypothetical sum (+)  and Buffer (cover maintained above and beyond the notional amount)
• Schemes are only allowed to offer CDS against investment-grade and higher-rated securities. 12.28.11. The synthetic debt security’s credit risk rating will match the reference obligations.
• The synthetic debt security’s liquidity risk value for Risk-o-meter purposes equals the Liquidity Risk Value of the reference obligation + 2 12.28.12. The Credit Risk Value for the Potential Risk Class (PRC) matrix must match the reference obligation.
• Debt index funds and exchange-traded funds (ETFs): These schemes can obtain exposure through synthetic debt securities, which can be considered replication by section 3.5.3 of the Master Circular.

Other Conditions

• Schemes must abide by the guidelines the RBI has published occasionally.
• Schemes may engage in CDS only using standard contracts approved by the Fixed Income Money Market and Derivatives Association of India (FIMMDA).
• All CDS contracts must be completed using the Request for Quote (RFQ) platform or, if there is a central counterparty, through the Central Counterparty.
• As a requirement of CDS contracts, MFs must guarantee the Two-way Credit Support Annex (CSA).

Conclusion

SEBI’s review of Credit Default Swap (CDS) regulations for mutual funds is a big step in fortifying the Indian financial system and shielding investors from excessive risk. Through increased transparency, exposure limitations, and stringent risk management procedures, SEBI guarantees mutual funds can utilise CDS products sensibly without jeopardising financial stability.

This encourages the growth of a more vibrant and compelling CDS market in India. It is a step in the right direction for investors seeking more security and confidence in their mutual funds.

When these adjustments are implemented, investors will receive more protection and transparency, and mutual funds will probably have better risk management skills. These improvements are just one more illustration of SEBI’s proactive approach to overseeing the rapidly changing Indian financial industry.

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