SEBI Proposes Expanding Mutual Funds' Role In CDS Transactions

Capital markets regulator SEBI on Friday proposed allowing greater flexibility to mutual funds in buying and selling investment product Credit Default Swaps in a bid to further develop debt market in the country.

Under the current framework, mutual funds are permitted to participate in CDS transactions only as users -to buy credit protection only to hedge the credit risk on corporate bonds held by them.

Furthermore, this transaction can be undertaken by mutual funds only in the portfolio of Fixed Maturity Plans schemes with a tenor of more than one year.

In its consultation paper, the regulator has suggested 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 proposal came after Reserve Bank of India on Feb. 10, 2022, specified the revised regulatory framework for CDS to further develop the debt market in the country. The guidelines sought to provide the necessary impetus for the development of CDS market by expanding the base of protection sellers including selling of protection by all major non-bank regulated entities including by mutual funds.

The Securities and Exchange Board of India has sought comments till July on the proposal.

In market parlance, CDS means a credit derivative contract in which one counterparty (protection seller) commits to pay to the other counterparty (protection buyer) in the case of a credit event and in return, the protection buyer makes periodic payments (premium) to the protection seller until the maturity of the contract or the credit event, whichever is earlier.

Accordingly, buying a CDS is akin to buying insurance. In case any debt security on which a CDS is bought defaults, the protection seller (seller of CDS) pays the notional amount (amount of debt security) and takes over the debt security in default.

Going by the consultation paper, SEBI has suggested that mutual fund schemes should be permitted to buy CDS only to hedge their credit risk on debt securities they hold in all schemes. In case the protected debt security is sold, schemes should ensure that the respective CDS position is closed within 7 days of selling such protected debt security.

MF schemes should buy CDS only from CDS programmes rated by Credit Rating Agencies.

On selling CDS, SEBI has suggested that mutual fund schemes should be permitted to sell CDS only as investors in synthetic debt securities --  sell CDS on a reference obligation covered with cash, Government-Securities and Treasury bills. Overnight and Liquid schemes should not be permitted to sell CDS contracts.

Additionally, the regulator has suggested that mutual funds should ensure a Two-way Credit Support Annex as part of CDS contracts. The Two-way CSA decreases the counter party risk  -- the risk that the protection seller is unable to pay, given the default on reference obligation-- since margin is kept by both sides.