The Securities and Exchange Board of India (SEBI) has issued a new circular on September 20, 2024, that brings significant changes to how Mutual Funds (MFs) can participate in the Credit Default Swaps (CDS) market. These changes, aimed at increasing the liquidity in the corporate bond market and offering greater flexibility to Mutual Funds, align with the broader regulatory framework set by the Reserve Bank of India (RBI) in its 2022 directions on credit derivatives.
Existing Framework and Its Limitations
Before this circular, the participation of Mutual Funds in CDS was limited to acting as “users” — that is, they could only buy credit protection to hedge against credit risk on corporate bonds. Additionally, this could only be done within the scope of Fixed Maturity Plans (FMP) with a maturity of over one year. While these provisions allowed MFs to manage credit risks in their bond portfolios, the scope was relatively narrow, restricting their ability to actively manage risk or participate fully in the CDS market.
The 2022 “Master Direction – Reserve Bank of India (Credit Derivatives) Directions” expanded the scope for non-bank financial entities, including MFs, to act as sellers of CDS protection, thereby broadening their role from risk management to active participation in the credit risk market. The SEBI circular is a reflection of this change, now allowing MFs to both buy and sell CDS, subject to certain risk management measures.
Key Changes in SEBI’s Circular
- Participation of Mutual Funds as Buyers of CDS
Mutual Funds can continue to buy CDS to hedge credit risk. The key changes include:
The CDS exposure cannot exceed the exposure to the debt securities held in the portfolio. This ensures that MFs use CDS strictly for hedging purposes, not for speculative trades.
If a protected debt security is sold, the corresponding CDS must be closed within 15 working days. This aligns the CDS exposure with the debt securities portfolio and ensures that funds don’t maintain unnecessary positions in the CDS market.
Exposure to a CDS contract for regulatory purposes, including limits on single issuer or sector exposure, will be attributed to either the debt security issuer or the seller of the CDS, whichever has the lower credit rating. This provision ensures that the CDS transactions do not add undue credit risk to the fund.
- Participation of Mutual Funds as Sellers of CDS
The circular introduces the possibility for Mutual Funds to sell CDS, providing them with a new revenue stream and adding liquidity to the market. The following conditions apply:
Mutual Funds can sell CDS only in relation to synthetic debt securities, which means they must have high-quality collateral like cash, government securities (G-Secs), or Treasury bills (T-bills) to cover the CDS position.
Liquid and Overnight schemes are prohibited from selling CDS contracts, limiting the risks associated with these types of funds that typically have lower risk profiles.
The cover for the CDS position must be calculated daily, including a buffer to account for fluctuations in the value of government securities used as collateral.
- Risk Management Measures
SEBI’s new guidelines emphasize robust risk management. For example:
The value of the cover must be recalculated daily to ensure it is sufficient to cover the notional amount of the CDS contract, plus a buffer for price fluctuations.
The cover allocated for a CDS position cannot be sold or used for other purposes until the CDS position is closed, ensuring that funds maintain adequate protection at all times.
The synthetic debt security exposure, calculated as the notional amount of the CDS, must be included in the fund’s overall exposure to a single issuer, group issuer, or sector. This prevents Mutual Funds from overexposing themselves to any particular sector or company through CDS transactions.
Implications for the Mutual Fund Industry
These changes represent a major shift in the Indian Mutual Fund industry’s ability to manage credit risk and participate in the CDS market. By allowing Mutual Funds to sell CDS, SEBI has provided them with a new tool to generate returns and manage liquidity. This move could lead to deeper corporate bond markets as funds become more active participants in managing credit risk.
Moreover, these guidelines come with robust risk management requirements, ensuring that the flexibility afforded to Mutual Funds does not translate into higher systemic risks. With this circular, SEBI has opened the door for more dynamic and flexible credit risk management practices, while ensuring the necessary safeguards are in place.
