Mutual Funds Gain Flexibility In CDS Markets: SEBI Circular

Posted On - 28 October, 2024 • By - King Stubb & Kasiva

Introduction

The Securities and Exchange Board of India (SEBI) has issued a circular allowing mutual funds in India to participate more actively in credit default swaps (CDS).[1] Previously limited to buying CDS for hedging purposes, mutual funds can now both buy and sell CDS, expanding their investment opportunities and contributing to the liquidity of the corporate bond market. The circular outlines specific guidelines for mutual funds as both buyers and sellers of CDS, including exposure limits, cover requirements, and transaction platforms.

Background

Current Participation of Mutual Funds in CDS (Before the Circular)

  • Limited Role: Mutual Funds were only permitted to buy CDS to hedge the credit risk on corporate bonds held by them.
  • Applicable Schemes: CDS transactions could only be done in portfolios of Fixed Maturity Plans (FMP) schemes with a tenor exceeding one year.

Revised Regulatory Framework by RBI

  • Master Direction by RBI (Feb 10, 2022): The Reserve Bank of India issued a revised framework for CDS transactions under the “Master Direction – Reserve Bank of India (Credit Derivatives) Directions, 2022”.[2]
  • Expansion of Participants: It aimed to expand the base of protection sellers, including non-bank regulated entities, to boost the development of the CDS market. This includes allowing Mutual Funds to sell protection in addition to buying.

Purpose of the Circular

Greater Flexibility for Mutual Funds: Mutual Funds are now permitted to both buy and sell CDS with appropriate risk management. This change:

  • Provides an additional investment product for Mutual Funds.
  • Helps increase liquidity in the corporate bond market.

In light of this, the circular modifies Clause 12.28 of the Master Circular for Mutual Funds dated June 27, 2024[3], setting new guidelines for Mutual Funds as both buyers and sellers of CDS.

Understanding the Modifications

Mutual Fund Schemes as Buyers of CDS

  • Hedging Purpose: Schemes may only buy CDS for hedging the credit risk of debt securities they hold.
  • Exposure Limits: The exposure to CDS cannot exceed the exposure to the underlying debt security and is not added to the gross exposure of the scheme.
  • Closing CDS on Sale of Debt Security: When a protected debt security is sold, the CDS position must be closed within 15 working days.
  • Risk and Exposure Calculation: Exposure is considered against either the issuer of the debt security (reference entity) or the seller of CDS, whichever has the higher credit rating. The exposure forms part of the overall single issuer limits.
  • Seller Rating: MFs can buy CDS only from sellers that have an investment-grade rating or higher.
  • Securities Eligible for CDS: Mutual Funds may buy CDS for both investment-grade and existing below-investment-grade securities in the portfolio.

Mutual Fund Schemes as Sellers of CDS

  • Synthetic Debt Securities: Mutual Funds can sell CDS as part of investment in synthetic debt securities, where CDS is sold on a reference obligation backed by Cash, Government Securities (G-Secs), or Treasury Bills (T-bills).
  • Cover Requirements: The notional amount of the CDS sold must not exceed the value of cover kept (cash/G-Sec/T-bills). The cover should include a buffer for price fluctuations.
  • Daily Review: The value of the cover must be reviewed daily.
  • Eligible Securities: Only CDS on investment-grade securities can be sold by MF schemes.
  • Synthetic Debt Exposure: The exposure from synthetic debt is counted in issuer and sectoral limits. The credit rating of synthetic debt security is the same as the reference obligation.

Other Key Conditions

  • CDS Contracts: All CDS contracts must be standardized by FIMMDA (Fixed Income Money Market and Derivatives Association of India).
  • Transaction Platforms: CDS transactions must occur through the Central Counterparty or the Request for Quote (RFQ) platform.
  • Two-Way CSA: Mutual Funds must ensure a Two-way Credit Support Annex (CSA) as part of CDS contracts.
  • Disclosures: MFs must disclose CDS seller ratings and CDS transactions with associate or group companies.
  • Contract Maturity: CDS contracts must mature before or on the winding-up date of the scheme.
  • Exposure Limit: Notional CDS exposure (both bought and sold) cannot exceed 10% of the scheme’s AUM and must comply with the overall derivatives exposure limit.
  • Valuation and Accounting: AMFI (Association of Mutual Funds in India) will issue guidelines for the valuation and accounting of CDS, using a waterfall approach with actual traded levels as the first preference.

Other Details

  • The changes arising from this circular are not considered a fundamental attribute change to the scheme, so investor consent is not required under Regulation 18(15A) of SEBI (Mutual Funds) Regulations, 1996.
  • The provisions of this circular come into force immediately.

Conclusion

SEBI’s new circular grants mutual funds greater flexibility in participating in credit default swaps, allowing them to both buy and sell CDS. This expansion opens new investment avenues for mutual funds and can contribute to increased liquidity in the corporate bond market. However, the circular also introduces stringent guidelines to manage risks associated with CDS transactions, ensuring that mutual funds participate in a responsible manner.

[1] https://www.sebi.gov.in/legal/circulars/sep-2024/flexibility-in-participation-of-mutual-funds-in-credit-default-swaps-cds-_86871.html.

[2] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12226.

[3] https://www.sebi.gov.in/legal/master-circulars/jun-2024/master-circular-for-mutual-funds_84441.html.