SEBI: It comes after RBI’s altered framework for the derivative instrument.
The Securities and Exchange Board of India (SEBI) has proposed a new framework allowing mutual funds to invest in Credit Default Swaps (CDS).
This move aims to diversify investment options and manage credit risks more effectively within mutual fund schemes.
Understanding Credit Default Swaps
A Credit Default Swap (CDS) is a financial derivative contract where:
- Protection Seller: Agrees to compensate the protection buyer in the event of a credit event (e.g., default) related to a reference entity.
- Protection Buyer: Makes periodic premium payments to the protection seller until the contract matures or a credit event occurs, whichever comes first.
Essentially, CDS functions similarly to an insurance policy, providing protection against credit risk.
SEBI’s Proposed Framework
In a consultation paper released on June 7, SEBI outlined the following key points regarding mutual funds’ participation in CDS:
Also read: Bajaj Housing Finance approves IPO to raise Rs 4,000 Crore
- Eligibility and Ratings:
- Mutual fund schemes can buy CDS only from programs rated by credit rating agencies.
- CDS can be purchased for both investment-grade and below-investment-grade debt securities.
- Restrictions on Selling CDS:
- Mutual funds may sell CDS as investors in synthetic debt securities or by using cash or government securities or treasury bills as reference obligations.
- Overnight and liquid schemes are prohibited from selling CDS contracts.
- Alignment with RBI Framework:
- SEBI’s proposal follows the Reserve Bank of India’s revised CDS framework dated February 10, 2022, which expanded the base of protection sellers, including mutual funds and other non-bank regulated entities.
Current Regulatory Framework
Under the existing regulatory framework:
- Mutual funds in India are allowed to participate in CDS transactions only as users, meaning they can only buy credit protection to hedge the credit risk on corporate bonds held in their portfolios.
- These transactions are restricted to Fixed Maturity Plans (FMP) with a tenor of more than one year.
Proposed Changes
SEBI’s consultation paper suggests expanding the participation of mutual funds in CDS transactions:
- Allowing mutual funds to buy CDS for all schemes.
- Permitting mutual funds to sell CDS for all schemes, except overnight and liquid ones.
Implications for Mutual Funds
The proposed changes are intended to:
- Provide mutual funds with more tools to manage credit risk effectively.
- Enhance the flexibility and investment options available to mutual funds.
- Align with global practices and regulatory frameworks to increase market robustness.
Conclusion
SEBI’s proposal to allow mutual funds to invest in Credit Default Swaps marks a significant step towards enhancing risk management and investment strategies within the mutual fund industry.
By expanding the scope of CDS transactions, SEBI aims to provide mutual funds with more robust tools to navigate credit risks, potentially leading to a more resilient and diversified financial market. The consultation paper invites comments on this proposal, signaling SEBI’s commitment to a collaborative approach in refining the regulatory framework.
