SEBI’s new rule: Mutual fund houses can now trade credit default swaps

The Securities and Exchange Board of India (Sebi) has allowed mutual fund houses to engage in the buying and selling of Credit Default Swaps (CDS). This decision is geared towards enhancing liquidity in the corporate bond market. Previously, mutual funds were limited to participating in Credit Default Swap (CDS) transactions solely as buyers. This restriction was in place primarily to mitigate credit risks associated with corporate bonds held in fixed maturity plans (FMPs) lasting over one year. 

Credit Default Swaps (CDS) can be likened to insurance contracts within the market realm, serving as a safeguard against a borrower's default. These financial instruments play a crucial role in helping mutual funds effectively navigate and mitigate risks associated with the debt securities they have in their portfolios. In securing a CDS, a mutual fund commits to paying a premium to the seller in return for financial protection should a designated bond (referred to as the reference entity) fail to meet its financial obligations.

In the recent circular issued on September 20, Sebi announced that mutual funds will now have the liberty to also act as sellers in CDS transactions. This expanded role in CDS transactions will serve as an additional investment avenue for mutual funds, broadening their portfolios and strategies.

The Sebi noted that the Reserve Bank of India in a circular in February 2022 stated that the framework for the Credit Default Swap (CDS) market has been revised to promote development. This revision includes the expansion of the base of protection sellers to major non-bank regulated entities, such as mutual funds.

Top points:

1. Mutual Fund Schemes as buyer of CDS 

a.  Schemes may buy CDS only for the purpose of hedging their credit risk on debt securities they hold in various schemes. The exposure of CDS shall not exceed respective debt security exposure, and such exposure may not be added to gross exposure of the scheme.

b.  In case the protected debt security is sold, schemes shall ensure that the respective CDS position is closed within fifteen working days of selling the above protected debt security.

c. The exposure of any protected debt security, for determining single issuer,  group,  sectoral limits and credit risk for various purposes including Risk-o-meter and Potential Risk Class (PRC) matrix of MF schemes,  shall be considered as exposure to either issuer of debt security (reference entity) or seller of CDS, whichever has higher credit rating (lowest long term rating of instruments of the seller of CDS shall be considered for comparison). 

d. The exposure shall form part of overall single issuer limits for the reference entity or seller of CDS, whichever is applicable. In  case  of  same  rating for  reference  entity  and  seller  of  CDS,  the exposure shall then be considered on reference entity and not on seller of CDS. 

e.  MF schemes shall buy CDS only from such sellers that have instruments with lowest long-term rating of investment grade and above. 12.28.5.  Schemes may buy  CDS  for investment grade and existing below investment grade debt securities in the portfolio, if any.

2. Mutual Fund Schemes as seller of CDS

a. The selling of Credit Default Swaps (CDS) by Mutual Fund Schemes is permissible under certain conditions. Specifically, MF Schemes are allowed to sell CDS only within the scope of investing in synthetic debt securities. This means that they may sell CDS on a reference obligation that is backed by Cash, Government Securities (G-Sec), or Treasury Bills. It is important to note that Overnight and Liquid schemes are prohibited from selling CDS contracts.

b. Cash, G-Sec and T-bills can act as cover. Government securities with maturity within +/- 6 months of the maturity of respective debt security (reference obligation) shall act as cover and such cover may be used for maintaining margin requirements on respective CDS.  

c. The required amount of cover shall be enough to ensure that notional amount does not exceed the value of cover kept, which shall be calculated as follows:   Notional amount in CDS sell contract (+)   Buffer, for price fluctuations on government securities, kept as cover: The buffer shall be calculated to address interest rate risk on government securities. 

d. The buffer shall be at least equal to three times the daily haircut applicable  for  the  said  G-sec instrument in case of repo transactions on Clearing Corporation of India Limited. The value of cover kept shall be reviewed on a daily basis. 

e. The cover shall be earmarked to CDS sell position and can be used for maintaining margin requirements on respective CDS. However, investment in aforesaid instruments as cover shall not be considered as  part  of  Liquidity  Ratio  –  Redemption  at  Risk  (LR-RaR)  and Liquidity Ratio - Conditional Redemption at Risk (LR-CRaR) eligible instruments and shall not be sold or used for any other purpose till CDS sell position is open. 

f. The exposure  of  synthetic  debt  security  (notional  amount)  shall  be considered in respective single issuer, group issuer and sectoral limits. Such exposure to the issuer, group and sector of the issuer shall be equal to the notional amount. 

g. The value of cover kept shall be reviewed on a daily basis. 

h. The cover shall be earmarked to CDS sell position and can be used for maintaining margin requirements on respective CDS. However, investment in aforesaid instruments as cover shall not be considered as  part  of  Liquidity  Ratio  –  Redemption  at  Risk  (LR-RaR)  and Liquidity Ratio - Conditional Redemption at Risk (LR-CRaR) eligible instruments and shall not be sold or used for any other purpose till CDS sell position is open.

i. The  exposure  of  synthetic  debt  security  (notional  amount)  shall  be considered in respective single issuer, group issuer and sectoral limits. Such exposure to the issuer, group and sector of the issuer shall be equal to the notional amount.

j. For the purpose of computing gross exposure of scheme investing in synthetic debt security, the exposure due to such investment shall be computed as follows:   Notional amount (+)   Buffer (i.e., cover kept over and above notional amount) 

k. Schemes shall sell CDS only against securities rated investment grade and above. 12.28.11. Credit risk rating of the synthetic debt security shall be same as of reference obligation. 

l. For the purpose of Risk-o-meter, liquidity risk value of the synthetic debt security shall be    Liquidity Risk Value of reference obligation + 2 12.28.12. For Potential Risk Class (PRC) matrix, Credit Risk Value shall be same as reference obligation. 

m. Debt Index funds and ETFs: Such schemes may also take exposure through synthetic debt securities  and  the same may  be  treated as replication as required under clause 3.5.3 of the Master Circular. 

Other conditions 

a. Schemes shall comply with the directions issued by RBI from time to time in this regard. 

b. Schemes  shall  participate  in  CDS  only  through  standard  contracts prescribed by Fixed Income Money Market and Derivatives Association of India (FIMMDA). 

c. All  CDS  contracts  shall  be  transacted  either  through  Central Counterparty, if any or Request For Quote (RFQ) Platform. 

d. MFs shall ensure Two-way Credit Support Annex (CSA) as part of CDS contracts.