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On Friday, September 20th, Securities and Exchange Board of India (SEBI): The regulatory authority overseeing the securities market allowed the Mutual Funds houses to participate in buying and selling of Credit Default Swaps (CDS) to improve liquidity and greater flexibility in the corporate bond market.
What is Credit Default Swaps?
Credit Default Swaps (CDS) is a financial derivative that allows an investor to swap their credit risk with another investor. To swap their credit risk, the lender buys the CDS from another investor for a little insurance premium who agrees to reimburse if the borrower defaults.
In short, CDS is your “just-in-case-the-borrowers-falls” insurance, letting you enjoy the high risk without losing the entire amount.
SEBI’s Move: Mutual Funds Can Now Participate in CDS
In the recent circular issued, SEBI’s allowed mutual funds to buy and sell in CDS instruments, this move marks a shift in the working of the Indian markets. Earlier, mutual funds were not allowed to interfere into such instruments due to concerns over higher exposure of risk. However, SEBI has now opened up this space, due to growing demand for risk mitigation tools in the corporate bond market.
“Such flexibility to participate in CDS will act as an additional investment product for mutual funds and also aid in increasing liquidity in the corporate bond market” SEBI noted.
Why is this move significant?
Previously, Mutual Funds were allowed to buy CDS only for hedging their credit risk on debt securities they hold in their various schemes. However, Mutual Funds are now allowed to sell CDS only within the scope of investing in synthetic debt securities. This means that they can only sell CDS that are backed by either Cash, Government Securities (G-Sec) or Treasury Bills (T-Bills). However, the net exposure of CDS should not exceed 10% of the total Asset Under Management (AUM) of the scheme and it should be within the overall limit of derivatives exposure as prescribed in Scheme Information Documents, SEBI noted. Further guidelines regarding valuations and accounting of CDS will be issued by Association of Mutual Funds in India (AMFI).
Conclusion
In summary, the SEBI’s strategy for revising the Indian debt market is encouraging, but it still poses several challenges which need to be fixed for the strategy to be successful. A thorough regulatory framework and guidelines such as risk management, margin requirement, and reporting standards is essential to sustain and grow the corporate debt market.
Thank you.
Regards,
Kautilya, IBS Mumbai.
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