Sebi moots allowing mutual funds to invest in credit-default swap

As the consultation paper released on June 7 by the Securities and Exchange Board of India stated, it is like buying insurance.

Market regulator Sebi has proposed allowing mutual funds to invest in credit default swaps (CDS).

A Credit Default Swap (CDS) is a credit derivative contract in which one counterparty (protection seller) commits to pay to the other counterparty (protection buyer) in the case of a credit event with respect to a reference entity and in return, the protection buyer makes periodic payments (premium) to the protection seller until the maturity of the contract or the credit event, whichever is earlier.

The consultation paper released on June 7 by the Securities and Exchange Board of India (Sebi) stated that it is like buying insurance.

Under the proposed framework, an MF scheme can buy CDS only from programmes that are rated by credit rating agencies and they can buy CDS for both investment grade and below-investment grade debt securities. Also, an MF may be permitted to sell CDS only as investors in synthetic debt securities, or in other ways, sell CDS as a reference obligation covered with cash or government securities or treasury bills. Therefore, overnight and liquid schemes will not be allowed to sell CDS contracts.

Sebi has proposed this following the RBI's revised CDS framework dated February 10, 2022, which sought to increase the base of protection sellers including selling of protection by all major non-bank regulated entities, including mutual funds.

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"Under the current regulatory framework, Mutual Funds in India are permitted to participate in CDS transactions only as users i.e, to buy credit protection only to hedge the credit risk on corporate bonds held by them," said the paper.

"Furthermore, the aforesaid transaction can be undertaken by Mutual Funds only in the portfolio of Fixed Maturity Plans (FMP) schemes having tenor of more than one year," it added.

The consultation paper is seeking comments on allowing participation of mutual funds in CDS buying for all schemes and CDS selling for all schemes except overnight and liquid ones.