Impact of SEBI permitting mutual funds to sell Credit Default Swaps in India

The recent decision by the Securities and Exchange Board of India (SEBI) to permit mutual funds to buy and sell Credit Default Swaps (CDS) is a significant development for the Indian financial market.

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.

Expanded Scope:

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. Now, mutual funds can buy CDS for all schemes and sell them for all schemes except overnight and liquid funds.

Purpose of CDS:

Credit Default Swaps act as insurance against the risk of default on debt securities. When a mutual fund buys a CDS, it pays a premium to the seller in exchange for protection against potential defaults on specific bonds it holds.

Impact on the Market

Enhanced Liquidity:

This move is expected to increase liquidity in the corporate bond market by allowing mutual funds to actively trade in CDS. Greater participation from mutual funds could lead to more efficient price discovery and a deeper corporate bond market.

Risk Management:

The ability to trade CDS will provide mutual funds with better tools for managing credit risk associated with their debt securities. This flexibility can help them optimize their portfolios and enhance overall stability within the mutual fund industry.

Regulatory Framework:

SEBI has established guidelines to ensure that the total CDS exposure for a scheme (both buying and selling) does not exceed 10% of its Assets Under Management (AUM). This limit is intended to maintain a balanced risk profile for mutual funds.

Investor Protection:

While this decision opens new avenues for investment, it also raises concerns regarding the complexity of CDS instruments and their potential use for speculative purposes. SEBI emphasizes the need for stringent investor protection measures, including clear disclosures and investor education initiatives.

Conclusion

SEBI's decision to allow mutual funds to trade in Credit Default Swaps marks a transformative step towards modernizing the Indian debt market. By enhancing liquidity and providing better risk management tools, this move aims to foster a more robust corporate bond market while ensuring that adequate regulatory safeguards are in place to protect investors.

This initiative aligns Indian practices more closely with those in developed markets, where CDS trading is an integral part of financial risk management. The success of this policy will depend on effective implementation, robust regulatory oversight, and ongoing education for investors regarding the risks and benefits associated with CDS trading.

Reference:

SEBI | Flexibility in participation of Mutual Funds in Credit Default Swaps (CDS)