SEBI opens CDS market for mutual funds
In a move that will deepen the credit derivatives market, SEBI has allowed mutual fund schemes to more aggressively participate in the credit-default swap (CDS) market.
However, it has put a cap of 10% of the scheme’s AUM as these contracts are less liquid and should be within the overall limit of derivatives assets as mentioned in the scheme information document.
CDS is a credit derivative contract that allows an investor to swap or offset their credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse it if the borrower defaults.
Mutual fund houses will be allowed to buy CDS products across schemes as a hedge against their credit risk against debt securities. They will be allowed to buy investment-grade as well as below-investment-grade securities only from sellers having instruments with lowest long-term rating of investment grade and above. However, they will have to close the position with 15 days of selling the insured security.
As sellers of CDS, mutual fund schemes will be allowed to do so only as part of investment in synthetic debt securities i.e. sell CDS on a reference obligation covered with cash/G-Sec/T-bills. For cover for CDS, government securities with maturity within +/- 6 months of the maturity of respective debt security (reference obligation) will be used and such cover may be used for maintaining margin requirements on respective CDS.
In addition, the value of cover kept shall be reviewed daily. 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.
Both overnight and liquid schemes won’t be allowed to sell CDS.
Importantly, mutual fund schemes shall participate in CDS only through standard contracts prescribed by Fixed Income Money Market and Derivatives Association of India (FIMMDA).