The Securities and Exchange Board of India (Sebi) on Friday allowed mutual funds to both buy and sell Credit Default Swaps (CDS), in a move that will increase liquidity in the corporate bond market.

Credit Default Swaps are like insurance contracts that protect its buyer against potential default by a borrower or a bond issuer.

It is a product where the purchaser makes payments to the counterparty (which takes the risk) till the maturity of the contract.

In this arrangement, the risk of default falls upon the seller of the swap who will have to reimburse if any default happens. They hogged the spotlight during the 2008 financial crisis when some of the large banks that had issued these instruments faced bankruptcy due to huge payouts as mortgage defaults surged.

Sebi said in a circular that this flexibility to participate in CDS would serve as an additional investment product for mutual funds.

Earlier, fund houses were only permitted to use CDS transactions to buy protection against the credit risk of corporate bonds they held. In other words they could only act as buyers. Further these transactions were limited to Fixed Maturity Plan (FMP) schemes with a duration of more than one year.

“It has been decided to allow greater flexibility to mutual funds to both buy and sell CDS with adequate risk management,” Sebi said.

Under the new framework, Sebi said that mutual funds can buy CDS to hedge the credit risk of debt securities they hold. However, the CDS exposure can’t exceed the value of the debt security being protected.

The regulator added that mutual funds can only buy CDS from sellers with an investment-grade rating or higher.

On CDS sellers, the regulator said that mutual funds can sell CDS as part of debt investments backed by cash, government securities or treasury bills.

However, overnight and liquid mutual fund schemes cannot sell CDS.

The total CDS exposure for a scheme — both buying and selling — cannot exceed 10 per cent of the scheme’s assets, Sebi added.