Capital markets regulator Sebi on Friday proposed allowing greater flexibility to mutual funds in buying and selling investment product Credit Default Swaps (CDS).

Mutual funds are permitted to participate in CDS transactions only as users — to buy credit protection only to hedge the credit risk on corporate bonds held by them.

Furthermore, this transaction can be undertaken by mutual funds only in the portfolio of Fixed Maturity Plans (FMP) schemes with a tenor of more than one year.

In its consultation paper, the regulator has suggested to permit participation of mutual funds in CDS buying for all schemes as well as CDS selling for all schemes except overnight and liquid.

The proposal came after Reserve Bank of India (RBI) on February 10, 2022, specified the revised regulatory framework for CDS.

The guidelines sought to provide the necessary impetus for the development of CDS market by expanding the base of protection sellers including selling of protection by all major non-bank regulated entities including by mutual funds.

In market parlance, CDS means 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 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.

Accordingly, buying a CDS is akin to buying insurance.

In case any debt security on which a CDS is bought defaults, the protection seller (seller of CDS) pays the notional amount (amount of debt security) and takes over the debt security in default.

Going by the consultation paper, Sebi has suggested that mutual fund schemes should be permitted to buy CDS only to hedge their credit risk
on debt securities they hold in all schemes. In case the protected debt security is sold, schemes should ensure that the respective CDS position is closed within seven days of selling such protected debt security.

On selling CDS, Sebi has suggested that mutual fund schemes should be permitted to sell CDS only as investors in synthetic debt securities — sell CDS on a reference obligation covered with cash, government-securities and treasury bills. Overnight and liquid schemes should not be permitted to sell CDS contracts.