Sebi allows AIFs to participate in Credit Default Swap transactions

Regulator Sebi on Thursday allowed alternative investment funds (AIFs) to participate in the Credit Default Swaps (CDS) market as protection buyers and sellers in a bid to facilitate deepening of the domestic corporate bond segment.

The new norms, which will come into force with immediate effect, allow business entities to hedge risks associated with the bonds market.

CDS is a specific kind of counter-party agreement which allows the transfer of third party credit risk from one party to another.

Under the new norm, Category-I and Category-II AIFs can buy CDS on underlying investment in debt securities only for the purpose of hedging, while Category-III AIFs can purchase CDS for hedging or otherwise, within permissible leverage, the Securities and Exchange Board of India (Sebi) said in a circular.

With regard to selling, Sebi said Category-II and Category-III AIFs may sell CDS by earmarking unencumbered government bonds or Treasury bills equal to the amount of the CDS exposure. Such earmarked securities may also be used for maintaining applicable margin requirements for the CDS exposure.

Further, exposure to CDS undertaken in these manner will not tantamount to leverage.

"Total exposure to an investee company, including exposure through CDS, shall be within the limit of applicable concentration norm as specified in AIF Regulations," Sebi said.

Category III AIFs are allowed to sell CDS, subject to the condition that effective leverage undertaken is within the permissible limits.

AIFs will have to report details of CDS transaction to the custodian by the next working day.

For Category II and Category III AIFs which sell CDS by earmarking securities, Sebi said in case the amount of earmarked securities falls below CDS exposure, such AIFs will be required to send a report to the custodian on the same day of the breach.

The AIF would bring the amount of earmarked securities equal to CDS exposure and report details regarding rectification of breach to the custodian by the end of next trading day. In case the AIF fails to rectify the breach, the custodian would report details of the breach to Sebi on the next working day.

Any unhedged position, which would result in gross unhedged positions across all CDS transactions exceeding 25 per cent of investable funds of the scheme of an AIF, would be taken only after intimating to all unit holders of the scheme, Sebi said.

Category I and II AIFs would not borrow funds directly or indirectly and engage in leverage except for meeting temporary funding requirements for not more than 30 days, not more than four occasions in a year and not more than 10 per cent of the investable funds. Further, such AIFs which transact in CDS will have to maintain a 30-day cooling off period between the two periods of borrowing or engaging in leverage.

In 2012, the capital markets regulator Sebi had allowed mutual funds to participate in Credit Default Swap transactions, which allow business entities to hedge risks associated with the bonds market.