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SEBI Allows AIFs to Participate in Credit Default Swap Transactions

Regulator SEBI allowed Alternative Investment Funds(AIFs) to participate in the Credit Default Swaps(CDS) market as protection buyers and sellers in a bid to facilitate the 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. 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.

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More About This Regulation:

  • 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.
  • With regard to selling, SEBI said Category-II and Category-III AIFs may 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 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% of investable funds of the scheme of an AIF, would be taken only after intimating to all unit holders of the scheme.
  • 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% 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.

What is Credit Default Swap(CDS):

  • A credit default swap (CDS) is a financial swap arrangement in which the buyer is compensated by the seller in the event of a debt default (by the debtor) or another credit event.
  • credit event is a trigger in the CDS market that triggers the protection buyer to terminate and settle the contract.
  • Bonds and other debt securities carry the risk of the borrower defaulting on the debt or its interest payments.

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