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SEBI allows participation of Alternative Investment Funds (AIF’s) in Credit Default Swaps (CDS)

Updated: Jan 23, 2023

As per Securities and Exchange Board of India (“SEBI”) circular SEBI/HO/AFD/PoD/CIR/2023/15 dated 12/01/2023, SEBI (“Alternative Investment Funds”) Regulations, 2012 (“AIF Regulations”), have been amended and notified to allow Alternative Investment Funds (“AIFs”) to participate in Credit Default Swaps (“CDS”) as protection for buyers and sellers.

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

As per the new norm, SEBI has laid down certain conditions applicable to various categories of AIF for buying CDS. The conditions are as follows:

1) Category I, II AIFs may buy CDS on underlying investment in debt securities, only for the purpose of hedging.

2) Category III AIFs may buy CDS for the purpose of hedging or otherwise, within permissible leverage limits.

The Circular further also specifies the conditions applicable to category II and III AIFs to sell CDS:

1) Category III AIFs may sell CDS, subject to the condition that effective leverage undertaken shall not exceed 2 times i.e. the gross exposure after offsetting for hedging and portfolio rebalancing transactions shall not exceed 2 times of the NAV of the fund.

2) 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. Exposure to CDS undertaken in the aforesaid manner shall not be tantamount to leverage.

3) The total exposure to an investee company, including exposure through CDS, shall be within the limit of applicable concentration norm as specified in AIF Regulations.

The Circular also specified certain other conditions applicable for transacting in CDS which include:

1) AIFs shall report details of CDS transaction to the custodian, by the next working day, in the manner as specified by the custodian.

2) Custodian, shall put in place a mechanism to collect necessary details from AIFs transacting in CDS, to monitor the compliance with conditions specified above.

3) 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, then such AIFs will be required to:

a) Send a report to the custodian on the same day of the breach.

b) The AIF shall bring the amount of earmarked securities equal to CDS exposure and report details regarding rectification of breach to custodian, by the end of next trading day.

c) In case the AIF fails to rectify the breach in the manner as specified above, the custodian shall report details of the breach to SEBI, on the next working day.

4) 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.

5) 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, on not more than four occasions in a year and not more than 10 per cent of the investable funds.

6) 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.

7) All CDS transactions shall be on a platform regulated by SEBI or Reserve Bank of India, to enhance transparency and disclosure.

8) AIFs transacting in CDS, shall also ensure compliance with applicable provisions of RBI notification on ‘Master Direction –Reserve Bank of India (Credit Derivatives) Directions, 2022, dated February 10, 2022 and other directives issued by RBI in this regard from time to time.

This circular shall come into force with immediate effect.

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