The Securities and Exchange Board of India (SEBI), in a landmark decision, has proposed a transformative change that could revolutionise the Indian debt market landscape by permitting mutual funds to actively buy and sell credit default swaps (CDSs). This move, signalling a significant shift in regulatory stance, aims to infuse dynamism into the market by enhancing liquidity, improving risk management tools available to investors, and fostering the development of a deeper and more robust corporate bond market.

By opening up this avenue, SEBI aims to align Indian practices with those in developed markets, where CDS trading is an integral part of financial risk management. This proposal, however, is not without its complexities and potential pitfalls. While offering a plethora of benefits, the introduction of CDS trading for mutual funds also raises concerns regarding the complexity of these instruments, the potential for speculative activities, and the need for stringent investor protection measures.

A credit default swap is a financial derivative that acts as insurance against the risk of a borrower defaulting on debt. The buyer of the CDS makes regular premium payments to the seller, who, in return, promises to compensate the buyer if the underlying debt instrument defaults. CDSs are used to manage credit risk, speculate on creditworthiness, and hedge against potential losses. Currently, Indian mutual funds are permitted to buy CDSs only for hedging purposes in fixed maturity plans (FMPs) with a tenor of over one year. SEBI’s proposal seeks to expand this, allowing all mutual funds to buy CDSs for all schemes and sell CDSs for all schemes except overnight and liquid funds. This move aligns with RBI’s 2022 revised regulatory framework for CDS, aiming to develop the debt market further.

Pros and Cons

By allowing mutual funds to participate in CDS markets, SEBI aims to increase trading activity and liquidity in the corporate bond market. This could lead to more efficient price discovery and a broader range of investment opportunities for investors. Further, mutual funds can utilise CDS to hedge their credit risk exposures, reducing the impact of potential defaults on their portfolios. This could enhance the stability and resilience of the mutual fund industry. In addition, increased participation from mutual funds could lead to a deeper and more vibrant corporate bond market. This could provide companies with alternative sources of funding and promote economic growth.

However, navigating through CDS is not free from shortcomings. CDSs are complex instruments that require sophisticated risk management expertise. Mutual funds might need to invest in additional resources and capabilities to effectively manage the risks associated with CDS trading. While CDSs are primarily used for hedging, they can also be used for speculative purposes. Unregulated speculation could lead to market volatility and systemic risks. SEBI needs to ensure adequate investor protection measures are in place, as retail investors might not fully understand the risks involved in CDS trading. Clear disclosures and investor education are essential. In developed markets like the US and Europe, CDS trading is well-established and plays a crucial role in risk management and price discovery. Mutual funds and other institutional investors actively participate in these markets. However, regulatory frameworks are robust, with stringent risk management requirements and investor protection measures.

Way forward

SEBI’s proposal marks a significant step towards modernising the Indian debt market. However, the success of this move hinges on several factors. SEBI needs to establish a comprehensive regulatory framework that addresses the complexities of CDS trading, including risk management, margin requirements, and reporting standards. Further, SEBI should focus on investor education initiatives which are crucial to ensure that investors understand the risks and benefits of CDS and make informed investment decisions.

In addition, importance should be given to developing a robust market infrastructure, including trading platforms, clearing-houses, and data repositories, which are essential to facilitate efficient and transparent CDS trading. SEBI’s decision to allow mutual funds to trade CDS has the potential to revolutionise the Indian debt market. It could enhance liquidity, improve risk management, and deepen the corporate bond market.

Williams is the Head of India at Sernova Financial and Kalidasu is a Ph.D student at Alagappa University, Karaikudi