9 Decoding Credit Default Swaps: A Comprehensive Guide to SEBI's Guidelines for Alternative Investment Funds

Key Takeaways:

- Category I and II AIFs can buy CDS only for hedging underlying debt investments.

- Category III AIFs can buy CDS for hedging or other purposes within permissible leverage limits.

- Category III AIFs can sell CDS within leverage limits or by earmarking unencumbered government securities.

- Total exposure to an investee company, including through CDS, must comply with concentration norms.

- AIFs must report CDS transactions to custodians and maintain compliance with leverage and disclosure requirements.

Detailed Narrative:

The Securities and Exchange Board of India (SEBI) has introduced guidelines to govern the participation of Alternative Investment Funds (AIFs) in Credit Default Swaps (CDS). These guidelines aim to promote transparency, risk management, and a well-regulated investment landscape.

Under the SEBI (Alternative Investment Funds) Regulations, AIFs are permitted to participate in CDS transactions, subject to specific conditions. The guidelines outline the circumstances under which Category I, II, and III AIFs can buy or sell CDS.

For Category I and Category II AIFs, the guidelines stipulate that they can buy CDS only for the purpose of hedging their underlying investments in debt securities. This provision allows these AIFs to mitigate potential risks associated with their debt investments.

Category III AIFs, on the other hand, have greater flexibility in their CDS participation. They can buy CDS for hedging purposes or for other investment objectives, provided that the effective leverage undertaken remains within the permissible limits specified by SEBI.

When it comes to selling CDS, Category III AIFs are permitted to do so, subject to the condition that the effective leverage remains within the prescribed limits. Additionally, Category II and Category III AIFs can sell CDS by earmarking unencumbered government bonds or Treasury bills equal to the amount of the CDS exposure. This earmarking of securities serves as a safeguard and ensures that the AIFs have sufficient collateral to meet their obligations.

Importantly, the total exposure to an investee company, including exposure through CDS transactions, must remain within the applicable concentration norms specified in the AIF Regulations. This measure aims to prevent excessive concentration risk and promote diversification within the AIFs' investment portfolios.

To ensure compliance and transparency, AIFs participating in CDS transactions are required to report the details of their CDS transactions to the appointed custodian by the next working day. The custodian, in turn, is responsible for monitoring the AIFs' compliance with the conditions specified in the guidelines.

In the event of a breach of leverage limits due to CDS transactions by Category III AIFs, the AIFs and custodians are required to follow specific procedures outlined in the guidelines. This includes reporting the breach to SEBI and taking necessary steps to rectify the situation within a specified timeline.

Furthermore, SEBI mandates that any unhedged positions resulting in gross unhedged positions across all CDS transactions exceeding twenty-five percent of the investable funds of an AIF scheme must be intimated to all unitholders of the scheme.

The guidelines also emphasize the importance of transparency and disclosure. AIFs transacting in CDS are required to ensure compliance with applicable provisions of the Reserve Bank of India's (RBI) Master Direction on Credit Derivatives and other directives issued by the RBI from time to time.

FAQs:

Q1: Can Category I AIFs buy CDS for purposes other than hedging?

A1: No, Category I AIFs can buy CDS only for the purpose of hedging their underlying investments in debt securities.

Q2: Are Category III AIFs allowed to sell CDS without any restrictions?

A2: No, Category III AIFs can sell CDS, but they must ensure that the effective leverage undertaken remains within the permissible limits specified by SEBI.

Q3: How do AIFs ensure compliance with concentration norms when participating in CDS transactions?

A3: The total exposure to an investee company, including exposure through CDS transactions, must remain within the applicable concentration norms specified in the AIF Regulations.

Q4: What is the role of the custodian in monitoring AIFs' participation in CDS transactions?

A4: The custodian is responsible for monitoring the AIFs' compliance with the conditions specified in the guidelines, including leverage limits and reporting requirements.

Q5: Are AIFs required to disclose their unhedged CDS positions to unitholders?

A5: Yes, any unhedged positions resulting in gross unhedged positions across all CDS transactions exceeding twenty-five percent of the investable funds of an AIF scheme must be intimated to all unitholders of the scheme.

Key Precedents:

- SEBI (Alternative Investment Funds) Regulations:

These regulations provide the overarching framework for AIFs, including provisions related to investment strategies and concentration norms.

- SEBI Circular No. SEBI/HO/AFD/PoD/CIR/2023/15 dated January 12, 2023:

This circular outlines the specific conditions and guidelines for AIFs participating in Credit Default Swaps.

- RBI Master Direction - Reserve Bank of India (Credit Derivatives) Directions, 2022:

AIFs transacting in CDS must comply with the applicable provisions of this RBI directive and other related directives issued by the RBI.

The SEBI (Alternative Investment Funds) Regulations and the subsequent circulars issued by SEBI establish the legal framework and guidelines for AIFs participating in Credit Default Swaps. These precedents outline the conditions, reporting requirements, and compliance measures to ensure transparency, risk management, and a well-regulated investment ecosystem.

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Here's AIF Master Circular's verbatim Chapter 9

Chapter 9 - Participation of AIFs in Credit Default Swaps{30}

Regulations 16(1)(aa),17(da), 18(ab) and 20(11) of AIF Regulations enable AIFs to participate in CDS in terms of the conditions as may be specified by SEBI from time to time. In this regard, the following is specified:

9.1. Conditions applicable to Category I, II and III AIFs for buying CDS

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

9.1.2. Category III AIFs may buy CDS for the purpose of hedging or otherwise, within permissible leverage as specified in para 5.2 of this Master Circular.

9.2. Conditions applicable to Category II and III AIFs for selling CDS

9.2.1. Category III AIFs may sell CDS, subject to the condition that effective leverage undertaken is within the permissible limits as specified in para 5.2 of this Master Circular.

9.2.2. Further, Category II AIFs and Category III AIFs may sell CDS, by earmarking unencumbered Government bonds/Treasury bills equal to the amount of the said CDS exposure. Such earmarked securities may also be used for maintaining applicable margin requirements for the said CDS exposure. Exposure to CDS undertaken in the aforesaid manner shall not tantamount to leverage.

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

9.3. Other conditions applicable for transacting in CDS

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

9.3.2. Custodian shall put in place a mechanism to collect necessary details from AIFs transacting in CDS, to monitor the compliance with conditions specified at para 9.1 and para 9.2 above.

9.3.3. The obligation of manager/AIF and custodian in case of breach of leverage limits due to transactions in CDS by Category III AIFs, shall be as specified in para 5.2.13 and para 5.2.14 of this Master Circular.

9.3.4. Further, for Category II AIFs and Category III AIFs which sell CDS by earmarking securities in the manner as mentioned at para 9.2.2 above, in case the amount of earmarked securities falls below CDS exposure:

a. The AIF shall send a report to 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.

9.3.5. Any unhedged position, which shall result it gross unhedged positions across all CDS transactions exceeding twenty-five percent of investable funds of the scheme of an AIF, shall be taken only after intimating to all unit holders of the scheme.

9.3.6. In terms of Regulations 16(1)(c) and 17(c) of AIF Regulations, Category I and II AIFs shall not borrow funds directly or indirectly and engage in leverage except for meeting temporary funding requirements for not more than thirty days, not more than four occasions in a year and not more than ten percent of the investable funds. In this regard, Category I and Category II AIFs which transact in CDS, shall maintain thirty days cooling off period between the two periods of borrowing or engaging in leverage.

9.3.7. All CDS transactions shall be on a platform regulated by SEBI or RBI, to enhance transparency and disclosure.

9.3.8. 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.

Note:-

{30}SEBI Circular No. SEBI/HO/AFD/PoD/CIR/2023/15 dated January 12, 2023