[Parv is a student at National Law University, Odisha.]
To the flourishing stride of alternative investment fund (AIF) regime in India, adds another feather in the form of gates for assuming and hedging credit risks. The Securities and Exchange Board of India (SEBI), through its recent amendment to the Securities and Exchange Board of India (Alternative Investment Funds) Regulations 2012 (Regulations) read with the circular dated 12 January 2023, has allowed AIFs to participate in credit default swap (CDS) transactions as protection buyers or protection sellers in the CDS market within certain regulatory limitations. Premised on the successful investment portfolios of AIFs in debt and securitized debt instruments (which account for around 30% of the total investment portfolio of AIFs, as evident here), this amendment is an endeavor to give an impetus to the not-so-successful corporate bond market in India. This article is an attempt to understand the enabling provision with a brief analysis of the same on the Indian market, more so on the Indian corporate bond market.
Understanding Alternative Investment Funds
AIFs are privately collected pools of funds that aim to invest in different asset classes including the highly-buzzed-around startups, and publicly traded entities among others. It is an alternative to those classes of investors who are looking for an alternative to the generally volatile stock market instruments and offers diversification in their portfolio. The Regulations provide for three classes of AIFs - Category I, Category II, and Category III AIFs - out of which the first two are more stringently regulated as compared to their third counterpart. The Regulations prohibit Category I funds to leverage while it is partially allowed for operating expenses in the case of Category II funds. However, the same is allowed even for investing when it comes to the Category III of AIF.
What is Credit Default Swap?
Emanating from the financial ecosystem of JP Morgan, CDS is a derivative contract that primarily aims to hedge against a credit risk. It is a kind of insurance to a lender (protection buyer) against the defaults of the borrower (referencing entity) in repayment of loans, especially corporate bonds. Such insurance is in lieu of a premium paid to the insurer (protection seller). Earlier, RBI had put in place the master directions with regard to credit derivatives in 2022, which defined CDS as a “credit derivative contract in which one counterparty (protection seller) commits to pay to the other counterparty (protection buyer) in the case of a credit event with respect to a reference entity and in return, the protection buyer makes periodic payments (premium) to the protection seller until the maturity of the contract or the credit event, whichever is earlier." The major drivers and players of the CDS market have hitherto been the scheduled commercial banks with a few exceptions like housing finance corporations and NBFCs also playing their role. Though the Indian legal regime allowed CDS quite a long time back, it has largely remained unsuccessful and not so prevalent till now. The proposed amendment is therefore brought to invigorate the CDS by the hands of AIF, categorically, in the Indian corporate bonds.
The New Norm: Understanding the Change in Law
The new norm allows Category I and Category II AIFs to buy CDS only for the purposes of hedging risks in underlying investments of debt. However, the new norm allows open hands to Category III funds to buy CDS for hedging as well as for other purposes within the permissible leverage limit, that is, an exposure of CDS not more than two times the net asset value of the fund. The amendment allows Category III AIFs to also sell off their CDS, provided that this 'effective leverage undertaken' is within the specified limits of SEBI. Not only that, but these Category III Funds are also required to earmark government securities at par with their CDS exposure. Similarly, Category II AIFs have also been allowed to sell off their CDS, provided that they earmark government securities equal to their CDS exposure. The SEBI has also made it clear in the new circular that the CDS exposure of an AIF shall not tantamount to leverage.
The new norm requires that the exposure to an investee company, even through a CDS, should not breach the prescribed concentration limits from SEBI. The market watchdog has also asked the AIFs to report about the CDS transactions to the custodian by the very next working day itself. It also casts a duty of instantaneous reporting (to the custodian) and rectification on Category II and Category III AIFs in case their earmarked securities go below their CDS exposures.
Further, the change provides that any unhedged position that leads to the gross unhedged positions of all CDS transactions exceeding 25% of the investable funds of the AIF scheme would be taken only after informing all the unit holders of the scheme. Additionally, to avoid prolonged leverage, the Category I and II AIFs transacting in CDS are required by the new norm to maintain a cooling-off period of 30 days between two periods of leverage or borrowing. Also, SEBI requires all CDS transactions by AIFs to be traded on some regulated platform in order to enhance transparency and accountability in the dealings.
Analysis and Observations
The permission to AIF to put their hands in the CDS market is an enabling gesture from SEBI to provide the wax of credit risk management to AIFs. By allowing AIFs that have already invested millions in debt securities, CDS offers them an important avenue of risk transference and management and also extends a shell of protection to them during unfavorable times of credit events.
This amendment marks a positive attitude from the SEBI to provide more feathers for growth to AIFs, unlike its earlier restrictive stance to any sort of guarantees from AIFs. With posing confidence in AIF to upkeep the nerve of economic stability, especially through the derivatives, SEBI has signaled in unequivocal terms that it is open to a more dynamic growth of the AIF sector.
However, a close look at the amendment flags some key issues which are highlighted here:
Low appetite for low-quality credit
The CDS may not be successful for high credit-quality corporate bonds like secured sovereign-backed, Triple AAA Bonds. It may hold good when it comes to the low-quality credit market. However, there is a very less appetite for low-quality credit in India including corporate bonds. This low-quality credit is usually offered as products from private unlisted funds, from whom the CDS sellers might be uninterested in buying owing to a lack of trust. This is one of the primary reasons why India’s corporate bond market has still not seen the sunshine of success. Therefore, this amendment is only a wax to the corporate bond industry but not the fuel for its progress.
Unclear stance over CDS by Category I AIF
While the amendment does allow Category I AIFs to buy CDS for hedging, it does not specify the after-modalities that need to be followed by the Category I AIFs. There has been no clarity provided with respect to the selling off of CDS by Category I AIF. They have been largely undermined in the amendment, though they have a crucial role to play in the AIF industry.
Not a good experience from mutual funds industry
Though the AIFs have been recently allowed to partake in CDS transactions, the same was allowed to the mutual funds industry around a decade ago. However, till now, the mutual funds industry has not even taken off when it comes to its dealings in CDS. Further, these amendments come at a time when SEBI itself is planning to revamp and mull afresh the present regulatory regime for CDS in the mutual funds industry.
Conclusion
The AIF industry is booming at an all-time high pace. With the latest amendment to the Regulations, AIFs have been allowed to participate in CDS transactions. This amendment is a welcoming step as it allows the AIFs to manage and transfer credit risk and take shell off from unfavorable credit events. However, the primary goal of the change, that is, to bring impetus to the corporate bond market of India, is not easy to be achieved. The corporate bond industry has hitherto been majorly lackadaisical owing to unlisted private functioning with less of sound trust in the market.
However, there has been an initial positive sign from AIFs as regards the new regulatory amendment. Therefore, what needs to be seen is what AIFs have got to do with the Indian corporate bond market in the near future using the derivative boat of CDS at their disposal.
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