The SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) were amended and notified on January 9, 2023 to allow Alternative Investment Funds (“AIFs”) to participate in Credit Default Swaps (“CDS”) buyers and sellers of protection from any credit default. Regulations 16(1)(aa), 17(da), 18(ab) and 20(11) of the 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, SEBI issued a circular on January 12, 2023 specifying the following conditions:

1. Conditions applicable to Category I, II and III AIFs for buying CDS:
   • Category I AIFs and Category II AIFs may buy CDS on any underlying investment by the AIF in debt securities, only for the purpose of hedging.
   • Category III AIFs may buy CDS for the purpose of hedging or otherwise, within permissible leverage as specified in SEBI circular no. CIR/IMD/DF/10/2013 dated July 29, 2013.

2. Conditions applicable to Category II and III AIFs for selling CDS:
   • Category III AIFs may sell CDS, provided that the effective leverage undertaken is within the permissible limits as specified in SEBI circular no. CIR/IMD/DF/10/2013 dated July 29, 2013.
   • 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.
   • Total exposure to an investee company, including exposure through CDS, shall be within the limit of applicable concentration norm specified in the AIF Regulations.

3. Other conditions applicable for transacting in CDS:
   • AIFs are required to report the details of CDS transaction to the custodian, by the next working day, in the manner specified by the custodian.
   • Customers shall put in place a mechanism to collect necessary details from AIFs transacting in CDS to monitor compliance with conditions specified in paragraphs A and B above.
   • 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 specified in para 3.4 of SEBI circular no. CIR/IMD/DF/10/2013 dated July 29, 2013 read with para 1 of SEBI circular no. CIR/IMD/DF/14/2014 dated June 19, 2014.
   • Further, for Category II AIFs and Category III AIFs which sell CDS by earmarking securities in the manner as specified in paragraph 4 above, in case the amount of earmarked securities falls below CDS exposure:
   1. the AIF shall send a report to the custodian on the same day of the breach.
   2. the AIF shall also bring the amount of earmarks securities equal to CDS exposure and report the details regarding rectification of breach to custodian, by the next trading day.
   3. in case the AIF is unable to rectify the breach in the manner specified above, the custodian shall report the details of the breach to SEBI, on the next working day.

• Any unhedged position, which shall result in gross unhedged positions across also CDS transaction exceeding 25% (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.
• In terms of Regulations 16(1)(c) and 17(c) of the AIF Regulations, Category I and II AIFs shall not borrow funds directly or indirectly and engage in leverage except for meeting temporary funding requirement for not more than thirty days, not more than four occasions in a year and not more than 10% (ten percent) of the investable funds. In this regard, Category I and II AIFs which transact in CDS, shall maintain a 30 (thirty) day cooling off period between two periods of borrowing or engaging in leverage.
• All CDS transaction shall be on a platform regulated by SEBI or Reserve Bank of India to enhance transparency and disclosure.
• AIFs transacting in CDS, shall also ensure that they comply with applicable provisions of RBI notification on “Master Direction – Reserve Bank of India (Credit Derivatives) Directions, 2020” dated February 10, 2022, as well as any other directives issued by the Reserve Bank of India in this regard from time to time.

Please find a copy of the circular, here.

This update has been contributed by Vinod Joseph (Partner) and Vasavi Khatri (Associate).

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