AIF Participation in Financial Reforms

As of 30 June 2022, Other Investments (“AIFs”) registered with the Securities and Exchange Board of India (“SEBI”) reportedly allocated 30% of their investments to debt and debt consolidation.1 In response, SEBI2 revised3 the AIF Regulations (“Decoration”) to allow AIFs to buy and sell credit securities (“CDS”)4 to hedge or value credit risk. This permission, however, is subject to certain restrictions and conditions, which are different for different categories of AIFs, which are further explained in a circle (“Circle“).5 It is explained below.


Part I

Part II

Part III

AIF is a CDS seller

Category I and Category II AIFs can buy CDS, but only to hedge risks on credit investments.

Category III AIFs can buy CDS for hedging risks on a credit investment.

A Category III AIF may also purchase CDS for purposes other than hedging risk. However, such exposures to CDS cannot exceed twice the fair value of the fund’s assets.6

AIF is a CDS seller

The Amendment and the Author are silent on this point. We find this unacceptable.

Category II AIFs can sell CDS by rating Government bonds without the risk equivalent to CDS exposure so that they do not reach the creation.

Category III AIFs can sell CDS if they “perform efficiently” within the permitted limits (eg, double the value of the underlying assets fund).

They can sell the CDS by rating the Government bonds without the hassles/ fees similar to the CDS exposure. Such CDS exposures cannot be generated.

Normal condition

It is not appropriate because the Amendment and the Circular are silent on the sale of CDS by Category I AIFs.

The amount of exposure to the investment company through CDS should not violate the regulatory requirements. These norms, for Category II AIFs, provide that not more than 25% of the AIF’s investment can be invested in a single investment company.

Any unsettled position results in the total unsettled position value of all CDS transactions exceeding 25% of the investment. it can be implemented after informing all business owners.


Sponsor / Manager of Category I or Category II AIF carrying out CDS transactions must appoint a custodian registered with SEBI irrespective of the size of the body.7

All Category III AIFs are required to appoint a custodian under the AIF Regulations.8


Details of CDS transactions must be reported to the custodian before the end of the next business day (on system dictated by the caregiver).

Offenses due to specific securities falling under the CDS exposure

It is not appropriate because the Amendment and the Circular are silent on the sale of CDS by Category I AIFs.

If specific securities of Tier II or III AIF fall under CDS exposure, it should

  1. report the violation to his guardian on the day of the violation;

  2. bring the amount of specific securities equal to the CDS exposure and report the correction information to the custodian at the end of the trading day ;

If the AIF fails to correct the violation, then the watchdog is required to report the information to SEBI on the next working day.

Violation of leverage limits

Not Applicable as Class II AIFs are not permitted to sell CDS in a similar manner to leverage.

A Category III AIF in violation of the appropriate leverage limit

  1. report the violation to his guardian on the same working day;

  2. report the violation to the operator by 10 a.m. the next business day;

  3. square off the overexposure and bring the exposure back within limits, and report this to all investors in the feed due date of limitation.

Rest period

Category I and Category AIFs trading in CDS must maintain a grace period of thirty days between two periods of any borrowing or surplus. you do.

Not applicable.

The Circular mandates that all CDS transactions must be conducted on a platform regulated by SEBI or the Reserve Bank of India (“RBI“). These transactions should also be in accordance with the Master Direction – Reserve Bank of India (Credit Derivatives) Directions, 2022 (“Director General“). The main aspects of the Master Direction relevant to AIFs of CDS transactions are outlined below.

  1. Organizational Identity: AIFs can enter into a CDS contract only to hedge or hedge the risks of investors (called “reference funds”) domiciled in India , against their credit risk of the CDS contract.9

  2. Identity Standards: The Master Directive refers to the underlying asset to which a CDS contract is linked as the “reference instrument”. AIFs are prohibited from entering into CDS contracts linked to asset-backed securities/mortgage bonds or structured obligations.10

  3. Related Section: CDS trading is not allowed if the specific reference is a related part of “hedge sale” or “sell protection”.11

  4. Accounting: To follow the guidelines prescribed by SEBI. In the absence of such conditions, AIFs should follow the guidelines issued by the Institute of Chartered Accountants of India.12


By allowing AIFs to participate in CDS, SEBI has made it easier for AIFs to manage and deliver their financial risk, and also to promote to new organizational games in the market. SEBI is still mulling over allowing Tier II AIFs to be securities buyers without designating unencumbered securities of equal value and the CDS. Despite this view, the Amendments are welcome since they allow AIFs to guarantee the creditworthiness of certain debt instruments. This allows greater flexibility as opposed to SEBI’s usual position against allowing AIFs to make any guarantee.

In any case, it remains to be seen whether the AIF industry’s demand for CDS trading is appropriate in the current framework. One may remember that mutual funds were allowed to participate in the CDS market ten years ago. However, the market did not go away. The cost of buying the CDS should be commensurate with the benefit that the AIF derives from credit risk protection. In the absence of market participants that allow commercial use of CDS transactions, the new regulatory environment is unlikely to allow the market to continue. It remains to be seen whether AIF interest in CDS trading will be maintained for the long term, or whether it will follow in the footsteps of mutual funds.

The authors would like to acknowledge and thank Athul Kumar (female, Symbiosis Law School, Pune) for his contribution to this thread.


1 SEBI Board Meeting Minutes on December 20, 2022.

2 SEBI (Substitute Investments) (Amendment) Regulations, 2023.

3 Regulations 16(1)(aa), 17(da), 18(ab) and 20(11).

4 A CDS is defined as “is a derivative contract in which one counterparty (the security buyer) makes payments to the other counterparty (the security buyer) in the form of a specific debt related to a reference entity and in return, the protection buyer makes periodic payments (premium) to the protection buyer until the maturity of the contract or the credit event, whichever is earlier.” See: Para 2(f), Master Direction – Reserve Bank of India (Credit Derivatives) Directions, 2022 (February 10, 2022, FMRD.DIRD.10/14.03.004/2021-22).

5 SEBI/HO/AFD/PoD/CIR/2023/15.

6 SEBI circular no. CIR/IMD/DF/10/2013 dated July 29, 2013.

7 Regulation 20(11), AIF Regulations.

8 Regulation 20(11), AIF Regulations.

9 Para 7, RBI Master Directions.

10 Para 7, RBI Master Directions.

11 Para 8, RBI Master Directions.

12 Para 12, RBI Master Directions.

Nishith Desai Associates 2023. All rights reserved.National Law Review, Volume XIII, Number 20

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