SEBI has modified Interest Rate Swap (IRS) rules for mutual funds in which it has done away with the 10% cap on IRS transactions through Clearing Corporation of India's (CCIL). However, the cap is still applicable on single counterparty transactions through market makers approved by RBI.
Mutual funds invest in IRS to hedge interest rate risk. IRS is a derivative that allows two parties to exchange future interest earnings without exchanging the debt papers.
It works like this - One party to this transaction agrees to give a fixed coupon on an instrument to a counterparty, and other party gives floating rate linked to a benchmark. It is difference in views that is traded. When a fund manager swaps fixed coupon on an instrument in the market, the instrument remains in the portfolio. It is a notional trade where the coupon (or part of the coupon) on a fixed rate instrument is swapped for floating rate.
Fund managers have to execute such transactions through market makers, which can be risky as the transaction carries a risk of other party failing to honour the deal. Hence, SEBI has capped exposure to a single counterparty at 10% to reduce extent of risk involved due to default.
Debt Guru Joydeep Sen said that SEBI has not kept single counterparty limit on CCIL transactions as the platform carries no such risk. “In mutual funds, there's a general rule that schemes cannot have over 10% exposure to a single stock or bond issuer. But there are certain exemptions to it like government securities and treasury bills as they are risk free. The same logic has been applied here. IRS transactions through CCIL are risk free because the counterparty in these transactions is CCIL. The absence of risk has made it possible for SEBI to allow such transactions without the 10% limit,” Sen said.
