The Securities and Exchange Board of India (Sebi) has allowed alternative investment funds to participate in credit default swaps (CDS) to protect buyers and sellers.

Category I and II AIFs may purchase CDS on underlying investments in debt securities for hedging purposes only. Category III AIF can buy CDS for hedging or other purposes within the leverage allowed, the regulator said on Thursday.

Experts say the impact may be limited as the current credit default swap market is very illiquid.

Category II and III AIFs may sell CDS by designating unencumbered government bonds and treasury bills equivalent to the above CDS exposure. Such designated securities may be used to maintain applicable margin requirements for CDS exposures, as described above. This exposure is not the same as leverage.

The aggregate exposure of investee companies, including exposure through CDS, will be within the limits of the applicable concentration norms in the AIF regulations.

The AIF should report the details of the CDS transaction to the Custodian by the next working day.

Any unhedged position which may result in the aggregate unhedged part of all CDS transactions exceeding 25% of the investable funds of the AIF scheme can only be taken after notification to all unitholders of the scheme.