Securities and Exchange Board of India (Sebi) is considering a new framework to allow mutual funds (MFs) to participate in credit default swaps (CDS) as part of a series of actions the regulator plans to develop a corporate bond market in the country.

The market watchdog set up a working group to identify flaws in a framework introduced over a decade ago that failed to get off the ground. The committee’s mandate includes recommending sweeping reforms to promote risk mitigation and invest in lower-rated corporate bonds, the people said.

In November 2012, Sebi allowed MF to participate in the CDS market, but only as a buyer. Additionally, the framework has a conservative cap on positions. Because of these and other constraints, volumes in the CDS market did not pick up.

“The market regulator wants to deepen the domestic corporate bond market. Greater participation through CDS will help reduce risk and increase demand for bonds rated below AA, which carry a credit risk premium,” one of the people said.

Mutual funds can only participate as protected buyers, meaning they can only use the mechanism to hedge their credit risk. They are not allowed to sell protections that limit their shorting in CDS contracts.

A CDS allows one investor to offset its credit risk with another investor willing to pay back if the borrower or bond issuer defaults. It facilitates the exchange of default risks through derivative contracts. Experts say that, as a class of stocks has an active derivatives market, corporate bonds need a similar infrastructure.

Industry insiders believe that the revised framework is the key to market development but will also face some challenges.

The CDS framework is being revisited while allowing alternative investment funds (AIFs) to participate as protected buyers and sellers. The decision was made earlier this month.

According to officials, the banking regulator is also expected to develop some framework for the CDS next month. Norms from other regulators will be crucial for the market to keep pace. Sebi’s framework will be in line with the changes prescribed by the RBI, officials said.

Industry experts believe that Category II AIFs will be more involved in the CDS market with the Sebi approval. Alternative investment funds such as private equity funds or debt funds fall into this category.