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Sebi may Tighten Liquid MF Rules

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The Securities and Exchange Board of India (Sebi) is considering a proposal to tighten rules for liquid mutual funds holding assets worth ?8 lakh crore or more to curb volatility in flows following the challenges facing finance companies in the wake of the debt default by Infrastructure Leasing & Financial Services (IL&FS). The capital market regulator is planning a short lock-in period for investments in liquid funds, in which investors — mostly large companies — park idle cash. Sebi may also make it mandatory for liquid funds to mark to market the value of more bonds and allow segregation of debt instruments in mutual fund portfolios that are in trouble, said three people aware of the development.
These measures are likely to be discussed at the Sebi-appointed mutual fund advisory committee meeting on Monday. A lock-in period, aimed at reducing volatility in flows, could reduce the popularity of the product among institutional investors, experts said. Most banks churn their portfolios toward the end of the quarter to meet capital adequacy norms, selling securities just before the three-month period is over so that the investment needn’t be provided for while calculating capital adequacy. They repurchase the same instruments within a week. “This leads to unneeded volatility,” said one of the people cited above. “In the past there have been instances where debt MFs have seen redemption of ?60,000-70,000 crore even as net flows were at a record high.”
NAVs of Certain Funds Could Fall
The move will, however, not go down well with the industry. The chief executive of a midsized mutual fund said the industry will lose out to competition in case lock-in is long. "A lock-in should be finely balanced. It should be just about long enough to soften the volatility in flows but it should not be too long to kill the product," the chief executive said. Liquid funds are popular with institutional investors as there are no restrictions on entry or exit. Though liquid schemes do not fetch the highest returns, investors prefer to park their excess money because the focus of this product is on liquidity. Also, this scheme category does not charge a fee for early redemptions.
 
Sebi may also make it mandatory for liquid funds to mark to market the value of all bonds that have maturity of 30 days or more. Fund houses are currently only required to factor in the mark-to-market value of securities with a maturity of 60 days or more. Liquid debt MFs only invest in debt securities with a maturity value of 90 days or less. Unlike listed equities, most corporate debt securities are not publicly traded. Even those that are, do not see much trading activity and hence prices quoted are often not fair value.
 
Currently, these funds calculate net asset value (NAV) based on indicative prices sent by rating agencies for securities with less than 60-day maturity and mark to market the value of others. If the requirement is increased to 30 days and above, the proportion of securities whose mark to market value is captured in the NAV increases. This will paint a more realistic picture about the portfolio for the investors. However, on the flip side, the NAVs of certain funds could see a fall due to changes in the valuation mechanism.
 
“Through this measure, Sebi wants to move away from simple accrual method to a more market-linked valuation. Liquid fund is a money market fund, hence it is good to be conservative,” said one of the persons cited above. “In India, it becomes more important because there is no liquidity in the corporate debt market.”

‘PRECAUTIONARY MEASURE’
The chief executive of a domestic fund house said the measure was precautionary in nature. “The tightening of liquid fund regulations post the Lehman crisis has ensured all liquid funds maintain highrated papers only. However, such lowering will impact returns in some of the schemes and shift the lending activity to 30 days from 60 days currently,” he said. The move is seen smoothening out abrupt changes in NAVs and improve transparency for unit holders.
 
Sebi is also planning to introduce new rules on segregation of mutual fund portfolios or so-called side-pocketing in the event of a default by a company on its bonds. Side-pocketing is a method by which a fund separates a single or group of instruments from the main portfolio. In current context, in case of a default, the fund house will be able to segregate the defaulted paper from the rest of the portfolio so the overall NAV doesn’t take a hit. This will prevent massive redemption pressure on a fund due to default in a single instrument.
 
The clamour for standardised regulations for portfolio segregation has increased significantly in the last two years. The defaults in debt paper of companies like Amtek Auto and JSPL led to big redemptions in some funds. However, the regulator is also planning to put in place sufficient checks and balances to prevent fund houses from misusing the facility. For instance, asset management companies (AMCs) will be allowed to carry out segregation only once in two or three years with the approval of the trustees. It will be allowed only in those papers with a default rating.

One of the persons cited above said the process had to be conducted in a manner that didn’t discriminate among investors. “Mutual funds should be designed in such a way that it is beneficial to existing investors as well as prospective investors,” the person said. “In a few instances, it has been noticed that some informed investors exited early while others were stuck.”
The Economic Times, 12th November 2018

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