SEBI’s restriction on inter-scheme transfer for mutual funds is a good step, but not enough

-Mr. Rajiv Shastri

Professor of Practice, NISM

Making debt instrument prices public, even with a small lag, would go a long way in increasing transparency in the MF industry

In the aftermath of the Franklin Templeton imbroglio, a lot has been written and said about how debt mutual fund (MF) schemes are managed, and there’s been debate about the possible changes that may impart a more secure investor experience.

The biggest challenges faced by the MF industry and many of its practices reflect the well-accepted fact that debt MF schemes offer more liquidity to their investors than that available in the underlying debt market to the schemes themselves. This liquidity mismatch is allowed to persist because, under normal market conditions, this does not cause any problem. It is only when market conditions deteriorate those significant challenges emerge.

India’s MF regulations not only accept, but also bless this liquidity mismatch in many ways. One of these is the ability of MF schemes to borrow to meet redemption requirements. The other is permission for the practice of “Inter-Scheme Transfers (ISTs)” which permits the transfer of securities from one scheme to another directly, bypassing the market.

Both these practices assume that the underlying asset market cannot provide the liquidity offered to investors in MF schemes. If the underlying asset markets were liquid enough, these would not be needed. This is also evidenced by the fact that both practices have evolved in ways reflective of underlying market liquidity.

It is extremely uncommon for equity funds to either borrow to meet redemptions or for ISTs to be carried out in equity shares because the equity market, in general, offers more liquidity than that required by equity schemes. It is unimaginable that an equity MF scheme will not be able to sell any of its assets in the market to generate liquidity to meet redemptions. If a few of its holdings are illiquid, there are others that are liquid and can be sold.

This, however, cannot be said for all debt MF schemes. To begin with, instrument level liquidity in the debt market is inherently inconsistent because unlike the equity markets, individual issuers can and do issue multiple instruments. The sheer number of debt instruments outstanding at any point in time makes it impossible for each instrument to be traded consistently. For example, even the famed liquidity of the government securities segment is restricted to a handful of the more than 100 government debt securities. In fact, there are close to 4,000 tradeable debt instruments issued by central and state governments available at any point of time, a small fraction of which are traded regularly.

To make matters worse, a fractured market structure with shared regulatory responsibilities and multiple trading & settlement platforms makes widespread participation in the debt markets impossible to achieve.

All these factors combine to focus corporate debt market liquidity on a few issuers and instruments based on some robust and other tenuous preferences. Only MF schemes that hold a dominant portion of their portfolio in instruments that meet established and robust market preferences experience adequate liquidity on their asset side and can independently ensure liquidity to their investors. Others cannot. One such preference that has proven robust through the years is that towards higher-rated instruments.

One of the consequences of the lack of liquidity for each of the numerous debt instruments is the absence of a market price for each of them. Fortunately, the debt market operates primarily on relative value where the price of each asset is intricately linked to another. As a result, it is possible to derive an estimate of the price of an illiquid instrument from that of traded liquid instruments.

Reflecting the divided state of the debt market, the task of ascertaining a daily price for each instrument is completed in two different ways. For instruments issued by central and state government, daily prices are calculated by Financial Benchmarks India Pvt. Ltd (FBIL). For all other debt instruments, CRISIL Ltd. and ICRA Ltd. provide daily prices to the MF industry. But the differences do not end here.

While the prices published by FBIL are publicly available, those used by the MF industry are kept confidential. Making these available in the public domain, even with a small lag, would go a long way in increasing transparency in the MF industry.

In any case, the prices are, at best, estimates. For central and state government debt instruments, though the relationship between instruments can vary, it is reasonably stable. The relationship between corporate debt instruments, on the other hand, is significantly more volatile. This is especially true for lower rated instruments. As a result, not only are such instruments illiquid they are extremely difficult to price correctly. This frailty only makes ISTs using these prices extremely suspect and increases the probability that one of the schemes involved benefits at the expense of the other. It also evokes the possibility that such a benefit can be transferred knowingly.

A recent circular issued by the Securities and Exchange Board of India (SEBI) imposes additional restrictions on ISTs and strengthens the accountability of Fund Managers (FMs) for the performance of transferred instruments. While this is extremely welcome, there is a lingering fear that it does not go far enough. A lower limit for the credit rating of instruments eligible for ISTs may just be the appropriate remedy. This, along with publicly available daily valuation prices will effectively ensure that this well-intended facility is not misused henceforth.

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