BackOpinion | The unintended consequences of Sebi rules on exit loads for liquid funds
There may be an impact on short-term money market rates and liquidity
PremiumOver the years, capital markets regulator Securities and Exchange Board of India (Sebi) has done a remarkable job in introducing regulations which make mutual funds transparent and accessible and, more importantly, in shaping asset management companies’ (AMCs) behaviour towards working in the interest of investors. Sebi has been even more steadfast in bringing in regulations for debt funds, especially post the 2008 Lehman crisis, when the Reserve Bank of India (RBI) had to open up a liquidity window to help liquid funds and debt funds to meet investor redemptions. The liquid fund and debt fund industry has come a long way since.
We should have no hesitation in stating that Indian liquid mutual funds, especially now, would be the best in the world in terms of risk management. A liquid fund a) can invest only in 91-day maturity; b) needs to hold 20% of its assets in cash equivalents and treasuries; c) will have to mark-to-market all investments daily; d) cannot invest in bank deposits and structured credits; and e) will have a graded exit load for up to seven days.
Except for point (a) which has existed for many years, points (b-e) have been Sebi’s response to the repeated cases of defaults, downgrades and liquidity mismatches leading to scheme borrowing for redemptions that many liquid funds have faced in the last four years. All these are in investors’ interest and no one can argue against their merit. In fact, I would argue, some of them were well overdue as reform measures.
Nevertheless, it is point (e); on the issue of exit loads, that may engender an unintended market dislocation. Let me explain.
The merit of an exit load has been long lobbied for by banks who claimed to miss out on short-term fixed deposits by corporates. Fixed deposits (FD) have a minimum maturity of seven days, whereas liquid funds are single-day investments. So technically, especially before the mark-to-market (MTM) rules came about, a corporate was enjoying FD-like assured returns with daily liquidity. Given that liquid funds and/or debt funds are not FDs and that their returns should not be guaranteed, there is merit in moving to full MTM and many would argue in favour of having exit loads. The seven-day exit load rule is thus no co-incidence. It is to bring liquid funds on a par with short-term bank deposits. Liquid fund managers also face ALM (asset-liability mismatch) issues everyday as large corporates and insurance firms move their money in and out. This may reduce post the introduction of exit loads.
Corporates, especially those who were daily investors and do not wish to expose themselves to MTM volatility and/or pay exit loads, may decide to stop investing in liquid funds and may move to the overnight fund category. Banks, another large investor which invests in liquid funds but mostly for arbitrage, will most likely cease investments in liquid funds given the exit load. This would lead to a drop in liquid fund assets under management (AUM). On its own, that is fine, but when seen in the context of Sebi’s fund categorization, it may have an impact on the 0-91 days money markets yields.
Liquid funds’ average AUM for September 2019 was about ₹5 trillion, of which 80%, approximately ₹4 trillion, was invested in treasury bills (T-bills), commercial papers (CPs) and certificates of deposit (CDs) of less than 91 days maturity. That ₹4 trillion, we estimate to be about 75% of the outstanding T-bills (net of that held by banks/primary dealers/state governments), CPs and CDs below 91-day maturity. So over time if 20% of liquid fund AUM moves out to other categories, there would effectively be ₹1 trillion of demand shortfall for below 91-day money market papers. Do note that the other likely fund categories where corporates may move their investments (overnight funds and ultra short-duration funds) have none or limited flexibility to buy these instruments given their own maturity restrictions. Unless banks replenish this demand by buying money market instruments, we may see some volatility and increase in short-term money market yields, especially during tight liquidity conditions, as an existing natural demand source from liquid funds may no longer exist. Also, a large move in AUM of overnight funds may depress overnight rates (TREPS or tri-party repo) well below what RBI may desire in terms of its monetary policy conduct.
So although the move to impose exit loads may have due risk management rationale, its likely impact on short-term money market rates and liquidity may create some unintended consequence on market behaviour.
Arvind Chari is head, fixed income and alternatives, Quantum Advisors Pvt. Ltd
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