Fund industry has to better manage liquidity in crises
PremiumThe FT insider trading case shows the need for fairness to all unitholders in a crisis
Indian debt and liquid funds have had a difficult run in the past few years, from high-profile defaults leading to sharp markdowns in liquid funds, to closure of Franklin Templeton (FT) schemes last year. In response, the Securities and Exchange Board of India (Sebi) has come out with a few measures for better management of liquidity, including the recent proposal on swing pricing. Are these enough? Are there other ideas for better liquidity management?
We have three levers at our disposal : The first is product governance, which includes product design, disclosures, and management; second is business conduct, including governance practices within the firm and tools used by regulators for effective supervision; and the third is investor education on the trade-offs between liquidity and returns. We will examine the first of the three here.
There are at least three inherent liquidity issues in debt mutual funds. First, most of them promise investors daily liquidity, which makes it necessary to incorporate design features sufficiently robust to align with it. Sebi’s requirement for funds to hold 10% in liquid assets must be seen in this regard. Second, even with prudent design, it is important to stress test the product’s capacity to respond to liquidity risks in difficult market conditions, something Sebi recently required funds to do. Last, funds are allowed to restrict redemptions with caveats, where it is in the best interests of investors; such measures must be implemented in a prompt, reasonable, and transparent manner.
In addition, the FT case highlighted the need for fairness to all unitholders during a crisis. When faced with high redemptions, debt funds liquidate the most liquid and high-quality assets, or borrow against their holdings. This confers a first-mover advantage in crisis. India is not the only market to grapple with these issues. In April , the US Securities and Exchange Commission consulted the market on several policy measures for money market funds during crises. Sebi’s proposal on swing pricing is based on IOSCO’s report on the subject. Let’s discuss that proposal, and a few other ideas which might be relevant in the Indian context.
Swing pricing: Swing pricing mechanism allows the fund to impose costs stemming from redemptions on redeeming investors by adjusting the fund’s NAV (net asset value) downward when net redemptions exceed a threshold. Sebi’s proposal has two components—an optional swing pricing at the discretion of the fund during normal times, and a mandatory industry-wide swing pricing during periods of market dislocation.
The design is thoughtful —exemptions for small redemptions, mandatory application during stress, and performance disclosures —but there are at least two problems. First, providing Sebi a role in identifying stress in consultation with the industry, rather than leaving it to the fund boards may result in less timely action, which would allow runs to continue and accelerate, at an advantage to early movers. At a broader level, an introduction of swing pricing highlights a design weakness of debt mutual funds compared with debt ETFs; the latter always reflects demand and supply in pricing, imposes liquidity costs on buyers and sellers transparently and accurately, and may incur lower management fees.
Capital buffers from sponsors: A second idea is capital buffers from fund sponsors, which provide dedicated resources to absorb fund’s losses under rare circumstances, such as when it suffers a large drop in NAV. These buffers may not fully mitigate the incentives for investors to redeem during stress, but will incentivize the sponsor to reduce excessive risk-taking by the fund.
Expand the use of side pockets during stress: Sebi allows funds to undertake side-pocketing of debt instruments in case of a credit event to ensure fairness to all unitholders. An idea is to expand its scope to specific portfolio assets where stressed markets have resulted in illiquidity and valuation concerns. It must be used with care. These are useful ideas to augment the liquidity toolkit, and worth considering. However, these tools should not be seen as freeing the sponsor from their responsibility to meet redemptions in an orderly fashion, and exercise prudence, including good diversification. Also, to foster trust, fund industry must focus on clear disclosures around liquidity risks, beyond Sebi’s product labelling framework (“riskometer").
Assets under management with credit funds grew in India as long as their inflows exceeded outflows. It was only when the trend reversed that those funds had to face the task of selling in an illiquid market. This problem could have been foreseen at the time these funds were created, but the funds industry chose not to draw attention to this weakness in design. Debt investors are still nursing the scars from the events of previous years. It is up to the industry and the regulator to tighten liquidity management and improve resilience to face the next crisis better.
Vidhu Shekhar, CFA, CIPM, is country head, India, CFA Institute.
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