Posts this month
A blog on financial markets and their regulation
The Securities and Exchange Board of India made several good moves
at its board meeting last week (their press release is here). The
huge move towards transparency has been widely welcomed in the
mainstream media and in the blogosphere.
I will therefore focus on the change that they have made to
prohibit early exit from closed end mutual funds. This change appears
to be directed towards Fixed Maturity Plans (debt funds) which were
designed to eliminate interest rate risk for investors by investing in
paper with the same maturity as the tenor of the scheme. The intention
was to lock in the rate of return at inception and avoid any price
risk at maturity. There could be a small reinvestment risk because of
reinvestment of intermediate coupons, but this was negligible given
the short maturity of most of these schemes.
This investor expectation about a predictable return has been
rudely shaken because of large redemptions by big corporate investors
during the liquidity crisis of October 2008. The mutual funds had to
sell some investments at a loss and more importantly the residual
portfolio quality also suffered because the best and most liquid
investments were sold. The RBI’s scheme to lend to mutual funds
does not solve this problem because the valuation of some assets is
suspect and the liquidity window actually helps redeeming investors
exit at an unrealistically high valuation.
SEBI’s move to simply prohibit premature exit restores the
closed end debt scheme to its original function and design. With this
in place, the RBI scheme for lending to mutual funds can be scrapped
and can hopefully be replaced by a scheme to lend against units of
mutual funds. This would provide liquidity to corporate investors who
now face an unanticipated liquidity need. Evidently, liquidity is a
privilege for which they should expect to pay a fair market price.
The SEBI press release also says that these Fixed Maturity Plans
should not invest in paper with maturity beyond the tenor of the
scheme. This too is necessary to ensure that these plan work as
advertised. However, the language used refers to all closed ended
schemes and would therefore appear to preclude a closed end equity
fund since by definition an equity share is perpetual in
nature. Hopefully, this will be fixed in the actual regulations.
I also think that SEBI needs to put in place a regulatory provision
for suspending redemptions even from open end funds in extreme cases
where it is impossible to determine the net asset value (NAV) of the
fund reliably. The ongoing financial crisis continues to
worsen. Earlier people like me worried mainly about defaults by real
estate companies and NBFCs. Now the fear extends to the corporate
sector as well with at least three of India’s largest business
groups being perceived to be at risk of severe financial distress.
We still hope this distress will stop short of default, but a
situation could arise where uncertainties about the financial
situation of systemically important borrowers could lead to a
situation where the NAV of mutual funds cannot be reliably
As far as I am aware, there is no explicit requirement in the
mutual fund regulations prohibiting redemption of units above net
asset value or prohibiting redemption if the NAV cannot be reliably
ascertained. (I think this is because the regulations were designed
largely to protect the investors from the fund and not to protect the
investors from each other.) I do not know whether a prohibition
against such unfair redemptions (fraudulent preference?) can be
inferred from general trust law. In any case, for complete clarity, it
would be useful to write these into the regulations.
There is enough international experience in dealing with the impact
of systemic defaults on mutual fund redemptions. I think Korea handled
the DTC crisis after the Daewoo bankruptcy in an admirable way and
there are lessons from there both for SEBI and for RBI. There are
useful lessons from the Lehman bankruptcy in the US as
well. Regulators should study these lessons and stand ready to apply
them if such unfortunate situations arise in India.