Towards Better Fund Liquidity Management During a Crisis
This is the second article in a series of three that explores the issues arising from the fallout of scheme closures of Franklin Templeton’s Indian arm. The first article can be accessed here.
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 the closure of Franklin Templeton (FT) schemes last year. In response, the Securities and Exchange Board of India (SEBI) has released 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 (a well-designed product will not fail when market conditions change); the 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 examine the first of the three here.
At least three liquidity issues are inherent 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, when 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 they 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 of this year, 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 a report on this subject by the International Organization of Securities Commissions (IOSCO). Let’s discuss that proposal, and a few other ideas that might be relevant in the Indian context.
A swing pricing mechanism allows the fund to impose costs stemming from redemptions directly on redeeming investors by adjusting the fund’s net asset value (NAV) 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—with exemptions for small redemptions, mandatory application during stress, and performance disclosures—but we see 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 as compared with debt exchange-traded funds: the latter always reflects demand and supply in pricing, imposes liquidity costs on buyers and sellers transparently and accurately (rather than through an arbitrary swing factor), 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 or is closed. These buffers may not fully mitigate the incentives for investors to redeem during stress, but they 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 in cases in which stressed markets have resulted in illiquidity and valuation concerns. Although side pocketing is less restrictive than a complete closure, it must be used with care.
These are useful ideas to augment the liquidity tool kit and are worth considering. These tools, however, should not be seen as freeing the sponsor from its responsibility to meet redemptions in an orderly fashion and to exercise prudence, including good diversification. Also, to foster trust, the fund industry must focus on clear disclosures around liquidity risks, beyond SEBI’s product labeling framework (“riskometer”). For example, funds need to disclose their general approach to dealing with situations in which they are under liquidity pressure from high-net-redemption requests.
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 up to the task of selling in an illiquid market. This problem could have been foreseen at the time these funds were created, but the fund industry chose not to draw attention to this weakness in design. Debt investors are still nursing the wounds from the events of previous years. It is up to the industry and the regulator to tighten liquidity management and improve resilience to better face the next crisis.
This article first appeared in Livemint.
Photo credit @ Getty Images / Daniel Grill