SEBI’s Strategic Shift and the Role of Mutual Funds in Navigating Risk and Boosting Quality

[By Yuvraj Sharma & Vandana Kaniya]

The authors are students of School of Law, Narsee Monjee Institute of Management & Studies, Hyderabad.

 

Introduction

In the recent SEBI circular dated June 8th, 2023, a significant change has taken place with SEBI permitting mutual funds to take part in repo transactions involving Commercial Papers (“hereinafter referred to as CPS”) and Certificates Of Deposits (“hereinafter referred to as CDs”). The regulatory authority has explicitly stated that these transactions are limited to corporate debt securities with a credit rating of AA and higher. This circular represents an expansion of the scope of repo transactions by mutual funds in the corporate debt market, signaling a significant shift in regulatory policies.

In this Blog, the author(s) aims to provide a comprehensive understanding of the circular. It likely delves into the implications of this regulatory change, exploring how it may impact the behaviour of mutual funds in the corporate debt market. In addition to this, the blog may discuss the potential benefits and risks associated with allowing mutual Funds to engage in repo transactions involving CPS and CDs. Overall, this SEBI circular introduced a crucial regulatory shift that warrants careful analysis and understanding, and the blog aims to provide a comprehensive exploration of its nuances.

Navigating Risk: Role of Retail Investors in Mitigating Corporate Risk Through Mutual Funds Engagement

This section of the article delves into critical aspect of how the inclusion of retail investor in the corporate bonds market, triggered by increase mutual fund involvement, has the potential to not only drive market growth but also play a crucial role in. mitigating excessive corporate risk.

During a repo transaction, mutual funds obtain short-term money by using corporate debt instruments as collateral. Essentially, this is borrowing money with the promise to repay it later at the going rate of interest against the value of corporate debt instruments.

The purpose of such repo transactions is twofold. Firstly, it allows mutual funds to raise short-term capital addressing immediate liquidity requirements. Secondly, it provides A mechanism to manage redemption demands, offering flexibility in meeting investor redemptions. This financial tool is crucial for maintaining the liquidity and operational efficiency of mutual funds.

The significance of the latest development lies in expanding the scope of rapport transactions to include CPs and CDs. CPs are defined as unsecured short-term debt regulations that companies issue to satisfy their immediate financial obligations. Conversely, certificates of deposit (CDs) are marketed as dematerialized fixed-income securities with a set maturity period that are issued by banks and other financial organizations. This development offers mutual funds more diverse options for collateral in repo transactions, potentially broadening their ability to raise short-term capital. It also reflects the adaptability of financial instruments to meet the evolving needs of market participants.

Over the last decade, the corporate bonds market has exhibited consistent expansion growing by 29 trillion rupees from 2012 to 2022. Despite this growth, the absence of engagement from retail investors is impeding the market’s potential for further development. Industry experts perceive the corporate bonds market as being at a crucial turning point, where the inclusion of retail investors could trigger exponential growth. This growth has the potential to substantially alleviate the excessive corporate risk currently borne by the banking system. Increased involvement by mutual funds could incentivize retail investor participation it means if mutual funds become more involved in a particular market or investment activity, it could encourage individual retail investors to participate more actively in that market.

Mutual funds actively participate in the corporate markets holding substantial share (ranking third among all categories) as of the end of the Financial Year, 2022. Recent data shows a growing trend in repo transactions within the corporate bond market. The latest SEBI circular signals a pivotal juncture for the expansion of the corporate bond market. The circular focus on increasing repo transactions for mutual funds in this market indicates a strategic move by the securities regulator to harness this potential growth. A comprehensive analysis of the circular’s modifications is essential to fully comprehend its impact.

The 2023 SEBI’s Circular

a. Credit Rating Revolution

The latest SEBI circular introduces a significant change by broadening the investment opportunities accessible to mutual funds. This expansion of feasible investments within the corporate bond market through repo transactions is not unprecedented. In November 2012, the SEBI circular permitted mutual funds to engage in repo transactions involving corporate debt Securities rated AA or higher deviating from the prior requirement of AAA-rated securities. This relaxation of credit rating standards enlarges the pool of securities that mutual funds could involve in repo transactions. This underscores SEBI’s history of taking proactive measures to stimulate the growth of the corporate bonds market.

b. SEBI’s Evolving Guidelines: A deep dive into credit rating parameters

The recent SEBI circular introduces additional to provide auxiliary support for mutual funds participating in repo transactions involving corporate bonds. As well as CPs and CDs. This report introduces a constructive tradition through guidelines aimed at assessing the credit rating of exposure objections. The revised exposure emphasis a comprehensive approach in evaluating elements like the Potential Risk Class (RPC) Metrix, liquidity ratios, risk meter, and other pertinent parameters, related to underlying securities. In essence it encourage a thorough analysis of various factors to examine creditworthiness.  This enhancement supplements the original November 2011 circular, which lacked specific criteria for evaluating the credit rating exposure in corporate bond repo transactions, by introducing constructive guidelines to assess elements such as RPC metrics, and liquidity ratios.

c. Amplifying Market Appeal: Impact of Circular on Bosting Confidence in Unsecured CP’s

The guidelines enhance confidence in short-term debt instruments particularly relevant for unsecured CPs issued by private firms. Despite CPs being vital for short-term debt raising, their secondary market remains small. The recent circular enabling mutual fund participation in CP repo transactions alongside structured risk assessment aims to amplify the secondary markets’ attractiveness for institutional investors. Another significant change in the circular pertains to the accounting of repo transaction exposure in corporate bonds if backed by a clearing corporation guarantee. Such exposure won’t count towards single issuer, group issuer or sector-level investment limits, incentivizing mutual funds engagement. This move also heightens safety, as the guaranteeing clearing corporation undergoes due diligence. However, the true impact emerges when viewed in conjunction with another SEBI circular from April 17, 2023.

d. Navigating Liquidity Dynamics

The recent circular synergizes this development with the existing infrastructure of the clearing corporation of India’s Tri-party repos. The essence lies in how a robust LPCC coupled with the flexibility for mutual funds to choose their clearing corporation based on rates, has the potential to significantly influence corporate bonds market liquidity. This highlights that an efficiently developed LPCC provides a strategic advantage, allowing mutual funds to navigate and optimize their clearing arrangements. This, in turn, can attract increased investments from both mutual funds and institutional investors, bolstering liquidity in the corporate bond market.

The circular ensures the resilience of the newly formed Limited Purpose Clearing Corporation (“LPCC”) by introducing a dispute resolution process and partnering with the clearing corporation of India’s Tri-party repos. A strong LPCC gives mutual funds the freedom to select their clearing company according to rates, which affects market liquidity for corporate bonds. In order to bring liquidity to the corporate bond market and draw in investment from mutual funds and institutional investors, this strategic strategy is being used in conjunction with recent modifications to the SEBI circular.

The circular has elicited a range of responses. Several analysts express scepticism, speculating that its effects on investors and the market would be restricted. On the other hand, some see it as a step in the right direction toward opening up the corporate bond market. The importance of the circular is highlighted by the attention and coverage given to it by the worldwide investor’s organization.   The complete impact of this circular will become clearer when mutual fund data for the upcoming financial year becomes available, allowing for a comprehensive assessment of its implication on market dynamics and investment behaviour.

Conclusion

A robust corporate bond market is advantageous for the economy, offering companies flexibility in capital raising and the ability to navigate market fluctuations and unfortunate circumstances at a reduced cost compared to traditional credit. The growth of the market is facilitated by a repo transaction, which also incentivizes investors to engage in short-term risk-taking. The recent SEBI circular reflects a proactive approach to fostering the expansion and enhancement of the corporate bond market. The circular broadens not only the spectrum of potential investment but also mitigates the risk of mutual funds. The forthcoming impact of these changes will soon become evident. The corporate bond market can’t diminish reliance on traditional banking channels, diversify funding sources and efficiently channel funds to productive sectors. The role of repo transactions as a tool for liquidity management and capital optimization can further elevate market resilience and offer an attractive product spectrum for investors. This interconnected approach aligns with the global trends in creating a well-structured debt market that contributes to the overall economy, stability and growth.

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