[Shloka Mathur is a 4th year B.B.A LL.B. (Hons) student at National Law University, Odisha.]
In its recent regulatory directive, the Securities and Exchange Board of India (‘SEBI’) has altered and expanded the scope of ‘liquid assets’ in its definition. These assets provide financial institutions with the necessary liquidity to manage risks effectively and ensure market stability. Liquid assets now include units of overnight/liquid mutual fund schemes and repo on corporate bonds. It is a type of asset that can be quickly and swiftly converted to cash in a short period without having a major impact on its value. They act as a financial buffer as they are assured of being readily available when needed.
The Background to Overnight/Liquid Mutual Fund Schemes
According to SEBI’s circular on the ‘Categorization and Rationalization of Mutual Fund Schemes’, schemes have been broadly classified into five categories namely – ‘Equity Schemes’, ‘Debt Schemes’, ‘Hybrid Schemes’, ‘Solution Oriented Schemes’ and ‘Other Schemes’. Overnight/Liquid Mutual Fund Schemes fall under the category of Debt Schemes. As defined by the Association of Mutual Funds in India (‘AMFI’), “a debt fund is a mutual fund scheme that invests in fixed income instruments, such as Corporate and Government Bonds, corporate debt securities, and money market instruments etc. that offer capital appreciation. Debt funds are also referred to as Income Funds or Bond Funds”.
Overnight mutual funds are open-ended debt funds that invest in debt instruments maturing in one day. Each day, the securities mature, and the fund manager reinvests the same in new one-day maturity securities, ensuring minimal risk as compared to other debt funds. The significance of overnight funds is that they offer investors a flexible option to utilize surplus cash. These funds are highly liquid in nature, allowing redemption after just one day. This short investment timeline reduces unnecessary exposure to market volatility and credit risk, making overnight mutual funds a secure and efficient option for managing idle cash for both individual and institutional investors.
Liquid funds belong to the category of debt funds which are short-term debt instruments having a maturity period of less than 91 days and include funds like government securities, certificates of deposit and commercial paper. One very integral characteristic about these funds is high liquidity which makes it possible for investors to get their money back when they want it, usually within a period of 24 hours. Consequently, investors are attracted to liquid funds as they provide security and stability— besides no lock-in period — hence suitable for parking surplus cash temporarily. However, although the returns depend on the market and are generally lower compared to other high-risk investments, these can be used for short-term goals or even for emergency funds.
Relation with Clearing Corporations
This step aligns with SEBI’s 29 May 2024 circular on ‘Norms for acceptable collaterals and exposure of Clearing Corporations’. This circular highlights norms for acceptable collaterals and determines the exposure ceiling for Clearing Corporations (‘CCs’). CCs are entities or organizations that are associated with an exchange to undertake functions like settlement, delivery and ensuring confirmation of transactions. They are also popularly known as ‘clearing firms’ or ‘clearing houses’ and are responsible for facilitating transactions smoothly for both buyers and sellers. Additionally, liquid assets as collateral are important for CCs as they ensure liquidity by quick conversion of these assets to cash and form an integral part of the risk management of CCs.
Before the new SEBI circular, the rules for overnight/liquid mutual funds as collateral required units to have a 10% haircut, categorized under ‘Cash Equivalents’. A haircut is a percentage reduction that is levied on the market value of an asset when it is used as collateral. It is a risk management tool that helps clearing corporations cover possible price volatility and ensure collateral sufficiency provided by the clearing members. A higher haircut percentage made the option of using liquid/overnight mutual funds as collateral less popular. With the new SEBI circular, the haircut on units of the growth plan of overnight mutual fund schemed is brought down to 5%. Accordingly, with the change, the value of these assets will rise when used as collateral. Moreover, this will directly impact and improve the liquidity position of CCs. It will also become a more favourable option for members to use these funds as collateral hence leading to a stable financial market and low risks.
Inclusion of Repo on Corporate Bonds
A ‘repo’, also known as a repurchase agreement is an instrument that facilitates collateralized short–term borrowing and lending through the purchase and sale of debt securities. In a repo transaction, the ‘borrower’ sells a security to the ‘lender’ with an understanding and formal agreement to repurchase the same or similar security after some period for a slightly higher price. Entities with short-term surpluses can lend securely, earn interest and mitigate credit risk through collateralization. Additionally, the Reserve Bank of India (‘RBI’) and SEBI have been consistently introducing regulatory developments to develop an active corporate bond repo in the market. In 2015, RBI permitted repo transactions which was later superseded by a directive released in 2018 promoting bonds issued by multilateral financial institutions to increase liquidity in the corporate bond market. In 2023, the government established the Limited Purpose Clearing Corporation, which, through AMC Repo Clearing Corporation Limited, facilitates repo transactions in corporate bonds, and then established the Corporate Debt Market Development Fund to provide liquidity to the market during periods of stress. These steps helped in increasing the transactions of corporate bonds and making it one safe option for the market. Therefore, the formal inclusion of repo on corporate bonds as liquid assets is an extension of the measures taken by SEBI, RBI and the government.
Why the Expansion?
The expansion of the scope of ‘liquid assets’ by SEBI is a commendable move that aligns with the global trend of promoting liquidity, risk management and making the market accessible to a wider audience. By broadening the definition, SEBI not only increases a larger pool of assets but also aims to safeguard the interests of the investor. Furthermore, this decision acknowledges the pressing need for an enlarged recognition of the demands of more flexible and dynamic definitions of liquidity in an increasingly fast-paced financial environment where traditional asset classification may no longer cope with real-time liquidity risks. With the formal inclusion, it is expected that trading in these funds would increase further hence diversifying the portfolios of investors. Liquid Funds over time have gained a lot of popularity as witnessed in March 2024 a steep increase in outflow amounting to Rs. 157,970.38 crore, a staggering increase of almost 88% from February 2024.
It is logical for SEBI to expand the scope of definition as the recent steps highlight the objectives of SEBI and its efforts to promote low-risk funds. However, one must critically evaluate whether these expanded definitions sufficiently mitigate risks or merely distribute them differently. The COVID-19 pandemic made the market realise the importance and necessity of ensuring liquidity of some part of the funds held. On the international front, regulatory bodies have been encouraging focus on risk management and liquidity. Institutions like the Basel Committee on Banking Supervision have incorporated strict liquidity requirements under the head of Basel III indicating the importance of liquidity.
Conclusion
SEBI’s directive represents a positive move forward in ensuring stronger market stability and resilience. Expanding the definition of liquid assets will now provide a lot of clarity to potential organizations and investors. This formal inclusion will lead to a rise in the investors’ confidence and will be witnessed by an increase in the transactions of overnight/liquid mutual funds and repo on corporate bonds. It would be essential for SEBI to monitor the impact and any developments that may arise with the change. As markets can, at times, tend to be unpredictable and unsafe, the best way to limit the exposure in such a situation will be to rely on the liquid assets and avoid any major loss. Eventually, there will be a boost of stability in the market and a balance will exist.
– Shloka Mathur