SEBI tightens the screws but it was long overdue
The last board meeting of SEBI made two very far reaching changes for liquid funds. For long, liquid funds have been the preferring parking place for corporates to keep money for the short term. Not only were liquid funds secured and tax effective, but the returns were at least 2-3% higher than bank deposits. So, what has changed?
How liquid funds operate?
To a large extent, the liquid funds managed to operate riskless in the market for two reasons. The liquid funds were backed by a portfolio of assets where were very short term assets like call money, CPs, CDs etc. Secondly, the liquid funds did not have to make a provision for MTM losses if the tenure of the bond was less than 60 days. Only for paper above 60 days maturity, the liquid funds were required to provide MTM provisioning. It was here that most liquid funds saw a huge opportunity. Good quality companies were raising funds through the commercial paper (CP) route. That was not the problem. The real problem was that the issuers of CPs were actually deploying these CP funds in long term infrastructure and realty projects. This created a huge risk of mismatch between liabilities and assets. In fact, that is where the entire crisis erupted. Financial companies raised hundreds of crores from liquid funds flush with cash. When they became due, they were just rolled over and it almost looked foolproof.
What has SEBI changed?
The IL&FS fiasco created a mini crisis for liquid funds in particular and NBFCs in general. Money markets became tight as lenders were just not willing to take on the risk at lower yields. SEBI was more interested in protecting investors. SEBI has, therefore, reduced the mandatory MTM provisioning period from 60 days to 30 days. Since MTM is a tough task to follow, most fund managers are now expected to reduce the average maturity of the fund lower and bring it closer to where MTM would not be required. The only challenge is that as you shorten the maturity of your fund holdings, you are forsaking on yield. In fact, conservative estimates are putting the total damage to yield of liquid funds at around 15 bps. That is a big difference for institutional investors. In addition, the gap between the fair value and stated value has also been compressed substantially.
Curious case of subsidy
One of the major objections that SEBI had on the liquid funds issue was that the small investors were subsidizing the large institutional and corporate investors. The 60 day leeway from MTM was actually working against the small investors. SEBI is right in the sense that corporates should know their risks and assume risks accordingly. If the outflows are any barometer, liquid funds may end up becoming leaner and meaner!
