Exchange Trading of Mutual Funds in India

In the last year and a half, the Securities and Exchange Board of India (SEBI) has taken a number of steps to develop the mutual funds industry in India. One significant move in this direction has been allowing trading of mutual funds at the country’s stock exchanges. After studying the feasibility of doing this in 2009, SEBI approved mutual fund transactions through stock exchanges in November last year. This was done to extend the convenience of the secondary market infrastructure to mutual fund investors who could earlier invest in funds only through the existing distributor/agent channel. India’s exchanges with a large number of trading terminals connected through numerous Lease Lines and VSAT terminals can reach investors in over 400 cities. Besides reach, exchange trading offers number of other benefits too: opportunity to invest in multiple asset class through a single (demat) account, aggregation of entire portfolio in a single place enabling easy monitoring and more efficient investment decision making, reduction of paper work and errors etc. Also the exchanges’ existing delivery vs payment process offers de-risking of settlement process and increases transparency. Following SEBI’s approval, the two Indian Exchanges, the National Stock Exchange of India (NSE) and the Bombay Stock Exchange (BSE) started trading in mutual funds in November-December, 2009 (NSE: Mutual Fund Service System, BSE: StAR MF). Under the current arrangements investors would be able to deal in Mutual funds that have signed up with the exchanges and in the schemes which the fund houses have permitted to be traded at the exchanges. Out of 40 Asset Management Companies, around 20-22 have signed up with the two exchanges so far. SEBI is planning to make listing of all schemes mandatory. A look at the figures (see graph below) reveals this new channel for investing in mutual funds has not been very popular among investors yet. It can be noted in this context, average daily transaction value (sales+redemptions) for the overall industry during May-July, 2010, had been around 690 bn Rs, which makes exchange trading around 0.3% of total trading during the same period. The occasional jump (July) in trading value is more because of market fluctuations than investors’ preference for exchange trading: Industry Assets Under Management went down by 10% in July as compared to May, as a result subscription went up. Though it has to be acknowledged that of late, there has been a push from the fund houses to encourage investors to take the exchange route. However, these are still early days for this new system. Moreover, since removal of entry load (distribution fee charged by agents to investors) in August, 2009, the industry has been in a state of flux with agents now focusing more on selling insurance products which have high distribution fees. To overcome this problem the fund houses have been trying a number of new distribution models in last one year for attracting new investors; but a clear pattern is yet to emerge. It can be argued with more investor education and awareness about the new technology channels and SEBI’s continuous push, exchange trading of mutual funds is likely to pick up in the future. Banks are a big player in mutual funds and the regulators’ urging banks to transact through exchanges may be one step towards achieving this. Another recent phenomenon is that many brokerages are placing orders through exchanges in the recent months. These all hold good promise for this new channel, however, its long term impacts are yet to be seen.

Front-running needs to be eradicated

‘Front-running’, the practice of traders or brokers benefiting from stock market transactions by leaking information of the trades to some of the other market participants in advance, has long been suspected in the Indian stock markets. I have had discussions with the domestic buy side in which they have taken me through the various stages of an equity transaction and pointed out the pre-trade, trade and post-trade stages in which there can be leakage of information that can be profited from. What is worse, the players who suffer from the practice just shrug their shoulders and describe it as something they can do little about. Similarly, when I have spoken of Indian brokerages that have become more capable technologically being used by foreign buy side firms, the same issue has turned up. The latter is wary of the possibility of insider trading or front-running damaging their profitability. Against this back drop, the ban on a trader of HDFC Mutual Fund by the capital market regulator, SEBI, on the basis of 38 instances of wrong doing over 24 trading days between April and July 2007 when the three investors colluding with the trader bought or sold shares before HDFC AMC’s trades were executed, is a welcome development. While it could be merely an initial move in cleansing the markets of an undesirable practice, it shows the capability and the willingness of the regulator to punish participants that undertake front-running. For the traders or brokerages that engage in such actions, it is crucial to understand the damage they are doing to the reputation of their firms and indeed the market as a whole by engaging in such practices. Firms that are very well capable of competing on an equal footing in the markets are being handicapped by the existence and indeed the mere talk of front-running. Such unfair practices are self-defeating and needed to be weeded out. The regulator is to be complimented on taking such an action and we hope that future transgressions would be similarly caught and punished. Furthermore, both buy side and sell side firms need to ensure that they have sufficient checks and balances in place to help the regulator eradicate the practice. Similarly, whistle-blowing needs to be encouraged, not just by individuals, but also firms that believe that their brokers or traders have let them down.

A new platform for SMEs in India

Small and Medium Enterprises (SMEs) are significant stakeholders in India’s economic development. Their contribution amounts to about one-fifth of the GDP, and they also count among the top three employment generators in the country. The Securities and Exchange Board of India (SEBI), after a careful examination of the topic about reviving the SME segment, identified the following concerns –
  1. The cost of raising capital for SMEs was high.
  2. The existing means of financing were not adequate. SMEs did not have easy access to funds from VCs/PE players.
  3. The existing compliance costs associated with raising funds were high.
In view of the above observations, it was decided that the eligibility conditions, listing requirements, corporate governance norms and disclosure standards should be suitably relaxed owing to the small sizes and low affordability of the SMEs. The need for a separate dedicated stock exchange for SMEs was therefore strongly felt. In November 2009, SEBI had announced the draft norms, and yesterday (May 19, 2010) it released guidelines for trading on the SME platform after incorporating changes based on opinions voiced by market participants and industry representatives. A post-issue upper limit of Rs. 25 crores capital at face value has been fixed for firms that intend to list in the segment. The disclosure norms have also been relaxed. The firms that intend to list in the segment will not be required to report financial numbers every quarter or even release complete annual reports. However, a statement containing the salient features of all the documents will be required, and periodical financial results may be submitted half-yearly instead of quarterly. The SEBI has the advantage of learning from the experiences of other SME platforms around the world, viz. the Alternative Investment Market (AIM) in London, the Growth Enterprises Market (GEM) in Hong Kong, and MOTHERS in Japan. The setting up of a new SME platform is a positive step, and clearly the expectations are that the SME segment in India should become more competitive.

SEBI succeeds in curbing ULIP threat to Mutual Funds

The Securities and Exchange Board of India (SEBI), India’s capital market regulator has succeeded in achieving its underlying objective in the recent row with the insurance regulator, Insurance Regulatory and Development Authority (IRDA). The removal of the front-load commissions for mutual funds by SEBI in mid-2009 had led to an environment in which the mutual funds were at a disadvantage against the insurance companies’ unit linked insurance plans (ULIPs), which had a large investment component. For ULIPs, the commissions for the agents continued to be high, at times more than 40% for the initial installments. As a result, there was mis-selling (over-selling and resorting to unfair practices) on part of the insurance agents. By raising the issue of its role in the regulation of the investment component of the ULIPs, SEBI ensured that the IRDA was forced to take action to prevent SEBI from encroaching into its domain of insurance regulation. In the end, IRDA had to increase the insurance component of ULIPs and also to create disincentives for people who were investing in ULIPs for a period of less than five years. Also, the commission structure of ULIPs had to become more transparent to prevent mis-selling. The two main beneficiaries of this action have been the mutual funds that have regained their pre-eminence as a tool for investment, and the consumers who are enjoying more transparency in ULIPs than earlier, albeit at the cost of fewer choices, as the ULIPs are no longer directly competing with mutual funds. There are some important issues that have been raised by this entire episode. The main one is that there needs to be a redressal mechanism through which the regulators can solve problems with each other. The ULIP episode has been a highly long-drawn public affair that caused a lot of confusion for the investors and companies alike. The insurance companies’ revenues due to ULIPs will also suffer as there would be less investment in them now. Furthermore, the episode does not reflect well on the reputations of the regulators or the Ministry of Finance. There were contradictory signals coming from the ministry as the Finance Minister referred the matter to the courts, but the his Minister for State supported the IRDA’s case in a written reply to the Upper House. The early stage of development of financial regulation in India means that there will be more turf wars. The government is possibly trying to create the infrastructure for their quick resolution through the creation of the Financial Stability and Development Council (FSDC). Whether it is through the FSDC or some other means, it is important to lay down clear guidelines to be followed. Otherwise the Indian financial markets would more and more resemble the Wild West, entertaining for sure, but too chaotic to make sense of. This issue has been dealt with in greater detail in a recent Celent report: Capital Market Regulation in India: Turf Wars Inevitable?