Done in by liquidity crunch

Font Size

Print

Feedback

Email

Discuss

: What has caused the current liquidity crisis in mutual funds? And what needs to be done to prevent its recurrence?
Short-term debt funds are under tremendous redemption pressure. It is important to understand the way these funds have positioned themselves. Operating on wafer-thin margins (the expense ratios are 30 basis points or less) and offering efficient service (redemptions before the current crunch was t+1), liquid and liquid plus funds provide access to short-term markets to a large cross section of investors. The hassle in the model was that liquid funds ended up providing liquidity intermediation for clients. Even while their underlying portfolio of CPs, CDs, PTCs and T-bills are essentially illiquid, liquid funds offer their clients a t+1 redemption. This they manage, in normal times, by laddering the portfolio, so that some redemptions routinely happens every day, and funds are there to meet client redemptions. When redemption pressures increase, as has now happened, the underlying portfolio, though good in quality, simply cannot be liquidated. Mutual funds do not take on asset-liability mismatch like banks. They don’t take short term funds and deploy them in long-term assets. The portfolios of liquid funds are in short-term assets, but illiquid ones, which is the problem. The dominance of buy-and-hold investors in debt markets is an issue that remains long unresolved, and the current crisis is a fall-out of that inertia.

Expensive loan not the solution
I have always wondered if the lack of presence in Delhi (no chairman appointments by the ministry), and the dominance of private sector players, works against the interests of the mutual fund industry. There are many instances of policy not addressing the real problems of the industry. Consider the response to the liquidity problem. Mutual funds have been asked to borrow from repo markets to meet their liquidity needs, which means you add high-cost liability to the existing portfolio, making the NAV worse than before, and adding fuel to the fire. Little wonder mutual funds did not use that window.