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The authors are Palash Varyani and Parv Jain, third year students at Institute of Law, Nirma University.
Introduction
In a recent development, the Securities and Exchange Board of India (SEBI) has unveiled a comprehensive framework for the establishment of the Corporate Debt Market Development Fund (CDMDF) within the Indian financial landscape. The CDMDF emerges as a pivotal financial instrument, carefully conceived as a 'backstop facility,' with the explicit purpose of acquiring investment-grade corporate debt instruments. This strategic initiative has been devised to impart a profound sense of assurance and bolstered confidence among market participants, particularly during periods of financial turmoil and instability.
This article undertakes a discerning examination, illuminating the imperative necessity for the CDMDF within the Indian financial landscape. Furthermore, it ventures into a comparative exploration of similar development funds operating in diverse international jurisdictions, while also delving into the plausible challenges and prospects of the current framework. It concludes by highlighting the importance of such a framework to secure investors in times of financial instability.
The Need for Corporate Debt Market Development Fund (CDMDF) in India
In April 2020, India's financial landscape was disrupted when Franklin Templeton India Mutual Fund abruptly closed six debt funds. This move, influenced by the COVID-19 pandemic's global declaration in March, sent shockwaves through investors, highlighting the vulnerability of corporate debt markets. As global equity markets plummeted by 37% in just 40 days, debt markets froze due to the overall financial instability.
Franklin Templeton faced an unprecedented challenge as massive redemptions and illiquid portfolios prevented quick liquidation of securities. Consequently, they decided to wind up six debt schemes. With an AUM of approximately Rs 25,000 crore, the ninth-largest fund house in India was caught in a complex situation, leaving a lasting impression on investors about corporate debt market risks.
This event emphasized the need for a well-structured solution: the establishment of a Corporate Debt Market Development Fund (CDMDF) in India. This fund would act as a regulated safety net during market disruptions, bolstering resilience and stability in the financial ecosystem. By allocating resources to this fund, India can fortify its bond markets to withstand uncertainty, ensuring a more secure financial landscape for the nation's economic prosperity.
Exploring the International Scenario
In various countries, similar programs were effective to a certain extent. For instance, the Secondary Market Corporate Credit Facility (SMCCF) in the USA and the Corporate Bond Purchase Program (CBPP) in Canada shared a similar objective.
The onset of pandemic-related events in March 2020 precipitated a sudden and substantial adverse impact on global financial markets. The proliferation of COVID-19 not only inflicted harm upon communities but also wrought considerable disruption upon economic activities across numerous nations, including the United States and Canada. This disruption reverberated throughout various sectors of the financial system.
In the USA, the availability of credit experienced a contraction for corporations and other debt issuers, while concurrently, the disruptions in economic activity heightened the imperative for companies to secure financing. In response to the profound stresses experienced within the U.S. corporate bond market, the SMCCF was introduced on March 23, 2020, as an unparalleled corporate bond purchasing program. By injecting liquidity into outstanding corporate bonds issued by qualified businesses and exchange-traded funds (ETFs) on the secondary market, it played a crucial part in strengthening credit support for significant employers. This fund continued to operate until December 31, 2020.
In Canada, the CBPP was introduced on May 26, 2020, to facilitate the flow of credit for corporate issuers in the country. TD Asset Management, acting on behalf of the Bank of Canada, oversaw all corporate bond purchases. The program was crafted to reinforce the liquidity and efficient functioning of the corporate debt market. This was accomplished through the acquisition of bonds via a meticulously structured tender process within the secondary market. It empowered various companies to secure imperative, long-term financing essential for sustaining their business activities. This, in turn, contributed significantly to the overall resilience of the Canadian economy. Moreover, the program augmented the efficacy of transmitting monetary policy measures to borrowers.
Similarly, the CDMDF will support India's bond markets, in times of financial turmoil and instability. Stakeholders have fervently supported the establishment of a regulated backstop facility to be used in the event of market disruption.
Challenges surrounding the CDMDF framework
The proposed framework, while commendable in its attempt to address market dislocations, is beset by a certain degree of ambiguity that grants significant discretionary power to the SEBI. In the framework described, the SEBI holds discretionary powers primarily conferred under Section 11(1) of the SEBI Act, 1992, in conjunction with the provisions of Regulation 77 of SEBI (Mutual Funds) Regulations, 1996. These discretionary powers are exercised with the dual objective of safeguarding the interests of investors in securities and promoting the orderly development and regulation of the securities market. SEBI, in collaboration with the Association of Mutual Funds in India (AMFI), is empowered to prescribe detailed guidelines for the purchase of securities by the CDMDF. The formulation of these guidelines is a discretionary process undertaken by SEBI, taking into account prudential limits and various other regulatory stipulations.
This discretion allows SEBI to adapt its guidelines to the evolving dynamics of the securities market and investor protection needs. When market conditions change or new issues arise, SEBI may take time to review and update guidelines to address these concerns. This can result in investors facing challenges or grievances until updated guidelines are in place. As a consequence, there may be circumstances where SEBI's attempts to alleviate investor grievances may be delayed. To rectify this potential shortcoming, it becomes imperative to delineate a systematic approach.
An additional facet requiring due consideration is the absence of an objective criterion for market dislocation identification. This lacuna may open the door to potential constitutional challenges, particularly in cases where market volatility in a widely-held security of large corporate entities precipitates a cascading effect within the broader debt markets. It is vital to address these concerns while upholding the principle of “intelligible differentia.”
Moreover, globally, experiences in jurisdictions such as Australia, UK, USA, and Indonesia have shown that measures taken during market dislocations can inadvertently lead to prolonged suppression of market rates, subsequently contributing to elevated inflation. Hence, a careful calibration of intervention measures is imperative to avoid unintended consequences.
Despite diligent preemptive measures and risk management protocols, there remains a vulnerability among certain mutual funds, primarily those with a predominant focus on high-risk, low-quality debt instruments, emanating from heavily leveraged corporate entities. This vulnerability stems from the possibility that these funds might gradually develop an overdependence on the protective cushion offered by the proposed safety valve, potentially leading to a situation where they rely excessively on the framework's safeguards to mitigate the inherent risks associated with their investment portfolios.
While the proposed framework offers a promising avenue to prevent future crises in the debt market, it is crucial to address these nuanced aspects and potential challenges to create a comprehensive and robust system that can effectively respond to market dislocations while minimizing unintended consequences.
Laying Down the Future Prospects of CDMDF
Upon meticulous examination of similar development funds established in various international jurisdictions, it becomes evident that the CDMDF holds a promising trajectory for its future. This optimistic outlook is substantiated by a multitude of compelling factors that merit consideration and elucidation:
Institutional Framework: CDMDF has been established to incorporate a lasting institutional structure. This framework remains dormant during normal market conditions but can be swiftly activated when market stress arises. Further, it functions as a protective buffer, thus, providing reassurance and stability to participants in the corporate debt market, safeguarding their interests during periods of market dislocation.
Fund Characteristics: CDMDF is structured as a 15-year closed-end fund, signifying a prolonged commitment to market stability. Asset management companies and specified debt funds are eligible to subscribe to its units. This subscription opportunity offers a valuable source of liquidity for debt fund investors, especially during challenging market phases.
Operational Guidelines: Detailed instructions about the types of securities eligible for purchase and the corresponding valuation procedures have been meticulously outlined in the provided guidelines.
Investment Grade Criteria: It is essential to emphasize that the CDMDF is exclusively allocated for investment-grade securities. In essence, only instruments that meet well-defined investment-grade criteria are deemed eligible for acquisition. This strategy ensures the availability of vital liquidity precisely when it is most critical. Moreover, the commitment to purchasing investment-grade securities instills investors with the confidence they need to entrust their capital to such instruments, as they can rely on available support when necessary.
Stress Period Relevance: The core purpose of CDMDF comes to the forefront during periods of financial stress. In normal market conditions, transactions proceed smoothly. However, during crises, the corporate debt market often experiences severe disruptions, as evidenced in previous instances like the Lehman crisis. Investors' diminished confidence in purchasing such securities during such times can hinder liquidity. CDMDF intervenes in these situations as a reliable backstop, stepping in to purchase these instruments. Thus, the fund's pivotal role is to provide critical liquidity precisely when it is most needed, primarily during moments of market duress.
Concluding Remarks
The introduction of CDMDF in India marks a significant stride toward fortifying the resilience and stability of the country's corporate debt market. It serves as a regulated backstop mechanism, instilling confidence among market participants during times of financial instability, and offering a vital safety net. Drawing lessons from similar initiatives in countries like the USA, UK, Australia, and Indonesia, it is evident that the CDMDF's institutional framework, extended commitment to market stability, operational clarity, and emphasis on investment-grade criteria position it for success. This fund not only addresses immediate market disruptions but also promotes investor trust in the long term.
Nevertheless, the potential challenges should be navigated carefully by the authorities to prevent unintended consequences and ensure the effectiveness of the CDMDF. Looking forward, it holds a promising future as a critical tool in safeguarding India's corporate debt market. By providing liquidity precisely when it is most needed and fostering confidence among investors, this framework contributes to a more robust and secure financial landscape for the nation's economic well-being. In doing so, it exemplifies a proactive approach to addressing market volatility and maintaining market stability.