The Securities and Exchange Board of India (Sebi) has tightened rules on inter-scheme transfers (ISTs) in mutual fund schemes. The regulator said inter-scheme transfers for managing liquidity should only be taken after all other avenues including using cash, market borrowing and selling securities in the market, for raising liquidity have been attempted and exhausted.

Inter scheme transfer refers to shifting of securities from one scheme to another within the same fund house done at the market price. The regulator has raised concerns over this practice as it has been prone to misuse with mutual funds transferring illiquid securities from one scheme to another.

“If there is still a scheme level liquidity deficit, then out of the remaining securities, outward ISTs of the optimal mix of low duration paper with highest quality shall be effected,” Sebi said in a circular on Thursday.

The regulator said the use of market borrowing before ISTs would be optional and fund managers may at their discretion take decision on borrowing in the best interest of unit holders. In case, option of market borrowing or selling of security is not used, the reason for the same should be recorded with evidence.

Fund houses were accused of transferring illiquid debt papers from a popular scheme to lesser known products in the past one year amid the liquidity squeeze in the bond market.

“This has put greater responsibility on the head of money managers. Whenever such regulations comes it looks like his hands are tied but it’s to ensure that he acts in the best interest of unit holders,” said a CEO of a leading domestic fund house. Sebi data show, in FY 2020-21( till end of August) ISTs of Rs 60,306 crore have been done. In the month of April, the highest number of ISTs were done worth Rs 21,815 crore.

The regulator said in its circular if security gets downgraded following ISTs, within a period of four months, fund manager of buying scheme has to provide detailed justification to the trustees for buying such security.

Besides, no ISTs of a security should be allowed, if there is negative news or rumors in the mainstream media or an alert is generated about the security, based on internal credit risk assessment.

Sebi said ISTs should be allowed only to rebalance the breach of regulatory limit. ISTs can be done where any one of duration, issuer, sector and group balancing is required in both the transferor and transferee schemes. Different reasons cannot be cited for transferor and transferee schemes except in case of transferee schemes is being a credit risk scheme.

“In order to guard against possible misuse of ISTs in Credit Risk scheme, trustees shall ensure to have a mechanism in place to negatively impact the performance incentives of Fund Managers, Chief Investment Officers (CIOs), etc. involved in process of ISTs in Credit Risk scheme, in case the security becomes default grade after the ISTs within a period of one year,” Sebi said. Adding that the new rules will become effective from January 1,2021.

Sebi said for close ended schemes, IST purchases would be allowed within three business days of allotment pursuant to New Fund Offer (NFO) and thereafter, no ISTs shall be permitted to/from Close Ended Schemes.

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