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Explained: Why Mutual Funds Are Tripping Over TrEPS?

Explained: Why Mutual Funds Are Tripping Over TrEPS?
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SEBI requires mutual funds to invest at least 5% of their assets in liquid assets. Mutual funds invest in a wide range of liquid assets, including Repurchase Agreements (Repos), Treasury Bills (T-Bills), Commercial Papers, Certificates of Deposit (CDs), money market instruments, and Tri-Party Purchase Agreements (TrEPS).

This regulation is part of SEBI’s efforts to ensure that mutual funds maintain sufficient liquidity to meet redemption requests and effectively manage the fund.

In this article, we will explore TrEPS’s story, beginning with an understanding of what it is, moving on to its risks and challenges, and finally, its impact on portfolio performance.

What are TrEPS?

TReps, or Tri-Party Repurchase Agreements, are Treasury bill repurchase agreements that provide mutual funds with a safe and liquid place to park their idle cash while meeting SEBI regulatory requirements.

They are short-term money market securities that allow investors to earn low-risk returns on their investments. In a TRep transaction, one party sells a treasury bill to another, promising to repurchase it at a later date for a specified price.

Relevance of Tri-Party Repo (TrEPS) in Financial Markets

Tri-party repos (or TrEPS) have become essential to the financial market due to their ability to provide secure short-term financing. They contribute to the liquidity of key fixed-income markets, such as government and corporate bonds. 

A tri-party agent is an intermediary between the borrower and the lender, facilitating services such as collateral selection, payment and settlement, custody, and management throughout the transaction. This system improves the efficiency of the underlying collateral and helps develop the term repo market.

Mutual Funds and TrEPS: A Perfect Match?

Mutual funds are increasingly investing in TrEPS for several compelling reasons:

  • Safety: TrEPS involves government-issued securities, offering high investment security.
  • Liquidity: They provide high liquidity, allowing quick access to cash when needed, making them ideal for short-term investment horizons.
  • Attractive Returns: TrEPS can offer higher returns than short-term options like savings accounts or fixed deposits, especially when interest rates are elevated.
  • Investing in TrEPS can have a positive impact on a mutual fund’s share price, as higher returns may increase the net asset value (NAV). 
  • Regulatory Compliance: The Securities and Exchange Board of India (SEBI) mandates mutual funds to invest a minimum of 5% of their assets in liquid assets, including TrEPS.
  • However, substantial and prolonged investment in TReps may influence the mutual fund share price, thereby affecting the overall portfolio’s return potential.

Key players involved in Mutual Fund TrEPS transactions

Here are the primary participants in TrEPS:

  • Seller (Borrower): This is the entity that starts the TrEPS transaction by selling securities and agreeing to buy them back later. In the case of mutual funds, the seller is usually a fund seeking to raise short-term capital.
  • Buyer (Lender): The buyer is the counterparty who purchases the securities, providing liquidity for the seller. The buyer earns interest when the securities are repurchased.
  • Tri-Party Agent: A tri-party agent acts as an intermediary, providing a variety of services such as collateral selection, payment and settlement, custody, and transaction management. This agent is critical to reducing counterparty risk and ensuring the trade runs smoothly.
  • Custodian: Custodian duties are frequently combined with those of the tri-party agent. The custodian stores the securities and ensures their safety and availability for the duration of the repo agreement.
  • Clearing Corporation: Institutions such as the Clearing Corporation of India Limited (CCIL) serve as the clearinghouse for TrEPS transactions, ensuring trade settlement and maintaining accounts for all members involved.
  • Regulatory Bodies: Regulatory authorities like the Securities and Exchange Board of India (SEBI) oversee the TrEPS market, setting guidelines to ensure transparency and protect the interests of all stakeholders.
  • Mutual Funds: Mutual funds are increasingly investing in TrEPS transactions to manage liquidity, earn short-term returns, and meet regulatory liquidity requirements.
  • Banks and Financial Institutions: These entities frequently participate as buyers or sellers in TrEPS transactions, utilizing the mechanism for liquidity management and short-term financing.

Benefits of TrEPS for mutual fund managers and investors

Tri-Party Repos (TrEPS) is an essential tool for mutual funds, fitting well within their investment strategies for several reasons:

  1. Liquidity Management: TrEPS efficiently manages mutual funds’ daily liquidity needs. This is critical for meeting investors’ redemption requests while maintaining the fund’s investment strategy.
  1. Risk Mitigation: TrEPS reduces the credit risk associated with lending and borrowing by using government securities as collateral, which is an important factor for mutual funds looking to protect their investors’ capital.
  1. Yield Enhancement: TrEPS can provide comparable returns to other short-term investments. This helps mutual funds increase the overall yield of their portfolios, which benefits their investor.
  1. Regulatory Compliance: Mutual funds are frequently required to maintain a portion of their portfolio in liquid assets. TrEPS’s high liquidity allows funds to comply with regulatory requirements while still earning returns.
  1. Portfolio Diversification: Investing in TrEPS allows mutual funds to diversify their portfolios beyond traditional stocks and bonds, potentially reducing overall portfolio volatility.

Risks and Challenges risks associated with investing in TrEPS

Here are some key points to consider:

  • Market Risk: TrEPS are subject to market risks, including changes in interest rates, which can affect the returns for mutual funds.
  • Operational Complexity: The involvement of a tri-party agent adds a layer of operational complexity, which can lead to increased costs and potential delays in transaction processing.
  • Collateral Management: There is a risk associated with the management and valuation of collateral, especially in volatile market conditions.
  • Counterparty Risk: Despite the presence of a tri-party agent, there is still counterparty risk if either the borrower or lender faces financial difficulties.
  • Liquidity Risk: In times of market stress, the repo market’s liquidity can dry up, making it difficult for mutual funds to liquidate positions quickly.
  • Regulatory Risk: Changes in regulations can impact the attractiveness and utility of TrEPS for mutual funds.
  • Overreliance: A mutual fund’s overreliance on TrEPS for liquidity management can lead to a concentration of risk if not properly diversified.
  • Interest Rate Fluctuations: The weighted average rate in the tri-party repo system can fluctuate, affecting the cost of borrowing and the returns on investment.
  • These drawbacks highlight the importance of careful consideration and risk management when mutual funds incorporate TrEPS into their investment strategies.

How do mutual funds manage these risks?

By implementing these strategies, mutual fund companies aim to mitigate the risks associated with TrEPS and protect the interests of their investors.

Diversification: By investing in a mix of assets, including TrEPS, mutual funds can spread their risk and reduce overall portfolio volatility.

Risk Assessment: Regularly assessing the risk profile of TrEPS investments to ensure they align with the fund’s risk tolerance and investment objectives.

Liquidity Management: Maintaining a balance between TrEPS and other liquid assets to ensure sufficient liquidity for meeting redemption requests.

Collateral Quality: Carefully selecting high-quality collateral for TrEPS transactions to minimize the risk of default.

Counterparty Selection: Working with reputable and financially stable counterparties to reduce counterparty default risk.

Regulatory Compliance: Adhering to regulatory guidelines to ensure proper risk management practices are in place.

Interest Rate Monitoring: We monitor interest rate movements closely to manage their impact on TrEPS returns.

Portfolio Monitoring: Continuously monitor the portfolio’s exposure to TrEPS and make adjustments based on market conditions.

Key Takeaways

In essence, TrEPS transactions provide mutual funds with a flexible, secure, and efficient way to manage cash, enhance returns, and maintain liquidity while adhering to regulatory guidelines and minimizing risk.

This alignment supports mutual funds in achieving their primary goals of capital preservation, liquidity, and return maximization for their investors.

But, as an investor, you must also be mindful of the associated risks, such as market volatility, operational complexity, and interest rate changes. 

Also, you must be aware of how these mutual Funds typically manage these risks through careful collateral selection, diversification, and monitoring of market conditions. This strategic approach allows mutual funds to optimize their performance and provide value to their investors. 

  1. Does TrEPS generate higher returns than traditional savings accounts? 

    TrEPS frequently provide higher returns than traditional savings accounts, making them appealing for mutual funds’ short-term investments.

  2. Can mutual funds use TrEPS as a long-term investment method? 

    TrEPS are typically used for short-term liquidity management, not long-term investment plans.

  3. How do interest rate changes impact TrEPS investments? 

    TrEPS returns are sensitive to changes in the broader interest rate environment, so interest rate fluctuations can have an impact on them.

  4. What happens if a counterparty in a TrEPS transaction fails?

    In the event of a default, the tri-party agent facilitates the liquidation of collateral to protect the interests of the non-defaulting party.

  5. Are TrEPS liquid investments for mutual funds? 

    TrEPS are highly liquid, allowing mutual funds to convert investments into cash in response to redemption requests quickly.

  6. Do regulatory bodies monitor TrEPS transactions?

    Yes, financial regulatory bodies establish guidelines and supervise TrEPS transactions to ensure transparency and protect investor interests.

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I’m Archana R. Chettiar, an experienced content creator with
an affinity for writing on personal finance and other financial content. I
love to write on equity investing, retirement, managing money, and more.

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