Possible innovations in Mutual Funds opportunity zone

1. Possible innovations in Mutual Funds opportunity zone By – MANISH BANSAL SEBI

2. Covered warrants • Financial Institutions including Mutual Funds (MFs) are sitting on tons of securities. Through the creative use of derivatives, specially options, institutions may unleash the value creating opportunities from these idle securities. • Covered warrant may be one such product.

3. Covered warrants • Covered warrant is a variant to the covered call strategy. • Covered call strategy is writing call options backed by the underlying shares. • Therefore, covered warrant is call option written by the issuer backed by the underlying shares. This warrant is separately listed and traded on the exchanges. • Underlying is locked till the exercise/expiry of the warrants. • Huge untapped opportunity for Mutual Funds lies in the covered call strategy itself.

4. Covered warrants • Value drivers: As the writing of options fetches money to the Mutual Funds, it delivers the values in the following two manners: • Reduction in the cost of acquisition of the underlying securities. • It helps generating money for institutions and their investors, while holding the underlying.

5. Covered warrants • Mutual Funds may also write naked warrants (call and put both). Of late, these cash settled warrants have become popular in the global markets. • In this case, as underlying is not there with the writer of option, to protect the interest of the investors, exchanges would margin the short position of these Mutual Funds.

6. Covered warrants • Products like index warrants and basket warrants are being architected by the market, at the global level. In India, there lies a titanic opportunity for Mutual Funds in these areas.

7. Covered warrants • Final proposal: • Mutual Funds may write both call and put warrants. • Product may be cash settled or delivery based. • Both the covered and naked warrants may be written by Mutual Funds. • Underlying for the warrant may be anything like equity, debt or any other hybrid product. • As Mutual Funds are the writer/seller of options, having obligation to perform the contract, they will either lock their underlying (in case of call warrants) or put the required money in a separate account (in case of put warrants) or pay margin to the exchanges (in case of naked warrants).

8. Other innovations… • Mutual Funds may create and/or invest in the products linked to: • Commodities • Currency • Bullion etc. • We may have all vanilla products and specialized products like options and exotic structures in these areas. • Direct investment in currencies, commodities and bullion may also be explored by the Mutual Funds (Say gold fund or wheat fund).

9. Other innovations… • Debt ETFs – Following a specific index in the fixed income market. • Collateralized Debt Obligations/ Collateralized Mortgaged obligations – Securitization of assets offers the tremendous opportunities to the Mutual Funds in these areas. • MFs may link themselves to the Credit Cards. Mutual Funds units may assume the position of the Virtual Cash, over the period of time, in all dimensions of life. • Trading of Credit derivatives (both purchase and sale). Mutual Funds may be allowed to create credit derivatives at the same time purchase credit derivatives. Therefore, they may run a credit derivatives portfolio with suitable disclosures in the offer document. • MFs may launch the stripped products.

10. Other innovations… • MFs may launch the structured products like combination of floaters and inverse floaters and CMO kind of structures. • MFs may become the Securities Bank – lending Securities to the market participants. • MFs may create synthetic products to trade say different underlying. For instance, trading of dollar with the help of the Difty and Dollax. • Mutual Funds may use FRAs and Swaps for strategic trading.

11. Other innovations… • Following ideas may be experimented with: • Derivatives Funds • Arbitrage Funds/Opportunity Funds • Derivatives Funds are visualized to take strategic positions in the derivatives market to create values for their investors. • Arbitrage Funds/ opportunity Funds are expected to shop across the cash and the derivatives markets to exploit the mis-pricing i.e. arbitrage opportunities, to create values for their investors.

12. Disclosures in the document Relevant disclosures with regard to the trading strategies of the funds and inherent risks in the schemes would be made in the offer document.

13. Value drivers • An opportunity for Mutual Funds Industry to widen the products base. • Opportunity to the small investors to participate in the derivatives market. • The big contract size of the derivative products. • Lack of specialized knowledge on the subject. • Opportunity for the derivatives market to have wider participation.

14. Value drivers • Arbitrage Funds would be less risky than the Vanila Mutual Funds. • These products would spark the innovation in the Mutual Funds Industry and help it unleash its creativity and imagination.

15. Regulations… • Final onus of the operations of the Mutual Funds lies with the Trustees and with their fiduciary capacity they are assumed to be exercising their prudence while allowing any scheme. • Regulations would ensure the transparency and proper disclosures to the investors. • Regulations would also bring the certain degree of discipline among the participants in the market.