How Blockchain could prove to be a boon for India’s mutual funds industry

Cryptocurrencies rose like a colossus in the year 2017. In stark contrast, 2018 was a year best forgotten. The year was marked by a sharp fall in value as RBI, the banking regulator in India, banned cryptocurrencies.

Cryptocurrencies are digital or virtual currencies designed to work as a medium of exchange, and use strong cryptography to secure financial transactions. Bitcoin, the world’s first and most popular cryptocurrency, slumped from a market cap of $229 billion on January 1, 2018, to $66.7 billion on December 29, 2018. Bitcoin is a type of cryptocurrency in which encryption techniques are used to regulate the generation of units and verify the transfer of funds.

Cryptocurrencies are not regulated by any central bank, are opaque, and can be used for money laundering and other illegal activities. RBI had cracked down on Bitcoins and banned banks from dealing with cryptocurrency traders. The government does not recognise cryptocurrency as legal tender and seeks to eliminate the use of cryptocurrencies for financing illegal activities.

No to Bitcoin, yes to Blockchain

Finance Minister Arun Jaitley stood firmly against cryptocurrencies, but welcomed Blockchain. Blockchain is an incorruptible digital ledger of economic transactions programmed to record not just financial transactions, but virtually anything of value.

Imagine a spreadsheet, duplicated thousands of times across a vast network of computers. The network is also designed to regularly update the spreadsheet, giving a basic idea of the Blockchain. The Blockchain database is not stored at a single location; the records are public, are regularly updated and easily verifiable. Blockchain is the base technology that maintains the Bitcoin transaction ledger. 

Blockchain was developed specifically for cryptocurrency, but can be adapted for use in business and financial services. Cryptocurrencies thrive on anonymity, while Blockchain, the polar opposite, work with identity. Financial services like the mutual fund sector need Know Your Client (KYC) and anti-money laundering compliances, and this is where Blockchain helps.

How Blockchain can help

The mutual fund sector needs fast operations, transparency, automation, and cost savings, and Blockchain can be a boon. Mutual funds are under ever-increasing regulatory scrutiny, with investors demanding cheap and prompt services. According to Calastone a leading technology company headquartered in London, the asset management industry of which mutual funds are a part could save up to $2.7 billion, globally. Blockchain could eliminate time-consuming manual and repetitive processes, saving the mutual fund industry in India several crores.

Blockchain helps with all major steps in the value chain of the asset management industry like customer on-boarding, portfolio management, trading and settlement, and reporting among others. It can store client information in an anonymised, immutable manner to meet regulatory standards.

This helps in KYC as any party to the transaction can audit customer data. An audit trail for all transactions related to the customer simplifies the compliance process, making hacking virtually impossible and money laundering difficult.

The mutual fund industry is all about wealth generation. Mutual fund managers make optimum investment decisions with risk in mind. Blockchain helps connect client needs with asset management strategies central to mutual funds with real-time customer data, stored at a single, secure location. It helps mutual fund managers with the investment decision-making process, vital for wealth generation, and protects portfolios from risk.

Side pocketing in mutual funds

A lot has been going on in the mutual fund industry, especially debt funds. Investors use liquid funds to stash away their savings for the short term. Liquid funds invest in debt security of short maturity, which offers high liquidity and safety. The IL&FS fiasco a few months ago wiped out an entire year’s gains in liquid funds. The NAVs of some liquid funds and ultra-short-term funds dropped by nearly 5 percent in a day.

The cause of all this action was the downgrade of IL&FS a three-decade-old infrastructure lending giant, which defaulted on repayments to Small Industries Development Bank of India Ltd. ICRA, a leading credit rating firm, downgraded IL&FS’s non-convertible debentures and commercial paper to junk.

With credit rating below investment grade, the value of securities in the portfolio of many mutual funds had to be written down by 25 percent. This affected the NAV of mutual funds, which had high exposure to IL&FS debt. When a 5-star rated liquid fund loses 5 percent in a day or 8 percent in a week, investors are in panic mode. Mutual funds see heavy redemptions.

The Securities and Exchange Board of India, the capital market regulator, was forced to step in and allowed “side pocketing” in mutual funds. This is a practice where mutual fund houses separate distressed debt from the rest of the portfolio. This prevents distressed assets from damaging returns generated from the more liquid and better-performing assets.

On a rating downgrade, the mutual fund house pushes distressed debt into a side pocket. Existing investors receive a pro-rata allocation. The fund’s NAV reflects the value of liquid assets with a separate NAV assigned to side pocket assets. The side pocket ensures liquidity for investors holding units of the main scheme. Investors can redeem units of the good fund and the bad fund is not open for redemption. On recovery of assets in the side pocket, investors, who were in at the time liquid assets were separated, receive the benefits.

SEBI has no plans to allow under-performing fund managers go scot free. Blundered investment calls causing portfolio segregation means debt fund managers would be penalised by forgoing a part of the annual bonus. The mutual fund house would not charge fees for managing the separated portion, avoiding a potential misuse of side pocketing.

Fund managers seek maximum protection on making investment calls and Blockchain could be the answer.

Blockchain could function as an early warning system, identifying flaws in the decision-making process. It could predict a financial crisis, or massive scams and frauds, saving the mutual fund industry several crores and the fund manager, his job and bonus.

Be wise, get rich.

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)