Why Mutual Funds Invest in TREPS?

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TREPS, or Tri-Party Repo, is a short-term borrowing and lending instrument widely used in the Indian financial markets. In simple terms, it is an overnight money market instrument that allows participants to borrow and lend funds against collateral, usually government securities. The collateral management, trade settlement, and other administrative functions are handled by a third-party entity, known as the clearing corporation, which reduces counterparty risk and ensures the smooth functioning of the transaction. Mutual fund house take advantage of this when they want to earn return in short time.

TREPS

Understanding the Need for TREPS in Mutual Funds.

Mutual funds, particularly those operating in the debt segment, are constantly seeking instruments that provide liquidity, safety, and stable returns. TREPS has become a preferred investment avenue for mutual funds due to several reasons:

Liquidity Management.

Mutual funds, especially liquid funds and overnight funds, require a high level of liquidity to meet redemption requests from investors. TREPS, being an overnight instrument, allows mutual funds to park their surplus cash in a secure and liquid asset, which can be easily converted to cash the next day. This ensures that the fund has ready access to liquid assets, enabling it to honor redemption requests without delay.

Low Credit Risk.

The primary feature of TREPS is that it is a collateralized borrowing mechanism. The borrower in a TREPS transaction provides government securities as collateral, which are considered to have the highest credit quality. This significantly reduces the credit risk for the lender, making it a safer investment option for mutual funds. The involvement of a clearing corporation as the third party also mitigates counterparty risk, adding an additional layer of security.

Better Returns Compared to Idle Cash.

Keeping cash idle in a mutual fund does not generate any returns and may even lead to a loss in value due to inflation. TREPS offers an opportunity to earn a return on surplus cash with minimal risk.

Although the returns from TREPS are relatively low compared to longer-term instruments, they are still preferable to earning nothing on idle cash.

This makes TREPS a more efficient cash management tool for mutual funds.

Regulatory Compliance.

Regulators such as the Securities and Exchange Board of India (SEBI) have established guidelines on the liquidity and credit quality requirements for mutual funds. TREPS, being a low-risk instrument with high liquidity, helps mutual funds comply with these regulatory requirements.

By investing in TREPS, mutual funds ensure that they maintain the necessary liquidity ratios and adhere to the prescribed risk management norms.

Interest Rate Sensitivity.

TREPS, being an overnight instrument, is not sensitive to interest rate changes in the market. Unlike long-term debt instruments, whose prices can fluctuate with changes in interest rates, the value of TREPS remains stable. This feature is particularly important for funds that aim to maintain a stable Net Asset Value (NAV), such as liquid funds, where any volatility could affect investor confidence.

Operational Convenience.

The operational aspects of investing in TREPS are relatively straightforward due to the involvement of a clearing corporation. The third-party entity manages the entire transaction, from matching the borrower and lender to ensuring the collateral is appropriately managed. This operational ease makes it convenient for mutual funds to participate in TREPS without worrying about the intricacies of repo transactions.

Diversification of Cash Management.

For mutual funds, especially those managing large amounts of assets, diversification of cash management instruments is crucial. Relying solely on a single type of instrument could expose the fund to concentration risk. By including TREPS in their portfolio, mutual funds diversify their investment in cash management instruments, spreading out the risk and optimizing returns across different avenues.

Frequently Asked Questions (FAQs):

Q: Are TREPS only used by debt mutual funds?
A: While TREPS are primarily used by debt mutual funds, particularly liquid and overnight funds, other types of mutual funds (like equity mutual funds) can also invest in TREPS to manage their short-term cash requirements efficiently. It helps them sustain returns when equity market is on all-time high.

Q: What is the typical return from TREPS?
A: The returns from TREPS are typically lower than those from long-term debt instruments. However, they are competitive with other overnight investment options like call money and offer better security due to the collateralized nature of the transaction.

Q: How does TREPS compare with traditional fixed-income instruments?
A: TREPS offers better liquidity and lower risk compared to traditional fixed-income instruments like bonds or certificates of deposit. However, the returns are generally lower due to the short-term nature of the investment. Due to its short term nature, fund house like to park ideal money here.

Q: Can TREPS impact the NAV of a mutual fund?
A: Since TREPS are overnight instruments with minimal price volatility, their impact on the NAV of a mutual fund is negligible. This is one of the reasons why liquid funds favor TREPS for cash management.

Q: What role does the clearing corporation play in TREPS?
A: The clearing corporation acts as a third-party intermediary in a TREPS transaction. It manages the collateral, ensures settlement of trades, and reduces counterparty risk by ensuring that both parties fulfill their obligations.

Q: Are there any risks associated with investing in TREPS?
A: The risks associated with TREPS are minimal, primarily because the transactions are collateralized with high-quality government securities. However, like any financial instrument, there is a small amount of risk, but it is significantly lower compared to other market instruments.

Q: How does SEBI regulate mutual fund investments in TREPS?
A: SEBI regulates mutual fund investments in TREPS by setting guidelines on the types of assets that can be held in mutual fund portfolios. SEBI’s regulations ensure that mutual funds maintain sufficient liquidity and manage risk effectively, making TREPS a compliant and favored option.

Conclusion.

TREPS has emerged as an essential tool in the liquidity management strategies of mutual funds. By providing a safe, liquid, and efficient avenue for parking short-term funds, TREPS helps mutual funds meet their liquidity needs, manage risk, and optimize returns on idle cash. The low credit risk, regulatory compliance, and operational convenience make TREPS a preferred choice for mutual funds, particularly in volatile market conditions where safety and liquidity are paramount.

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