Sebi steps in to curb front-running by mutual funds

The Securities and Exchange Board of India has approved amendments to its mutual fund regulations aimed at establishing an institutional mechanism to curb front-running and fraudulent transactions.

The markets regulator floated a consultation paper in this regard in May last year after noticing a significant spike in the number of front-running and insider trading activities.

Front-running refers to trading in a stock or any other financial asset while having insider knowledge of a future transaction. In February 2023, Sebi restrained the former chief dealer of Axis Mutual Fund, Viresh Joshi, and 20 other individuals from accessing the securities markets in a case of alleged front-running of the trades of Axis Mutual Fund.

“The mechanism shall consist of enhanced surveillance systems, internal control procedures and escalation processes to identify, monitor and address specific types of misconduct including front running, insider trading, misuse of sensitive information, etc,” Sebi said in a statement on Tuesday.

On the requirement to record all communication by dealers and fund managers, Sebi exempted recording face-to-face communications, including out-of-office interactions, during market hours. This will be made effective after implementation of the institutional mechanism by asset management companies.

The regulator asked industry body Association of Mutual Funds in India (Amfi) to specify detailed standards for such institutional mechanisms. 

The regulator also approved streamlining of prudential rules for passive mutual fund schemes regarding exposure to the securities of group companies.

Currently, mutual fund schemes are not allowed to invest more than 25% of their net asset value in a sponsor’s group companies. This restricts passive funds to effectively replicate the underlying index in cases where the group companies of a sponsor comprise more than 25% in an index. 

This also puts such asset management companies at a relative disadvantage as compared to other AMCs that may not have a sponsor group company accounting for over one-fourth of an underlying index, the regulator said.

Therefore, to create a level-playing field, Sebi has approved amendments to allow passive equity schemes on specific indices to take exposure up to the weight of the constituents in an underlying index. This exposure, however, would be subject to an overall cap of 35% investment in the group companies of sponsors, it said.

Moreover, the regulator approved a framework to provide flexibility for increased contribution by non-resident Indians, overseas citizens of India, and resident Indians in the corpus of certain foreign portfolio investors based out of International Financial Services Centres in India and regulated by the International Financial Services Centres Authority.

The flexibility for such participation shall be subject to certain conditions to manage regulatory risk, the regulator said.