Explained: Sebi tightens reigns on mutual funds to prevent insider trading

The Securities and Exchange Board of India (SEBI) has taken a strong stance against front-running and insider trading in mutual funds. Business Standard explains the key decisions made by Sebi;s board

The Securities and Exchange Board of India (Sebi) has taken a strong stance against front-running and insider trading in mutual funds. Here's a breakdown of the key decisions made by the regular:

Institutional mechanism 

SEBI mandates Asset Management Companies (AMCs) to implement a robust "institutional mechanism" to identify and deter potential market abuse. This mechanism will involve:

Enhanced Surveillance: Using technology and data analysis to monitor trading activity for suspicious patterns.

Internal Controls: Developing stricter internal procedures to prevent employees, dealers, and connected entities from engaging in misconduct.

Escalation Processes: Establishing clear protocols for reporting and investigating suspected violations.

Increased Accountability: SEBI emphasizes that AMC management will be held directly responsible for ensuring the effectiveness of the institutional mechanism.

Whistleblower Mechanism: SEBI requires AMCs to implement a system allowing employees to anonymously report suspected misconduct within the company.

These decisions come after SEBI uncovered instances of front-running in Axis AMC and LIC

Front-running: This occurs when someone uses privileged information about upcoming trades to make personal trades before clients, profiting unfairly.

In the Axis AMC case, broker-dealers, certain employees and connected entities were found to have front-run the trades of the AMC and in the case of LIC, an employee of a listed insurance company was observed to be front-running the trades of the company. 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.

"Considering the recent front-running instances observed by Sebi, the board approved amendments to Sebi (Mutual Funds) Regulations, 1996 for enhancing the existing regulatory framework by requiring AMCs to put in place a structured institutional mechanism for identification and deterrence of potential market abuse including front-running and fraudulent transactions in securities," the regulator said.

Addressing challenges with recording:

Sebi previously required recording all communication by dealers and fund managers. However, concerns were raised about the burden this placed on AMCs and the potential for employee departures. Sebi will now exempt AMCs from recording face-to-face interactions (including out-of-office communication) during market hours once the institutional mechanism is implemented. This exemption aims to achieve a balance between effective oversight and a less restrictive work environment.

Level playing field for passive funds

Sebi has revised prudential norms for passive schemes (funds that track a specific index).

Currently, mutual funds cannot invest more than 25% of their assets in companies belonging to the same group as the fund manager (sponsor group). This rule can disadvantage passive funds when the underlying index has a high weighting of sponsor group companies (more than 25%). To address this, Sebi has now allowed passive funds to invest up to the weightage of the sponsor group companies in the index they track, with an overall cap of 35%. This allows for more accurate replication of the index.