Ta3473 Ind Final Report

TA 3473-IND
Development of a Secondary Debt Market
Final Report
February 2002
The International Securities Consultancy Limited

9/F Carfield Commercial Building 75-77 Wyndham Street, Central, Hong Kong Also in London and the Middle East
In association with:
The BISYS/Aries Alliance Professional Services Group
Introduction
ADB TA 3473-IND
Development of a Secondary Debt Market Introduction
The International Securities Consultancy Limited (ISC) in association with The BISYS/Aries Alliance Professional Services Group. (Aries Group Ltd.) under contract with the Asian Development Bank (ADB) conducted this technical assistance (TA) project on Development of a Secondary Debt Market for the Ministry of Finance (MOF). There are three elements to the Technical Assistance (TA) project: (i) the preparation of the report to the Terms of Reference (TOR) provided by the bank and as modified during the course of the project (ii) the carrying out of study tours by the MOF and (iii) the holding of a seminar for key participants. It was initially intended that the study tours should have been carried out before the completion of the report and the holding of the seminar. Circumstances have been such that that has been impossible so instead the results of the seminar will be used to determine the agenda and locations of the study tours. The report is presented in two volumes, as agreed at an Inception Meeting with the MOF. Volume 1 is a summary of facts. Volume 2 concentrates on analyses and recommendations. They can be read as stand alone documents. The TA commenced in late January 2001. The Project Team has so far spent most of the 24 man months allocated to the project, including local consultants' time. For this project, the domestic man months input was twice that of international consultants (and at the evaluation stage the total points assigned to the domestic consultants exceeded those for the international consultant). The project team assigned to this TA consists of: Stephen Wells Team leader, Ms Chitra Ramakrishna, Dr Sudipta Dutta Roy, Dr Ajay Shah, Dr Susan Thomas, Eugene Callan, Barry Bird and Chris Thomas. At ISC, Susan Selwyn-Khan, ISC Group Managing Director, senior director Mrs Valerie Mc Farlane have had overall input and ISC staff Ms Connie Tsui and Ms Lisa Highsted have been involved in seminar preparation. This document reflects changes agreed at the Hyderabad forum, from and extensive review by market participants and from the Tripartite meeting. The TOR are attached as Annex 1 to this introduction. Annex 2 shows how the original TOR have been covered. Annex 3 gives a list of people met by the consultants during the project.
T.A. 3473-IND: Development of a Secondary Debt Market Final Report February 2002 The International Securities Consultancy Limited
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Annex 1 Terms of Reference
ANNEX 1 TERMS OF REFERENCE Terms of Reference for Consultants

A. International Consultants
The international consultants will work in close collaboration with the domestic consultants. The terms of reference for the consultants follows. 1. Capital Market Regulations and Tax Expert (4 person-months)/Team Leader
The team leader will be responsible for the overall organisation and management of the technical assistance (TA) and the timely delivery of outputs. The consultant must have extensive experience formulating a program for legal, regulatory, accounting, and tax reforms for the capital market based on the principles of best international practices. Building on completed studies on the domestic debt market in India, the consultant will have the following responsibilities: (i) Jointly with the international capital market operations specialist and the domestic fixed income securities analyst, undertake a quantitative study of the current interest rate regime in India and the economic variables determining its dynamics, including Government fiscal and monetary policies. Identify legal and regulatory constraints pertaining to all market transactions on the secondary debt market. Impediments impinging on market development of new debt-related financial instruments such as securitized papers, interest rate futures, and options. will also be specified. The scope of this study should encompass laws and regulations binding on the financial instruments being traded on the secondary debt market, as well as the institutions involved in the domestic debt market. including financial intermediaries, issuers, and investors of fixed-income securities in India. The incentive structure for financial intermediaries, issuers, and investors should also be analysed. Study accounting and tax-related issues for the development of the secondary debt market. The study will review disclosure standards for bond issues, including private placements and tax on securities transactions. Accounting principles and taxes applicable to fixed-income securities and newly developed debt-related financial instruments such as securitized papers, interest rate futures, and options will also be studied. Accounting principles and taxes applicable to the institutions such as issuers, investors, and financial intermediaries will be covered under the study to the extent applicable to activities on the secondary debt markets. On the basis of these studies and best international practices, recommend clear and comprehensive legal, regulatory, accounting, and tax frameworks that will promote a fair, equitable, efficient, and transparent domestic debt market in India. The frameworks will also ensure an enabling environment for the development of the domestic debt market with scope for trading and investment in new financial instruments such as securitized papers, interest rate futures, and options. All
(ii)
(iii)
(iv)
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modifications needed to the current system to establish such frameworks should be clearly identified with a strategic sequence of reform measures to be taken. The consultant will present the proposed frameworks during the forum on developing the domestic debt market for discussions and feedback; incorporate the feedback and discussions on the proposal; finalize the reform program jointly with the international capital market operations expert and assess the enforcement capacities of the regulatory and supervisory bodies to assume new responsibilities proposed under the new frameworks and determine their capacity building needs. The consultant in coordination with Asian Development Bank (ADB) staff, will be responsible for all arrangements and preparation of the national forum for the development of the domestic debt market and the study tours to be conducted prior to the national forum by the officials directly involved in designing and implementing the reform agenda. 2. Capital Market Operations Expert (4 person-months)
The consultant will have solid experience in capital market operations reform; have practical knowledge in all aspects of fixed-income securities trading and investment. and best international practices; and be familiar with the state-of-the-art information technology being adopted by the global capital markets in trade executions, clearing, and settlement systems. In coordination with the team leader, the consultant will be responsible for organising the work process of the domestic securities operations specialist. domestic fixed-income trading specialist. and the domestic fixed-income securities analyst to produce a clear and practical strategy for the following: (i) building (a) a fair and efficient system for trade execution that will provide timely and transparent trading information, and (b) an efficient clearing and settlement system that will overcome various constraints identified in the market infrastructure (the recommended market infrastructure will be capable of all transactions of new debt-related financial instruments such as trading and investment in securitized papers, interest rate futures, and options; the system will also aim at compatibility with the global bond trading system); resolving other pending barriers hindering efficient and transparent trading activities in the domestic debt market, including institutional capacities of financial, market intermediaries, issuers, and investors; improving the attractiveness of financial instruments on the secondary debt 8 market for trading; developing effective secondary market mechanisms to enhance liquidity and hedging instruments for managing risks in the domestic debt market; and creating a benchmark index for efficient pricing and performance measurement of the domestic debt market.
(ii)
(iii)
(iv)
(v)
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The consultant will present the proposed strategy to the national forum on developing the domestic debt market jointly with the international capital market regulations and tax expert. Subsequent to incorporating modifications to the strategy on the basis of feedback obtained in the forum, the consultant will finalize the proposed reform program, with clear indications of benefits, costs, constraints and risks of implementation. B. Domestic Consultants
The domestic consultants will assist the team leader in organizing and preparing the forum for the development of the domestic debt market Subsequent to the forum, the domestic consultants will be responsible for providing expert input into finalizing the reform program. 1. Securities Legal/Regulatory/Tax Specialist (4 person-months)
This consultant should be familiar with laws, regulations, accounting principles, and taxes of securities transactions in India. In full collaboration with the international capital market regulations and tax expert, the consultant will (i) review the legal and regulatory frameworks of trading and investing in fixedincome securities in India. and identify legal. regulatory, accounting, and tax constraints impeding efficient operation; and design enabling legal. regulatory, and tax frameworks for an efficient, liquid. and transparent secondary domestic debt market; and identify required changes in legislation consistent with the proposed legal, regulatory and tax frameworks; and review the capacity of regulatory and supervisory bodies to determine capacity-building needs. Securities Operations Back Office Specialist (4 person-months)
(ii)
2.
The consultant will have solid experience in all aspects of back-office operations of fixedincome securities trading and investment. In full collaboration with the international capital market regulations and tax expert and the international capital market operations specialist, the consultant will (i) study the current practice of trading and settlement of fixed-income securities, and specify factors hindering efficient functioning of the secondary domestic debt market and propose changes; and review institutional capacities of the investors and financial intermediaries to actively participate in the secondary domestic debt market. Fixed-Income Trading Specialist (4 person-months)
(ii)
3.
The consultant will have extensive trading experience in fixed-income securities. In close collaboration with the international capital market operations specialist, the consultant will
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(i)
specify factors in the market mechanism, market infrastructure, the current market practices and the price discovery system in particular, constraining investors active participation in the secondary domestic debt market; and propose measures for improvement; and identify potential investors to increase heterogeneity of market participants. Fixed-Income Securities Analyst (4 person-months)
(ii) 4.
The consultant will have extensive experience as a fixed-income securities analyst. In close collaboration with the international capital market regulations and tax expert and international capital market operations specialist, the consultant will (i) assist in defining the current interest rate regime and analyzing the economic variables determining its dynamics, including the fiscal and monetary policies of the Government; quantitatively assess the current level of market liquidity, volatility and market concentration in the secondary domestic debt market; and forecast the level of market liquidity, volatility, and market concentration under the new regime proposed under the T A; evaluate the existing hedging mechanism for fixed-income securities, and propose measures for improvement; and support creation of a benchmark index to facilitate pricing and performance measurement.
(ii)
(iii) (iv)
Bank Format Deliverables

(Extract from Technical Assistance Document) A. Objective
The objective of the TA is to formulate a concrete program for creating an enabling environment for the devilment of the secondary domestic debt market in India by sequentially resolving key constraints in the interest rate regime; legal, regulatory, accounting, and tax frameworks; institutional capacities; and the supporting market infrastructure. B. Scope
The TA will consist of the following three components. The first component will analyze four facets of the secondary domestic debt market to identify key factors constraining its development: (i) The current interest rate regime on the capital market will be analyzed to identify distortions and the scope of its impact on secondary debt market development. This
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will include the economic variables determining its dynamics, including fiscal and monetary policies of the Government. (ii) Legal, regulatory, accounting, and tax frameworks pertaining to all transactions in the domestic debt market will be analyzed. Disclosure requirements and the transparency of private placements will be studied. Specific impediments to new debt-related instruments such as securitized papers and interest-rate futures and options will be identified. The study will examine appropriateness of laws, regulations, accounting, practices, and taxes applicable to all market participants, financial intermediaries, issuers, and investors of fixed-income securities to ensure a fair, efficient, and transparent bond market. The incentive structure for market participants and the capacity of regulatory and supervisory bodies to monitor and enforce regulations will be fully assessed. Market mechanisms and support infrastructure, including the execution system (trading conventions, clearing and settlement practices), transaction costs (tax, commissions, and others), and market transparency (disclosure of contracted price and volume) will be studied. Adequacy of the current market infrastructure to support transactions of new debt-related instruments such as securitized papers and interest rate futures and options, as well as its compatibility with global bond trading systems, will be assessed. The impact of effective hedging and secondary market mechanisms, such as repos and futures on market liquidity will be studied, and alternative instruments recommended. The creation of an index for the debt market will be supported to facilitate pricing and performance measurement of fixed income securities. The adequacy of financial instruments available for investment and trading to enhance market activities on the secondary debt market, and specific capacity constraints of market participants issuers, financial intermediaries, and investors will be studied. Potential investors and traders of fixed-income securities will be identified to increase the heterogeneity of market participants.
(iii)
(iv)
On the basis of these four studies, the following will be prepared: (i) an analysis of the current interest rate regime on the capital markets; (ii) clear and comprehensive legal, regulatory, accounting, and tax frameworks to support market efficiency, growth, liquidity, and transparency; (iii) a strategy to eliminate impediments to the secondary debt market in a sequential manner, and (iv) a plan to modernize market infrastructure. The legal, regulatory, accounting, and tax frameworks will facilitate the development of new debtrelated financial products. The modernized market infrastructure will be capable of transacting all new debt-related financial instruments and be compatible with the global bond trading system for future integration. The second component will organize and conduct study tours for 10-12 officials from MOF, RBI, SEBI, and other Government agencies directly involved in designing and implementing the reform agenda for developing the secondary debt market. The study tours will give participants first-hand experience, practical knowledge, and exposure to best practices of well-functioning debt markets, preferably in the region. The study tour will address specific issues with a set of predetermined and practical goals. The findings of the study tour will be presented in a forum on development of the domestic debt market.
T.A. 3473-IND: Development of a Secondary Debt Market Final Report February 2002 The International Securities Consultancy Limited Page 6
The third component will finance the holding of a forum on development of the domestic debt market for policymakers and regulators, such as MOF, RBI, and SEBI, and market participants such as the issuers, financial intermediaries, and investors of the bond market. The TA findings will be discussed during the forum, tentatively scheduled for November 2000, and the consultants will present the studies findings and a strategy for reforming the secondary debt market prepared under the TA. On the basis of this presentation, the participants will discuss courses of actions to be taken to formulate and implement the reform program.
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Annex 2 Comparison
ANNEX 2 COMPARISON Comparison of Draft Final Report Format to Banks Original Set of Areas of Study
BANK FORMAT (i) The current interest rate regime in India and the economic variables determining its dynamics, including fiscal and monetary policies of the Government. An analysis of the current interest rate regime on the capital market will be undertaken to identify distortions and the scope of its impact on secondary debt market development. Deliverable: An analysis of the current interest rate regime on the capital market. AT DRAFT FINAL REPORT STAGE The economic policies of the Indian government and their effect on interest rates are important barriers to bond market development through (1) the levels of macro-economic variables (2) the means of implementing them and (3). the debt management tactics of the Reserve Bank of India (RBI). The level of the fiscal deficit is a major influence on the market. It has prevented movement towards a purely market determined pricing structure, ensures that investment guidelines are maintained and probably crowds out corporate borrowing. This is discussed in Volume 2 Chapter 2 Macro Economic Issues. The large range of macro economic targets together with the lack of clearly stated objectives and variability of policy are also reviewed in Volume 2 Chapter 2 Macro Economic Issues. The high level of uncertainty and volatility that the policy implementation causes are significant causes of uncertainty The intervention of the RBI in the primary debt market together with the lack of transparency in the issuance schedule is also a barrier to market determination of prices and thus to the development of a secondary market. This is discussed in Volume 2 Chapter 4 Issuance and Instruments. The contention that there is not an independent yield is addressed in Volume 1 Chapter 3 Empirical Characterisation of the Government Bond Market. (ii) Legal, regulatory, accounting, and tax frameworks pertaining to all transactions in the domestic debt market. The legal and regulatory framework is discussed functionally in Volume 2 Chapters 3 - Participants, 4 Issuance 5 - Trading and 6 - Settlement. There are a number of issues relating to functional regulation that are barriers to development. In particular, regulations governing investment by financial institutions, governing public issues, lack of regulation and requiring timely trade reporting, there are also a functional areas where lack of regulation or lack of clarity are obstacles, e.g. dematerialisation of corporate debt stock and regulation of trading. Additionally there is a discussion of the style and nature of regulation/enforcement in a separate chapter (Volume 2 Chapter 8 Regulation and Enforcement). The current regulatory style tends to involve too much control and insufficient enforcement combined with a tendency for over-reaction to political pressures.
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Annex 2 Comparison
BANK FORMAT
AT DRAFT FINAL REPORT STAGE Taxation is reviewed in Volume 2 Chapter 7 - Taxation. The taxation structure is extremely complex and appears to have been developed without any overall guiding aims. It is also extremely volatile with frequent changes making long-term planning , of the sort associated with bond issuance and investment , difficult. Accounting standards are discussed with disclosure in Volume 2 Chapter 8 Regulation and Enforcement. Accounting standards are close to international standards but significant differences remain. This is likely to become a barrier to wider participation in the market for both issuers and investors.
Specific impediments to new debt-related instruments such as securitised papers and interest-rate futures and options will also be identified.
We did not observe specific impediments to new debt-related instruments. Though the barriers we noted would apply equally to such instruments. The barrier on of stamp duty on transfers into and out of Special Purpose Vehicles has now been removed. Embryonic derivatives markets exist but our view is that pricing quality and participant diversity is not yet sufficient to support fully-fledged derivatives markets. Innovative instruments are discussed in Volume 2 Chapter 4 Issuance and Instruments. Our sense is that the development of these instruments, as well as development of the market as a whole, will not be possible until the problems associated with repos, short-selling and stock borrowing are resolved. As mentioned above regulation is discussed functionally in several chapters and structurally in Volume 2 Chapter 8 Regulation and Enforcement as are accounting standards. Taxation is addressed in Volume 2 Chapter 7 Taxation. We make extensive reference to the lack of transparency in the secondary market. The regulation of issuers is addressed in Volume 2 Chapter 4 Issuance and Instruments. In particular we address the dominance of private placements with low information requirements, but only available to the top corporations, and the difficulty of public issues. We note that the bond market is only open to the very highest grade issuers (in Indian terms). Issues relating to participants are covered in Volume 2 Chapter 3 Participants. There are real issues relating to the dominance of state ownership among market participants. This, combined with restrictive investment guidelines, severely restrict incentives. The intervention of the RBI in the primary market seriously affects the incentives of primary dealers and we were led to question whether there was any real gain to becoming a Primary Dealer.
The study will examine appropriateness of laws, regulations, accounting practices, and taxes applicable to all market participants, financial intermediaries, issuers, and investors of fixed income securities to ensure a fair, efficient, and transparent bond market.
The incentive structure for market participants will also be analysed. Furthermore, the capacity of regulatory and supervisory bodies to monitor and enforce regulations will be fully assessed.
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Annex 2 Comparison
BANK FORMAT Deliverable: Clear and comprehensive legal/regulatory/accounting/tax frameworks that will support market efficiency, growth, liquidity, and transparency.
AT DRAFT FINAL REPORT STAGE We have serious reservations about the capacity of the regulatory and supervisory bodies. These relate to pure capacity issues, lack of clear responsibilities for front-line regulation and weaknesses in regulatory development techniques. These are addressed in Volume 2 Chapter 8 Regulation and Enforcement and Chapter 9 Development Methodology The review of these issues leads to clear and comprehensive recommendations for a framework that will support the future development of the market. These are presented in summary in Volume 2 Chapter 1- Key Recommendations and in the detail sections within the other chapters
(iii)
Market mechanisms and support infrastructure, including the execution system (trading conventions, clearing and settlement practices), transaction costs (tax, commissions, and others), and market transparency (disclosure of contracted price and volume).
The trading structure is analysed in Volume 2 Chapter 5 Trading where there is extensive discussion of transparency, both pre and post trade. The integration of over the counter and onexchange markets will be a critical issue in market development. It is essential to ensure the over the counter market is not destroyed by clumsy regulatory efforts to bring the market on to a regulated exchange. But equally it is critical that the on-exchange market is not destroyed by lack of transparency in the over the counter market. Commissions and other costs are noted but do not seem critical barriers to development (unlike transparency, which clearly is). Current and planned market infrastructures are quite sophisticated. They are reviewed in Volume 2 Chapter 5 Trading and Chapter 6 - Settlement. The barriers in the market are related to participants and regulation.
Adequacy of the current market infrastructure to support transactions of new debt-related instruments such as securitized papers and interest rate futures and options as well as its compatibility with global bond trading systems will be assessed. Also, the impact of effective hedging and secondary market mechanisms, such as repos and futures on market liquidity will be studied and alternative instruments recommended.
Barriers to hedging mechanisms are discussed in Volume 2 Chapter 5 Trading. There are significant barriers to repos but the major barrier to hedging and arbitrage is the prohibition on short-selling of government securities. As noted above we did not see the development or liquidity of the market as being adequate to support derivatives trading at present but there are no major institutional barriers as the market develops. We make recommendations for developing an infrastructure to support inter dealer brokers trading to allow laying off of positions by primary dealers. ICICI, a major investment bank and bond market participant operates an index that shows all the desirable features of a wellconstructed index .
Creation of an index for the debt market will be supported to facilitate pricing and performance measurement of fixed income securities.
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Annex 2 Comparison
BANK FORMAT Contain proposals for solutions and implementation of these solutions including assessment of barriers and risks. (iv) Adequacy of financial instruments available for investment and trading for enhancing market activities on the secondary debt market and specific capacity constraints of market participants issuers, financial intermediaries, and investors. Also, potential investors and traders of fixed income securities will be identified to increase heterogeneity of market participants.
AT DRAFT FINAL REPORT STAGE The review of these issues leads to clear and comprehensive recommendations for a framework that will support the future development of the market. These are presented in summary in Volume 2 Chapter 1- Key Recommendations and in the detail sections within the other chapters Instruments are discussed in Volume 2 Chapter 4 Issuance and Instruments. This includes discussion of repos. There are recommendations to reduce fragmentation of the issuance (too many small issues) of government bonds. Fragmentation of corporate bonds is a consequence of the dominance of private placements and will be addressed by changes to the public offer process but mostly by expansion of participant numbers.
Participants capacity issues are raised in Volume 2 Chapter 3 Participants. There is a serious lack of participants particularly participants that are genuinely commercially independent. There are a number of dominant incumbents though new entrant competition is beginning to make an impact. We make recommendations for strengthening competition. There are also restrictive investment guidelines applying to many state entities and actual or potential barriers to entry. Discussed with respect of trading and settlement in volume 2 Chapters 5 and 6 In general the infrastructure is new and of high quality .Our concerns are with the methodology rather than the up-to-dateness of systems. These are discussed in vol2 Chapter 9. The impediments have been documented throughout Volume 2 Chapters 2 to 9. Recommendations to remove these barriers have been examined with participants and are presented in these chapters. They are brought together in Volume 2 Chapter 1 - Key Recommendations.
(v)
Modernisation of the market infrastructure.
(vi)
A strategy to eliminate impediments to the secondary debt market in a sequential manner.
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Annex 3 List of People Met
ANNEX 3 LIST OF PEOPLE MET

Name S. Mehta D. N. Upadhye A Balasubramanian J. Beswick K. Ramanathan R. Vaidyanath S. Purdy M. Agrawal P. Agrawal R. Ravimohan Dr. Chiragra Chakraborty Manoj Yadav Position Country Head - India Deputy General Manager Chief Dealer Chief Executive Officer Head of Fixed Income General Manager Chief Representative Manager Head - Corporate Ratings Manager - Corporate Ratings Managing Director (in capacity as Vice-President, DFHI) Head-Operations Global Securities Services Director Co-Head Global Markets India Senior Vice President - Head of Debt Managing Director Executive Director Organisation AIG Bank of India Birla Sun Life Mutual Fund Birla Sun Life Mutual Fund Birla Sun Life Mutual Fund Bombay Stock Exchange CGU CRISIL CRISIL CRISIL currently at UTI Institute of Capital Markets Deutsche Bank
Hari Shankar Chaitanya Chetan Shah J. J. Mehta
Deutsche Bank - Custody Services Deutsche Bank - Global Markets DSP Merrill Lynch
M. Barve Dr. Nachiket Mor Ashish Ghiya K. V. Subramanian N. Balasubramanian Sudershan Sharma Sudipto Lahiry A. Gokhale K. Kulkarni A. S. Unnikrishnan
HDFC Mutual Fund ICCI Limited ICICI Limited
Assistant Manager Deputy General Manager Vice President Deputy Manager Assistant Vice President Vice President Manager
ICICI Limited ICICI Limited ICICI Limited ICICI Limited ICICI Securities and Finance Company ICICI Securities and Finance Company IDBI
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Name B. Mythili M. Balasubramanian G. V. Nageswara Rao Pradeep Madhav Binay Chandgothia
Position Deputy General Manager Deputy General Manager Managing Director Senior Vice President Head - Fixed Income
Organisation IDBI IDBI IDBI Capital Market Services Limited IDBI Capital Market Services Limited IDBI-Principal Asset Management Company Ltd. Infrastructure Professionals Enterprise Life Insurance Corporation of India Life Insurance Corporation of India M. P. Chitale & Co. National Securities Depository Ltd. National Securities Depository Ltd. National Securities Depository Ltd. National Securities Depository Ltd. National Stock Exchange of India Limited National Stock Exchange of India Limited National Stock Exchange of India Ltd Reserve Bank of India Reserve Bank of India - Information Technology Reserve Bank of India - Internal Debt Management Reserve Bank of India - Internal Debt Management Reserve Bank of India - Internal Debt Management Reserve Bank of India - Internal Debt Management Securities and Exchange Board of India Securities and Exchange Board of India Securities and Exchange Board of India
A Singh G. N. Bajpal S. C. Bhargava Rajendra P. Chitale Amit Sinha C. B. Bhave Gagan Rai V. R. Narasimhan Dr. Gangadhar Darbha Ravi Narain Golak C. Nath Dr R. K. Pattnaik K. R. Ganapathy
Vice Chairman Chairman Secretary Managing Partner Assistant Vice President Managing Director Executive Director Senior Vice President Consultant Managing Director & CEO Manager, Wholesale Debt Market Director Chief general Manager-In-Charge
A. P. Gaur
Director
Chandan Sinha
General Manager
Dr. T. C. Nair
Chief General Manager
Usha Thorat
Chief General Manager
Dr. M. T. Raju Pratip Kar Prof. J. R. Varma
Economic Adviser Executive Director Board Member
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Name D. Basu
Position Chairman
Organisation Securities Trading Corporation of India Limited Securities Trading Corporation of India Limited Securities Trading Corporation of India Limited Securities Trading Corporation of India Limited Smif Securities Standard Chartered Bank
P.K. Naik
Senior Dealer
R. V. Joshi
Managing Director
S. R. Kamath
General Manager
I. Panju Tarun Saigal
Director Head Fixed Income Global Markets India Deputy General Manager (Insurance) Managing Director & CEO Vice President & Advisor Senior Vice President Senior Vice President Chief Executive Officer Chairman Managing Director
A. B. Lal
State Bank of India
B. Virupaksha Goud J. Vishwanath Murthy L. Viswanathan R. H. Mewawala R. Vij Dr. R. H. Patil R. Ravimohan
Stock Holding Corporation of India Stock Holding Corporation of India Stock Holding Corporation of India Stock Holding Corporation of India Templeton Asset Management The Clearing Corporation of India Ltd. The Credit Rating Information Services of India Limirted Unit Trust of India Unit Trust of India - Corporate Office Unit Trust of India - Funds Management Unit Trust of India - Funds Management Unit Trust of India - Research, Policy and Planning Unit Trust of India - Research, Policy and Planning UTI Institute of Capital Markets
M. M. Kapur S. K. Basu K. Nathani R. Rangarajan Dr. S. Nayak
Executive Director Executive Director Manager General Manager Chief General Manager
V. C. Shukla
Assistant General Manager
Dr. Uma Shashikant
Professor
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TA 3473-IND
Volume 1: The Current Situation

February 2002

Volume 1 The Current Situation
Table of Contents
Chapter 1 The Government Bond Market..................................................................... 1 Instruments ...................................................................................................................... 1 Issuance Procedure .......................................................................................................... 9 Participants .................................................................................................................... 12 Secondary Market Trading ............................................................................................ 18 Role of the RBI.............................................................................................................. 22 Chapter 2 The Corporate Bond Market ...................................................................... 23 Regulator ....................................................................................................................... 23 Credit Rating Agencies.................................................................................................. 23 Primary Market.............................................................................................................. 23 Listing............................................................................................................................ 35 Market Makers............................................................................................................... 35 Credit Premia................................................................................................................. 35 Secondary Market.......................................................................................................... 37 Chapter 3 Empirical Characterisation of the Government Bond Market................ 42 Introduction ................................................................................................................... 42 Debt Issuance................................................................................................................. 43 Rates in the Primary Market.......................................................................................... 56 Secondary Market: Activity on NSE-WDM ................................................................. 60
Volume 1 The Current Situation Chapter 1 The Government Bond Market
Chapter 1 The Government Bond Market

1. The Government securities market in India has witnessed significant changes with the initiation of financial sector reforms since the late 1980s. The Vaghul working group (1987) had recommended, among other things, the creation of an active secondary market for money and securities through a process of establishing new sets of institutions. Based on the recommendations of the Chakravarty Committee (1991) and the Vaghul working group, various measures were initiated to develop the debt market. To make Government securities an attractive investment avenue, the maximum coupon rates were progressively raised from a low of 6.5% in 1977 78 to 11.5% in 198586. Simultaneously, the maximum maturity period was reduced from 30 to 20 years. Major changes have taken place post-1992; this chapter lays out these developments and their impact on the functioning of the market.
INSTRUMENTS
2. The Government of India conducts its market borrowings by means of Treasury Bills (T-Bills) and dated securities. As of March 31, 2001, there were 170 Government securities outstanding, comprising 54 T-Bills and 116 dated securities.
Treasury Bills
3. T-Bills are short-term instruments with a maturity of less than a year. They are issued at a discount to face value (Rs. 100), the rate of interest on the instrument being calculated as the return over the maturity period. Until very recently, the Reserve Bank of India (RBI) conducted weekly auctions for 14-day and 91-day TBills and fortnightly auctions of T-Bills of 182-day and 364-day maturities. Effective May 14, 2001, 14-day and 182-day T-Bills have been discontinued. Auctions of 364-day T-Bills were introduced on April 28, 1992 and replaced the then-existing 182-day T-Bills. 91-day T-Bills were introduced on January 9, 1993. 14-day and 182-day T-Bills are relatively new instruments, having been introduced in the market on June 6, 1997 and May 26, 1999, respectively. 364-day T-Bills form part of the Governments budgeted market borrowings during the year and have constituted, on average, about 11.5% of the Governments market borrowings during 199899 to 200001. Besides supporting the Governments need for short-term funds, the introduction of T-Bills at varying maturities less than a year was intended to help develop the short-term rupee yield curve which could be used as a benchmark for pricing of non-sovereign instruments of similar maturities. T-Bills provide risk-free investment opportunities for investors with short-term surpluses. They are also eligible for repo and liquidity adjustment facilities.
4.
5.
6.
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Any person in India, including individuals, firms, corporate bodies, trusts and institutions (including foreign investment institutions), can hold the bills. 7. The gross amounts raised via 364-day T-Bills have increased during the period 199899 to 200001, concomitant with a decline in amounts raised through 91-day T-Bills (Table 1.1).
Table 1.1 Gross borrowings via T-Bills (Rs. crore) 364-day 182-day 91-day 14-day
Year
Total
199293 199394 199495 199596 199697 199798 199899 199900 200001
8796.74 (86.7) 21019.76 (56.2) 16139.88 (56.5) 1874.74 (13.6) 8240.63 (24.6) 16246.56 (17.3) 10300.00 (23.0) 13000.00 (31.9) 15000.00 (42.1)
2900.00 (7.1) 2600.00 (7.3)
1350.00 (13.3) 16350.00 (43.8) 12450.00 (43.5) 11950.00 (86.4) 25200.08 (75.4) 12840.18 (13.7) 16348.00 (36.6) 8257.50 (20.2) 7605.00 (21.3)
- 10146.74 (100) - 37369.76 (100) - 28589.88 (100) - 13824.74 (100) - 33440.71 (100) 64940.60 94027.34 (69.1) (100) 18150.00 44698.00 (40.6) (100) 16653.41 40810.91 (40.8) (100) 10450.50 35655.50 (29.3) (100)
Notes: (i) 364-day T-Bills were introduced in April 1992, 91-day in January 1993, 14-day in June 1997 and 182-day in May 1999. (ii) Figures in brackets are percentages of total. Source: Compiled from data in Handbook of Statistics on Indian Economy 2000, RBI.
Dated Government Securities

8. Both the Central and State Governments regularly access the market for their funding needs by issuing dated Government securities. Being eligible as Statutory Liquidity Ratio (SLR) investments, these securities provide an attractive investment option for banks and institutions with investible funds.
Central Government Securities 9. As of March 31, 2001, there were 116 Central Government bonds outstanding, comprising an amount of Rs. 3,87,854 crore. Table 1.2 shows the amounts raised since 199596.
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Year
Table 1.2 Borrowings of Central Government by issuance type (Rs. crore) Auctions Private placement Tap/floatation Price-based Yield-based No. Amount No. Amount No. Amount No. Amount
Total No. Amount
199596 199697 199798 199899 199900 200001 18 17 51645 (57.3) 56000 (55.9)
9 15441.95 (40.1) 9 18911.06 (67.8) 8 27000 (62.2) 16 43500 (51.9) 3 9500 (10.5) 8 23500 (23.5)
5500 (14.3) (0) 11000 (25.4) 30000 (35.8) 27000 (30.0) 18000 (18.0)
3 11 8 5
8 17522.57 (45.6) 3 9000 (32.2) 2 5390.38 (12.4) 5 10252.82 (12.2) 1 2129.85 (2.4) 1 2683.45 (2.7)
20 38464.52 (100) 12 27911.06 (100) 13 43390.38 (100) 32 83752.82 (100) 30 90094.85 (100) 31 100183.5 (100)
Notes: (i) Proportion of total issue in parentheses. (ii) Price-based auctions were introduced in May 1999.
10.
Most Government bonds are coupon-paying instruments, paying semi-annual coupons. During the last few years, however, the Government of India has issued new instruments such as zero coupon bonds, floating rate bonds, capital indexed bonds and partly paid stock. a. Zero coupon bonds maturing in 2000 were first issued in January 1994 (the first series). This was followed by a second issue of Rs. 2000 crore in February 1995 at an implicit yield of 12.71%. Issues of ZCB II and ZCB III (second and third series) for Rs. 3000 crore each were conducted on July 27, 1995 and July 13, 1996 at implied yields of 13.85% and 13.72%, respectively. A second issue of ZCB III for an amount of Rs. 2000 crore was sold on tap on October 7, 1996. b. Floating rate bonds were issued for the first time on September 29, 1995. These bonds were of 4-year maturity. Interest on the bonds was to be paid semi-annually in March and September, with the rate of interest set at 1.25 per cent above the average of the implicit yields on 364-day T-Bills during the immediately preceding six months. The issue mobilised Rs.1554.31 crore at a yield to maturity (YTM) of 13.73 per cent and was redeemed on September 29, 1999. The Government of India issued 2 FRBs of maturities 5 years and 8 years respectively in November and December 2001. The salient features of the auctions are outlined below:
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c.
d.
The base rate will be the average of the implicit yields in primary auctions of 364-day T-Bills held prior to the relative half-year period; The auctions were conducted on a uniform pricing basis; Bids were to be submitted in terms of mark-ups over the base rate; Both auctions were over-subscribed by large amounts; - the 5-year paper was over-subscribed over 4 times and the 8-year paper 1.25 times. The mark-ups arrived at on the basis of the bids received was -0.05 per cent for the 2006 paper and -0.01 per cent for the 2009 paper. These imply coupons of 7.01 per cent and 6.98 per cent respectively for the 2 securities for the first semi-annual coupon payment. Market players have been demanding issuance of FRBs to hedge against interest rate risks, and the aggregate amounts of bids received would indicate the appetite for such instruments. However, the negative mark-ups over a 1-year rate appear puzzling. Capital indexed bonds carrying a coupon of 6% and maturity of 5 years were issued on December 29, 1997. The issue received only a lukewarm response from the market, mobilising only Rs. 704.52 crore. These bonds will be redeemed on December 29, 2002. The repayment of the principal amount at maturity will be adjusted for inflation since the issue date, based on the Wholesale Price Index (WPI). The Index ratio for the purpose is to be calculated as the ratio of the reference WPI (August 2002) to base WPI (August 1997). Partly paid stock (13.85% 2006) aggregating Rs. 5000 crore was sold on tap by the RBI in June 1996. The subscription amount for this stock was to be paid in four equal monthly instalments of 25% of the face value starting June 24, 1996. The issue was fully subscribed.
State Government Bonds 11. State Governments conduct market borrowings to finance part of their fiscal deficit. However, such financing constitutes a very small proportion of the financing, the major part being accounted for by loans from the Central Government, small savings schemes, and loans from financial institutions and provident funds. As of March 31, 2001, there were 295 State Government bonds outstanding, with maturity dates ranging from September 2001 to January 2011 and coupon rates ranging from 10.52% to 14%. The total outstanding issue size was of the order of Rs. 43,176 crore, with an average issue size of Rs. 146 crore.
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12.
Table 1.3 shows the amounts raised since 199596.

Table 1.3 State Government borrowings (Rs. crore) Gross Net
Year
199596 199697 199798 199899 199900 200001
6274 6536 7749 12114 13706 11420
5931 6536 7193 10700 12405 11000
Source: Handbook of Statistics on the Indian Economy, 2000.
13.
Until very recently, the RBI conducted State Government borrowings in common tranches. The maturity of the loan was 10 years, and the coupon was fixed at 25 basis points above the Central Governments 10-year coupon rate to reflect the credit premium of State Governments versus the Central Government. The fixed coupon differential has now been abolished, but since the amounts raised by individual states are typically small, the RBI conducts the sale/auctions by aggregating the requirements of a number of states into a single issue. For instance, 27 State Governments approached the market for an aggregate loan amount of Rs. 3800 crore on May 8, 2001. The loan offered 10.35% coupon for 10-year maturity. The individual amounts ranged from Rs. 5 crore for Arunachal Pradesh and Sikkim, to Rs. 500 crore for Uttar Pradesh. Table 1.4 shows recent auction results an the spread of yields.
Table 1.4 Market Borrowings of States: Summary of Auction Results
State
Date of auction Amount of issue (Rs. crore) 1. West Bengal 08.08.2000 250 2. Maharashtra 08.08.2000 280 3. Andhra Pradesh 08.08.2000 400 4. Tamil Nadu 08.08.2000 290 5. Kerala 29.08.2000 200 6. Karnataka 05.12.2000 250 7. Kerala 17.04.2001 200 8. Gujarat 20.07.2001 190 9. Gujarat 06.08.2001 250 10. Andhra Pradesh 13.08.2001 475 11. Madhya Pradesh 13.08.2001 105 12. West Bengal 13.08.2001 250
Source: RBI Annual Report 2000-01
Cut-off yield (Per cent) 11.80 11.70 11.80 11.70 11.75 11.57 10.53 9.50 9.40 9.53 9.55 9.72
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14.
Conducting sales in common tranches has the drawback that financially better off (i.e. the more creditworthy) states raise their loans at the same coupon as troubled states. Since 199899, states have been given the flexibility of independently entering the market for loans of between 5% and 35% of their budgeted borrowing programmes. The first auction of a State Government stock was held on January 13, 1999 when the Government of Punjab raised Rs. 60 crore through a 10-year stock. A few states have raised funds through auctions, while some others have raised funds through tap sales. This has allowed reflection of inter-state differences in creditworthiness in the rates determined. For instance, the State Development Loan auction on August 20, 1999 set a coupon of 11.77% and 11.74%, respectively, for the Andhra Pradesh and Tamil Nadu Governments. On August 9, 2000, Andhra Pradesh and West Bengal raised 10-year loans at 11.80% coupon, while the coupon on Tamil Nadu and Maharashtra loans was 11.70%, reflecting the higher creditworthiness of the latter two states.
Government Guaranteed Bonds 15. Apart from the direct obligations of Central and State Governments in terms of their market borrowings, there are contingent liabilities on account of the guarantees that are provided by them to certain entities to support the latters fundraising activities for promoting economic activities. In nominal terms, the amounts outstanding in terms of these guarantees have been increasing over the years, though as a proportion of GDP, the figures show a declining trend (Table 1.5).
Table 1.5 Outstanding Government guarantees (Rs. crore) Year-end Centre States * Total
1995 1996 1997 1998 1999
62468 (6.0) 65573 (5.4) 69748 (4.9) 73877 (4.7) 74606 (4.2)
48479 (4.7) 52631 (4.3) 63409 (4.5) 73751 (4.7) 83075 (4.7)
110947 (10.7) 118204 (9.7) 133157 (9.4) 147628 (9.4) 157681 (8.9)
Notes: (i) * 17 major states. (ii) Figures in brackets are percentage of GDP. Source: RBI Annual Report 19992000.
16.
Apart from these contingent liabilities, State Governments also issued letters of comfort to banks and financial institutions, which are in the nature of implicit guarantees. To contain the impact of such guarantees that might subsequently devolve on the states, the Technical Committee on State Guarantees 1999 recommended that Governments eschew the practice of providing letters of comfort and, in its place, provide for credit enhancement in terms of guarantees within the overall limits set for the purpose. There is, however, a significant difference in risk associated with investment in State Government securities versus State
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Government guaranteed bonds. To adequately reflect this, the RBI guidelines require banks to assign a risk-weight of 20% to investments in the latter category.
Fixed Income Derivatives

17. With a view to deepening the money market and enabling financial market players to hedge their interest rate risks, fixed income derivatives i.e. interest rate swaps and forward rate agreements were introduced by the RBI in the market in 1999. The guidelines required the use of a domestic money or debt market instrument as the underlying benchmark for such deals. The Mumbai Inter-bank Offer Rate (MIBOR) has emerged as the most widely accepted benchmark. Interest rate swaps accounted for nearly all of the 928 outstanding deals as of November 17, 2000; the notional principal on these transactions amounted to Rs. 12,620 crore. To provide more flexibility for the development of this market, the RBIs Monetary and Credit Policy for 200001 permitted the use of interest rates implied in the forex market as an underlying benchmark rate.
18.
Repos
19. Repos (often known as ready forward contracts or buy-back deals) act as money market instruments for collateralised short-term lending and borrowing. In a standard repo transaction in which a bank sells its securities to a buyer, receiving cash in exchange, it simultaneously enters into a contract to buy back the security at a later date at a pre-specified price. The repo rate is the annualised rate of interest for the funds transferred from the lender to the borrower. Being a collateralised transaction, the repo rate acts as the floor for all other short-term rates of interest. In India, repos can be executed either as (i) inter-bank deals or (ii) by any permitted entity with the RBI as the counterparty. Banks, primary dealers and satellite dealers are permitted to undertake repos and reverse repos. Non-bank entities are permitted to undertake reverse repos only. In view of the continuing demand from market participants to widen the scope of repo transactions, a report was prepared by a sub-group of the RBI Technical Advisory Committee on Government Securities. The report, submitted in April 1999, covers all aspects of repo transactions, including legal status, regulatory framework, standardisation of accounting and risks involved. The recommendations, which include widening of the participant base and expansion of the list of eligible instruments, would go a long way to develop the repo market. We detail these in Volume 2.
20.
21.
Inter-bank Repos 22. Inter-bank repos were allowed in India prior to 1992 subject to certain regulations, viz. that (i) they be exclusively confined to Government securities, (ii) the repurchase date be fixed after a minimum period of 30 days from the date of sale, and (iii) that the prices be in alignment with market rates prevailing on the date of
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the transaction. Further, banks were permitted to enter into such sales transactions only if they were in actual possession of the securities in their investment portfolio, and such transactions were to be strictly inter-bank. 23. Large-scale violations of the guidelines led to the securities scam of 1992, following which the RBI imposed severe restrictions on the usage of the repo facility by different participants. Repos in Government bonds and other approved securities were banned, and only T-Bills were eligible as repo instruments. To prevent the recurrence of abuses that the then-existing system had encouraged, viz. non-documentation of commitments to repurchase/resell, the RBI introduced the Delivery versus Payment (DVP) system in 1995 to mitigate the possibility of settlement and/or counterparty risks. Since then, the constraints imposed on the repo market have gradually been relaxed; currently, all dated Government securities are eligible for repos. Banks, primary dealers and satellite dealers are allowed to participate in both repo and reverse repo transactions. Certain non-bank entities having current and Subsidiary General Ledger (SGL) accounts with the RBI are allowed to participate in reverse repo for lending money to other eligible participants. The Monetary Policy for the first half of 199798 made Public Sector Undertakings (PSU) bonds and private debt instruments eligible for repos, provided they are in dematerialised form in a depository and the transactions are put through recognised exchanges. This is yet to take off in a big way the levying of stamp duty and the low level of dematerialisation having been a barrier for a long time. With the Finance Bill 2000 waiving stamp duty on transactions in debt instruments held in dematerialised form, a major hurdle has been removed. A supportive initiative has also come from the RBI Credit Policy of April 2001, which laid down guidelines for banks and primary dealers investments in corporate bonds. Fresh investments are henceforth to be made only in dematerialised form, and deadlines have also been set for dematerialising all outstanding holdings. Short-selling is prohibited; entities entering into repo transactions are not permitted to effect any sale transaction without actually holding the securities in their portfolio.
24.
25.
Repos with the RBI Liquidity Adjustment Facility 26. The RBI has been using repos actively for liquidity management, both for absorbing liquidity as well as for injecting funds into the system; repos conducted by the RBI form a major part of the total repo transactions. The repo rate has thus emerged as a benchmark rate, acting as a floor for the call money rate. To enable efficient use of repos for liquidity control and to prevent interest rate arbitraging, the RBI introduced a system of daily fixed rate repos from November 29, 1997. The Liquidity Adjustment Facility (LAF) was introduced in June 2000, replacing the Additional Collateralised Lending Facility earlier extended to banks and the Level II liquidity support earlier extended to primary dealers. The funds are
27.
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expected to be used for day-to-day mismatches in liquidity. Under this scheme, the RBI conducts daily repo and reverse repo auctions. The auctions are conducted on a variable rate uniform price basis. They are normally of one-day tenor, but for intervening holidays and Fridays. 28. The Credit Policy 200102 has announced certain amendments to the LAF scheme. The RBI will henceforth have an option to switch over to fixed rate repos on an overnight basis. Furthermore, multiple price auctions on an experimental basis were introduced in May 2001. The RBI would also have the discretion to introduce longer-term repos as and when required.
ISSUANCE PROCEDURE
29. The Public Debt Office (PDO) of the Internal Debt Management Cell of the RBI conducts issuances on behalf of the Government.
T-Bills
30. T-Bill issuances follow a fixed calendar, with 14-day and 91-day T-Bill auctions, until May 2001, being conducted every Friday. 182-day and 364-day T-Bill auctions were conducted once every fortnight, on the Wednesday preceding the non-reporting and reporting Fridays, respectively. Effective May 14, 2001, 14-day and 182-day T-Bills have been discontinued. Further, to synchronise dates of payment for 91-day and 364-day T-Bills, auctions of 91-day T-Bills are now held every Wednesday. The RBI notifies the amounts to be offered at the auction. These are currently set at Rs. 250 crore and Rs. 750 crore, respectively, for the 91-day and 364-day T-Bill auctions. Participants can submit bids for a minimum amount of Rs. 25,000 and in multiples of Rs. 25,000. Non-competitive bids are accepted from State Governments and non-government provident funds. These are, however, kept outside the notified amount and allotment is made at the weighted average cut-off price determined in the auction. Auctions are of the discriminatory price type (successful bidders pay their respective bid prices) for 364-day T-Bills and uniform price type (all successful bidders pay the cut-off price) for 91-day T-Bills. (14-day and 182-day T-Bill auctions, when in existence, were also of the discriminatory price type.) Important changes have taken place in the T-Bill issuance procedure in recent years. Until April 1998, while the issue amount for 91-day T-Bills was notified before every auction, there was no notified amount for the 364-day T-Bill auctions, which possibly provided the RBI with greater leverage in setting yields on the latter. Consequently, while the yields on these instruments generally moved in tandem, there were periods during which the 364-day yield was held almost unchanged while the 91-day yield was increased in line with market sentiments. Such a situation occurred, for instance, between October 1997 and April 1998 when the 364-day yield remained nearly constant while the 91-day rate was increased by
31.
32.
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112 basis points. It is worth mentioning at this point that four 364-day T-Bill auctions were cancelled during this period. 33. Issuance procedures for all T-Bills were harmonised at the same time (April 1998) with the introduction of notified amounts for 14-day T-Bill auctions. From June 1997 to April 1998, there was no notified amount on this instrument. The notified amounts were announced before the auction but could be set at different levels for different auctions. This was changed in April 1999 when the notified amounts for 14-, 91- and 182-day T-Bills were set at Rs. 100 crore and for 364-day T-Bills at Rs. 500/Rs. 750 crore. In the initial years, the RBI used to pay primary dealers an underwriting commission for their primary purchases; in May 1997, this was replaced by a scheme of underwriting fees. Underwriting of T-Bill auctions by primary dealers was withdrawn effective April 20, 1999 and a system of bidding commitments introduced in its place. The minimum bidding commitments are so obtained that all primary dealers together absorb 100% of the issue. Effective 199899, non-competitive bids are kept outside the notified amount to provide certainty to both sets of bidders as regards the amounts to be allotted to them. Based on bids submitted, the RBI decides on a cut-off price; all bids below the cut-off price are rejected. Allotments to successful bidders are at their respective quotes, except in 91-day T-Bill auctions, which is done on a uniformpricing basis. The unsubscribed portion of the notified amount (i.e. the notified amount less the face value of competitive bids accepted) could earlier devolve on the RBI and/or the primary dealers based on the latters underwriting commitment; since April 1999, devolvements are only on the RBI (Table 1.6).
Table 1.6 Summary information on devolvements in T-Bill auctions 364-day 182-day 91-day 14-day No. % No. % No. % No. % 199293 0 0 13 85.0 199394 0 0 11 5.1 199495 0 0 17 20.1 199596 0 0 30 33.2 199697 0 0 15 15.4 199798 0 0 20 13.6 0 0 199899 12 21.2 30 38.8 20 36.4 199900 7 17.4 8 28.0 31 31.1 25 23.3 200001 6 12.2 3 5.8 14 15.1 11 14.0 Notes: (i) Up to April 1999, devolvements include both primary dealers and RBI. (ii) Prior to 199899, there was no notified amount for 14-day and 364-day T-Bill auctions. (iii) 14-day and 182-day T-Bills were introduced in June 1997 and May 1999, respectively. (iv) Percentage refers to percentage of notified amount for the full year. (v) From 199899 onwards, non-competitive bids are kept outside the notified amount. Year
34.
35.
36.
The move to an auction system from an ad-hoc issuance procedure was expected to facilitate a price discovery process that would result in market-related rates on these instruments. In Chapter 3 we analyse how successful this initiative has been,
Page 10
whether the extent of market-relatedness is uniform across maturities, and whether there exists a two-way information flow between the primary and secondary markets.
Dated Government Securities

37. An auction system for government bonds was introduced in 1992, marking a move towards market-related rates of return on these instruments. Auctions are conducted through both yield-based and price-based auctions. In yield-based auctions, securities are issued at par. The RBI announces the maturity of the new security and bidders quote in terms of coupon. Price-based auctions are a relatively new step taken by the RBI to enable finer bidding by market participants. The first pricebased auction was conducted by the RBI on May 12, 1999. All auctions are of the discriminatory price type, with bids below the cut-off yield (or above the cut-off price) being allotted the bid amounts at their respective yields (prices). In order to maintain a stable interest rate environment, the RBI, on occasions, also accepts private placement of Government paper. Securities that are privately placed with the RBI and those that devolve on it are subsequently offloaded through the RBIs open market operations. Tap issues are issues sold to market participants on a first-come first-served basis; these are issued at par (Rs. 100). Unlike T-Bills, the RBI does not have a fixed calendar for auctions of dated Government securities. The RBI announces an auction four to five days prior to the auction date through a public notification. The notification includes details of the security to be auctioned, maturity and coupon for a price-based auction and maturity for a yield-based auction, along with the amount to be auctioned. The issue amount typically varies between Rs. 2000 crore and Rs.5000 crore. A day prior to the auction, the RBI conducts an auction for the underwriting fee to be paid to primary dealers. The primary dealers submit bids (amounts and underwriting fee demanded) to the PDO of the RBI. Primary dealers bidding commitments and success ratios being for the full year, it is not mandatory for them to bid at all auctions. Likewise, it is not mandatory on the part of the RBI to accept the quoted fees; the RBI can, in principle, reject all bids. Starting with the lowest fee quoted, the RBI accepts underwriting commitments up to 100% of the notified amount. The auction is of the multiple price type, i.e. each primary dealer receives his underwriting fee for the amount he has committed to underwrite at the rate he has quoted. Once the underwritten amounts are decided, primary dealers bid for the security for an amount not less than the amount they have committed to underwrite. Sealed bids (for a minimum of Rs. 10,000 and in multiples of Rs. 10,000) are submitted by market participants at the PDO. Participants are allowed to put in multiple bids. While commercial banks and financial institutions can submit their bids directly to the RBI, co-operative banks and corporates route their bids through primary dealers. The RBI sets a cut-off price; bids above the cut-off price receive allotment
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38.
39. 40.
41.
at their respective prices. The balance devolves on the primary dealers, depending on their underwriting commitments, and/or the RBI at the weighted average price of successful bids. Table 1.7 shows the level of past devolvements.
Table 1.7 Summary information on devolvements: Dated Government securities
Year
No.
Percentage of notified amount at auctions that devolved (average)

Total RBI Primary dealers
Percentage of total issuance during the year

Total RBI Primary dealers
199596 199697 199798 199899 199900 200001
11 6 5 8 3 9
69.90 33.80 71.10 51.50 39.89 64.16
69.90 30.82 62.04 37.29 0 41.10
0 2.98 9.06 14.21 39.89 23.06
37.16 20.28 39.29 15.41 3.30 27.19
37.16 18.49 34.28 11.16 0 17.42
0 1.79 5.01 4.25 3.30 9.78
Notes: (i) Devolvements include private placements. (ii) Notified amounts are amounts issued through auctions and private placements exclusive of issues sold on tap.
42.
The system of underwriting imposes an implicit cost on primary dealers, which is difficult to precisely quantify. Primary dealers are allowed to submit multiple bids (at different prices). However, these must, in total, be at least equal to the amount they have committed to underwrite. In a situation where all the bids that a primary dealer has submitted are not accepted but some part of the issue devolves on him as underwriter, the price he pays for the devolved amount is the weighted average price of successful bids, which is higher than his unsuccessful bid price. In the absence of published information on the rejected bids (amounts and prices), it is difficult to arrive at a measure of this cost. However, it is important to recognise that, assuming that the RBI uses a book-building procedure to weigh the costs and benefits of each marginal bid to arrive at the cut-off, a cost to the primary dealer is a gain to the RBI. The RBI participates as a non-competitive bidder in auctions of T-Bills and bonds, primarily to absorb part of the issue at the weighted average price in the case of an under-subscription (also termed a devolvement).
43.
PARTICIPANTS
Intermediaries
44. Primary dealers and satellite dealers act as intermediaries and market makers for Government securities.
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Primary Dealers 45. Guidelines for setting up the institution of primary dealers were announced by the RBI in March 1995. It was envisaged that primary dealers would: a. strengthen the infrastructure in the Government securities market and help make it vibrant, liquid and broad-based; b. ensure development of underwriting and market-making capabilities for Government securities outside the RBI; and c. improve the secondary market trading system which could contribute to price discovery, enhance liquidity and turnover, and encourage voluntary holding of Government securities among a wider investment base. Primary dealership can be set up as subsidiaries of scheduled commercial banks or financial institutions. Companies incorporated under the Companies Act 1956 and subsidiaries/joint ventures set up by entities incorporated under the approval of the Foreign Investment Promotion Board (FIPB) can also apply for primary dealership. In all cases, the entities should be engaged predominantly in the securities business in particular, the Government securities market. A primary dealer is required to have net owned funds of Rs. 50 crore. Discount and Finance House of India (DFHI) was the first entity to be granted primary dealership in March 1996,1 followed by the setting up of the Securities Trading Corporation of India (STCI) in March 1996. As of July 2001, there were 16 primary dealers (and four more had received in-principle approval) operating in the bond market. The ownership structure of primary dealers is shown in Table 1.8.
Table 1.8 Ownership structure of primary dealers Ownership No.
46.
47.
48.
Public sector bank subsidiary Private sector Foreign 49.
8 3 5
Primary dealers do not have unique access to primary auctions, but the RBI extends other incentives including facilities such as current and SGL accounts, liquidity support linked to bidding commitments and success ratio, freedom to deal in money market instruments and favoured access to open market operations. Primary dealers have access to Level I liquidity support up to three times their Net Owned Funds at the Bank Rate and access to the LAF. Performance of primary dealers is assessed by the RBI and judged on the basis of their bidding commitments and the success ratio achieved at primary auctions. Their success in secondary market trading is measured by their turnover in Government securities: the outright turnover has to be three times their holding in
50.
DFHI was founded in April 1988 to trade in the overnight money market, T-Bills and commercial bills. From 199293 onwards, DFHI was authorised to deal in dated Government securities. Page 13
Government dated securities and five times their holding in T-Bills. In their role as market makers for Government paper, primary dealers are also required to provide two-way quotes for Government securities. Satellite Dealers 51. Satellite dealers constitute the second tier of market makers for Government securities. The institution of satellite dealers was put in place in December 1996 with the objective of widening the scope of organised dealing and distribution of Government securities. Satellite dealers were expected to further strengthen the infrastructure for distribution, enhance liquidity and turnover in Government securities, provide a retail outlet for Government securities and encourage voluntary holding among a wider investor base. The eligibility conditions are the same as for primary dealers, with a lower Net Owned Funds requirement of Rs. 5 crore. The RBI extends facilities including holding of SGL, Constituent Subsidiary General Ledger (CSGL) and current accounts, and liquidity support through reverse repos. In addition, satellite dealers can raise funds through commercial paper and are permitted to transact in the repo market with other eligible participants and in eligible instruments. As at January 2001, the RBI had granted registration to nine entities as satellite dealers and four were in operation. Satellite dealers are regulated by the RBI.
Brokers 52. Brokers play an important role in the secondary government bond market, bringing together counterparties and negotiating terms. They provide research and market intelligence, as well as anonymity during negotiation. Once a deal is finalised, the broker is required to furnish details of the deals to the exchange of which he is a member. Broker-negotiated deals account for about 6070% of trading (as revealed by the ratio of volume of trade reported on the Wholesale Debt Market (WDM) segment of the National Stock Exchange (NSE) to the total volume reported to SGL). The NSE specifies maximum rates of brokerage that can be charged by members trading on the WDM. These range from a brokerage of 50 paise per Rs. 100 (0.5%) for order values up to Rs. 25 lakhs, to 5 paise per Rs. 100 (0.05%) for order values exceeding Rs. 10 crore. The Securities and Exchange Board of India (SEBI) regulations prohibit an institution from putting more than 5% of its government bond trading through a single broker. Brokers are regulated by the exchange of which they are a member (NSE, in this case) and by SEBI.
53.
Investors
54. The main investors in Government securities include banks, financial institutions (including term-lending institutions), insurance companies, mutual funds, especially gilt funds, non-bank finance companies, pension and provident funds, corporates and individuals. (We classify the last three categories as retail investors.) Commercial banks, as a group, have been the single largest holder of Government
Page 14
securities, accounting, on average, for about 60% of the outstanding Government securities. The Life Insurance Corporation of India (LIC) also holds a significant proportion of outstanding Government securities. The RBI is also a substantial holder as a result of devolvements and private placements. Holdings by other financial sector players and retail investors are minuscule, at an individual level, indicating significant potential for widening the investor base for Government securities (Table 1.9).
Table 1.9 Ownership pattern of Government securities
End-March RBI (percentages) Commercial banks LIC Others
1996 1997 1998 1999
7.3 2.8 10.7 9.1
64.9 63.0 58.9 59.5
16.8 18.7 18.0 17.9
11.0 15.5 12.4 13.5
Source: Report on Currency and Finance 19992000, RBI.
Banks 55. The banking system in India comprises commercial banks and co-operative banks. Scheduled commercial banks comprise public sector banks these include the 19 nationalised banks along with the State Bank of India (SBI) and its seven associates, 34 Indian private sector banks and 45 foreign private sector banks (as of March 31, 2000). Regional banks comprise the third category of commercial banks. Banks are regulated by the RBI. Scheduled commercial banks are the largest investors in Government of India securities. Regulations require these banks to maintain 25% of their net demand and time liabilities (NDTL) as SLR investments. Government securities, along with other approved securities, are eligible as SLR investments. Partly due to the lack of better investment opportunities (low credit demand from corporates), and on account of Government securities providing market-related rates of interest, thereby providing attractive investment opportunities, banks have, in the recent past, invested in these instruments in excess of their mandatory SLR holdings. More stringent capital adequacy, income recognition and provisioning norms have also played a role in guiding banks investment decisions. As per the RBI Credit Policy of April 2001, the banking system holds 35% of NDTL in Government securities. The RBI guidelines stipulate classification of banks investment portfolios (which include Government securities, other approved SLR securities and non-SLR securities) into three categories: held for trading, available for sale and held to maturity categories. The category in which a particular security is classified determines its valuation methodology. The held to maturity category can constitute a maximum of 25% of investments and is valued at acquisition cost, unless that is higher than the face value, in which case the premium is amortised
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56.
57.
over the remaining maturity. The other two categories are marked to market. Until recently, the RBI announced YTMs for valuation of unquoted securities; this task has recently been handed over to the Fixed Income and Money Market Dealers Association (FIMMDA) and the Primary Dealers Association of India (PDAI). 58. For the purpose of capital to risk-weighted asset ratio computations, from March 31, 2000, banks are required to assign a market-risk weight of 2.5% for Government and other approved securities.
Financial Institutions 59. Financial institutions constitute an important set of players in the Government securities market. These can be broadly categorised as All-India financial institutions (AIFIs), state-level financial institutions (SFIs) and other institutions. AIFIs include development banks,2 specialised financial institutions3 and investment institutions.4 The first two categories of financial institutions are regulated by the RBI. There are no guidelines on investment in Government securities for financial institutions; however, most financial institutions hold Government securities in both their investment and trading portfolios. Their investment categorisation and valuation norms are the same as for the banks.
60.
Insurance Companies 61. Until 2000 only two insurance companies were permitted to operate in India: Life Insurance Corporation of India, which had a monopoly in life insurance; and the General Insurance Corporation of India (GIC), which provided general insurance. Both are state-owned. The Insurance Regulatory and Development Authority (IRDA) Act was enacted in 1999 in recognition of the need to open up the sector to other players. Subsequently, in April 2000, the RBI laid down guidelines permitting banks to enter the insurance business, subject to certain conditions. Since then, a number of new companies, including joint ventures, have started up. Investment norms for insurance companies such as LIC and GIC make insurance companies also a captive market for Government securities. The norms for LIC, for instance, stipulate that not less than 50% of investment should be in Central and State Government marketable securities and loans to the National Housing Bank (NHB). Between 199596 and 19992000, LICs investments in Central and State Government securities constituted an average of 55.7% of its investment portfolio. Insurance companies are regulated by the IRDA. In the case of banks entering the insurance sector, while their equity holding or participation in any other form is
62.
63.
3 4
Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI), Industrial Investment Bank of India (IIBI) and Small Industries Development Bank of India (SIDBI). Export Import Bank of India (EXIM-Bank), Infrastructure Development Finance Corporation (IDFC), etc. Life Insurance Company of India, General Insurance Company of India and Unit Trust of India (UTI). Page 16
subject to compliance with the IRDA/Government notifications, the authority to grant case-by-case approval rests with the RBI. Mutual Funds 64. Mutual funds can be classified into five groups according to the amount invested in debt instruments: a. debt funds that invest more than 75% of their funds in debt instruments; b. balanced funds that invest between 60% and 75% in debt instruments; c. income funds that invest in corporate debt instruments; d. gilt funds that invest only in Government of India and State Government bonds: and e. money market mutual funds that invest in money market instruments, i.e. instruments that have a maturity of less than a year. Dedicated gilt funds are a relatively recent entrant in the market, the first gilt fund having been set up in December 1998. These are mutual fund schemes floated by asset management companies with exclusive investments in Government securities. With Government securities yet to establish themselves as a viable investment avenue by individuals, gilt funds indirectly provide retail investment in gilts. Facilities extended by the RBI to gilt funds include liquidity support, SGL and current accounts, transfer of funds through the RBIs Remittance Facility Scheme and access to the call money market. Mutual funds are regulated by SEBI.
65.
Pension and Provident Funds 66. Pension and provident funds have until now covered only the organised sector of the workforce. At the individual enterprise level, the Employees Pension Fund (EPF) and Employees Pension Scheme (EPS) provide employees with the opportunity to subscribe to these schemes. In addition, the Public Provident Fund (PPF) scheme provides a provident fund option for the uncovered section of the workforce. Investment guidelines are laid down by the Employees Provident Fund Organisation (EPFO) and require that 40% of investments be made in Central and State Government and Government guaranteed bonds. Government securities act as a suitable investment option for pension and provident funds that are interested in investing in risk-free instruments that provide a reasonable rate of return. Provident funds are permitted to participate in 91-day TBill auctions as non-competitive bidders.
67.
Retail Investors 68. To encourage wider participation and retail holding of G'secs the RBI in December 2001 introduced a scheme for non-competitive bidding at primary auctions. According to this scheme, non-competitive bids upto a maximum of 5 per cent of the notified amount would be accepted at the weighted average cut-off price / yield. The other features of the scheme are as follows:
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a. b. c. d. e. f. g. 69.
Eligibility to place non-competitive bids extends to any person including firms, companies, corporate bodies, institutions, provident funds and trusts who do not have a current account or SGL account with the RBI; Regional Rural Banks (RRBs), Urban Co-operative Banks (UCBs) and NBFCs are also covered under the scheme; Bids are to be placed through any bank or PD offering the scheme; Banks / PDs can recover a maximum of 6 paise per Rs.100 (face value) as brokerage / commission / service charges; An investor can make a single bid for an amount not exceeding Rs. 1 crore; Bids can be placed for amounts of Rs.10,000 (face value) and multiples thereof; In case the bid amount falls short of the reserved amount, the shortfall is to be taken to the competitive portion.
The first auction allowing bids under this scheme was conducted for a 15-year maturity paper on January 14, 2002. At just over Rs.148 crore, the total amount of bids received for the non-competitive portion was far short of the reserved amount (Rs.250 crore of a notified amount of Rs.5000 crore). The competitive portion, in contrast, was heavily over-subscribed; the RBI received bids worth over Rs.16,056 crore. While this may be indicative of the differing maturity-wise investor preferences, it could also be attributable to the low information dissemination regarding the scheme.
SECONDARY MARKET TRADING

70. Secondary market trades in Government securities can be executed through members of either the NSE or The Stock Exchange, Mumbai (BSE). Trading on the NSE commenced in June 1994; trading on the BSE has been permitted since November 2000. Short-selling is not permitted.
Negotiation of a Trade
71. Most of the secondary market trading in Government of India securities is negotiated trades. These can be negotiated directly between two counterparties or negotiated through brokers. Where a broker is involved, the trade must be reported to the NSE-WDM. In all cases the trades are reported to the RBI-SGL. A third avenue through which secondary market trading in Government of India securities takes place is an electronic limit order book market on the WDM segment of the NSE (NSE-WDM), also called the continuous market. The trading system on WDM, known as NEAT (National Exchange for Automated Trading), allows fully automated screen-based trading that, in principle, enables members across the country to trade simultaneously with each other. The secondary market, however, still remains largely a telephone-based market, with trades subsequently reported on the NSE-WDM and the Subsidiary General Ledger of the RBI (RBI-SGL).
72.
73.
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Trading Conventions
74. Trades are negotiated in terms of value and not in terms of the number of securities. A market lot is defined as Rs. 1 crore. Prices are quoted exclusive of interest accrued, i.e. as clean price. The secondary market follows the 30/360 convention for the purpose of computation of accrued interest for dated Government securities. The rate of interest on securities with maturity less than a year is computed as simple interest on an actual/365 basis. For broker-negotiated trades, the T+5 settlement system allows a deal transacted on day T to be settled any time up to the fifth business day hence. In practice, an average of 6062% of the trades reported on the WDM settle on the same day. T+0 and T+1 trades account for about 98% of trades reported. The exchange imposes a shut period of three working days before a coupon due date; no secondary market transactions are allowed during this time period. Coupons and redemption amounts are credited directly to participants current accounts held with the RBI. When the date of redemption of a T-Bill falls on a holiday, the holder receives the redemption amount on the previous business day. When the date of coupon payment or redemption for a dated Government security falls on a holiday, the amounts are paid out on the following business day.
75.
76.
77. 78.
Post-trade Reporting
79. The NSE-WDM constitutes, on average, about 60% of the total trades negotiated and comprises those trades that are negotiated through brokers. Volumes on WDM have grown since June 1994 when the NSE-WDM was launched (Table 1.10).
Table 1.10 Secondary market activity on WDM (Rs. crore) Year Total G'secs T-Bills
199596 199697 199798 199899 199900 200001
11867.68 42277.59 111263.3 105469.1 304216.2 428581.5
7727.76 27352.25 84720.27 84574.05 282880.3 390952.3
2259.84 10957.05 18865.79 10706.34 11006.95 23143.53
Source: National Stock Exchange of India.
80.
All trades are required to be reported to the RBI-SGL for settlement. The consolidated data from the RBI-SGL (Table 1.11) show an average annual growth rate of over 102% in secondary market volumes over the period 199596 to 1999 2000.
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Volume 1 The Current Situation Chapter 1 The Government Bond Market Table 1.11 Secondary market transactions in Gsecs: RBI-SGL (Rs. crore) Year Outright Repo Total
199596 199697 199798 199899 199900
29531 (23.2) 93921 (76.4) 161090 (86.7) 187531 (82.2) 456515 (84.7)
97648 (76.8) 29021 (23.6) 24619 (13.3) 40697 (17.8) 82739 (15.3)
127179 122941 185708 228228 539255
Source: Report on Currency and Finance 19992000, RBI.
81.
Outright transactions account for a larger share of the total transactions compared to repos. Outright transactions as a proportion of the total transactions increased from 42.1% in 199495 to 84.7% in 19992000, reflecting the enhanced liquidity and maturity of the Government securities market.
Settlement
82. All trades in Government securities are settled on a gross basis through the DVP system operated by the RBI. Most participants hold these securities (T-Bills as well as dated securities) in dematerialised form. (The securities are issued in dematerialised form or as stock certificates.) Larger debt market participants such as banks, primary dealers and financial institutions hold these securities in an SGL account maintained with the RBI. Accounts of smaller participants are held in CSGL (or SGL II) accounts maintained by eligible participants (such as primary dealers) with the RBI for the purpose. National Securities Depository Ltd (NSDL) has a CSGL account; it provides investors the facility for trading and settlement of Government securities through their individual accounts with the NSDL. Simultaneously, participants maintain a current account with the Deposit Account Department of the RBI. The DVP settlement system involves simultaneous credits and debits from these two accounts. Attempts to settle trades that are not covered by stock in the SGL account will fail (since short-selling is prohibited). This effectively rules out intra-day trading. The settlement system is as follows: a. After the trade is struck, the seller of the securities fills in the details of the trade in a physical RBI settlement Form III. b. The seller takes the form, physically, to the buyer, who cross-checks the details and counter-signs the form. c. The form is then submitted to the SGL accounts department where trade details are processed.
83.
84.
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d. e. 85.
For a T+0 trade, the buyers SGL account gets credited with the securities on the same day, as does the sellers account with the funds. For a T+1 trade, the securities and funds are credited on the next day.
Gross settlement occasionally leads to a problem of gridlock when the buyers current account does not have sufficient funds to settle a particular trade on a gross basis, though on a net basis it has sufficient funds to settle all trades transacted during the day. To facilitate settlement of securities transactions in case of gridlock, the RBI introduced a special fund facility, effective October 3, 2000, to provide collateralised intra-day funds to banks and primary dealers who are eligible for the Collateralised Lending Facility (CLF) and Liquidity Support Facility (LSF), respectively, from the RBI. For such players, the RBI extends credit at the Bank Rate on a collateralised basis and against undrawn CLF/LSF. In addition, each of the beneficiary parties is charged a flat fee of Rs. 25 per transaction.
Transparency
86. As is typical of over-the-counter telephone markets, there is no pre-trade transparency. Primary dealers are obliged to give two-way quotes over the telephone, though often they are unable to do so because of the prohibition on short-selling All trades are reported to the RBI for settlement. Trades involving NSE brokers are also reported to the NSE. In both cases the reporting requirement is same day. The NSE trade reports are prepared each day for all reported trades, which may settle up to five days hence. The RBI trade reports are available on the day of settlement, which may include trades that have taken place up to five days before.
87.
Open Market Operations

88. The RBI uses open market operations as an instrument of indirect monetary control to withdraw or inject liquidity into the system (Table 1.12). The RBI puts out a buy/sell list of securities and their respective prices for this purpose. The open market operations are timed so as not to jeopardise the fresh borrowing programme but nevertheless have a significant net effect. Open market operations in dated Government securities have been in operation for a fairly long time; T-Bills were brought into the ambit of open market operations in 199899. During 19992000, net purchases of T-Bills under these operations amounted to Rs. 4509 crore as against net sales of Rs. 3321 crore in 199899. During 200001, net sales of TBills amounted to Rs. 2674 crore. Securities that devolve on the RBI during a public issue or that are privately placed with it are also sold to the market through open market operations. The net effect of these operations is generally neutral.
89.
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Volume 1 The Current Situation Chapter 1 The Government Bond Market Table 1.12 Open market operations of the RBI (dated securities) (Rs. crore) Year Purchase Sales Net sales
199596 199697 199798 199899 199900 200001
1146 705 467 0 1244 4471.05
1729 11140 8080 26348 36613 23795.1
583 10435 7614 26348 35369 19324.05
Sources: RBI Annual Report 19992000; RBI Bulletin, July 2001.
ROLE OF THE RBI

90. The RBI, as discussed, conducts the Government borrowing programme, acting as a merchant banker to raise funds at the best possible rates. In so doing, it has to, on the one hand, respond to the changes in the economy and, on the other, bear in mind the impact of its actions on the interest rate structure. The shift from a regulated interest rate regime to market-related borrowings has brought into prominence the potential conflict of roles of the RBI as debt manager and as the monetary authority. For instance, acceptance of a private placement, while containing the impact on interest rates in the short term, would increase money supply (being an implicit form of monetisation) and fuel inflation in the long run unless the effect is sterilised by offloading the securities in subsequent open market operations (OMOs). Further, every decision of the RBI in primary issuance is interpreted, by the market, as a signal by the RBI acting in its role as monetary authority. In this context, arguments for separating the roles by establishing an independent Debt Management Office have been discussed and debated for some time now, an issue that we address in Volume 2.
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Volume 1 The Current Situation Chapter 2 The Corporate Bond Market
Chapter 2 The Corporate Bond Market

91. In this report the term corporate debt encompasses the entire non-sovereign debt. Issuers of corporate debt are banks, financial institutions, public sector undertakings, municipal corporations and private corporates. Unlike the Government bond market, which clearly demarcates the issuer and the investors, the corporate bond market is a highly interdependent market with issuers (investors) in one segment being the investors (issuers) in another segment.
REGULATOR
92. The RBI and the SEBI share the regulatory role for the primary issuance market. The money market being under the purview of the RBI, the RBI issues guidelines for the issuance of commercial paper. Guidelines for the issuance of debt instruments are laid down by SEBI. The information disclosure requirements for the offer document that is mandatory for a public issue are decided by SEBI. The listing agreement that issuers sign with the exchanges is also drafted along SEBI guidelines. The secondary corporate debt market is regulated by SEBI. The Fixed Income and Money Market Dealers Association, in its role as a selfregulatory organisation for fixed income and money market instruments, also prescribes norms to promote operational flexibility and smooth functioning of these markets.
93.
CREDIT RATING AGENCIES

94. There are three domestic and one international credit rating agencies in India. The three large financial institutions have been the primary promoters of the domestic credit rating agencies. Credit Research and Information Systems of India Ltd (CRISIL), with the Industrial Credit and Investment Corporation of India Ltd as the primary promoter, has a strategic alliance with Standard & Poors (S&P). The Indian Credit Rating Agency (ICRA), promoted by Industrial Finance Corporation of India, has a strategic tie-up with international rating agency Moodys. Credit Analysis and Research (CARE) was promoted by Industrial Development Bank of India. The latter had a tie-up with Fitch Ratings India Pvt. Ltd, which was discontinued when Duff & Phelps merged with Fitch. Fitch Ratings India Pvt. Ltd is now the only international rating agency having an independent presence in the Indian market.
PRIMARY MARKET
Instruments
95. Instruments in the non-Government debt market include commercial paper, certificates of deposit, corporate bonds/debentures and institutional bonds.
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Commercial Paper 96. Commercial paper, introduced in India in 1990, is an unsecured money market instrument that can be issued either in the form of a promissory note or in a dematerialised form through any SEBI-approved depository. Commercial paper can be issued by corporates,5 primary dealers, satellite dealers and AIFIs that are permitted to raise short-term resources under the umbrella limit fixed by the RBI.6 The aggregate amount of such issuance should be within the limit as approved by the Board of Directors or as specified by the credit rating agency for the specified rating, whichever is lower. Banks and financial institutions, however, have the flexibility to fix working capital limits for corporates, duly taking into account the resource pattern of the companies financing, including commercial paper. Commercial paper can be issued for maturity ranging from 15 days to one year, in denominations of Rs. 5 lakh or multiples thereof. They must be rated by at least one of the four credit rating agencies and must have a minimum rating of CRISIL P-27 or the equivalent thereof. Most commercial paper is privately placed. Investors in commercial paper include banks, corporates, unincorporated bodies, individuals, non-resident Indians (NRIs) and foreign investment institutions (FIIs). The RBI guidelines prohibit underwriting. Prior to the issuance, the issuer of commercial paper is required to appoint an issuing and paying agent. Only scheduled banks are eligible to act as issuing and paying agents. It is the agents responsibility to ensure that the issuer has the minimum credit rating stipulated by the RBI and that the amount mobilised through the issuance is within the quantum indicated by the credit rating agency for the specified rating. The credit rating agency also decides the validity period of the specified rating. Commercial paper is issued at a discount to face value. On maturity, when the paper is held in physical form, the holder of the paper is required to present the instrument for payment to the issuer through the issuing and paying agent. When held in dematerialised form, the holders have to get them redeemed through the depository and receive payment from the issuing and paying agent. The pricing of commercial paper usually lies between banks lending rates (alternative source of funds for issuer) and the representative money market rate for the relevant maturity (alternative investment option for investor). Table 2.1 presents summary information on end-of-year outstanding amounts of commercial
97.
98.
99.
100.
101.
Corporates must have a net worth not less than Rs. 4 crore and also have their sanctioned working capital limits from banks/financial institutions with the borrowing account classified as a standard asset by the financing bank. Issues of commercial paper together with term money borrowings, term deposits, certificates of deposit and inter-corporate deposits should not exceed 100% of its net owned funds as per the latest audited balance sheet. Indicating strong/superior capacity for repayment of obligations. Page 24
paper along with their corresponding interest rates. Three-month NSE-MIBOR rates have also been presented for comparison.
End-March Table 2.1 Commercial paper: Outstanding position Outstanding Interest rate 3-month MIBOR amount (Rs. (% p.a.) (average) crore)
1995 1996 1997 1998 1999 2000 2001
604 76 646 1500 4770 5663 5847
14.0-15.0 20.2 11.3-12.3 14.2-15.5 9.1-13.3 10.0-12.0 8.75-11.25
N.A N.A N.A N.A 11.16 * 10.54 10.44
Note: * DecemberMarch. 3-month MIBOR went public on December 1, 1998. Sources: Report on Currency and Finance 19992000, RBI; RBI Bulletin, July 2001; NSE.
102.
The rate on commercial paper being normally lower than the short-term lending rates of banks and financial institutions, highly rated corporates have in recent years shown a preference for raising short-term funds through the commercial paper route. From the banks point of view, despite the interest rate differential between loans and commercial paper, the saving on transaction costs of bank loans and the relative profitability of commercial paper as a short-term instrument have made commercial paper an attractive investment avenue for short-term surplus funds. This explains the recent growth of issuance of this instrument. It is also corroborated by the increase in banks accommodation to the corporate sector via investment in commercial paper and bonds, relative to the extension of long-term loans (Table 2.2).
Table 2.2 Scheduled commercial banks: Growth of investments in commercial paper, bonds and debentures vis--vis credit (Rs. crore) Outstanding as on Commercial paper Bonds (PSUs) Debentures Bank credit (corporate)
March 27, 1998 March 26, 1999 March 24, 2000 March 23, 2001
2443 4006 (64.0) 5037 (25.7) 7401 (46.9)
18767 24169 (28.8) 30604 (26.6) 37738 (23.3)
9778 17857 (82.6) 23064 (29.2) 26798 (16.2)
324079 368837 (13.8) 435958 (18.2) 509082 (16.8)
Note: Growth rates in parentheses. Source: RBI publications.
103.
Banks are sizeable investors in the primary market for commercial paper, to some extent attributable to the differential stamp duty between banks and non-banks (Table 2.3). (There are also inter-state differences in stamp duty rates.) As
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secondary market transactions do not attract stamp duty, mutual funds and other non-bank investors prefer to buy commercial paper in the secondary market.
Table 2.3 Commercial paper: Stamp duty structure by tenor Tenor Banks Non-banks
Up to 90 days 91180 days 181364 days
0.05 0.15 0.20
0.125 0.375 0.50
Source: Report of the Group to review guidelines relating to commercial papers, RBI.
104.
In a recent report a FIMMDA working group has recommended to the RBI that banks and financial institutions be permitted to issue commercial paper. The group has further recommended that the RBI either approve umbrella limits or issue separate norms for issuance of commercial paper by banks, financial institutions and primary dealers, and that the issue of waiver of stamp duty be addressed.8
Bonds and Debentures 105. Bonds and debentures are securities (secured or unsecured) that are issued for maturities greater than a year. They can be issued by financial institutions, banks, public sector undertakings, state-level undertakings and the private corporate sector. As in the case of Government securities, these can be zero-coupon or coupon-bearing instruments. Coupon-bearing instruments are issued either as fixed rate or floating rate instruments. The coupon for fixed rate instruments is either preannounced or decided through a book-building procedure; the latter mode is usually followed for private placements. Instruments can be taxable or tax-free; the latter are instruments that are issued either by particular groups of issuers having tax-free status (e.g. infrastructure companies such as the Konkan Railway Corporation), or for a specific purpose (e.g. infrastructure bonds of IDBI and ICICI). Unlike Government bonds, institutional bonds and debentures can have: a. A different face value for different bonds, i.e. the face value may not be Rs. 100; b. a final redemption amount that is split into a series of cash flows over a period of time; c. different frequencies of cash flows for coupon-bearing bonds; d. call and/or put options before the final redemption date. As an illustration, Table 2.4 presents selected bond issuances privately placed by ICICI and IDBI. The fixed rate, regular return bond issued by ICICI has annual, semi-annual and quarterly interest payment options. The step-up bond pays a higher rate of interest for each succeeding year. The deep discount bond issued by IDBI has two put and call options before maturity. The step bond pays out its redemption amount in instalments after an initial holding period.
106.
The Finance Bill 2000 addresses the issue of stamp duty. Page 26
Date of issue
Table 2.4 Features of select institutional bonds (private placement) Bond type Face value Tenor Interest Frequency (Rs.) (yrs) (p.a.)
ICICI
27-Apr-98 27-Aug-98 RRB-FX RRB-FX RRB-FX Step bond 5000 5000 5000 5000 5 5 5 7 12.75 13.0 13.5 9.0 13.0 14.5 15.5 16.5 16.5 18.0
Options
Quarterly Semi-annual Annual year 1 Annual year 2 year 3 year 4 year 5 year 6 year 7
Term Redemption amount term
IDBI
21-Sep-98 22-Feb-99 DDB Step bond 10000 5000
17.5 1st put/call 2nd put/call 10.0
7 12.25 2500 2085 2085 2085 2085 5 6 7 8 9
Notes: (i) RRB-FX: Regular Return Bond fixed rate. (ii) DDB: Deep Discount Bond. Source: PRIME.
107.
Bonds and debentures can be issued either through a public issue or can be privately placed with institutions. Over the last five years, issuers have shown a distinct preference for private placements over public issues (Table 2.5).
Table 2.5 Corporate debt issues (Rs. crore) Public issue Private placement
Year
199596 199697 199798 199899 199900 200001
2940 6977 1929 7407 4698 4144
10035.3 (73) 18390.8 (204) 30983.3 (252) 38747.7 (445) 54701.4 (711) 62461.8 (881)
Note: Number of issues in parentheses. Source: PRIME database.
108.
The dominance of private placement in total issuances is attributable to a number of factors. First, the lengthy issuance procedure for public issues, and in particular, the
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information disclosure requirements, provide a strong incentive for eligible entities to opt for the private placement route. Secondly, the costs of a public issue are considerably higher than those for a private placement. Thirdly, the amounts that can be raised through private placements are typically larger than those that can be garnered through a public issue. 109. Taxable bonds constitute a major proportion of bond issuances by public sector undertakings. Table 2.6 presents a comparison of amounts raised by public sector undertakings via taxable and tax-free instruments since 199596.
Table 2.6 Bonds issued by public sector undertakings (Rs. Crore) Year Tax-free Taxable Total
199596 199697 199798 199899 199900
547.4 67.0 570.1 586.7 400.0
1743.8 3327.3 2412.4 4355.1 8221.8
2291.2 3394.3 2982.5 4941.8 8621.8
Note: Include both publicly issued and privately placed instruments. Source: Handbook of Statistics on Indian Economy 2000, RBI.
110.
In the recent past, the corporate debt market has seen high growth of innovative asset-backed securities. The servicing of debt and related obligations for such instruments is backed by some sort of financial assets and/or credit support from a third party. The instruments are termed structured because these securities may be structured to achieve a desired rating level through specific choices relating to the type and amount of assets and particular structural features.
Issuance Procedure
Public Issue 111. Guidelines for public issue of debt instruments are determined by SEBI. In case of a company, the guidelines require the following: a. Credit rating: obtaining and disclosure in the offer document of a credit rating for all instruments. For a public or rights issue of an amount greater than Rs. 100 crore, two ratings from two different credit rating agencies must be obtained and disclosed. If the company has obtained credit ratings from more than one credit rating agency, all ratings, including the unaccepted ones, must be disclosed. Further, all ratings obtained during the preceding three years must also be disclosed. b. Debenture trustee: appointment of a debenture trustee in the case of an issue of a debenture with a maturity exceeding 18 months. It is the responsibility of the debenture trustee, among others, to obtain from the companys auditors a certificate in respect of utilisation of funds during the
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c. d.
e.
implementation period, and to supervise the implementation of the conditions relating to the creation of security for the debentures and debenture redemption reserve. Debenture redemption reserve: a debenture redemption reserve must be created for debentures with a maturity that exceeds 18 months. Creation of charge: for secured issues a security (charge) must be created within six months of the date of issue of debentures. Unsecured bonds and debentures are treated as deposits under the Companies (Acceptance of Deposits) Rules 1975. Filing of letter of option: in case of convertible instruments and the rollover of non-convertible debentures, a letter of option containing disclosures with regard to credit rating, debenture holder resolution, option for conversion, justification for conversion price, etc., has to be filed with the Board through an eligible merchant banker.
112. 113.
The interest rate on debentures can be freely determined by the issuing company. The guidelines for the issuance of bonds by development financial institutions (such as ICICI and IDBI) are similar. Development financial institutions are free to retain any amount received, even if it is less than the minimum target amount. With prior permission, they are allowed to retain some or all of the over-subscribed amount; the maximum target amount (i.e. including over-subscription) cannot exceed twice the minimum target.9 It is mandatory, for subscription for public issues, for the issue to be kept open for a minimum of at least three working days and a maximum of 21 working days. There are a number of intermediaries involved in the public issuance of any debt instrument: a. merchant bankers; b. lead managers; c. registrars; d. advertising agencies; e. printers; f. collecting bankers. These add substantially to the cost of a public issue.
114.
115.
Private Placement 116. Private placement is currently a largely unregulated market. Provided the number of investors to any such single issue is restricted to 49, an issuer can offer to privately place its securities. In the absence of stipulated disclosure requirements, issuers (including unrated borrowers) have preferred to raise funds through this route. SEBI and the RBI, on their part, had hitherto refrained from laying down guidelines for the private placement market in view of the fact that investors in this
For instance, the initial issues of IDBI flexi-bonds used to target Rs. 750 crore, with an option to retain over-subscription up to an additional Rs. 750 crore. Page 29
segment are qualified institutional buyers (QIBs). This, combined with the significantly lower costs associated with a private placement and the larger amounts that can be raised on average, explains the phenomenal growth of this segment as compared to public issues. 117. However, the scenario is set to change with the technical group set up by the RBI laying down recommendations to regulate banks investment in non-SLR instruments (which include corporate bonds and debentures). The group has outlined a format for disclosure requirements that banks should require, as well as conditions regarding documentation and creation of charge for privately placed issues. Recommended disclosure requirements include, among others: a. general information related to the company, its Board of Directors, listing of the issue, opening, closing and earliest closing dates, names and addresses of auditors, lead managers, trustee (in case of debentures) and rating; b. particulars of the issue, including objectives, project cost and means of financing; and c. the interest rate payable on application money until allotment. The group has also recommended that the extant regulation of SEBI applicable to ratings of publicly issued debt also be made applicable to private placements (including preference shares redeemable after 18 months). It has also recommended the listing of privately placed instruments. In view of these recommendations, the RBI issued a circular to commercial banks in June 2001 advising them to: a. put in place appropriate systems to ensure that investment in privately placed unrated instruments is made in accordance with the systems and procedures prescribed in their investment policies as approved by the Board; and b. prescribe a policy for minimum disclosure standards with the approval of the Board. It has further advised that investment policies be formulated, taking into account the following: a. that banks should undertake their own credit analysis and rating even in the case of rated issues; b. an internal system of rating be put in place for unrated issues and issues of non-borrower companies; c. entry-level minimum ratings/quality standards and industry-wise, maturitywise, duration-wise and issuer-wise exposure limits be specified; d. investments in privately placed instruments should be well diversified; and e. appropriate risk management systems be put in place and portfolio quality be periodically tracked.
118.
119.
120.
121.
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Issuance Volumes Public issue 122. The public issue market is dominated, both in terms of number of issues and amount raised, by the two leading financial institutions, ICICI and IDBI. These two institutions accounted for the entire debt offerings in 199899 and all but one issue in 19992000. Noida Toll Bridge was the only other issuer. Noida approached the market in 19992000 with a public issue of Rs. 56.78 crore. Financial institutions can raise resources by way of bonds or debentures subject to an overall limit of ten times their net owned funds. In addition to taxable zero coupon (deep discount) and coupon-paying instruments, financial institutions are permitted to issue tax-free bonds (infrastructure bonds). It is interesting to note that the financial institutions, while dominating the public issue market, have raised significantly larger amounts through the private placement route (Table 2.7).
Table 2.7 Debt raised by financial institutions (Rs. crore) Public issue Private placement
123.
IDBI 199798 199899 199900 ICICI 199798 199899 199900 IFCI 199798 199899 199900 0 0 0 3367.1 (100.0) 3543.8 (100.0) 1786.5 (100.0) 1734.0 (22.0) 3064.4 (23.9) 2574.9 (37.6) 6132.0 (78.0) 9745.4 (76.1) 4274.0 (62.4) 984.9 (12.1) 4342.0 (34.2) 2073.5 (27.0) 7186.5 (87.9) 8341.0 (65.8) 5602.6 (73.0)
Source: Handbook of Statistics on Indian Economy 2000, RBI.
124.
We mentioned earlier that it is mandatory for issuers to obtain credit ratings from at least two different credit rating agencies for the public issue of bonds/debentures. It is interesting to observe here that both ICICI and IDBI had a AAA rating for all their instruments, indicating certainty about the timely payment of interest and principal. Noida Toll Bridge also had a AAA (Structured Obligations) rating for its instruments. This highlights another possible reason why most corporate debt issuance is done via the private placement route. The alternative sources of funds for a corporate are
125.
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retained earnings, loans from banks and market borrowings. A corporate can expect to raise debt from the market at finer rates than the prime lending rate of banks and financial institutions only with a AAA-rated paper. This limits the number of entities that would find it profitable to enter the market directly. On the other hand, for raising debt for a particular purpose, e.g. to shore up Tier II capital, crossinstitutional holdings are easier to negotiate via the private placement route. To the extent that building up a retail investor base is not important or necessary for the fund-raising entity, it would prefer to use the private placement route. 126. The recent downgrading of IDBI by CRISIL is expected to have an impact on the institutions cost of funds. It may also have an impact on the quantum of funds raised by the institution through public issues.
Private placement 127. In terms of amounts raised, AIFIs and banks have dominated the private placement market, followed by the private corporate sector and state-level undertakings. The aggregate volumes raised by the private corporate sector together with the number of issuers is indicative of the small average issue size for this category of issuers. Bank bonds, which are issued for raising Tier II capital, are almost entirely privately placed. The other categories of issuers are the state-level financial institutions and public sector undertakings (Table 2.8).
Table 2.8 Private placement: Issuer-wise summary (Rs. crore) AIFIs and State financial Public sector State-level banks institutions undertakings undertakings
Private corporate
199899 No. of issuers 199900 No. of issuers 200001 * No. of issuers
18603.8 (48.0) 28 14539.1 (27.0) 44 21672.7 (41.3) 43
313.6 (1.0) 2 2605.8 (5.0) 6 2286.1 (4.4) 4
3110.4 (8.0) 17 8435.6 (15.0) 18 7839.2 (15) 19
9479.5 (24.0) 30 16526.3 (30.0) 48 11466.44 (21.9) 48
7425.6 (19.0) 127 12594.7 (23.0) 117 9169.1 (17.5) 100
Notes: Percentage of total in parentheses. *Issues with tenor and call/put option of one year or more. Source: PRIME database.
128.
Table 2.9 presents a profile of the top issuers in the last three years. In the AIFIs and banks category, other than the three large financial institutions, Industrial Investment Bank of India and State Bank of India featured among the largest issuers. The issue size for this category is typically large; for instance, IDBI made four issues of its Omni bonds series in 199899, retaining amounts of between Rs. 500 crore and Rs. 1500 crore. GE Capital Services and Reliance are the largest issuers in the private corporate segment. The average issue size in this segment is
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small; in 199899, GE Capital made a total of 15 issues with amounts varying between Rs. 6.25 crore and Rs. 88 crore.
Table 2.9 Issuer profile: Top 10 issuers (Amounts are in Rs. crore) SFIs PSUs SLUs Name Amount Name Amount Name Amount
AIFIs/Banks Name Amount
Private Name Amount
199899
IDBI ICICI IFCI IIBI 5462.4 3086.7 2922.2 996.5 SAIL HUDCO 766.9 681.2 APSEB 2018.6 MKVDC 1157.9 KSEB 705.0 GE Caps 691.7
199900 ICICI 1991.8 WBIDFC 1818.8 IDBI 1930.4 IFCI 1565.1 200001 ICICI 6413.1 APPFC 1548.3 SBI 2500.0 IDBI 1455.1 IFCI 1508.0 PFC 1780.3
Source: PRIME.
MTNL IOL IRFC RECL HPCL
2619.0 MKVDC 2469.0 1622.3 TCoAP 1600.0 1092.8 1079.7 1000.0 GEB 981.2
GE Caps Reliance
1927.0 1572.0
129.
An analysis of the instruments used for private placement issuances in the last three years is presented in Table 2.10. The most preferred instruments are nonconvertible debentures and regular return bonds (RRBs) issued at fixed rates.
Table 2.10 Private placements: Summary by instrument type No. of issues 199899 199900 200001*
Non-convertible debentures Regular return bonds fixed Bonds (type not known) Regular return bonds floating Regular return debentures floating CDs Cumulative bonds Cumulative Return Bonds floating Deep discount bonds Deep discount debentures Step-up debentures Step-up liquidity Syndicated Tax-free Total instruments
AprilDecember Source: PRIME database.
222 228 13 9 18 1 6 2 1 6 506
344 325 128 13 27 5 3 1 1 12 859
317 383 27 2 20 8 1 16 774
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130.
In recent years, new instruments, viz. floating rate bonds, have been issued in the market. Various benchmarks have been used for pricing these instruments (Table 2.11).
Table 2.11 Benchmarks for floating rate instruments No. of issues 199899 199900
Secondary market G'sec yield1 NSE-MIBOR2 NSE-MIBID3 EPF rate4 Reuters MIBOR5 MIBOR6 SBI-PLR7 Minimum term deposit rate (BoB)8
1 3 1 6 6 1 1
4 7 1 5 1 1 -
Notes: 1. Weighted average secondary market yield on Government securities for the specified maturity. 2. NSE-MIBOR. 3. NSE-Mumbai Inter-bank Bid. 4. Rate of interest on the Employees Provident Fund Scheme 1952. 5. Reuters-MIBOR. 6. MIBOR. 7. State Bank of India prime lending rate. 8. Bank of Barodas minimum deposit rate. Source: PRIME.
131.
An analysis of the ratings of private placement issues (Table 2.12) reveals that AAA-rated instruments constituted a major proportion of rated instruments, although an average of 32% of privately placed issues were not rated. Structured obligations have SO suffixed to their credit rating.
Table 2.12 Private placements: Rating summary Rating 199899 199900 200001
AAA AAA(SO) AAA(FSO) AAAAA & variants A & variants Others Not rated Not known Total
99 20 6 27 13 55 162 64 443
113 7 21 1 105 27 88 247 110 711
181 7 1 2 63 49 108 191 5 596
Note: Variants: +, -, (SO), (FSO). Source: PRIME database.
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LISTING
132. To facilitate secondary market trading, most securities are subsequently listed on the stock exchanges. This holds even for private placements, since, although the primary issuance in such cases is restricted to a handful of investors, the requirement of an exit route and liquidity necessitates this as a criterion from the investor side. From the issuer point of view, secondary market trading enables a wider (albeit still largely institutional) holding for the original issue. As can be seen from Table 2.13, the National Stock Exchange has emerged as the preferred exchange for listing of private placements. Eligibility criteria for listing on the NSE-WDM include a minimum paid-up capital of Rs. 10 crore or market capitalisation of Rs. 25 crore (net worth of Rs. 25 crore in the case of unlisted companies) and a credit rating for listing of private placements. Public issues are directly eligible, as a minimum of two credit ratings forms part of the issuance procedure.
Table 2.13 Private placement: Listings on stock exchanges Year No. of issues Listed NSE BSE Others Unlisted
133.
199899 199900 200001

Source: PRIME.
88 137 203
83 133 196
7 2
14 9
329 551 385
MARKET MAKERS
134. One prominent set of entities missing in the corporate bond market are the primary dealers and satellite dealers who play the market-making role in the Government of India bond market. To a certain extent, merchant bankers play the role of market maker in the primary issuance market, some of whom underwrite the stock at a floor price. In the secondary market, the issuing company often plays the role of market maker for its debt instruments. This is especially true of financial institutions who have a large stock of debt issues and who continually source funds through new issues. Some mutual funds that invest purely in debt instruments also play a marketmaking role. By actively making a market for their own debt funds, they in turn make a market for the underlying debt instruments.
135.
136.
CREDIT PREMIA
137. The credit (default) risk inherent in non-Government debt instruments translates into a premium in terms of the rates offered on these instruments vis--vis sovereign risk-free instruments of similar maturity. In the primary market, issuers account for this by adding a premium over the secondary market YTM of a Government security of similar tenor. In empirical analyses of credit premia,
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spreads are computed as the difference between secondary market YTMs of corporate paper and Government paper of similar residual maturity. In principle, a correct measure of the premium offered in primary issues can be obtained as the coupon differential between corporate and sovereign papers of the same tenure, since both are issued at par. 138. In practice, such an exercise is rendered difficult by the fact that it is extremely rare to match issuance of a Government security and an institutional security of similar maturity during the same period. Over 1998-99, we could obtain such matching for only 4 regular return bonds issued by ICICI (Table 2.14). These show a coupon differential varying between 95 basis points and 190 basis points (column labelled premium 2) over the most recently issued comparable Central Government security. Whilst the coupon differential represents the credit premium when coupon payment frequencies are the same, they may not be the correct measure when frequency of interest payments are different. To account for the difference in frequency of interest payment between the ICICI (annual) and Government (semi-annual) securities in 2 cases, we computed the equivalent annual interest rate for the Government securities. Computed this way, the premium comes down by almost 1/3rd compared to that computed as simple coupon differentials.
Table 2.14 Premia on AAA-rated paper over Government paper
139.
ICICI bond Government security Credit premium issue date tenor coupo Frequenc issue coupon interest premium premium n y date 1 2 27-Apr5 13.0 H 7-Apr-98 11.1 1.90 1.90 98 18-Jul-98 3 12.5 Y 2-Jul-98 11.55 11.88 0.62 0.95 5 13.5 H 2-Jul-98 11.75 1.75 1.75 9-Dec-98 3 12.5 Y 8-Dec-98 11.47 11.80 0.70 1.03
Notes: Interest is the equivalent annual interest payment for semi-annual coupon rate on the GoI security. This is presented for comparison in the case of the two ICICI issues that make annual interest payments.
140.
It is however possible to design a framework to estimate a term structure of credit spreads using either primary issuance or secondary market information, using a sovereign term structure as the benchmark. In such a framework, the sovereign term structure provides the risk-free spot rates for different maturities. The NSEZero Coupon Yield Curve, which we discuss in detail in Chapter 3, can provide such a benchmark. A term structure for credit premium for each rating category can then be estimated which would depict the appropriate credit premia at different maturities. An interesting feature of the corporate debt market in India is that, even within the same rating category, the premia offered differ significantly depending on the nature of ownership of the issuing organisation and its nature of business. It is not
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141.
uncommon, for instance, to find a higher spread for triple-A rated private manufacturing companies compared to a financial institution. This to some extent reflects difference in investors default risk perception on account of the implicit Government support that underlies a financial sector security (on account of the larger repercussions that such default may generate) vis--vis its private sector counterpart.
SECONDARY MARKET
Trading
142. 143. Corporate bonds can be traded either as a bilateral agreement between two counterparties or as a broker-organised trade involving an exchange. Corporate bonds are traded on the BSE, the NSE-WDM and the NSE-Continuous Market (CM). As at April 30, 2001, there were 799 corporate securities listed on the BSE. Trades on the NSE-WDM are conducted for both listed securities there were 951 listed and deemed-listed securities as of March 31, 2001 and non-listed permitted securities. The latter category includes commercial paper, bank bonds and institutional debentures there were 587 such permitted securities on NSEWDM on March 31, 2001. Although the NSE-CM trades mostly equity shares, some debt instruments are also traded here. The trading for the fixed income segment (F-group) on BSE is Thursday to Wednesday. Transactions are netted out at the end of the cycle. On the NSE-WDM, trades can be conducted for a T+0 to T+5 settlement horizon. On the NSE-CM segment, debt instruments are traded and cleared exactly as equity shares are traded and cleared. Trading is done anonymously, on the electronic, limit order book market. The settlement cycle is from Wednesday to Tuesday.
144. 145. 146.
Trading Conventions 147. Prices quoted in the secondary market for corporate bonds are dirty prices, i.e. inclusive of accrued interest. This is different from the Government bond market, where prices are quoted exclusive of accrued interest. Trades are conducted in terms of value (as opposed to number of securities) quoted in relation to face value of the instrument. The shut period in the case of corporate bonds is 30 days; this is the period preceding a coupon payment date when exchange-based trading in the particular instrument is temporarily stalled.
148. 149.
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Volumes 150. The NSE-WDM accounts for the bulk of the exchange-based secondary market activity in corporate securities (Table 2.15).
Table 2.15 Secondary market activity in corporate bonds (Rs. crore) Year NSE-WDM NSE-CM BSE
199596 199697 199798 199899 199900 200001 151.
1880.08 3968.27 7677.24 10188.79 10329.06 14485.73
39.43 108.78 291.28 103.48 354.08 64.76 150.60 85.68 42.96
The breakdown of volumes on NSE-WDM is presented in Table 2.16. We note that, while volumes have recorded an increase over the years, in relation to the Government securities market, the secondary market for corporate bonds has shrunk in size.
Table 2.16 Volumes on NSE-WDM (Rs. crore) 199596 199697 199798 199899 199900
200001
PSU bonds Institutional bonds Bank bonds Corporate securities Others Total As %age of Gsecs
996.03 153.43 136.75 593.87 1880.08 18.8%
1968.53 799.95 503.12 696.64 0.03 3968.27 10.4%
2522.2 1526.61 1185.33 2427.58
1729.18 3278.44 861.38 4227.75
1527.76 3345.13
3616.55 4270.44
804.89 2026.89 4615.23 4515.901
15.52 92.04 36.05 55.95 7677.24 10188.79 10329.06 14485.73 7.4% 10.7% 3.5% 3.5%
Electronic Limit Order Book Markets 152. One difference between trading in Government of India securities and the trading of corporate debt is that corporate debt is traded, albeit in small volumes, on the electronic limit order book (ELOB) markets today. Traded volumes in corporate bonds on the NSEWDM continuous market, for instance, are small compared to the volumes on the negotiated market (Table 2.17) but have more than doubled between 19992000 and 200001. Also, a clear trend is revealed in terms of the shift in composition between the negotiated market and the continuous market. This is most likely the outcome of the SEBI circular (dated September 14, 1999) which prohibited negotiated deals in listed corporate debt securities other than
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government securities on the exchanges. Such trades would henceforth have to be done only through a price-order matching mechanism as in the case of equity. 153. However, the volumes in the negotiated market are still considerable (Table 2.17) and order levels in the ELOB have contracted to almost nothing (Table 2.18). This could be attributable to two factors. First, there are a large number of non-listed securities that are permitted to trade on the NSE. Trades in these securities take place in the negotiated market. Secondly, counterparty limits set by members often put an effective constraint on perfectly anonymous price-order matching. Bulk orders, as a consequence, have to be executed as negotiated deals.
Table 2.17 Corporate debt: Negotiated market versus ELOB (Rs. crore) Negotiated volumes WDM ELOB volumes
Year
199900 200001
3045.56 4270.00
661.51 1617.58
Table 2.18 Corporate debt: Number of orders placed on the ELOB market Year WDM ELOB orders
1994 199495 199596 199697 199798 199899 199900 200001
387 258 24 6 4 290 640 206
Settlement
154. Trades on the BSE debt segment are settled through the Clearing House. Delivery orders and money statements are issued on the Thursday following a trading cycle. Pay-in and pay-out, money as well as securities, occurs on the Friday. Instruments under objection are required to be returned by the buyer members on Saturday. These are collected by seller members on Monday. Auction sessions for shortages/objections are conducted by BOLT (the BSE on-line trading system) on Tuesday. Auction pay-in/pay-out of securities is done on Wednesday. Netting is not permitted for trades conducted on the NSE-WDM, and settlement is done on a trade-by-trade basis on the settlement day. There is no guarantee of settlement for trades conducted on this segment. All trades on NSE-CM are cleared through the National Securities Clearing Corporation, Ltd (NSCCL). The NSCCL provides novation on all such trades, i.e.
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155.
156.
they become the legal counterparty to every trade. Thus, there is no counterparty settlement risk in trading corporate bonds on the NSE-CM. National Securities Depository Ltd offers the facility of settlement to retail investors through the network of depository participants. 157. NSCCL has a network of regional clearing centres through which physical securities, if any, and funds are collected and distributed. These regional centres are linked to the central office, forming a common national clearing and settlement agency. This allows for efficient settlement of market transactions. Positions are netted during the trading cycle and the net positions are settled on a T+5 basis, i.e. on the Monday following a trading cycle. Pay-in of securities takes place on Monday (on Tuesday for dematerialised securities) and pay-in of funds on Tuesday. Pay-out of funds and securities to the concerned parties is done on Wednesday.
Coupon Payments and Redemption

158. Issuing companies make payments of coupons by issuing interest warrants in the name of the investor. Recently, companies have also started providing the option to investors to use an electronic clearing system, whereby investors accounts are credited directly with the amount of interest payment. Redemption amounts are also paid out in a similar manner.
Securitised Debt
159. Securitised debt deals in India can be traced back to 1991 when Citibank securitised auto loans and placed a paper with GIC Mutual Fund. According to estimates, 35% of all securitisation deals between 1992 and 1998 were related to hire purchase receivables of trucks and the rest towards other auto/transport segment receivables.10 A working group was appointed by the RBI in June 1999 to examine the applicability of securitisation in the Indian financial system. Following the recommendations of the group, securitised instruments are now recognised as securities under the Securities Contract (Regulation) Act.
160.
Supportive Policy Measures

161. The secondary market for corporate bonds is expected to receive a boost with the following two changes: a. The Finance Bill 2000 passed a waiver on stamp duty payment on transfer of debt securities, as long as they are dematerialised. This removed a big factor that fragmented liquidity across geographical locations. Since different states imposed different levels of stamp duty, trading with participants from different states means larger transactions costs compared with trading within the state. Stamp duty was a substantial cost at 0.5% of the value of the security.
10
This section draws heavily from the RBI Report on Trends and Progress of Banking in India, 19992000. Page 40
b.
In the credit policy announcement of April 2001, the RBI has made it mandatory for banks, financial institutions, primary dealers and satellite dealers to make fresh investment in and to hold commercial paper only in dematerialised form with effect from June 30, 2001. Further, all outstanding stock of commercial paper should be dematerialised by October 31, 2001. This is also to be extended to corporate bonds and debentures and accordingly, with effect from October 31, 2001, fresh investments in these instruments should only be in dematerialised form, whether publicly issued or privately placed. Also, all outstanding stocks of bonds and debentures should be dematerialised by June 30, 2002.
162.
Since the announcement of the 2000 Budget, NSDL has dematerialised debt instruments of around 165 companies and a total of 2100 securities as of December 2001. This included all types of instruments irrespective of whether they are listed, unlisted or privately placed. With the RBI announcement, it can be expected that these numbers will increase. (The corresponding figures for commercial paper were 231 issues and 1,151 securities.)
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Volume 1 The Current Situation Chapter 3 Empirical Characterisation of the Government Bond Market
Chapter 3 Empirical Characterisation of the Government Bond Market

INTRODUCTION
163. Chapter 1 discussed the structure of the Government bond market. We discussed the instruments, primary market issuance mechanism, secondary market trading and settlement, and the participants in the Government bond market. In this chapter we present an empirical characterisation of the Government bond market with a view to providing answers to the following sets of questions: a. Debt issuance: i. How important has been the role of the primary debt market in financing the Governments fiscal deficit? ii. What is the maturity pattern of the outstanding Government debt? iii. Is there a seasonality in the Government borrowing programme, and does it exert any discernible impacts on the cost of borrowing? iv. How concentrated is the outstanding amount at each maturity, and is there a scope for active consolidation of debt? b. Rates in the primary market: i. Do primary market rates move in tandem with each other? ii. What does the term structure of interest rates look like? iii. Are primary market rates aligned with those in the secondary market, or is there an independent secondary market yield curve? iv. How volatile are interest rates at different maturities? c. Secondary market: i. What is the size of the secondary market? ii. What is the average turnover for the most actively traded Government securities? iii. What are the factors, besides the term structure, influencing the pricing of Government securities? The first set of questions related to debt issuance is tied to issues of sustainability of the fiscal deficit, the optimal pattern of Government debt, cost of debt and fragmentation of the debt market. The issues of sustainability and the choice of the optimal maturity profile are beyond the scope of this project. However, the figures provide a backdrop against which we can analyse the issues related to development of the secondary debt market, taking the size of the primary market as given.
164.
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DEBT ISSUANCE
Deficit Financing and the Debt Market
165. The debt management policy of the Government has undergone significant changes in recent years. Reliance on market borrowings as a means of financing the fiscal deficit has grown over time (Table 3.1).
Table 3.1 Centres gross fiscal deficit and its financing (Rs. crore) Year GFD Market borrowings Other liabilities Deficit External
199495 199596 199697 199798 199899 199900 (RE) 200001 (BE) * 200102 (BE)
57703 60243 66733 88937 113349 108898 111275 116341
20326 (35.23) 33087 (54.92) 20012 (29.99) 32499 (36.54) 68988 (60.86) 77065 (70.77) 76383 (68.64) 77353 (66.5)
32834 (56.9) 17031 (28.27) 30550 (45.78) 56257 (63.25) 42650 (37.63) 27457 (25.21) 34936 (31.4) (31.9)
961 9807 13184 -910 -209 3470
3582 (6.21) 318 (0.53) 2987 (4.48) 1091 (1.23) 1920 (1.69) 906 (0.83) -44
(1.6)
Notes: Proportion of deficit in parentheses. * Revised estimate has been put at Rs. 111,972 crore. Source: Handbook of Statistics on Indian Economy 2000, RBI.
166.
In terms of size, the primary market for Government debt is large. However, as mentioned in Chapter 1, the holding of Government debt is concentrated among institutional investors, notably banks and insurance companies. Many commentators believe that there is tremendous potential for widening the investor base for Government securities among retail investors. This, of course, requires a two-pronged approach, increasing their awareness about Government securities as an option for investment and improving liquidity in the secondary market that will provide them with an exit route.
Maturity Pattern of Outstanding Debt

167. Market borrowings comprise borrowings by way of T-Bills, which are short-term instruments with maturity less than a year, and dated Government securities with maturities ranging from one to 20 years. As of March 31, 2001, there were 170 Central Government securities outstanding, comprising 54 T-Bills and 116 dated
Page 43
securities. The total outstanding amount in dated securities was over Rs. 3876 billion, up from Rs. 2796 billion at end-March 2000. 168. The maturity pattern of outstanding Government borrowings has witnessed an interesting transformation over the last two decades. The predominance of longterm loans (maturity beyond ten years) underwent a sharp decline from an average of over 75% of total outstanding debt during the decade of the 1980s to about 64% by the first half of the 1990s. During the period 199697 to 19992000, long-term loans constituted less than 25% of the Governments outstanding borrowings (Table 3.2).
Table 3.2 Maturity pattern of Government of India's rupee borrowings Year Undated < 5 years 510 years > 10 years Total (end-March)
198081 198586 199091 199596 199697 199798 199899 199900
258 251 -
1864 (11.9) 3601 (10.2) 6056 (8.6) 65010 (38.3) 87263 (45.2) 102041 (41) 129078 (41.4) 143041 (37.5)
2583 (16.5) 5469 (15.5) 3928 (5.6) 51386 (30.3) 55873 (29) 101683 (40.8) 132272 (42.4) 147651 (38.7)
10960 (70) 25983 (73.6) 60393 (85.8) 53130 (31.3) 49757 (25.8) 45300 (18.2) 50255 (16.1) 91189 (23.9)
15665 35304 70377 169526 192893 249024 311605 381881
169.
The maturity pattern of Government bonds as at March 31, 2001 (Graph 3.1) reveals fairly uniform repayment volumes until 200910 followed by a spike in 201011 and a steep decline in subsequent years. Fragmentation of issues is clearly a problem in the years from 200102 to 200607, with an average of ten issues maturing in each of these years. By contrast, between 200708 and 200910, the repayment volumes are comparable to that during the earlier years; however, there is an average of only five issues maturing in any year. An interesting contrast is observed in that the two highest repayment obligations, of over Rs. 32,000 crore in 200304 and over Rs. 38,000 crore in 201011, are spread over ten and six issues, respectively. The repayment obligations decline sharply post 201011, indicating significant scope for lengthening the maturity profile of Government debt, depending, of course, on participants appetite for long-dated paper.
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Graph 3.1 Maturity pattern of Government debt: March 31, 2001

45000 40000 35000 10 12 15 13 11 6 10
8 16
6
14
12
Amount (Rs. crore)
30000 25000 20000 15000
10
3
6
2 10000 5000 0 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2
1 1
2 0
0 2016-17 2017-18 2018-19 2019-20
Year
(The numbers above the bars are the number of issues maturing in each year.)
170.
The evidence on fragmentation is important in the context of the introduction of Separate Trading of Registered Interest and Principal of Securities (STRIPS) which requires, as a prerequisite, consolidation of existing loans. Partly on account of the legal problems associated with consolidating pre-1992 loans with those issued post1992, the RBI has, until now, followed a passive process of consolidation.
Seasonality of the Government Borrowing Programme

171. The Governments budgeted market borrowings are announced in the Union Budget in end-February. While the issuance of bonds is spread out over the year and does not follow a fixed calendar, in order not to crowd out corporate demand for funds in the busy season (OctoberMarch), these are usually concentrated in the slack season (AprilSeptember)11 (Table 3.3). Typically, the number of issues in the second half of the financial year is about half that in the first half. Barring 199596 when the amounts raised in the two halves were marginally different, the ratio of borrowings in the busy season to that in the slack season has varied between 1:5 (199798) and 1:2 (199900 and 200001).
11
The slack and busy seasons are linked to the agricultural cycle. Page 45
2020-21
Table 3.3 Seasonality of Central Government borrowings Year Number of issues Amounts raised (Rs. crore) Slack Busy Slack Busy (AprSep) (OctMar) (AprSep) (OctMar)
199596 199697 199798 199899 199900 200001 172.
11 8 10 21 20 19
9 4 3 11 10 12
20634.24 20911.06 36685.87 61120.94 59629.85 67183.45
17830.28 7000.00 6704.52 22631.88 30000.00 33000.00
The seasonal pattern in the Government borrowing programme notwithstanding, the quantum of funds raised in the busy season is substantial. The question naturally arises as to whether the Government, at such times, crowds out private borrowing. This could occur in either of two ways: (i) the corporate sector not being able to access the quantum of funds it requires; and/or (ii) the cost of borrowing in the busy season being higher than that in the slack season. The figures reveal that there is no obvious pattern in the relative cost of debt during the busy and slack seasons (Table 3.4). This could be on account of (i) differences in the maturities of loans raised during the two halves of the year, and/or (ii) the RBI ensuring adequate supply of funds during the busy season by taking appropriate steps such as relaxation of the cash reserve ratio (CRR). There is no clear pattern in the maturity differences across the two halves of the year; a more positive finding is the absence of any obvious relationship between the average maturity of the funds raised and the cost of borrowing.
Table 3.4 Seasonality of borrowing programme: Maturity and cost patterns Weighted average cost Year Weighted average maturity (WAC) (years) (YTM) Slack Busy Slack Busy
199596 199697 199798 199899 199900 200001
6.45 5.73 6.48 7.11 12.62 9.94
4.94 4.86 7.33 9.31 12.92 12.13
13.76 13.73 12.05 11.79 11.94 10.80
13.74 13.57 11.76 12.07 11.38 11.25
Notes: (i) Slack season AprilSeptember; busy season OctoberMarch. (ii) Maturity and cost computations for 199798 are exclusive of the capex bond.
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173.
This could be attributable to the credit policy measures of the RBI, e.g. reductions in CRR, that ensure availability of funds, thereby preventing an upward shift in the interest rate structure. Supportive changes in administered interest rates also help (Table 3.5). This is welcome, inasmuch as the alternative situation would have adverse consequences for the cost of corporate debt.
Table 3.5 Chronology of CRR changes since 199596 CRR rate Effective date Bank rate Effective date
14.5 (-0.5) 14.0 13.5 13.0 12.0 11.5 11.0 10.5 10.0 9.75 9.5 10.0 10.5 10.25 10.0 11.0 10.5 10.0 9.5 9.0 8.5 8.0 8.25 8.5 8.25 8.0 7.5 5.75 5.50
11-Nov-95 9-Dec-96 27-Apr-96 11-May-96 6-Jul-96 26-Oct-96 9-Nov-96 4-Jan-97 18-Jan-97 25-Oct-97 22-Nov-97 6-Dec-97 17-Jan-98 28-Mar-98 11-Apr-98 29-Aug-98 13-Mar-99 8-May-99 6-Nov-99 20-Nov-99 8-Apr-00 22-Apr-00 29-Jul-00 12-Aug-00 24-Feb-01 10-Mar-01 19-May-01 3-Nov-01 29-Dec-01
11.0 (-1.0) 10.0 9.0
16-Apr-97 26-Jun-97 22-Oct-97
11.0 10.5 10.0 9.0 8.0
7-Jan-98 19-Mar-98 3-Apr-98 29-Apr-98 2-Mar-99
7.0 8.0 7.5 7.0 6.5
2-Apr-00 22-Jul-00 16-Feb-01 1-Mar-01 22-Oct-01
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Success of the auction procedure

174. The auction system for issuance of Government securities, as mentioned in Chapter 1, was initiated in 1992. While 364-day T-Bills and dated Government securities are issued on a multiple price basis, 91-day T-Bills are auctioned on a uniform pricing basis. Two indicators can be used to gauge the success of the auction procedure for 364day T-Bills. The first indicator, devolvement at primary auctions [Chapter 1, Table 1.5], indicates that the degree of success of these auctions has improved significantly over the 3 years from 1998-99 to 2000-01, both in terms of numbers as well as proportion of total notified amount. There have, in fact, been no devolvements in 364-day T-Bill auctions between September 2000 and September 2001. Devolvements, however, do not provide a complete picture regarding the success of an auction. In a multiple price auction, each successive bid is accepted at a lower price, and it is possible that the range of prices / yields represented by successful bids is quite large. In such an event, the average price received by the Government is much lower than the price received from the highest bid. The second indicator that we present below - the difference between the average yield of successful bids and the cut-off yield - captures this aspect of the auction process12. By this measure, the larger the difference, the less successful is the auction.
175.
176.
12
US market participants use an equivalent measure, the difference between the average and the stop yields, to determine the success of auctions. Refer Fabozzi (1997). Page 48
Table 3.6 Measuring the success of 364-day T-Bill auctions
Issue date 2000-01 Apr. 4 Apr. 19 May 5 May 17 May 31 Jun. 14 Jun. 28 Jul. 12 Jul. 26 Aug. 9 Aug. 23 Sep. 6 Sep. 20 Oct. 4 Oct. 18 Nov. 1 Nov. 15 Nov. 29 Dec. 13 Dec. 27 Jan. 10 Jan. 24 Feb. 7 Feb. 20 Mar. 7 Mar. 21 2001-02 Apr. 4 Apr. 18 May 2 May 16 May 30 Jun. 13 Jun. 27 Jul. 11 Jul. 25 Aug. 8 Aug. 20 Sep. 5 Sep. 19 Source: RBI
Devolvement (Rs.crore) 500.00 500.00 295.00 75.00 40.00 416.78 -
Cut-off yield Weighted average yield (per cent) (per cent) 9.2896 9.2419 9.1107 9.0988 9.2419 9.2419 9.2419 9.2419 10.2901 10.7174 10.9139 10.7910 10.9139 10.5217 10.3875 10.2293 10.1200 10.1079 10.0473 9.9868 9.6732 9.4212 9.2657 9.0037 8.6602 8.9562 8.8495 8.8021 8.5305 8.4128 8.0497 7.9797 7.6890 7.3537 7.3768 7.2731 7.1696 7.1008 7.3192
Difference (basis pts)
9.0750 9.1941 9.2419 9.2419 9.2419 10.2414 10.6807 10.8156 10.7665 10.9139 10.4972 10.3631 10.2171 10.0594 10.0837 10.0110 9.9626 9.6491 9.4212 9.2061 8.9325 8.6012 8.8969 8.7903 8.7903 8.5069 8.3776 8.0030 7.9447 7.6658 7.3307 7.3653 7.2616 7.1352 7.0778 7.3192
2 5 0 0 0 5 4 10 2 0 2 2 1 6 2 4 2 2 0 6 7 6 6 6 1 2 4 5 3 2 2 1 1 3 2 0
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177.
We make the following observations: a. Looking at the low devolvement amount at the auction conducted on August 23, 2000, one would infer that the auction was successful. The range of yields of the successful bids, at 10 basis points, is however quite large. While devolvements were low in the second half of 2000-01, the spread of yields represented by the successful bids was quite high. Barring a few cases, the dispersion of yields represented by successful bids is lower during April-September 2001 (average of 6 basis points) as compared with 2000-01 (average of 10 and 7 basis points respectively in the April-September 2000 and October 2000-March 2001 periods).
b. c.
178.
Put together, the 2 indicators together reveal an improvement in the degree of success of the auction procedure in the period. This may be indicative of a better alignment of primary and secondary market yields, facilitated by improvement in information flow between the primary and the secondary market. This issue is analysed further below.
Consolidation of Loans
179. Among developed markets, the US and the UK Governments have, in recent years, been actively consolidating borrowings to a few select securities. In a scenario where new issuances have been declining significantly in response to the emergence of fiscal surpluses, this is imperative to preserve / improve the liquidity of securities ['The Changing Shape of Fixed Income Markets', BIS Working Paper No. 104, September 2001]. In India, consolidation may, a priori, appear to be a non-issue in the face of huge amounts of Government borrowing. However, the relevance of this aspect is underscored by the following observations: a. During the period from January-December 2001, an average of 66 dated securities traded during a month, as against the 116 securities that were outstanding in end-March 2001. Clearly, with a large number of outstanding securities being illiquid, issuance of newer securities would result in further fragmentation of the secondary market; b. The huge proportions of illiquid securities held in banks' and institutions' investment portfolios would pose a problem as regulation moves to 100 per cent mark-to-market portfolio valuation; c. The fragmentation of the secondary market is an obvious issue of concern for the introduction of STRIPS. Since 1999, the RBI has been following a policy of passive consolidation of loans through re-issuance and re-opening of existing issues, to the extent possible and taking into account their impact on the maturity profile of outstanding debt. The reissuances are conducted as price-based auctions; the first price-based auction was held on May 12, 1999 with the re-issuance of the 11.19% 2005 and 12.32% 2011 securities. Re-issues have constituted a major proportion of the issuances in the last three years and 16 securities have been re-issued during this period (Table 3.7).
180.
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Volume 1 The Current Situation Chapter 3 Empirical Characterisation of the Government Bond Market Table 3.7 Summary information on re-issues (Rs. crore) No. of times Total re-issue Outstanding re-issued amount issue size
Security
11.10% 2003 11.75% 2004 11.19% 2005 11.68% 2006 11.90% 2007 12.00% 2008 11.40% 2008 11.99% 2009 12.29% 2010 12.25% 2010 11.30% 2010 12.32% 2011 11.03% 2012 12.40% 2013 11.83% 2014 11.43% 2015 12.30% 2016 12.60% 2018
1 1 1 2 3 1 1 3 1 2 2 4 2 1 2 2 4 1
2500 4000 3000 4500 9500 3000 3000 8500 5000 8500 6000 9000 7000 3000 8000 6000 8500 2000
6500 5645.57 6000 7500 13500 7000 6000 13500 8000 9500 9000 11000 9500 5691 11500 12000 13129.85 4631.88
(i) (ii) (ii) (iii) (iv) (v) (vi) (iv)
Notes: (i) Includes private placement (PP) of Rs. 2000 crore. (ii) Includes PP of Rs. 3000 crore each. (iii) Includes PP of Rs. 2000 crore. (iv) Includes PP of Rs. 1500 crore each. (v) Includes PP of Rs. 6000 crore. (vi) Includes on-tap sale of Rs. 2129.85 crore.
181.
The passive consolidation process has helped contain the total number of outstanding securities to more or less the same level as at end 199899. Such reissuance has also helped the emergence of benchmarks at different maturities. Other benefits ensuing from a consolidation programme are: a. creation of critical volumes in coupon amounts at any particular maturity, paving the way for the introduction of STRIPS; and b. containment of the fragmentation of the secondary market. Otherwise, the liquidity and volumes in a particular maturity may become fragmented over a large number of issues. We must, however, iterate at this point that there is no clear one-to-one relation between outstanding issue size and secondary market volumes. That is, while reissuance of existing securities prevents fragmentation, it cannot ensure liquidity and volumes in the re-issued security. Considering the benefits that emanate from consolidation of loans, it is worthwhile exploring whether the outstanding pattern of Government debt provides scope for a more active consolidation of loans. Admittedly, consolidation of issues is only one of the many factors that affect the choice of security to be issued/re-issued. There are concerns related to the weighted average cost of debt, optimum maturity profile and creation of benchmarks. In this context, the maturity pattern of Government debt as of March 31, 2000 provides a backdrop for analysing the RBIs borrowing
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182.
183.
schedule during 200001. The maturity pattern reveals fairly uniform bunching repayment volumes until 201011 barring repayments of over Rs. 29,000 crore in 200304 and a sharp decline beyond this period. Fragmentation of issues is clearly evident in the years from 200102 to 200607, with an average of ten issues maturing in each of these years. While a policy of active consolidation may present itself as a strong case for consolidating loans in this maturity segment, legal problems act as a constraint in the way of consolidating pre-1992 loans with those issued post-1992. Further, the absence of call provisions on Government securities also acts as a constraint on extinguishing existing loans other than by the process of natural attrition. This has been pointed out by the RBI informal working group on STRIPS. In this context, it is useful to note that of the 44 outstanding loans issued prior to 1992, 21 would be redeemed by 200506. 184. With active consolidation being infeasible in this segment, passive consolidation would require non-issuance of new securities and/or re-issuance of existing securities. Analysing the Government borrowing programme in 200001, we find that the RBI issued two new securities in this segment, the 9.9% 2005 and the 10.2% 2005. These may have had the objective of reducing the WAC of debt or of creating a benchmark security in this maturity segment. Figures presented in Table 3.8 in fact show a decline of 55 basis points in the WAC of debt in 200506. As far as their volumes in the secondary market are concerned, however, we find that these were actively traded only in the months following their issuance, thereby imposing a cost in terms of fragmenting the secondary market at this maturity. The trade-off between the two objectives is real four of the ten outstanding issues were pre-1992 loans and the average coupon on the remaining was 12.82%. Yet, in hindsight, this raises questions as to whether re-issuance of either of the existing issues (10% 2006) rather than issuing new securities would have better served the RBIs objectives.
Table 3.8 Government borrowing programme in 2000-01: Impact on cost of outstanding debt As of March 31, 2000 As of March 31, 2001 Maturity No. of secs WAC No. of secs WAC in WAC
200102 200203 200304 200405 200506 200607 200708 200809 200910 201011
15 13 10 10 10 10 6 6 4 5
11.75 11.69 11.83 11.75 12.61 12.24 11.77 11.93 11.59 11.62
15 13 10 10 12 11 6 7 4 6
11.75 11.69 11.77 11.75 12.06 12.06 11.79 11.83 11.75 11.69
0 0 -0.06 0.00 -0.55 -0.17 0.02 -0.10 0.15 0.06
185.
The case for more active consolidation is stronger between 200607 and 201011, where the repayment volumes are comparable to that during the earlier years while there is an average of only five issues maturing in any year. The figures in Table 3.7 show a reduction in WAC in two of the five years. The analysis of the impact of
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issuance/re-issuance in this segment (Table 3.9) reveals that success has been achieved in some maturities as regards the creation of a benchmark. However, the evidence is by no means unequivocal and does not provide clear answers as to the best possible means to achieve these multifarious objectives. Volume 2 addresses these issue in greater detail and outlines recommendations for consolidation of loans.
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Maturity/outstanding
Table 3.9 Analysis of Government borrowings: 200001 Secondary market Primary market Activity post-issuance Observations
200203
13 securities o/s
200304 10 securities o/s
2007-08 6 securities o/s
200809
11.15% 2002 (o/s amount Rs. 1. A case for re-issuance of 5000 crore) actively traded 11.15% 2002? right through April 2000Jan 2001. increase in Re-issuance of 11.10% 2003 in O/s amount Rs. 6500 crore. 1. Further 12.5% 2004 (o/s amount Rs. repayment obligations in May 2000; Rs. 2500 crore; Not among top ten traded 11196.01 crore) actively 200304. securities. traded right through the year. YTM 9.47. 2. Fragmentation. 3. A case for re-issuance of 12.5% 2004? 11.98% 2004 (o/s amount Rs. 11.75% 2004 re-issued in July O/s amount Rs. 5645.57 crore. 1. Fragmentation. 2000; devolvement of Rs. Not among top ten traded 2. A case for re-issuance of 5000 crore) sporadically 11.98% 2004? 3545 crore out of a total of Rs. securities. among top ten traded 4000 crore; YTM 10.95. securities. Issue of 9.9% 2005 in April Actively traded in MayJune 1. Creation of benchmark? 2000; Rs. 3000 crore; YTM 2000. 2. WAC of debt? 9.88. 3. Fragmentation. Issue of 10.2% 2005 in July Actively traded in July 2000. 2000; Rs. 3000 crore. Re-issue of 11.68% 2006 in 0/s amount Rs. 7500 crore; 1. Benchmark? May 2000; Rs. 2500 crore at actively traded for most of the 2. Critical volumes. 3. Fragmentation? balance period of the year. YTM of 9.93. Private placement of 11.00% Actively traded post-issuance. 2006 in July 2000; Rs.3000 crore. 11.9% 2007, after active Re-issued in June 2000; O/s amount Rs. 13,500 crore; 1. Benchmark security. trading in 19992000, saw devolvement of Rs.2495 crore actively traded. 2. Synchronisation with decline by AprMay 2000; of Rs. 4000 crore; YTM 10.71. secondary market activity? o/s amount Rs. 9500 crore. Some activity in 12% 2008; 11.4% 2008 issued in Aug O/s amount Rs. 6000 crore; 1. Creation of benchmark.
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Maturity/outstanding
Table 3.9 Analysis of Government borrowings: 200001 Secondary market Primary market Activity post-issuance Observations
6 securities o/s
o/s amount Rs. 7000 crore.
actively traded post-issuance.
200910 4 securities o/s 1. 2. 3. 4. 1. 2. 3. 4. post-Nov
11.99% 2009 actively traded; o/s amount Rs. 10,500 crore.
Benchmark. Critical volume. Fragmentation. in WAC of o/s debt. Critical volumes? WAC of o/s debt? Fragmentation. A case for re-issue of 12.32% 2011?
201011 5 issues o/s
12.32% 2011 actively traded between AprilJuly 2000.
O/s amount Rs. 13,500 crore; actively traded. O/s amount Rs. 8000 crore; actively traded only in May 2000. O/s amount Rs. 9500 crore; actively traded only in May 2000.
2000; Rs. 3000 crore of which Rs. 2750 crore devolved. Re-issued in Sep 2000; Rs..3000 crore of which Rs..375 crore devolved; YTM 11.4937. Re-issued in Nov 2000; Rs. 3000 crore at 11.27 YTM. 12.29% 2010 re-issued in Apr 2000; Rs. 5000 crore at 10.26 YTM. Re-issue of 12.25% 2010 in May 2000; devolvement of Rs. 994.5 crore of Rs. 6000 crore; YTM 10.52. Re-issued in Jan 2001; Rs. 2500 crore at 10.67 YTM. Private placement of 11.3% 2010 in Jul 2000; Rs. 3000 crore; re-issued in Dec 2000; Rs. 3000 crore at 11.10 YTM. Actively 2000. traded
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RATES IN THE PRIMARY MARKET

Relative Rates
186. Graph 3.2 plots the cut-off yields at 91-day and 364-day auctions over the period from January 1993 to March 2001. Interestingly, co-movement between the rates notwithstanding, the spread between these instruments has not been constant over time. Over the period considered, the spread has varied between a maximum of over 350 basis points in July 1996 and negative spreads of about 40 basis points in September 1998.
Graph 3.2 Movement in T-Bill yields
14 13 12 364-day 11 per cent p.a 10 9 91-day 8 7 6 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00
187.
The extent of volatility in the primary market spread of 364-day over 91-day yields is more clearly visible in Graph 3.3. While some of this is attributable to the availability of liquidity at the respective maturities, the evidence could also be indicative of RBIs leverage in setting one rate vis--vis the other. As described in Chapter 1, paragraphs 31 et seq. the differences in issuance procedures for TBills of different maturities could have implications for the extent of marketrelatedness in the primary auctions. It is reasonable to argue that on occasions when the spread widened, the primary market cut-off for either/both was out of alignment with market expectations.
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Graph 3.3 Time-series of spread: 364-day over 91-day

4
2 per cent 1 0 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 -1
188.
The issue is best analysed in terms of the information flow between primary and secondary markets at different maturities. This requires a time series of secondary market rates, which is difficult to compile from information on secondary market trading per se, since paper of a specified maturity may not witness regular trading. Information on secondary market trades could, however, be used to estimate the term structure on each day, from which one could read off spot rates associated with particular maturities.
Pricing Benchmark: The NSE-ZCYC

189. Globally, yield curves estimated from secondary market trades in Government securities are used as pricing benchmarks for non-sovereign instruments and for tracking daily movements in the interest rate structure. [In recent years, these markets have seen a shift in favour of interest rate swap curves]. In India, the NSEZero Coupon Yield Curve (NSE-ZCYC) is increasingly being used by market participants as a basis for valuation of fixed income instruments. The NSE-ZCYC uses information on secondary market trades from the NSE-WDM to estimate the term structure on a daily basis. The features of the NSE-ZCYC are: a. It depicts the term structure of interest rates the relationship between spot rates and associated maturities which is technically different from the yield curve which depicts the YTM-maturity relation. It uses the Nelson-Siegel [Journal of Business 1987] functional form for the underlying term structure, which specifies the spot rate maturity relation in terms of 4 estimable parameters.
b.
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c. d.
It incorporates institutional features typical to the Indian bond market, viz. settlement and day-count conventions. Both T-Bills and dated securities are used as observations in the estimation since, for the purpose of pricing, the latter can be viewed as a bundle of zero coupon instruments. The specification of the underlying fundamental value of a coupon paying instrument as the sum of the present values of the discounted stream of cash flows, in fact, forms the basis of any term structure estimation framework.
190.
Both T-Bills and dated securities are used as observations in the estimation since, for the purpose of pricing, the latter can be viewed as a bundle of zero coupon instruments. The specification of the underlying fundamental value of a couponpaying instrument as the sum of the present values of the discounted stream of cash flows, in fact, forms the basis of any term structure estimation framework. Graph 3.4 plots the year-end estimated term structure for the last three years. The plot reveals, beyond the three-year maturity horizon, a near-parallel downward shift in the term structure between end-March 1999 and end-March 2000. During 2000 01, rates have fallen further at the short end; however, beyond 12 years, the estimated rates are higher than at end-March 2000. ZCYC estimates are available from February 1998 to the present. Box 3.1 provides more details on the NSEZCYC.
Graph 3.4. The NSE-ZCYC
31-Mar-99 13 12 11 31-Mar-00 31-Mar-01
191.
per cent p.a
10 9 8 7 6 0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5 10.5 11.5 12.5 13.5 14.5 15.5 16.5 17.5 18.5 19.5
maturity (years)
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192.
An estimate of the ZCYC proves useful for the following: a. It provides a benchmark risk-free term structure against which nonsovereign paper can be priced after adding an appropriate credit spread. b. It can be used to price bonds that do not trade on a given day, and therefore provides a methodology for valuing portfolios of Government bonds. c. Analysis of time-series of interest rates at different maturities provides useful insights into the volatility of interest rates and shifts in the interest rate structure. d. The above also forms an input for analysis of Value at Risk (VaR) of portfolios. An interesting finding that emerges from the pricing of individual securities off the estimated term structure is that there are important security-specific attributes that go into determining prices over and above the term structure. We analyse this further below
193.
Primary MarketSecondary Market Interaction

194. With a time-series of interest rates at different maturities available from the NSEZCYC, it is now possible to address a host of issues. We mentioned in Chapter 1 that the move to an auction procedure was expected to facilitate a price-discovery process that would lead to market-related yields on these instruments. We observed that primary market yields on 91-day and 364-day T-Bills, while moving together over time, have witnessed large spreads at different points of time. Does this indicate non-alignment of either of these rates with secondary market rates during these periods? How successful have auctions been in arriving at a market-related cut-off? Is the extent of market-relatedness uniform across maturities? Does there exist a two-way information flow between the primary and secondary markets? To answer these questions, we designed an empirical study in terms of a time-series analysis of the primary and secondary market rates for T-Bills (Box 3.2). Our findings reveal that: a. the 14-day primary market rate comes first in terms of market-relatedness, followed by 91-day and 364-day rates, respectively; b. the secondary market takes the primary cut-off as a strong, but not the only, signal; and c. the extent of responsiveness in all cases depends on whether the primary rate is initially above or below the secondary rate, with the secondary market aligning downwards when the primary rate is set below secondary, and the primary rate aligning downwards in the alternate scenario. The implications of our findings are as follows. Establishment of marketdetermined (as opposed to market-related) rates is possible only when price adjustment is the only equilibrating mechanism. As long as the issuing authority has leverage in adjusting quantities to set rates, either through change in the notified amount or by accepting a devolvement, a market-related rate is difficult to achieve. Does there exist an independent secondary market yield curve? The evidence of two-way interaction implies that primary cut-offs are viewed as a strong, but not the only, signal for secondary market rates. In a scenario of
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195.
increasing integration between different markets, the secondary debt market could, for instance, be incorporating information on exchange rate behaviour.
Volatility in Interest Rates

196. The movement of 91-day and 364-day T-Bill primary yields over time reflects the extent of volatility in short-term rates over the period considered. We expect, a priori, that short-term rates, affected as they are by the short-term liquidity mismatches, would be relatively more volatile than long-term rates. How does the volatility of short-term rates compare with that of long-term rates? Secondary market rates derived from the NSE-ZCYC reveal a monotonically declining relation between maturity and the volatility of interest rates (Graph 3.5), which supports our prior notion. The graph plots, maturity-wise, the intra-month standard deviation of rates at various maturities. The choice of months, March 1998, March 1999 and March 2000, is only illustrative and the pattern is mirrored in other months.
Graph 3.5 Volatility in interest rates
Mar-98 0.8 0.7 0.6 standard deviation 0.5 0.4 0.3 0.2 0.1 0 0.25 1 3 period (years) 7 10 Mar-99 Mar-00
SECONDARY MARKET: ACTIVITY ON NSE-WDM

197. As in most other markets, secondary market activity is concentrated in a few securities, also referred to as benchmark securities. Investor interest in these papers is partly driven by the RBI policy of re-issuing certain securities at each maturity, which on the one hand increases the notional amount outstanding and on the other, signals RBI preference for emergence of the benchmark. Barring few exceptions, other features common to highly traded bonds are a residual time to maturity that
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lies between four and eight years, and time since issuance not exceeding three years (Table 3.10). Monthly information on the most actively traded securities during 200001 reveals that secondary market activity in a security varies over time, a fact that is masked by the annual figures.
Table 3.10 Secondary market trading on NSE-WDM: Most traded securities Traded %age of total Issue Turnover Issue Maturity volume traded size ratio date date volume (Rs. crore) (Rs. crore)
199900
1 2 3 4 5 6 7 8 9 10 11.99% CG2009 12.32% CG2011 12.4% CG2013 11.83% CG2014 11.9% CG2007 12.5% CG2004 12.29% CG2010 11.98% CG2004 11.4% CG2000 11.15% CG2002 33001.00 24658.42 20971.90 20873.59 13082.41 13062.00 12382.05 11421.60 10268.50 8862.13 10.85 8.11 6.89 6.86 4.30 4.29 4.07 3.75 3.38 2.91 10500 11000 5691 11500 9500 11196.01 3000 5000 6000 5000 3.1 2.2 3.7 1.8 1.4 1.2 4.1 2.3 1.7 1.8 7-Apr-99 29-Jan-99 20-Aug-98 12-Nov-99 28-May-98 23-Mar-94 29-Jan-99 8-Sep-98 29-Sep-98 1-Sep-97 7-Apr-09 29-Jan-11 20-Aug-13 12-Nov-14 28-May-07 23-Mar-04 29-Jan-10 8-Sep-04 29-Sep-00 1-Sep-02
168583.6 200001
1 2 3 4 5 6 7 8 9 10 11.4% CG2008 11.3% CG2010 12.5% CG2004 11.03% CG2012 11.9% CG2007 11.99% CG2009 11.15% CG2002 11.43% CG2015 11% CG2006 11.68% CG2006 56202.84 39491.23 35488.64 28964.03 20751.25 19341.35 16533.00 12443.57 10664.00 10016.21
55.41
13.11 9.21 8.28 6.76 4.84 4.51 3.86 2.90 2.49 2.34 6000 9000 11196.01 9500 13500 13500 5000 12000 3000 7500 9.4 4.4 3.2 3.0 1.5 1.4 3.3 1.0 3.6 1.3 31-Aug-00 28-Jul-00 23-Mar-94 18-Jul-00 28-May-98 7-Apr-99 1-Sep-97 7-Aug-00 28-Jul-00 10-Apr-99 31-Aug-08 28-Jul-10 23-Mar-04 18-Jul-12 28-May-07 7-Apr-09 1-Sep-02 7-Aug-15 28-Jul-06 10-Apr-06
249896.12
Note: Issue sizes are end-year figures. Source: NSE.
58.3
Secondary Market Prices: Influence of Security-specific Attributes

198. The differential volumes across securities translate into differential pricing over and above that explained by the difference in present values of cash flows. The less liquid a security is in the secondary market, the more likely it is that the buyer of the security will charge an illiquidity premium (lower price) over a liquid paper with similar features. In terms of outcome, then, if one were to price all securities off the term structure alone, the errors between market price and the model price are likely to reveal a correlation with secondary market activity. The relative liquidity/illiquidity of securities can in turn be traced to specific attributes that make particular bonds more attractive compared to others with similar cash flow structure.
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199.
Experience in other markets suggests that high amounts of outstanding stock in a security encourage secondary market activity in the paper. The hypothesis that higher amounts of outstanding stock activate the secondary market for the security presupposes that higher outstanding amounts translate into higher floating stock. The turnover ratios of the most actively traded securities do not reveal an obvious relationship between issue size and secondary market activity. In both years, the highest turnover ratios were witnessed in papers with smallmedium issue sizes. A possible reason could be that the floating stock assumption would not hold if certain groups of investors (say, insurance companies and provident funds) adopt a buy-and-hold strategy. The proportion so held may, however, not be high, and depends on the maturity of the paper, and it is worthwhile analysing the distribution of trading activity by outstanding amount. Graph 3.6 plots secondary market activity, issue size-wise, over the last three years. We have categorised issue size into five groups (figures given alongside are in Rs. crore). While the evidence seems blurred in 1998, over the last two years, the plot does reveal some degree of correlation between outstanding amounts and secondary market trading activity. However there is conflicting evidence as mentioned above and the existence of an outstanding value/trading relationship in India is not clearly discernible.
Graph 3.6 Secondary market activity by outstanding amount (Issue) Size Does Matter
200.
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1998 1999 2000 10000+ 7000-10000 5000-7000 3000-5000 0-3000
201.
High outstanding amounts, however, are neither necessary nor sufficient to activate the secondary market activity in a paper, as revealed by case studies of the secondary market trading histories of the 11.40% 2008 and 12.30% 2016 securities. With a notional outstanding amount of Rs. 3000 crore, the 11.40% 2008 is one of the smallest outstanding issues. In September 2000, the first month following its issuance, the security experienced a turnover ratio of 2.4 on NSE-WDM. The security remained among the top ten traded securities during the entire period from October 2000 to April 2001, and had an average turnover ratio of 1.5, which is equal to the turnover ratio of the total outstanding Government debt (Graph 3.7). A high outstanding amount is clearly not necessary for secondary market activity.
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Graph 3.7 Large issue size not necessary for secondary market activity 11.40% 2008 on NSE-WDM (non-repo trades) 10000
8000 Sep 29: re-issue of Rs. 3000 cr
6000
4000
2000
Aug 31: issue of Rs. 3000 cr
Aug-00
Sep-00
Oct-00
Nov-00
Dec-00
Jan-01
Feb-01
Mar-01
Apr-01
202.
That high outstanding amounts are not sufficient to ensure secondary market activity is illustrated by the trading history of the 12.30% 2016. The security was introduced in the market by way of an on-tap issue in July 1999 and was quickly followed by a private placement and a re-issue. Up to March 2001, there have been three more re-issuances. With an outstanding issue size of Rs. 13,129.85 crore, this security counts among the largest issues. The highest secondary market volume of Rs. 1500 crore, witnessed in December 2000, corresponds to a turnover ratio of about 0.16. The secondary market activity in this paper declined steadily after the re-issue of February 2000 and was wiped out completely by September 2000. A reissue in January 2001 revived interest for a brief while before it virtually crashed from its peak level in March 2001 to negligible levels in April 2001 (Graph 3.8). The history of this security reveals that high outstanding amounts alone are not sufficient for secondary market activity. That high outstanding amounts are not sufficient for liquidity is also borne out by the traded volumes on NSE-WDM in 12.29% 2010 and 12.25% 2010, two securities that were re-issued during the year 200001. With outstanding issue sizes of Rs. 8000 crore and Rs. 9500 crore, respectively, these securities were actively traded only in the months immediately following re-issuance in April and May 2000, respectively. Rather, these case studies indicate that other factors, such as the maturity of the security, may have a greater influence on secondary market activity.
203.
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Graph 3.8 Issue size is not sufficient either 12.3% 2016 on NSE-WDM (non-repo either) 2500 2000 1500 1000 Jan 15 1500 cr re-issued
Nov 24 3000 cr re-issued
Feb 11 2000 cr re-issued
Jul 2: 2129.85 cr on-tap Jul 16: 2500 cr PP 500 Jul 30; 2000 cr re-issued 0 Mar-00 Nov-99 Nov-00 Mar-01
10+ 7 to 10 5 to 7 3 to 5 1 to 3 0 to 1
Jul-99
204.
If investors prefer to hold bonds of a certain maturity spectrum, this would translate into higher liquidity for these securities. The distribution of secondary market trading over the last three years (Graph 3.9), in terms of maturity, does not reveal any clear preference pattern. A clear preference in favour of short maturity papers is, in fact, visible only in 1998.
Graph 3.9 Secondary market activity by residual maturity : revealed preference?
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1998 1999 2000
205.
The lack of a clear pattern could be on account of the influence of other factors that influence investor preference patterns. Time since issuance is one such factor that is likely to influence an investors preference for a security. Graph 3.10 depicts secondary market activity during the last three years by time since issuance; we have provide for six age-blocks. There is ample evidence that secondary market activity in a security is highest in the immediate post-issuance period (up to three years). Investor interest wanes as the age of a bond (time since issuance) increases. This pattern is found in other bond markets that the consultants
206.
Jul-00
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have experience of activity tends to concentrate in the newly issued securities and then dies away in all but the largest issues.
Graph 3.10 Secondary market activity by time since issuance: New is Beautiful
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1998 1999 2000 10+ 7 to 10 5 to 7 3 to 5 1 to 3 0 to 1
207.
That the age of a bond exerts a strong influence on the extent of secondary market activity is clearly revealed in the case of the 11.50% 2011 and 11.50% 2011A securities. The 11.5% 2011 security was issued on August 5, 1991 and matures on August 5, 2011. The 11.50% 2011A was issued on November 23, 2000 and matures on November 23, 2011. The cash flow amounts of the two bonds are the same and the cash flow structures almost similar. However, an important difference between them is their age. Secondary market activity in these papers on NSEWDM reveals a concentration of activity in the more recent issue (Table 3.11).
Table 3.11 Activity on NSE-WDM: Influence of age (outright transactions) (Rs. crore) 11.5% 2011A 11.5% 2011 Traded value Weighted YTM Traded value Weighted YTM
Nov-00 Dec-00 Jan-01 Feb-01 Mar-01 Apr-01 208.
1032.05 3172.00 2417.32 1764.08 915.02 2047.37
11.501 11.243 10.725 10.385 10.299 10.244
24.00 16.00 195.15 156.00 70.20 35.00
11.549 11.165 10.667 10.460 10.516 10.348
A plausible explanation for this runs as follows. The 11.50 2011 is probably held by public sector banks in their held to maturity category which is valued at acquisition cost. There is little incentive to move the security to a different category since it would then have to be marked to market, which may lead to a depreciation of assets; consequently, there would be few sellers. The amount of floating stock of this security is therefore small, which adversely impacts the liquidity of the paper. There are other attributes, besides residual maturity and time since issuance, that determine the relative attractiveness of securities. Coupon rate on a security,
209.
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relative both to other securities with similar maturities and to other securities in a different maturity bracket, for instance, could be one such factor. The effect of this factor works through the substitutability of securities within particular maturity brackets as well as, to some extent, across different maturities. In terms of outcome, the influence of these attributes is reflected in significantly different secondary market volumes for different instruments. Such phenomena often translate into significant differences in pricing over and above what can be explained by differences in the cash flow structures of two bonds. Buyers willing to buy an illiquid paper in the secondary market charge an illiquidity premium, which increases the YTM and pushes its price below that of a similar instrument. 210. An empirical analysis of the influence of maturity, time since issuance and outstanding issue size indicates that these security-specific attributes do, in fact, have a non-trivial impact on pricing of individual securities (Box 3.3). Once the impact of these factors is explicitly incorporated into pricing, pricing errors decline significantly from that when prices are read off the term structure alone. Our analysis indicates that illiquidity premium plays an important role in the pricing of individual securities and can be traced back to security-specific features.
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Box 3.1 Term Structure of Interest Rates in India: The NSE-Zero Coupon Yield Curve
The term structure of interest rates forms the basis for the valuation of all fixed income instruments. Modelled as a series of cash flows due at different points of time in the future, the underlying price of any fixed income instrument can be calculated as the present value of the stream of cash flows, each discounted using the interest rate for the associated term to maturity. A plot of interest ratematurity pairs, on a given date, is the term structure of interest rates, or the zero coupon yield curve. Empirical analysis of the term structure of interest rates has a long history in developed countries such as the US and the UK; work on term structure estimation in India, by comparison, is of more recent origin. The primary reason for the latter can be traced to the dormant debt market in India prior to the 1990s. Implementation of financial sector reforms since 1991, in particular those relating to the development of the debt market, have brought into prominence the need for an econometric framework for estimation of the daily term structure. Simultaneously, the secondary debt market has witnessed significant growth, which in turn has made it possible to provide daily estimates of the term structure. The NSE-ZCYC adopts the Nelson-Siegel functional form and uses information on secondary market trades from the WDM segment of the NSE to provide daily estimates of the sovereign term structure. Marking an improvement over previous empirical studies in the Indian context, the estimation framework for the NSE-ZCYC takes into account important institutional details related to the Indian debt market. The T+5 settlement system currently in existence often leads to significant variations in prices for trades settled on the trading day vis--vis those settling n days into the future. There are two influences to which this can be attributed. First, trades that do not settle on the trade date could be negotiated as futures transactions, the price for which would differ from the spot price (a trade that settles on the trade date itself) by the cost of carry. The opportunity cost for the seller could be approximated by the foregone return in the call money market (say), while the return is given by the interest (coupon) that accrues for these days. The estimation framework proxies the overnight rate by the short-term rate derived from the estimated term structure, and accounts for the settlement day effect by incorporating a cost of carry correction over the spot price. In addition, expectations about the likely directionality of interest rates would be built into the contract if the term structure is expected to undergo a significant change by the time the deal is settled. Cash flows for deals that do not settle on the trade date should therefore be discounted at rates that are expected to prevail on the settlement date. The empirical estimation uses implied forward rates (these being the best predictors of expected future spot rates) to discount the cash flows for such trades. Estimate s of the daily ZCYC are available for the period from February 1998 to the present.
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The estimated term structure can be put to numerous uses. It can be used to value government securities that do not trade on a given day and to construct a Government bond index. It can be used to price all non-sovereign fixed income instruments after adding an appropriate credit spread. Estimates of the ZCYC at regular intervals over a period of time provide us with a time-series of the interest rate structure in the economy, which can be used to analyse the extent of impact of monetary policy. Time-series of ZCYC also form an input for VaR systems for fixed income systems and portfolios.
Abridged version of G. Darbha, S. Dutta Roy and V. Pawaskar (2000), Term Structure of Interest Rates in India: Issues in Estimation and Pricing, unpublished paper, National Stock Exchange of India Ltd. References McCulloch (1971), Measuring the Term Structure of Interest Rates, Journal of Business, XLIV (January), 1931. Nag, Ashok K. and Sudip K. Ghose (2000), Yield Curve Analysis for Government Securities in India, Economic and Political Weekly, January 29, 33948. Nelson, Charles R. and Andrew F. Siegel (1987), Parsimonious Modelling of Yield Curves, Journal of Business, 60(4), 47389. Subramanian, K.V. (2000), Term Structure Estimation in Illiquid Government Bond Markets: An Empirical Analysis for India, Journal of Fixed Income (forthcoming). Thomas, S. and V. Saple (2000), Estimating the Term Structure of Interest Rates in India, unpublished paper, IGIDR.
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Box 3.2 Is There an Independent Yield Curve? An Empirical Analysis
When a T-Bill auction is announced, market participants place bids for the amount of the paper they would like to subscribe to, along with the expected rate of interest. The Reserve Bank determines a cut-off yield; bids below the cut-off are allotted their bid amount at their respective quotes. In case of a shortfall of the accepted amount from the notified issue size, the balance amount devolves on the RBI and/or the primary dealers at the weighted average cut-off yield. If the RBI exercises significant leverage in setting yields, the primary market response to secondary market information will be weak. On the other hand, if the market views the primary cut-off as a strong signal about the rates that would obtain at different maturities, the secondary market will respond strongly to primary market information, and an independent secondary market yield curve will be difficult to achieve. In an ideal situation, we would expect a two-way information flow between the primary and secondary markets. The information feedback between primary and secondary markets can be analysed in terms of the correlation and lead-lag relation between the primary and secondary market rates for each instrument within a co-integration/vector error-correction framework (Engle and Granger (1987), Johansen (1988)). The first step in such an exercise is the identification of a cointegrating vector, which can be interpreted as the long-run equilibrium between the primary and secondary market rates. If a long-run equilibrium relation exists, there exists an error-correction mechanism that moves the system towards equilibrium, should there be a deviation in any period. Two error correction equations with the primary and secondary market rates as the dependent variables constitute the vector error correction model (VECM) (Equation 1). Equation 1 pmrt = 11 pmrt 1 + 11 smrt 1 + 21 pmrt 2 + 21 smrt 2 ........ + 1 ( pmr smr ) t 1 + u1t Equation 2 smrt = 21 pmrt 1 + 21 smrt 1 + 22 pmrt 2 + 22 smrt 2 + .... + 2 ( pmr smr ) t 1 + u 2t The coefficient on the cointegrating vector in the individual equations of the VECM provides a measure of the responsiveness of each rate to a deviation from the long-run relation. Statistically significant coefficients in both equations imply the existence of a two-way information flow between the markets; which rate plays the greater role in the error correction process is reflected by the size of the coefficients.
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The exercise is carried out separately for 364-day, 91-day and 14-day rates. The cut-off yields in each auction provide the primary market rates. Instruments of same (residual) maturity may not always trade in the secondary market; secondary market rates at each of these maturities on their respective auction dates are read off the NSE-ZCYC. The period of analysis is from February 1998 to March 2001. This provides us with 160 weekly observations for 91-day and 14-day rates and 80 fortnightly observations on 364-day rates. We impose the cointegrating vector (1, -1); i.e. in the long-run equilibrium, the primary and secondary market rates for any chosen maturity are equal. The error correction (EC) term is therefore the spread between the primary and secondary market rates. Estimates of the coefficients on the EC term in the individual equations (Table B2.1) reveal the following: i. ii. iii. The 14-day primary cut-off yield and secondary market rates both respond to deviations from the long-run equilibrium; the extent of response is of comparable magnitude. The extent of response of the 91-day primary yield to deviations from equilibrium, while statistically significant, is numerically small. The extent of response of the secondary market rate is, by comparison, significantly higher. There is two-way response also in the case of 364-day rates; the degree of response is comparable for both markets but small in numerical terms.
Table B2.1 Extent of responsiveness: Estimates of coefficients on EC terms Primary Secondary market market coeff t-ratio Coeff t-ratio
14-day 91-day 364-day -0.16 -0.04 -0.09 -3.16 -1.70 -2.44 ** * ** 0.19 0.21 0.10 3.51 4.01 2.26 ** ** **
* Denotes significance at 10%, ** at 5%.
The difference in frequency of observations means that results for the 14-day and 91-day rates are not strictly comparable to the 364-day rate; some observations are, however, in order. In terms of the degree of market-relatedness of primary yields, the 14-day rate emerges as most responsive, followed by the 364-day and 91-day rates, respectively. The degree of responsiveness of secondary market rates is also not uniform across maturities. The responsiveness of the 91-day secondary market rate is the highest among the three, and this takes the lead in the equilibrating mechanism, indicating that at this maturity, the market takes strong signals from the primary yields set by the RBI. Most importantly, the magnitudes of secondary market response are low across all maturities, which means that the market also factors in other information, besides the primary cut-off, in arriving at their rates.
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Our results (Table B2.2) reveal the following: i. At 14-day maturity, both primary and secondary yields respond strongly to negative EC, while at 91-day maturity only the secondary yield response is statistically significant with respect to negative EC. ii. Interestingly, on the part of the RBI the reaction is different. It responds to negative ECs on the 14-day market, but to positive ECs in the 91-day market, indicating a discretionary approach. Also, numerically the response is smaller in the 91-day case, definitely pointing to its rate-setting behaviour (in an exogenous) manner in the latter case. In the case of 364-day maturities, only primary yields respond to negative EC, while neither responds significantly to positive error correction models (ECMs).
Table B2.2 Asymmetric response: Estimates of coefficients on EC terms Positive EC Negative EC coeff t-ratio Coeff t-ratio
14-day primary 14-day secondary 91-day primary 91-day secondary 364-day primary 364-day secondary -0.60 0.41 -0.46 0.66 -0.11 0.61 -1.13 0.73 -1.73 1.19 0.35 1.66 * -0.11 0.18 -0.03 -0.22 -0.09 0.05 -2.16 3.43 -1.22 3.83 -2.23 1.01 ** ** ** **
* Denotes significance at 10%, ** at 5%.
Our results can be interpreted as follows. At both 14-day and 91-day maturities, secondary yields are significantly responsive only to negative ECs, indicating that market alignment happens only in the downward direction, i.e. when the market thinks the RBI is signalling lower interest rates. When the primary cut-off is higher than the secondary rate, there are no statistically significant effects. In the case of 364-day T-Bills, primary yields appear to be market-related, but markets do not seem to view primary yields as a strong signal, possibly indicating that the secondary market rate depends on other factors. What are the implications of our findings for auction outcomes? Our findings would indicate that, with corrections happening in terms of both primary and secondary market rates in the case of 14-day maturities, the extent of devolvement would be less than in either 91-day or 364-day segments. At 91-day maturity, we have only the secondary market responding while the primary market holds relatively firm, and the reverse is the case with 364-day T-Bills. The extent of devolvement in these two cases would depend on the extent of response, which, as we have seen, is higher in the case of 91-day than 364day maturities. Together, this implies that, in terms of an ordering of devolvement proportions, the numbers would increase with maturity for these three instruments.
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How does this compare with the actual auction outcomes for these instruments? Note that, since devolvement is not a [0,1] outcome, the comparisons are valid in terms of proportions of issue amount devolved, rather than number of occurrences per se. The period of analysis witnessed devolvement in 66 auctions of 14-day T-Bills, accounting for 59.4% of the notified amounts in these auctions. Eighty-three auctions of 91-day T-Bills devolved; the devolved amount constituting 60.0% of the auctioned amount. By comparison, 25 devolvements of 364-day T-Bills accounted for 68.2% of the notified amount. The actual outcomes are therefore consistent with the nature and extent of information flow indicated by our analysis. What are the implications of our analysis with respect to the objective of facilitating a price discovery process through an auction procedure? An auction will provide a marketclearing yield only when price adjustment is the only market-clearing mechanism. As long as the issuing authority has leverage in adjusting quantities to set rates, either through change in notified amount or by accepting a devolvement, a market-related rate is difficult to achieve. Does there exist an independent secondary market yield curve? The answer that emerges from our analysis is that primary cut-offs are viewed as a strong, but not the only, signal, as far as secondary market rates are concerned. In a scenario of increasing integration between different markets, the secondary debt market could, for instance, be incorporating information on exchange rate behaviour.
Abridged version of G. Darbha and S. Dutta Roy (2001), Is There an Independent Yield Curve? Evidence from the T-Bill Market, unpublished paper, NSEIL. References Engle, R.F. and C.W.J. Granger, (1987), Cointegration and Error Correction: Representation, Estimation and Testing, Econometrica, 55, 25176. Johansen, S. (1988), Statistical Analysis of Cointegrating Vectors, Journal of Economic Dynamics and Control, 12, 23154.
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Box 3.3 Idiosyncratic Factors in Pricing of Government of India Bonds
The term structure of interest rates forms the basis for the valuation of all fixed income instruments. Empirical literature for developed countries demonstrates, however, that other economic factors also exist which cause individual bonds to be priced differently from the price indicated by the estimated term structure. Explanations include volume effects (infrequently traded bonds trading at lower prices), effects of differential taxation of income and capital gains, tax clientele effects (different rates of tax for different entities) and use of select bonds for special purposes such as overnight repos and in lieu of estate taxes. Also, it is recognised that distinguishing between the explanations is rendered difficult by the fact that securities are affected by multiple factors at the same time. The role of these other factors is non-trivial even for the simplest, relatively homogenous category of Government bonds, and manifests in terms of high pricing errors when model prices are derived only as present value relations. Not properly accounted for, these large errors can in turn cause a distortion in the estimated term structure. The empirical literature has followed two approaches to address this issue. One approach is to purge the estimation of the term structure of these effects by restricting the data set to the use of benchmark securities. Elton & Green (1998) and Eom et al (1998), on the other hand, demonstrate that it is possible to identify security-specific attributes that can explain these pricing errors. In the Indian context, Subramanian (2000) designs a weighting scheme in terms of the number of trades and total volume traded that down-weights the price errors of illiquid securities in the regression estimation. While this approach reduces the volume effect on the estimated term structure, it does not, however, analyse the nature and significance of such effects. The present study is, to the best of our knowledge, the first comprehensive attempt to provide an analysis of the importance of various idiosyncratic factors in the pricing of Government of India bonds. The data for the study are compiled from secondary market trades in Government securities reported on the Wholesale Debt Market (WDM) segment of the National Stock Exchange (NSE). The estimation framework is the same as that used for the NSE-ZCYC. We find that significant pricing errors exist when Government bonds are priced using the term structure alone. Residual maturity, time since issuance, current yield and issue size are identified as the security-specific attributes that account for most of these pricing discrepancies.
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Abridged from Gangadhar Darbha, Sudipta Dutta Roy and Vardhana Pawaskar (2002); Idiosyncratic Factors in the Pricing of Sovereign Bonds: an Analysis of the Government of India Bond Market, NSEIL. References Elton, Edwin J. & T. Clifton Green (1998); Tax and Liquidity Effects in Pricing Government Bonds, Journal of Finance, LIII(5), 1532-62. Eom, Young H, Marti G. Subramanyam & Jun Uno (1998); Coupon Effects and the Pricing of Japanese Government Bonds: an Empirical Analysis, Journal of Fixed Income, September, 69-84. Subramanian, K.V; Term Structure Estimation in Illiquid Markets, Journal of Fixed Income, (June 2001), pp. 77-86.
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TA 3473-IND
Volume 2: Analysis and Recommendations

February 2002

Volume 2 Analysis and Recommendations
Table of Contents
Chapter 1 Executive Summary ....................................................................................... 3 Summary of Main Recommendations ............................................................................. 6 Chapter 2 The Recommendations in Full .................................................................... 10 Participants .................................................................................................................... 10 Issuance and Instruments............................................................................................... 14 Trading........................................................................................................................... 18 Clearing and Settlement Systems Recommendations ................................................ 22 Study Tour Report ......................................................................................................... 35 Chapter 3 Secondary Market Participants .................................................................. 62 Narrow Investor Base/Little Diversity .......................................................................... 62 Lack of Bond Market Education ................................................................................... 65 Banks ............................................................................................................................. 66 Mutual Funds................................................................................................................. 70 Mutual Fund Sector Development................................................................................. 71 Insurance Companies..................................................................................................... 75 Pension Funds................................................................................................................ 77 Retail Investors .............................................................................................................. 83 Primary Dealers ............................................................................................................. 86 Brokers........................................................................................................................... 87 Foreign Securities Houses ............................................................................................. 89 Credit Rating Agencies.................................................................................................. 90 Chapter 4 Issuance and Instruments............................................................................ 92 Government Securities .................................................................................................. 92 Corporate Debt Securities............................................................................................ 105 Chapter 5 Trading........................................................................................................ 126 Current Situation Government Debt......................................................................... 126 Current Situation Corporate Debt............................................................................. 127 Current Market Model Restricts Access...................................................................... 129 Lack of Transparency .................................................................................................. 136 Government Securities Market.................................................................................... 147 Chapter 6 Clearing and Settlement ............................................................................ 157 Current Situation.......................................................................................................... 157 Regulatory Developments Affecting Settlement......................................................... 160 Infrastructure Developments Affecting Settlement..................................................... 161 International Standards ................................................................................................ 163 Chapter 7 Taxation ...................................................................................................... 180 Introduction ................................................................................................................. 180 Forms of Taxation Imposed on Investors .................................................................... 181 Structural Issues........................................................................................................... 183
Volume 2 Analysis and Recommendations
Specific Issues Requiring Attention ............................................................................ 185 Impact on Transactions and Provision of Services...................................................... 191 Other General Recommendations................................................................................ 192 Chapter 8 Regulation and Enforcement .................................................................... 194 India's Current Financial Regulatory Structure ........................................................... 194 General Regulatory Issues ........................................................................................... 196 Chapter 9 Macro-economic Issues.............................................................................. 209 Introduction ................................................................................................................. 209 Policy Effects............................................................................................................... 209 Magnitude.................................................................................................................... 210 Implementation............................................................................................................ 213 Currency Exchange Rate ............................................................................................. 215 Monetary Policy .......................................................................................................... 217 Recommendations ....................................................................................................... 217 Chapter 10 Development Methodology...................................................................... 219 Impending System Developments ............................................................................... 220 Knee-Jerk Regulation .................................................................................................. 221 Recommendations ....................................................................................................... 222 Chapter 11 Endnote ..................................................................................................... 223 Appendix A Glossary of Terms ................................................................................... 224 Appendix B Real Time Gross Settlement (RTGS) .................................................... 227 Introduction ................................................................................................................. 227 Background.................................................................................................................. 227 Payment Processing..................................................................................................... 228 Limitation of Payment Risks ....................................................................................... 229 Intra-day Liquidity....................................................................................................... 230 Message Flows ............................................................................................................ 236 System Relationships................................................................................................... 241 Queuing ....................................................................................................................... 245
Volume 2 Analysis and Recommendations Chapter 1 Executive Summary
Chapter 1 Executive Summary

1. This volume presents an analysis of the issues and makes proposals for their resolution. It is based upon several strands of enquiry: a. Interviews by consultants with practitioners and participants in India; b. Interviews by consultants with practitioners and participants outside India; c. A study tour for key Indian market participants to Germany and the USA (see Appendix B); d. Examination of previous reports by international bodies and by domestic participants; e. Examination of best practice in other national debt markets. The fieldwork in India was carried out during the first half of 2001 and the study tour was conducted in November 2001. This report incorporates comments made at the Hyderabad forum, feedback received from an extensive review by Indian debt market participants and discussions concluded at the Tripartite meeting which was attended by the Asian Development Bank, the Ministry of Finance, the Securities and Investment Board of India, the National Stock Exchange of India and the Bombay Stock Exchange. These timings are important as the pace of change in the Indian market has been rapid since the start of reform in 1992 and 2001 was a year of notable activity. Though the economic climate was not propitious, a large number of initiatives and activities were taking place in the capital markets generally and specifically debt markets. Some of the activities that were occurring or reached completion in 2001 included (but are not restricted to): a. Movement away from account period settlement; b. Prohibition of informal carry-forward arrangements; c. Development of the Negotiated Dealing System for government securities; d. Development of a Clearing Corporation for government securities; e. Work on RTGS; f. Demutualisation of the BSE; g. Fiscal Responsibility Bill; h. Action on dematerialisation of corporate debt. These are the continuation of a process that was initiated in 1992 to reform capital markets, which has included: a. Extremely rapid progress in developing and broadening equity markets; b. The building of a high-quality infrastructure for equity settlement and trading; c. The establishment of a national securities regulator; d. The liberalisation of the mutual fund sector resulting in rapid growth e. The opening up of the life and general insurance sectors.
2.
3.
4.
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5.
Debt markets have seen less development but nonetheless major institutional changes have taken place in the government debt market including: a. A move to a price-based auction structure for issuance; b. The dematerialised holding of government debt; c. The institution of a primary dealer system which has attracted domestic and foreign participation; d. Developments to allow repos, Forward Rate Agreements and other hedging instruments. The corporate debt market has seen less movement but there has been a move towards dematerialisation of stock which is expected to bear fruit in the near future by bringing about a major reduction in transaction costs through the waiving of stamp transfer tax on dematerialised transfers. There has also been a development of a credit rating industry. All this has been accompanied by the emergence of significant financial institutions, including some world-class players, from the previously state-owned domestic institutions as well as an influx of the major global players. Therefore the purpose of this research was to identify remaining problems and suggest ways that the process in Indias debt market could be completed so that the markets could fulfil their role in capital mobilisation. The report has been structured into a number of key topics that represent the chapters 3 to 9, which are: 3. 4. 5. 6. 7. 8. 9. Secondary market participants; Issuance and instruments; Trading; Clearing and settlement; Taxation; Regulation and enforcement; Macro-economic issues.
6.
7.
8.
9.
10.
Each chapter contains recommendations for action. The recommendations are themselves brought together in Chapter 2 Recommendations in Full. Our experiences in India also suggested some points about the methods for handling market and systems developments and these are covered in Chapter 10 Development Methodology.
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11.
The table below captures the most critical of the recommendations. However, they can be encapsulated in a very few points: a. Reduce the direct role of government in the financial markets in the determination of interest rates by establishing an independent public debt office function; b. Reduce the direct role of government as owner of financial institutions to permit the development of a diversity of views/objectives in investment decisions; c. Remove restrictions on investment decisions by institutional investors such as pension funds and life insurance companies and maximise outsourcing of investment decisions and treasury functions to professional fund managers; d. Institute changes in pension provision to support a system of properly funded and independently managed pension schemes which will benefit future pensioners and capital markets; e. Simplify public issuance procedures and standardise and regularise private placement documentation in order to remove the current bias towards private placement and thus improve access to the market by retail investors; f. Remove any impediments to the interaction of the institutional and retail market by ensuring that banks can access the stock exchanges on behalf of their customers; g. Improve post-trade transparency on secondary debt markets to permit efficient price discovery and thus encourage wider participation in the market; h. Involve the market more formally in decisions on design of financial infrastructure projects; i. Permit short selling of government securities; j. Ensure rolling, dematerialised settlement is applied to corporate debt instruments.
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SUMMARY OF MAIN RECOMMENDATIONS

Area Barriers Critical recommendations
Participants
There are too many state-owned or Government should divest itself of controlled participants and therefore ownership and/or control of not enough diversity of financial institutions. views/objectives to allow for a fully liquid market. Existing participants, such as banks, Allow more flexible investment provident funds and life insurance policies and permit wider use of companies are subject to excessive outsourcing to fund managers. directions in or restrictions on their investment decisions. Bond market skills are in short supply. State-owned entities, in particular, find it hard to retain the skilled staff for success in bond markets. Pension arrangements are underdeveloped and hence a major source of potential capital market activity is not present Impose competency requirements on bond market participants. Reform human resources policies supporting market wages, bonuses and firing. Investigate the feasibility of introducing fully funded pension schemes independent of the current provident fund structure. Move to a genuinely price-driven Government primary market through setting up an independent public debt office function. Introduce annual calendar for dated securities with understanding that it may be updated as circumstances change. Impose minimum documentation standards and public disclosure on private placements. Reform the process for public issues to reduce time, costs and risk.
Issuance
Government primary market is perceived by the market as not genuinely price-driven. Lack of an auction calendar for dated securities prevents participants from planning their investment cash flows and creates uncertainty Private placements are inadequately documented and specified too much is informal. Public issues are slow, expensive and risky; they are therefore rare.
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Area
Barriers
Critical recommendations
Trading
Trading structure suitable for professional market in Mumbai but excludes direct access by potential participants including nonprofessional investors (retail and corporates) and investors located away from Mumbai. Arbitrage is not possible between separated wholesale and retail government bond market segments because major participants (banks and primary dealers) are excluded from accessing the retail exchange market by RBI regulations. This reduces quality of prices in the retail market. Trading is highly opaque, with an inevitable reduction in market quality and exclusion of new participants. Short-selling is prohibited. There is a lack of clarity on the scope, functionality, regulation and operation of the Negotiated Dealing System (NDS) being developed by the RBI. The RBI does not have the regulatory and operational skills and experience for operating securities markets.
Retain negotiated market facilities, but encourage developments to allow wider access for other investors.
Permit banks and primary dealers) to open accounts with NSDL for government stock. Permit banks to settle government stock transactions through brokers.
Require and ensure adequate enforcement of timely trade reporting and publication. Encourage electronic order matching. Remove prohibition on shorting in a controlled manner. Publish details of the NDS for review by the market.
The RBI should take steps to acquire or access the necessary operational and regulatory capabilities.
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Area
Barriers
There is no clear regulatory structure for enforcing regulation in a multi-venue trading market. There is a significant regulatory gap relating to banks trading of debt securities. RBI has regulatory authority over banks and SEBI regulates brokers, mutual finds and exchanges. This leads to inconsistencies in regulation e.g. reporting of trades. Settlement
SEBI and the RBI must ensure the responsibilities for regulation and enforcement in the secondary markets result in consistent treatment of all trades irrespective of their origin. Ideally all trading should be under a single, clear regulatory remit.
There are many encouraging Publish specifications, business developments: the Clearing cases, operational plans, etc., for Corporation of India for key infrastructure developments. Government securities, rolling settlement and dematerialisation for corporate securities. However, there is a risk that lack of preparation, planning and publication will reduce the obvious benefits. The current lack of a Real Time Gross Settlement (RTGS) system is a problem, but the unrealistic timetable for its development may also present difficulties. Publish comprehensive specifications and plans for the RTGS project program to allow independent review and market input. Obvious distortions should be removed. Future proposals to change the tax system should be scrutinised for impact on capital markets. Clarify and strengthen role of selfregulatory organisations as frontline regulators. A vigorous campaign of enforcement of current rules applicable to broking firms is required to change expectations of non-enforcement.
Taxation
The tax system is extremely complex and changes frequently, resulting in anomalies and biases against debt securities. Current regulatory structure focuses too much on response and control. Needs to focus on ways to foster a culture of compliance. Enforcement lacks assurance and consistency.
Regulation and Enforcement
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Area
Barriers
Macroeconomy
The Reserve Bank of Indias (RBI) Policy-makers should simplify macro-economic objectivists are too policy objectives and be more open numerous. about medium-term objectives. The market perception is that RBI interventions are too frequent and unpredictable, leading to destabilisation of the bond market. The fiscal deficit is unsustainable and puts an excessive strain on the bond market. The programme to reduce the deficit lacks credibility. The Fiscal Responsibility Act should be accompanied by a guide showing how the targets will be achieved.
Market Development
There is currently an ad-hoc approach to systems development.
Provide an education programme for regulators and other agencies to cover the operation of markets and There is a reactive approach to the development processes used in regulatory issues and developments, the sort of sophisticated market that with a lack of consultation. India is becoming.
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Volume 2 Analysis and Recommendations Chapter 2 The Recommendations in Full
Chapter 2 The Recommendations in Full

PARTICIPANTS
Lack of Participants
12. While considerable steps have been taken to open up the market, the most obvious deficiency is a lack of participants with the skills, full commercial orientation and consequent diversity of opinion that is necessary if a market is to become liquid. It is certainly the case that it is possible to have a liquid market with a good participant base and poor infrastructure, but the converse (which is the case in India) is not true. Infrastructure does not create markets. Therefore, the policy direction of the Government agencies charged with responsibility for financial markets should be to encourage greater diversity among participants. This will require: a. Divestment of state holdings in financial institutions as rapidly as is prudent. Currently the state is a major holder of banking, insurance and mutual fund institutions. Experience elsewhere suggests that state-owned financial institutions are unlikely to be successful participants in financial markets. It is unlikely that state-owned entities will develop the requisite commercial orientation, independence and human resources that are necessary for success in competitive financial markets. Their problems are exacerbated by their ambivalent status (guaranteed or not) and their susceptibility to non-commercial pressures. b. Avoidance (or removal) of any bias that tends to restrict entry other than where there is a genuine and demonstrable prudential need. Frequently there seems to be a view that only allowing entry for the largest participants will guarantee stability and security. However, size is no guarantee of probity or sustainability, though it can clearly help, and a policy of preferring the largest effectively excludes any but the current players. Prudential controls on access should be based on regulatory compliance, rather than on the assumption that large entities will not cheat or fail. c. Removal of explicit guarantees from state-owned or other entities. These distort the competitive framework and prevent new entrants from gaining access. d. Clarification of implicit guarantees. These similarly distort the competitive framework but are even more corrosive since they are unspecified but assumed. Hence it is even more difficult to compete against them. e. Modifications to market infrastructure and market design, to allow direct participation by entities outside the narrow group that currently the market. This includes removal of constraints such as participation in the government securities settlement system, and the constraints faced by participants outside Mumbai.
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Lack of Bond Market Education

13. Inevitably, given the relative newness of Indias capital markets, there is a lack of the skills that are the norm in more developed markets. While normal commercial pressures (which do not yet exist in the Indian market given the high level of state ownership, etc.) will tend to weed out the incompetent and unskilled participants, and generate appropriate incentives for building human capital, the regulatory authorities can sharply accelerate the process by imposing standards on participants. In order to start the process by which formal qualifications become the norm throughout all Indian bond market participants, the Securities and Exchange Board of India (SEBI) should impose minimum competency standards, to be demonstrated by formal qualifications, on bond market participants. This would build on SEBIs success of imposing certification requirements on the exchangetraded derivatives market. Similarly, and unsurprisingly, given the history of administered interest rates there is a low perception of interest rate risk among investors. This is pervasive, and a matter of concern, as it raises the possibility that investors will be drawn into inappropriate assets. SEBI should do more in the way of publicising the risks and rewards of fixed income investment, as well as the appropriate investment horizon for investment in medium/long-dated marketable securities.
14.
Banks
15. Banks are obliged to hold a large proportion of their assets in Government securities (their statutory liquidity reserve (SLR) requirement). This requirement will make it difficult for them to act in a commercial manner even if they were inclined to do so and imposes costs on banks, through their being forced to invest in a sub-optimal portfolio. The requirement for an SLR is over and above prudential requirements on banks to ensure financial stability. The RBI has gradually reduced this requirement and should continue that policy in line with the commitment to reduce the fiscal deficit. However, since banks as a whole hold more Government debt than they are obliged to do, this action would remove a potential rather than a current barrier for many banks. Banks are required to perform monthly mark to market on those securities that are held in their trading portfolio. Securities deemed as held to maturity are not marked to market (which is not in conformity with International Accounting Standards). Those deemed available for sale must be marked to market at least annually. Securities can only move from one category to another once a year. Both allowing banks to hold securities at book value and limiting movement between groups put a brake on banks ability to trade. Any deviation from a complete marking to market of assets and liabilities results in incorrect information about the bank being disseminated to regulators and shareholders. The requirement to mark to market monthly should be extended at least to the available for sale category and, ideally, to all holdings. It would be prudent to have a phased programme working towards full mark to market.
16.
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17.
State-owned banks do not have incentive structures that enable them to retrain staff of the skill and quality required for successful bond market operations. The stateowned banks have, according to the RBI, been subject to extensive poaching of staff by private sector participants. For state-owned banks to participate successfully in the longer term in bond market trading they will have to make major changes to their personnel policies including changes to salary structures, bonus incentives and dismissal, Where banks do not have in-house skills, or they lack the organisational structure for a different type of business, they should be allowed to outsource management of their portfolios to professional fund management companies by holding gilt mutual funds or similar assets instead of Government stock in their SLR. Such outsourcing is particularly beneficial insofar as it allows banks to clearly compare alternative competing fund managers, and possibly to utilise competition from external fund managers to impose greater discipline on an internal fund management division. Currently banks can hold their excess of SLR in gilt funds1, but not the core holding. If outsourcing were allowed on an unrestricted scale, banks would be able, but not be obliged, to diversify their portfolio management.
18.
Mutual Funds
19. The Unit Trust of India (UTI) operates a product, US-64, which is not a true net asset value (NAV) fund, i.e. its valuation and dividends are not linked directly to its investments. It is intended that US-64 should become an NAV fund in 2002, which we support. Additionally, UTI is too large for the market for example, US-64 has routinely experienced limitations in market liquidity when compared with its needs. This leads to management problems, ambiguity as to its status (guaranteed or not) and vulnerability to price impact when it trades. Its size and historic status as the only fund also distorts the market for mutual fund products. Its recent problems reinforce the sense that the eventual solution should involve reconstruction into a number of smaller, private entities.
Insurance Companies
20. The Life Insurance Company of India (LIC) was until recently the only life insurance company and still dominates the market. However, the sector is now opening to new entrants competing with LIC (as is the general insurance sector). In common with scheduled banks, LIC is obliged to invest heavily in Government bonds. This restricts LICs ability to compete for investment business with new entrant companies. It also imposes a burden on current LIC policy-holders. Further it removes a potential major player from the corporate debt market. The requirement should be withdrawn. The dominant position of LIC in the market means it is among the largest holders of Government debt. Its ability to trade is constrained by its size, as the market sees
21.
1
Gilt Funds are a subset of mutual funds that invest exclusively in Indian government debt. They have access to RBI settlement facilities, have accounts in the SGL depository and have access to RBIs liquidity support. Page 12
LICs orders as opportunities to front-run. LIC should be encouraged to split its funds to reduce the size of its trading. It should also be allowed to outsource fund management, either by purchasing mutual fund units or by inviting external fund management companies to run different parts of its portfolio. 22. The perception that LIC is Government-guaranteed gives it a strong competitive advantage over other insurers trying to enter the market. In order to level the playing field, the Insurance Regulatory and Development Agency should institute a partial guarantee system for life companies against loss through default or fraud covering licensed life companies. A full indemnity would remove responsibility from investors, which might encourage rash behaviour. The guarantee should be self-funded and will require the regulator to monitor companies to ensure solvency and probity. LICs position should be clarified so that it is covered by the partial guarantee scheme but not otherwise guaranteed.
Pension Funds
23. Most formal pension provision in India is through provident funds organised at the national or employer level. Provident funds are required to invest almost exclusively in Government debt. Provident funds should be permitted to invest more widely than the current investment guidelines allow and encouraged to use external fund managers subject to limitations and constraints to ensure prudent investment and use of appropriately regulated managers. Provident fund returns are not based on returns in fund management; they are set by the Government. This suggests three important areas of reform: a. The residual responsibility in the case of bankruptcy, in the case of exempt funds (which are run at the firm level) is uncertain, and responsibility for the solvency of funds should be clarified. b. Provident fund returns should no longer be set by the Central Government as it is currently not clear who bears the risk; returns should reflect the investment performance of the fund. c. Provident and pension funds should be required to mark assets to market and be subject to regular actuarial solvency audits. Most citizens are outside the organised employment sector and have no formal pension provision. The OASIS proposal visualises an innovative system for individual accounts, where asset management would take place through external fund managers. When implemented, the OASIS scheme should not introduce a limitation on the number of managers able to offer the scheme, but accept any manager that can meet the prudential requirements. Mutual funds can offer pension plans, but only if they observe the investment guidelines imposed on provident funds. Investment restrictions on private pension schemes operated by mutual funds should be removed in line with those on provident funds, but subject to similar requirements to ensure prudent investment.
24.
25.
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Brokers
26. India has a very large number of small stock-broking firms. Experience in other markets suggests that a compliance culture is more likely to develop if there are a significant number of large firms that have reputations for regulatory integrity to protect. A current SEBI rule prohibits regulated institutions from giving more than 5% of their business to any one broker. This is one factor hindering the emergence of larger firms. While accepting the concerns that led to this requirement, it seems unreasonably severe, especially for smaller mutual funds. The proportion of business that can be given to a single broker should be raised significantly, but the requirement should not be abolished.
Foreign Securities Houses

27. Currently foreign entities cannot take a controlling stake in Indian financial institutions they must be junior joint venture partners. While this has not deterred foreign entrants, the likelihood is that it has limited their willingness to commit to the Indian market. Experience of other markets suggests that committed foreign participants (involving a controlling interest) can improve the quality of a market through encouraging a compliance culture. The authorities should consider removing a potential barrier by liberalising their approach to and removing ownership restrictions on joint venture businesses. Many developing markets require foreign firms to establish their local market subsidiaries by residence in the local market (i.e. they must have a local registered address) and hence be subject to local rules and taxes.
ISSUANCE AND INSTRUMENTS

Absence of Independent Pricing
28. The RBI reserves the right to intervene in auctions for T-Bills and dated securities. It has done so on numerous occasions by setting a (unpublished) cut-off price and taken substantial devolvements of stock on to its own book. This undermines the price formation process, since prices are set by the RBI rather than by supply and demand in the market. The ensuing sale of devolved stock also unsettles the aftermarket. The uncertainty generated is almost certainly incorporated in the bids made in the primary market, so the RBI is paying an uncertainty premium because of its interventions. The RBI should abandon the practice of intervening in the auctions of securities. Auction prices should clear the market. The extent of devolvement has been considerably reduced of late (though the RBI has taken a considerable amount of stock through private placement about 25% of the total issue in the current year). The effects are: a. The market knows the RBI could take a devolvement in future so continues to react to that uncertainty. b. The substantial volumes of private placements mean the auction process, including its price formation role, is bypassed to a considerable extent.
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29.
c. General high levels of uncertainty as to the RBIs strategy 30. It is hard to establish the credentials of a non-interventionalist policy, as markets take a long time to be convinced that intervention will not happen. In order to establish credibility and so more quickly reduce the uncertainty premium, the Government should set up an independent Debt Management Office (DMO) to be its sole representative in the market. The constitution of the DMO would prevent it from acting other than as a price taker in auctions and confine its interventions to technical situations. We understand that this is under consideration. We urge that it be considered speedily and that a plan for implementation be published.
Lack of Transparency and Predictability in Issuance

31. There is no calendar for dated security auctions. The market is therefore unaware of the maturity profile of forthcoming issues or, indeed, of the total amount as the borrowing target has been exceeded in recent years. The DMO should adopt a policy of maximum transparency in respect of its funding needs, security maturity dates and the timings of auctions. It should be stressed that calendars can only ever be indicative since funding requirements may change. This is true in other markets as well as India therefore a calendar can only be a current best estimate. Any information that the DMO shares with the market will always be provisional since it is subject to changing circumstances, but if the market is as well informed as the DMO then a considerable source of uncertainty is removed. Having said that the less the calendar is changed, the greater the benefit to market participants. The transparency policy should become a continuous interaction between the market and the issuing authority involving a two-way flow of information.
Cumbersome Issuance Procedure

32. Primary auctions of dated securities are underwritten by primary dealers. Given the possibility of intervention through setting an unpublished cut-off price, it is hard to see how the primary dealers can decide realistic rates for underwriting and, since they are not obliged to underwrite, they probably err on the side of caution. Therefore, we suspect the procedure is costly and apparently gives relatively little reassurance since the RBI has historically received large devolvements of nonunderwritten debt. In any event, the market is now sufficiently mature with adequate, well-capitalised primary dealers for the RBI to move away from what is probably unnecessary and expensive insurance. The underwriting procedure should be discontinued.
Fragmentation of Gilt Issuance

33. The number of dated securities, at 116, is large and there are many issues maturing in most years. This fragments liquidity in an already illiquid market. The RBI has made it a policy to re-open existing stocks rather than issue new stocks, but the level of fragmentation remains high. The DMO should therefore take a more active stance aiming to reduce the number of issues in the three- to 15-year maturities to one or two main issues per maturity through conversion issues and switches. There
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is also a case for favouring issuance of zero-coupon bonds, since these are easier to price and trade in a market where many participants have weak skills and IT systems. The RBI and the Government of India are making efforts to introducing STRIPS in the Indian Markets.
Restricted Repo Market

34. The recommendations of RBIs Committee should be accepted. In particular: a. Widen the participant base by allowing all Subsidiary General Ledger (SGL) account holders to conduct repos. With the RBI Credit Policy of April 2001 having laid down a timeframe for making the call money market a strictly inter-bank market, it would become imperative for non-bank entities to use the repo market for fund management. b. Widen the list of eligible instruments. Repos are currently allowed in Central Government securities (T-Bills and dated bonds). State Government securities are not eligible instruments for repo transactions with the RBI but are for market repos. The sub-group had recommended widening the list of eligible instruments to State Government securities, corporate and Public Sector Undertakings (PSU) bonds, and bonds issued by financial institutions (FIs). c. Specify uniform repo accounting standards. Since only buy/sell-back repos are allowed, most entities treat them as an outright sale and an outright purchase, while a few treat them as collateralised borrowing in the money market. d. Introduce greater flexibility by allowing rollover repos. Reducing settlement risk for repos is one important area for further progress. Settlement of repos is currently through the RBIs Delivery versus Payment (DVP) end-of-day system. This involves a level of counterparty risk. The implementation of the Clearing Corporation of India (CCI) will address this. CCI will act as a legal counterparty to all transactions and set collateral requirements for all participants. This will be more important when more instruments are allowed, as SGL accounts held with RBI only hold Government securities. This is also the foundation for extending the repo market to all economic agents in the country.
35.
Lack of Specificity in the terms of Corporate Bond Private Placements

36. Currently the documentation for private placements (the main issue method for corporate debt) is very sketchy. Many things that would normally be expected in a bond specification are unstated or assumed. Prevailing market practice seems to involve renegotiation during the currency of the bond. The bonds which are currently traded on the market seem to be really like syndicated loans, and like syndicated loans, they are difficult to trade. Without tighter structuring of bonds, the market will remain limited to the current issuers and investors. There is a need for a regulatory initiative to tighten the documentation required for private placings. This should be accompanied by improving bankruptcy/default procedures to give bondholders a realistic chance of obliging companies to honour their commitments.\
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37.
Implementing a regulatory requirement for more comprehensive documentation would be complex and slow involving changes to primary legislation. We suggest the same outturn may be achieved by: a. Producing a model issue document for private placements. This would require comprehensive description of default procedures among other things. This could be produced by a trade association or a regulator. b. Requiring those regulated by SEBI and the RBI (by rule issued by those regulators) to only make investments in stocks that adhere to the model documentation. It is likely that market forces will reinforce this (with finer rates for placements that adhere to the code) but the nature of the Indian market suggests regulatory reinforcement would be necessary. There are precedents for this sort of action for example the RBIs requirement that banks only invest in dematerialised stock.
Cumbersome Process for Public Issues

38. Very few issuers make public issues of debt; most are private placements. Most institutional investors do not participate in public issues, which are essentially retail. More public issues would widen the potential market for corporate debt securities. The main reason issuers prefer private placements is that the current SEBI requirements for public issues impose a process which is long, costly, duplicative, and imposes risks on issuers and investors. Windows of opportunity for issuance are often very short and a protracted procedure for approval will not be used. There commendations do not call for a lowering of standards but rather a speeding up of the process and the removal of requirements to duplicate and review disclosures that have already been made public. The current procedure is a deterrent to public issues and should be modified as follows: a. Disclosure: All new bond issues should be made against a short-form prospectus, regardless of whether they were being presented as a public or private placement for issuers with an equity issue in public form. SEBI should require, in agreement with the exchanges, that the standard of issue documents should be improved and that private placement offering documents should be standardised, albeit at a lower requirement level than for public placements. b. Time taken: The approval of new issues should be delegated to stock exchanges, within an updated set of disclosure requirements produced by SEBI. This would reduce one level of duplication. Moreover, this approval should be recognised as meeting the accepted Indian standards by any other Indian exchange on which the issuer wishes to have his or her issue listed (though individual exchanges may, if they wish, impose additional liquidity or marketability requirements for admission to trading). The approving exchange must have an announced timetable process, from initial request to approval for listing, which is no longer than eight weeks. SEBI should remain responsible for monitoring and ensuring that the exchange meets not only this timetable but also the accepted standards for the approval process. c. Interest rate risk exposure: The accepting, or receiving, bank should accept responsibility for issuing allotment letters or allotment approvals and for ensuring that the allotment allocation process is completed within 24 hours of
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the closing of acceptance. Further, it should ensure that the permissions, or allotment letters, are released no later than 24 hours thereafter (i.e. 48 hours after the close of acceptances). This should be part of the exchanges approval requirements. d. Costs: Estimates of costs for a public issue are between 4% and 4.5% of the proceeds. Much of the costs for the public issue process are a result of duplication for issuers that have already made equity issues and/or bond issues. In such cases, it should only really be necessary to announce the use of the money and the application and allocation process.
Requirements for Multiple Credit Ratings

39. A number of investors, particularly provident funds, impose a requirement for three credit ratings. This seems quite excessive, and we recommend that it should be considered as an unreasonable and unfair practice for any investors to insist that an issuer obtain more than two credit ratings, unless the two provided differ by more than one rating grade.
Requirements of Various Government Departments for Approvals and Verifications of Security Values
40. Collateral valuations required for issue documents must currently be provided by Government departments. The valuations should be removed from Government departments and placed in the hands of commercial independent valuation firms. SEBI should build and operate a register of all such firms prepared to follow their trade association guidelines for valuations, and be prepared to supply a list of all such approved firms to the issuers sponsoring brokers and/or underwriters.
Sinking Fund Requirement

41. The legal requirement for all publicly issued bonds with more than 18 months to maturity to have a debenture redemption reserve should be removed as it has been in many developed markets. The requirement adds significantly to the issuers costs during the early life of the bond; but, in a growing economy with moderate inflation, it offers little offsetting gain in security.
TRADING
Market Structure
42. Both Government and corporate debt markets are almost entirely telephone negotiation markets. This is consistent with other debt markets elsewhere in the world. SEBI has previously mandated that equity trading should be done through exchange order books, and this has been successful by unifying small and large investors through a single system with price-time priority. SEBIs existing regime permits negotiation by institutions, but requires that both buy and sell orders have to be exposed to the market for possible improvement. However, the needs of debt
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markets may be different and we do not recommend that any action be taken that might damage the current negotiated bond markets. Policy-makers should continue to recognise the needs and preferences of wholesale participants in both Government and corporate markets by allowing negotiated dealing to continue. SEBI should continue to take a pragmatic approach with the corporate debt market by permitting negotiation but requiring reporting, and possibly exposure, to the market for improvement. 43. However, there is a need and certainly a policy objective of allowing nationwide access for investors to the bond markets. This need may be met by anonymous electronic order books. The stock exchanges should therefore be encouraged to provide or continue to provide retail/second-tier participant functionality through order books. The regulatory structure should allow all present participants in the over-the-counter (OTC) market to choose between the existing OTC market, or anonymous order matching, without prejudice to either. The bond markets in most OECD countries came about before modern technology. Hence, existing market structures there may not fully reflect the opportunities for a current market design which exploits technology. In recent years, there has been some move from telephone trading in other bond markets towards electronic crossing systems and negotiation systems. The advantages include lower costs and easier regulation compared to OTC telephone markets. This suggests that there is a greater scope for electronic markets in India than is found elsewhere in the world. SEBI and the exchanges should creatively exploit these opportunities.
44.
Lack of Transparency
45. The Government bond secondary market is very opaque, as there is no requirement for timely reporting or publication of trades. Greater transparency benefits price formation and market integrity (through higher visibility) and encourages new participants. The RBI should impose timely reporting and publication requirements for trades in Government securities. The reporting requirements should include provisions to prevent multiple reporting and to flag abnormal trades that may otherwise give a misleading impression of current trading. The corporate debt market is similarly opaque. SEBI should impose timely reporting requirements on all trades in corporate debt, specifically to include unlisted debt, spot transactions and any other transactions that are currently not reported, including provisions to prevent multiple reporting and to flag abnormal trades that may otherwise give a misleading impression of current trading. Institutional investors, especially the larger ones (i.e. UTI and LIC), have opportunities for cross trading between different funds within the same house. We recommend that reporting and publication of these transactions (in Government and corporate securities) be made mandatory so that all bond trades are published by an exchange. This would serve the function of validating the cross-trade prices by exposing them, and also add valuable information on current prices in illiquid
46.
47.
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stocks. Many funds already book in-house crosses through brokers to expose and validate the price. 48. In order to strengthen enforcement of trade reporting, SEBI should require trading system operators to ensure that trade reports received by them are published with all speed and to install simple analysis routines to identify patterns suggesting delay of reporting. They should be required to retain trading reports for a number of years adequate to cover the length of investigations into malpractice, etc. To strengthen enforcement further, SEBI and the exchanges should develop the mechanisms for monitoring compliance with trade reporting requirements. Compliance with trade reporting regulations is not part of the normal banking solvency inspections in India (or anywhere else). These will include mechanisms to: a. collect and investigate market complaints; b. conduct on-site investigations; and c. tape telephone conversations. It is worth noting that these proposals would make the Indian bond market more transparent than most other bond markets around the world. We believe that the special situation of the Indian market particularly the need to attract a wider range of participants supports the need for greater transparency (see Chapter 5 Trading for fuller discussion).
49.
50.
Lack of Regulated Trading Venue for Private Placements

51. Currently the exchange trading mechanisms for corporate bonds make no differentiation between public issues and private placements. Since the secondary market is exclusively professional at present, this does not matter. However, if significant retail interest in the secondary market were generated, there would be a possibility of retail investors buying privately placed bonds. This would be undesirable, as the level of disclosure for private placements is far below that deemed necessary by SEBI for bonds available to the general public. SEBI should require the exchanges to create separate, regulated private placement segments in their secondary markets. Participation by non-professional investors in the private placement segment could be prevented by applying a substantial minimum order size. India has a number of competing trading venues for bonds and equities. This situation has recently come about in more developed markets, and regulators there have been concerned about the possibility that front-line regulation and enforcement will be reduced as a consequence of competitive pressures on trading systems. The situation in India is more long-established, but there are indications that cross-venue regulation and enforcement are lacking. To address this, SEBI should develop a plausible, feasible and sustainable regulatory strategy for a situation where there are competing trading venues. This would be of huge benefit to the equity market, but would also remove a significant barrier to developing
52.
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confidence and hence use of the secondary corporate debt market. In particular, SEBI should draw up plans to ensure that: a. responsibility for front-line identification of possible abuse is clearly defined; b. adequately trained staff are available to carry out the surveillance activities in the front-line regulators; c. the regulatory and enforcement staff are adequately empowered and have sufficient operational independence, etc., to carry out their surveillance and enforcement duties; and d. adequate and appropriate technical resources are available to the surveillance staff.
Negotiated Dealing System (NDS)

53. The RBI is introducing an electronic negotiation system to supplement the current telephone trading mechanism. This is an important development, since it will replicate the existing functionality of the National Stock Exchanges (NSE) Wholesale Debt Market (WDM), but feature better settlement procedures for the Government bond market. There have been a number of presentations to the market and meetings with participants. However market participants seem not to have concrete documentation about the functionality, requirements or value of the new system. There is a significant likelihood that they will not use the new system beyond aspects where RBI makes this mandatory. To reduce this risk, the RBI should publish and disseminate comprehensive documentation on the NDS to enable the user base to validate the functionality and to inform the user base as to what is required of them in order to be able to use the system. It should take steps to acquire the expertise necessary to regulate the secondary market in Government securities. It should also take steps to acquire the technical expertise necessary to operate the NDS.
Prohibition on Short-Selling
54. Short-selling of Government stock is prohibited by the RBI. Relaxation of the prohibition has been under consideration for some considerable time. The ban continues to be a real barrier. This has a number of detrimental effects on the market. Specifically, it prevents primary dealers from fulfilling their obligation to make two-way quotes, excludes intra-day trading, and restricts a number of useful arbitrage strategies that would, if made possible, improve the pricing efficiency of the market. The RBI should remove the prohibition on short-selling of Government debt (when covered by borrowing) for primary dealers. This should not be done until the clearing corporation is operational and effective and robust stock borrowing is in place. Automated stock borrowing will only be available for business settled at the clearing corporation. Short-selling should therefore only be permissible for users of the clearing corporation.
Lack of Hedging Mechanisms

55. Primary dealers need vehicles for hedging risk and unwinding positions. While swaps and FRAs are permitted their development has been slow and volumes
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remain low. Primary dealers have no effective mechanism for anonymously reducing positions taken in the course of their business. They may deal directly with other primary dealers or through normal brokers, but either of these methods risks compromising their anonymity and exposing their position to the market. In other markets, specialised Inter Dealer Brokers (IDBs) provide this service, but India has no framework for such entities. The RBI should develop a framework for supporting IDBs in the Government bond market. IDBs would offer a valuable hedging tool for primary dealers. The framework would involve a regulatory structure, monitoring and enforcement capability, and settlement access to SGL accounts at the RBI.
CLEARING AND SETTLEMENT SYSTEMS RECOMMENDATIONS

56. The settlement situation in India has changed quite dramatically during the time the project has been running. Two natural recommendations to move to rolling settlement and to dematerialise corporate debt have happened or look likely to happen. In addition, three important infrastructure projects are at varying stages of completion: a. the CCI; b. the Interim Dealing System (IDS) to link the NDS to the SGL system: and c. the Real Time Gross Settlement (RTGS) system.
Lack of Information on CCI Implementation

57. The CCI is an important development for the Government bond market. It will permit retail access and also offer important benefits to wholesale players. However, there is considerable uncertainty among current participants as to the value of CCI. To a large extent this is based on lack of information about the nature, functionality and operation of CCI. As with NDS, the relevant development authorities should publish concrete and thorough documentation relating to CCI, showing details of: a. business and technical design; b. business case and rationale; c. implementation plan; d. testing strategy; e. processing capacity; f. settlement processes; g. operational plans and reliability standards; h. risk controls; i. governance; j. access; k. tariffs; and l. protection of customer assets. The release of such documentation will help in many ways: it will generate greater debate and criticism, and it will help economic agents prepare themselves for participating in CCI.
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58.
59.
It has not been possible for project consultants to perform a detailed assessment of the business viability or technical suitability of both the NDS and the CCI because of lack of documentation.
Lack of Information on IDS Implementation

60. The IDS is intended to link the NDS to the current SGL system (i.e. to remove the need for manual delivery of transfer forms to the RBI). As for CCI, it has proved as impossible for the consultants to obtain information in any detail as it has for market participants. This is risky, as settlement of Government securities cannot occur unless the IDS is operational and used correctly by participants. To reduce this risk, the relevant development authorities should publish material relating to IDS, showing: a. business and technical design; b. business case and rationale; c. implementation plan; d. testing strategy; e. processing capacity; f. settlement processes; g. operational plans and reliability standards; h. risk controls; i. governance; j. access; k. tariffs; and l. protection of customer assets.
Lack of Clarity on Rolling Settlement

61. SEBI has acted to mandate a welcome shift to rolling settlement from accountbased settlement for Indias securities markets. While the requirements and timetable for movement of equities to rolling settlement is very clear, the same is not true for debt instruments. The circular setting out the timetable does not specifically mention corporate debt issues. Rolling settlement should be made mandatory for all trades in corporate debt. SEBI should clarify the inclusion of corporate debt instruments in the move to rolling settlement.
Absence of securities lending 62. The market lacks an infrastructure for securities lending (as opposed to the modified carry-over provisions that have recently been banned by SEBI). In the Government market the prohibition on short-selling has rendered stock borrowing unnecessary. (The banks are allowed to make up their SLR shortfall by repo stock.) Further development requires a stock-borrowing infrastructure to be in place. Therefore, we recommend the authorities develop and implement a securities borrowing and lending programme. This should happen after market regulators, exchange management and market participants have undertaken a study of programmes operational in comparable markets. The programme should be
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undertaken as a structured project with specific performance deadlines and accountability. The programme should be constituted as a working committee with implementation accountability to the Ministry of Finance. Lack of clarity on dematerialisation 63. As with rolling settlement, SEBI has been very clear as to its requirements for dematerialisation of equities. However, its intentions for corporate debt are less sure. The current situation, as we understand it, is that issuers may opt to dematerialise debt but are under no obligation to do so (and given the lack of trading, there may be little incentive for many). Pressure from the investor side has come from an RBI requirement that banks and primary dealers only hold debt securities in dematerialised form to be completed by June 2002.. SEBI should clarify policy with respect to dematerialisation of corporate debt issues. It should formulate and publish rules and regulations specifically related to the dematerialisation status of corporate debt issues. This should include plans to encourage rapid dematerialisation of corporate debt. The programme should apply equally to privately placed debt as to public issues.
Lack of Delivery versus Payment systems 64. Corporate debt is mainly settled inter-office or through custodians by exchange of cheques and physical certificates. This limits participation in the market and imposes risks on current participants. SEBI, in conjunction with the depositories, should formulate and publish a regulatory mandate requiring the settlement of trades in corporate debt to take place on the basis of DVP. At present, settlement regulation specific to corporate debt trades is ill defined. Clarification would remove any ambiguity from the marketplace.
Unrealistic plans for RTGS 65. India does not have facilities for electronic transfer of funds, which effectively limits settlement to entities located in Mumbai. The RBI has a commitment to introduce RTGS 15 to 18 months after NDS. This timescale seems extremely ambitious given the complexity and critical nature of RTGS. We recommend that the RBI conduct a complete disclosure review using a qualified, independent entity to assess the viability of the RBIs design, development, testing and implementation plans for the proposed RTGS system. It is also recommended that the RBI modify its plans, as and if required, in order to ensure the credibility of the securities markets and the safety of the financial system. We now understand that a development contract has been awarded and that this requires the system to be delivered in 20 months. However there remains a total lack of published detail and plans. We remain concerned about the project and the lack of published documentation, plans and specifications does nothing to alleviate our concern.
66.
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Potential for regulatory confusion 67. Regulatory jurisdiction is generally clear; essentially, the RBI regulates banks, primary dealers and the Government securities market, and SEBI regulates exchanges, brokers, mutual funds and corporate issuers. There are two remaining sources of possible regulatory confusion: a. the settlement and trading of Government securities conducted outside of the RBI-operated NDS, i.e. on stock exchanges; and b. the settlement and trading of corporate debt by entities that are regulated by the RBI. SEBI and the RBI should clarify regulatory jurisdiction in these two areas.
68.
Taxation
Structural issues 69. The Government should build upon the Planning Commission advisory group and its report of May 2001 by explicitly aiming to rationalise the tax structure applying to the capital markets with the aim of achieving neutrality between different instruments and market participants. Tax neutrality should be the driving principle except where such neutrality explicitly and demonstrably conflicts with clearly defined social or micro-economic aims. The Government should commit to the principle of stability for investment taxation and phased change. Committing for a number of years allows investors to make longer-term decisions and removes one factor making for excessive short-terms (which is a feature of Indian markets). Introducing changes in a number of stages allows the capital markets to build the change into their expectations and avoids discontinuities. To avoid reintroducing inconsistencies, etc., any future proposals to change taxes relating to the capital markets should automatically be subject to examination by an expert committee. Their aim would be to move to or maintain tax neutrality, and their specific brief would be to ensure that: a. the proposed tax changes are supported by a clearly argued case addressing the reasons for the change and the likely effects on the markets; and b. the impact on capital markets of the proposed change would not be to introduce distortions or inconsistencies that were disproportionate to any gains that might be achieved.
70.
71.
Distorting effects of income tax 72. It is clear that the complexities of the income tax system will affect investment decisions and cause market distortions. We have noted elsewhere that individual investors can earn good, tax-free returns from post-office deposits. We see here that they can also achieve tax benefits if they invest in infrastructure bonds. It is
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unlikely that individuals will invest in corporate bonds under the present tax regime given the secure, tax-advantaged investments already on offer. 73. As well as general complexities, the structure imposes a clear disadvantage on bond investors since equity dividends are exempt from tax while bond interest (and interest on deposits) is not. Therefore, the recommendation is for a programme to reduce and remove the existing exemptions, deductions and rebates applied to income tax on investment income. Exceptions should be made where the tax advantage is providing a demonstrable social or economic benefit, such as pension contributions, but in general the aim should be to remove the biases and distortions that have been introduced over the years. To avoid instability as well as being consistent with the need for stability and predictability in taxation, the removals should be phased over a number of years, but not too many perhaps three years would be appropriate. The situation of provident funds allowing tax-free early withdrawals, as well as compromising their purpose of providing pensions, is also providing an alternative, highly tax-advantaged medium-term investment for individual investors. If it were fulfilling the objective of providing adequate pensions, then the tax-free status could be justified but not as a medium-term savings vehicle. Naturally we would not recommend withdrawing a tax concession that encouraged prudent pension planning and could also support the development of pension funds as significant investors in a bond market. However, we would argue for a review of the tax-free early withdrawal provision and would recommend that this be removed.
74.
75.
Income tax and Capital Gains Tax (CGT) distortions 76. Over a predefined period the authorities should implement a programme moving towards a unified, harmonised system with one rate of tax for income, short-term and long-term capital gains applicable to all investors. As before, the aim should be to reduce the biases created by the interaction of differential taxes. Again, as before, to maintain stability the programme should be phased in and preannounced.
Anti-bond bias in CGT 77. There is no rationale for disadvantaging bond investors in such a specific and obvious way; this looks almost accidental, or as if a review of the discrepancy has been overlooked. It should be remedied either by allowing the indexation option for bonds or perhaps, given a commitment to low inflation, by removing the indexation option altogether.
Other distortions in CGT 78. Disallowing capital losses to be offset against other income results in an asymmetry of treatment. Investors will, on occasions, be paying tax on gains but be unable at other times to offset losses against tax. In practice, one suspects that tax planners will get around this, so the current situation looks like an anomaly without a
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purpose. It would be simpler and probably make no revenue difference if capital losses could be offset against any income/gains. 79. The CGT structure lacks consistency and logic. It gives the impression of having been incrementally developed without major consideration being given to the overall effect of the reforms made at each stage. The serious discussion of the possibility of allowing the Industrial Development Bank of India (IDBI) (which is a commercial entity, albeit with a large Government stake, in competition with other commercial entities) to have a special dispensation allowing it to offer a CGTexempt bond illustrates that ad-hoc adjustments continue to exist. We cannot emphasise strongly enough that this sort of process leads to tax structures that are complex, unpredictable and which give rise to market distortions. Therefore, it is recommended that: a. the capital gains tax regime should be simplified wherever possible, and over time the trend should be towards a unified, harmonised system with one rate of tax for income, short-term and long-term capital gains applicable to all investors; and b. the approach to tax policy needs to change so that the tax system should not be seen and treated as a mechanism for achieving short-term policy fixes.
Distortion and bias against bonds in mutual fund taxation 80. The scheduled withdrawal of exemptions for US-64 and for equity funds in March 2002 should be supported. This is to be welcomed because it will correct the antibond bias inherent in the current structure. Inevitably there will be pressure to extend the exemption and this should be resisted firmly. It is recommended that the tax treatment of corporate earnings should be neutral between in-house and externally managed funds.
81.
Stamp duty 82. Stamp duty should be reduced and ideally eventually eliminated as this is a barrier to trading. Evidence from other markets suggests that the elasticity of demand for trading is high, so that reductions in transaction costs lead to proportionately larger increases in trading volumes. The revenue losses from abolition can also be significant and this might deter complete abolition, as it has in the UK. The situation in India is different in that, by-and-large, equity transactions are free of stamp duty since most are in dematerialised form. Therefore, the revenue effect of total abolition would not be great. In one regard, stamp duty has an important beneficial effect by adding to the pressure for dematerialisation of corporate bonds. As that would undeniably be a good step for the market, the recommendation is to leave transfer stamp duty unchanged for the present but formalise the waiver for dematerialised holdings.
83.
84.
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Service tax on financial intermediaries 85. It is not obvious why mutual funds should be exempt, but asset managers are not. This is a substantial tax burden and will seriously distort the asset management market. It is recommended that the exemption for mutual fund asset managers be extended to the provision of all asset management and advisory services.
Other tax-related matters 86. Earlier research into Indias tax system has advocated the need to maintain ongoing development/implementation of the policy under which revenues are collected, to reform the administration and collection of taxes and to make refinements to the legal process of hearings/appeals. These are all initiatives aimed at achieving a tax system that will minimise tax-induced distortions and provide a system that will be simple, transparent, administratively feasible and politically acceptable, and result in a broader tax base which yields an enhanced revenue productivity. We support these initiatives as they should help to produce an efficient and equitable tax system in which both domestic and international investors can have confidence. The changes affecting the capital markets should be incorporated into a broader overall review of Indias taxation system to ensure that a coherent and comprehensive system is developed and that inconsistent/conflicting regulations arising from piecemeal regulatory amendments are avoided. In order to inform the markets and to canvass opinion from the market practitioners, who will be instrumental in determining whether Indias secondary bond markets are a success, a series of public consultations and explanations need to be undertaken prior to any proposed tax changes being implemented.
87.
Regulation and Enforcement

Too much control, not enough regulation 88. Responsibility for surveillance and enforcement should be clearly delegated to the self-regulatory organisations (SROs). Currently it is not clear who has the responsibility. The exchanges, for example, have extensive rules but these are, to a large extent, aimed at eliminating settlement risk. Where the rules operate against market abuse it is not clear that they lead to sanctions stopping trading or even cancelling trades is not a valid enforcement mechanism since they do not punish but only prevent it getting worse. Recent developments suggest that SEBI initiates investigations and requests data from the exchanges. This will not work, as SEBI is too remote from the day-to-day trading and probably lacks resources. We have discussed elsewhere the potential problems of regulation with competing trading venues there is a risk that exchanges will cut back on expensive surveillance, since their efforts to improve the market also benefit their competitors. SEBI needs to make very clear to exchanges that their continued authorisation depends upon demonstrating their ability to fulfil the front-line regulatory responsibility.
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89.
SEBI should state and promulgate regulatory principles. These are different to the regulations themselves, which become the job of the SROs. As an example, cornering and bear-hammering are abuses that should be outlawed by regulatory principles, but short-selling is a technique that can be used abusively. However, short-selling, of itself, is not an abuse. Therefore, a decision on shortselling should be taken by the SRO on the basis of its proven ability to regulate short-selling so that it cannot be used abusively. Areas where regulatory principles are needed include, but are not limited to: a. Client money: evidence from the recent problems with manipulation suggest that strict segregation of client money (which is admirably enforced in the settlement system) is not enforced at the firm level. b. Conduct of business and suitability: there seems to be very little regulation and practically no enforcement covering the treatment of clients. Given the predominantly retail nature of Indias equity market and the desire to expand retail access to the debt market, this is particularly worrying. It is apparent that clients have been advised in ways that were unsuitable and which in other jurisdictions would have resulted in investigation followed by sanctions. c. Promotional material and marketing: much current material is truly misleading, especially with respect to risk, with investments that involve significant risk being marketed as risk-free. Participants must develop compliance functions and this must be mandated. A compliance culture implies that firms monitor themselves. To do this they need to have designated compliance functions with specific and individual responsibility for compliance. These functions need to have access to the highest management of the firm, since it is at that level (if anywhere) that a commitment to reputation as opposed to short-term gains will be strongest. The function is best staffed by compliance professionals since, like auditors, they have a professional reputation to uphold which makes them more tenacious in resisting commercial pressures. The best participants may already have this function, but a requirement and enforcement by the national regulator will be needed to force the less compliant. Inevitably, two issues will come up opposing such a requirement: a. Cost: for small firms this can be significant. However, it is absolutely essential that the requirement is universally enforced. It may be hard, but if a firm cannot afford to monitor its compliance with regulations, then it should not be in business. b. Human capital: skilled compliance professionals are scarce in India. They were in other markets before there was a requirement creating a demand. It would be hard to believe that India, with its highly educated and sophisticated workforce in the capital markets, could not respond to a need for compliance officers. If there is no requirement, then the supply will certainly not materialise, but in other markets the demand led to a rise in salaries for compliance staff which brought forth the supply. Encourage and support trade associations these are important networks supporting the development of a regulatory culture. Inevitably, they tend to reflect the culture of the leading firms and these are the firms most likely to view a regulated market as essential for their business success. They are also important in
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90.
91.
standard setting and in addressing industry human capital shortages through organising/stimulating the development of training programmes. The debt market already has the Fixed Income and Money Market Dealers Association (FIMMDA) and the Primary Dealers Association of India (PDAI), so the groundwork exists. Trade associations also act as lobby/consultation groups, and the regulators could raise and strengthen their profile by ensuring they are involved in consultations on regulatory developments. This makes them attractive to smaller participants whose voices otherwise do not get heard. 92. Move away from institutionally based regulation towards functional regulation. Most Indian regulation is at the level of the institution, so that most participants only have one regulator. This is increasingly not the pattern elsewhere. Institutionally focused regulation raises difficulties when activities are undertaken by more than one type of participant or when a participant wishes to enter new activities. We note below that the apparently clean split between SEBI and RBI has actually led to some gaps, which are a consequence of an institutional approach. There may be an argument that this may mean that some participants have two regulators and this might lead to cost and confusion. However, cross-institution overlaps of business (e.g. banks transacting securities business) are likely to be increasingly the case as the financial sector develops and participants move into new areas of activity (as they will need to if they are to compete globally anyway). It is worth noting that this is now common in other markets and is achieved with little real problem. The agreement between SEBI and RBI should be revisited with a view to ensuring not only that there are no gaps, but also that the structure is sufficiently flexible to accommodate cross-institutional overlaps of business.
Regulatory overlap 93. Consideration needs to be given to exploring the scope for streamlining the regulatory processes. Where possible, responsibility for regulating particular aspects of the market or areas of business should be assigned to a single regulator, e.g. the Insurance Regulatory and Development Authority should determine which organisations are suitable to write insurance business. However, having said that, the current situation of regulatory overlap is preferable to one in which some firms defy easy categorisation and thereby end up not being regulated by either party.
Gaps in surveillance responsibility 94. On-exchange trading of government debt (currently negligible) is subject to both RBI and SEBI regulation. Currently RBI regulated entities are not permitted to undertake exchange trading in government debt, but if they were to (which we recommend elsewhere) it is not clear how SEBI would execute its authority over trading. While exchange trading is clearly within SEBIs purview, This lack of clarity on regulation of on-exchange trading of Government bonds is a risk, as much of this business, if it materialises, will be for unsophisticated investors. This leads to the risk of a scandal involving retail investors. The regulatory responsibility should be made clear. As a practical matter, SEBI already regulates
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other exchange business, and reflecting its greater experience in retail investment, we suspect SEBI might be the most appropriate regulator. 95. We see the lack of transparency in spot trades of corporate bonds as a serious barrier and have discussed this in the Trading chapter (Chapter 5). Spot business between banks should be brought within one or other regulatory remit. Our preference would be for SEBI.
Lack of regulatory development structure 96. We would recommend a more structured approach to regulatory development than seems to be the case at present. Some indications of the sort of approach we have in mind are given in the chapter on Market Development (Chapter 10) and we would advise regulators to adopt a more measured approach, avoid hasty responses, seek genuine consultation and be willing to listen to practitioners. We would strongly recommend that the regulators address their policy-making systems and establish firm protocols for damage limitation and risk assessment scenarios against their statutory and moral obligations.
Lack of enforcement against brokerage firms 97. SEBI should consider taking very strong regulatory action with particularly meaningful penalties against as many relevant firms for breaches of rules and regulations as is necessary. We have found from experience in other markets that this provides a shock tactic for all licensed firms that breaches will not be tolerated. The outcomes tend to include: a. a reduction of licensed firms, some for cancelled licences and others which simply resign their licences, realising they cannot make legitimate profits; b. a combining of resources of better-quality firms, often through a trade association, to ensure more disciplined procedures and encouraging the fulfilment of higher standards; c. more business moving on to the transparent exchange platform, to ensure clearer regulatory treatment and lower cost of regulation; and d. a significant improvement in investor confidence. Whilst this may appear to be a drastic action, the results in terms of increased awareness of regulation and the consequence of non-compliance will be beneficial to the market. The realisation that compliance is not optional, and the consequently greater emphasis on in-firm compliance monitoring, will be a sustainable benefit to the market as a whole. Participants will come to appreciate that regulatory sanctions will hurt those that receive them. This should only need to be a one-off measure taken after considerable planning and executed with concerted action.
98.
Low level of skill and competency in brokerage firms 99. SEBI should consider individual licensing competency testing. This competency testing should include examining: a. brokers for understanding of products, regulation, exchange systems, investment analysis and advice, and application of knowledge; and
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b. fund managers for their product base, regulatory knowledge, investment analysis and portfolio management skills. 100. Once this has been established, SEBI could also consider requiring a process of continued professional development. Such a complete process would ensure that only adequately trained personnel could give investment advice to the public and only suitably qualified personnel could manage portfolios for the public. This need is particularly apparent in the bond markets, where the level of expertise among many participants is seriously deficient. Experience in other countries suggests that once the regulator has set the standards, a host of private sector training suppliers emerge to fill the requirement.
101.
Lack of encouragement of competition 102. While regulation is vital, it should not stifle the benefits of competition. As well as not acting to exclude new entrants unless there are sound and demonstrable regulatory grounds for doing so, regulation should not restrict the development and innovation of new products. The regulators should therefore take a broad view of product licensing. They should not insist on licensing individual products, but rather should endorse product types. Regulators cannot and should not protect people from making what turn out to be wrong decisions risk is an inherent and necessary part of investing. At the same time, regulators have a duty to protect against false or misleading claims. Informed consumers are able to make sound choices between competing products only if they are well informed. Financial products are notoriously susceptible to misinformation because of their complexity, duration and volatility. At the same time, the critical nature of decisions that affect long-term savings makes it all the more important that decisions are made with full and fair presentation of the facts. One of the key marketing tools are league tables of past performance. In terms of financial product choice, this is often the main plank for marketing and selling such instruments. Although, as many regulators quote, past performance is no guarantee of future performance, investors will often look at performance tables before deciding on a particular product provider. Independent fund managers are therefore particularly aware that out-performance against, for example, index benchmarks and their competitors is vitally important and can be the major reason for increases in new business. To this end, we see it as a regulatory role both to educate the public in the unavoidable risks of investment and to set strict standards for the use of performance criteria and statistics. The public and professionals would gain confidence from the validity of data published under the regulatory standards set and appreciate the value of the products (i.e. from investor education).
103.
104.
105.
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No review of infrastructure system developments 106. In order to reassure itself that system changes initiated by exchanges and other infrastructure providers do not compromise the integrity or the operational robustness of the markets, SEBI should instigate a procedure to review material changes to trading and other systems. Operators proposing changes should be required to submit the changes to SEBI for assessment (within a specified time period) and approval where those changes are likely to affect the integrity of the market or the business of participants.
Poor disclosure 107. SEBI should initiate and lead a review by the exchanges of the existing disclosure requirements on an international market comparative basis and provide proposed changes that would make Indias requirements more compatible on the world stage. Indias standards have been gradually improving in this area domestically but could also benefit from the establishment of a corporate governance code and ethos for issuers. (We understand that SEBI has issued a draft code of corporate governance.) It is imperative that the international market should view the Indian market positively, and this will only stand a chance of happening when such disclosure standards are met. The Institute of Chartered Accountants of India (ICAI) should move as rapidly as possible to ensure compliance between Indian accounting standards and international best practice especially in the areas of research and development, foreign exchange, borrowing costs and business combinations. With particular reference to the bond market they need to move towards IAS standards on bond valuation, repos and market transactions. The current differences matter less in the current climate where the market involves a limited number of sophisticated investors (who can make adjustments) and a host of unsophisticated retail investors (in the equity market). However, if the market is to become broader and if, in particular, it wishes to attract foreign investor interest, conformity to international standards will become more pressing. We note that a number of top-rate companies including those that have sought listing overseas already produce accounts to international standards. Respondents in India have suggested that the level and degree of sophistication of Indias accounting standards is generally quite good, and the research above indicates support for the view that India is close to international accounting standards in many areas. However, concern was expressed that the interpretation and implementation of the standards still leaves something to be desired, and we recommend that the authorities and practitioner bodies ensure, through the auditing and review processes, that closer adherence to both the spirit and text of the standards is applied. This will have increasing importance as Indias international investing audience grows. Attention needs to be paid to the potential for confusion and conflict to arise from accounting standards being formulated and/or interpreted by more than one body.
108.
109.
110.
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The situation of having the National Advisory Committee on Accounting Standards (NACAS), the ICAI and the Accounting Standards Committee of SEBI all involved in accounting issues may lead to duplication of effort, or worse, disagreement with one another on how certain issues should be handled.
Macro-Economic Issues
111. The Reserve Bank of India (RBI) should, as far as possible, avoid having multiple objectives for economic management and should simplify its macro-economic objectives. The trend in the global economy has been away from multiple objectives, as it became increasingly clear that macro-economic management could not deliver them. As the Indian economy becomes more open to the world it will find that global economic forces remove the ability to pursue economic policies that are not consistent with those of the other major economies. In the domestic bond market the multiple objectives already lack credibility with commercially motivated investors, and the high level of intervention required causes confusion. Where it is at all practicable the RBI should adopt a longer-term approach towards monetary policy, such that the number of apparent policy changes is reduced. This can often be achieved by a broad publication of a stable outline policy that then only needs to be tweaked to affect short-term circumstances. As a first step, the RBI should be more transparent in its policy objectives. Even if the objectives are faulty, letting the market know what they are, and acting in a consistent and visible way to achieve them, enables market participants to factor them into their forecasts in a rational way, leading to smoother adjustment. In the longer term, international forces will oblige India to adopt a simpler and smaller range of policy objectives and the RBI would be well advised to prepare to move in that direction. It is obvious that a large and growing Government deficit puts strains on the ability of corporations to issue debt. The current level of Central Government borrowing is roughly the same as the current level of interest payments. India is in danger of falling into the debt trap that it wisely seeks to avoid. Indias international credit rating remains low, perhaps mainly because of concerns about the fiscal deficit. The Government of India has itself recognised that the burden of debt is not sustainable in the longer term and has introduced the Fiscal Responsibility Bill with the intention of sharply reducing Government borrowing by 2005. While the policy aim is sound, the policy itself lacks credibility both in the Indian market and even more so outside India. The Government should resist moves to dilute the provisions of the bill, however rational and realistic these may seem, as that will entirely destroy the bills credibility. The credibility of the policy could also be considerably enhanced if, after enactment, the Government of India were to publish a strategy for medium-term policies to achieve the goals of fiscal responsibility. Currently the policy has the appearance of an unrealistic and distant target, rather than a practical guide.
112.
113.
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Market Development Methodology

Poorly developed market development skills 114. There is a striking lack of awareness of the needs of a market development process suitable to the sophisticated market that India is becoming. This manifests itself in two ways: a. an unstructured and ad-hoc approach to systems development, with little documentation and little involvement of the potential users of the systems in the design or decisions on functionality; and b. a reactive response to market issues which tends to vary between a laxity of enforcement followed by a draconian clampdown. The issues are not anticipated, so there can be no preparation and each issue becomes a crisis. The decisions are then taken with little or no consultation or involvement of market participants and strikingly little awareness of the business impact of reactive responses. Frequently they are highly damaging to the market. This weakness appears to be a legacy from previous times when India was more of an administered economy and when the market participants were far less sophisticated than they are now. So an approach that has worked in the past is now less appropriate. There is a need to develop the processes and skills applied in sophisticated markets. This suggests an education programme involving two facets: a. Development of a programme of education for regulators and other agencies on the facts of market design and structure, the business of market participants and the impact of regulation. This should look beyond India to encompass the experiences of foreign markets, encompassing all aspects, covering their own and comparable, foreign markets. b. Implementation of a programme of experience exchange with equivalents in developed markets, enabling them to understand the development process in those other markets and translate it into an Indian context. The exchange element will enable those from developed markets to understand the Indian situation and assist in adapting approaches to suit its special needs.
115.
STUDY TOUR REPORT

Choice of Venues for Study Visit
116. The project included a study visit by representatives of the Indian capital market. The choice of countries for the visit was made after careful examination of the current status of the Indian capital market and where its development path was leading. Broadly there were: a. Emerging Asian markets b. Eastern Europe c. Mature markets
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117.
None was a particularly good match to the Indian situation. Emerging Asian markets were seen as inappropriate because they: a. Were generally much smaller b. Had less mature financial sectors c. Had less mature political structures d. Had less direct state involvement e. Were more open to the world economy and financial systems Eastern European markets were poor comparators because they: a. Were starting from a near collapse and failure b. Had little legal infrastructure c. Had little technical infrastructure d. Had immature political environments Finally India was not like the mature markets because those markets have: a. Diversity of participants b. Strong regulatory cultures c. Relatively stable political systems d. Legacy infrastructure e. Reduced state involvement Given the lack of a perfect match it was felt that the development path that India should be following was that of the mature markets. Many features of the Indian situation such as strong infrastructure and a long-established legal process - put it on the threshold of the mature market group. Accordingly the destinations for the study visit were chosen from among the mature markets Germany and USA. The UK is relatively well known to the Indian market participants and the project team included strong UK market experience so the UK was not chosen.
118.
119.
120.
121.
Overview of bond markets in Germany and the USA

Germany 122. Germany has a large government bond market. The government ran a substantial deficit during the early 1990s as a consequence of re-unification but its fiscal freedom is now constrained by the Stability Pact designed to protect the Euro. Its government bond has long been a benchmark as investors sought easy investment in a hard currency. With the advent of the Euro, Germany no longer has hard currency status. It now runs modest deficits within the constraints of the Stability Pact (and a long-standing policy of fiscal prudence). The majority of government debt is held by foreigners. The German banking system is segmented between commercial banks and cooperative/mortgage banks (for housing loans). The mortgage banks have been large issuers of debt (Pfandbriefe). These are not government guaranteed but the
123.
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constrained business model of the mortgage banks means their debt can achieve near sovereign ratings. Pfandbriefe have become in important asset class among international investors especially with the introduction of jumbo Pfandbriefe issued in large tranches. 124. German industry has traditionally organised its domestic currency borrowing through commercial banks rather than in the market (banks are large holders of equity). German domestic corporate debt issues are almost exclusively bank issues. There is very little debt issued other than by credit institutions. German corporates borrow in other currencies in the Euromarkets. These have traditionally been highly rated issues but in recent years the Euromarkets have seen high-yield issues particularly by telecom companies and German companies have participated. The secondary market is entirely OTC with no reporting obligations. The exchanges have made attempts to attract the business on exchange but with little success to date. Ownership and trading is very predominantly institutional. Settlement is DvP and dematerialised. The clearing process is run by Clearstream Banking (a subsidiary of the Deutsche Brse). Investors can also settle through Euroclear.
125.
126.
USA 127. The US Treasury bond market is the worlds largest bond market. Over the years the US government has run substantial deficits that have been financed by T-bond issues. Currently the US government is in fiscal surplus but is expected to move into deficit. The need to redeem maturing bonds and the desire to keep the market operational for times of deficit means the US government is a substantial issuer of new bonds. A number of quasi-government entities also issue bonds. The degree of government guarantee varies from the small issues of the Small Business Administration (used to finance venture capital) that are entirely government guaranteed to the mortgage (Fannie Mae and Ginnie Mae) and student loan (Sallie Mae) backed issues that are not formally guaranteed but are assumed to have an implicit guarantee. US municipalities borrow in the bond market. A number of major municipalities are significant issuers (New York, Chicago etc) but most of the numerous issues are small issued by small towns and localities. Coupon payments and capital gains on municipals are tax-free. Hence the municipal market has attracted significant retail participation (unlike other US bond markets where the investors are overwhelmingly institutional, including a high representation of foreign institutions). The fragmented nature of the US banking system has meant that banks role in industrial finance is less than in most other countries. US corporates are substantial issuers of debt securities at all levels of credit quality. There is a public market (i.e.
128.
129.
130.
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stock offered to all investors) and a privately placed market for offerings confined to professional investors. 131. The SEC regulates the issue of corporate bonds and municipalities particularly the disclosure. This also goes for privately placed bonds which must also be registered with the SEC. The secondary market is strictly OTC NYSE has recently abandoned its bondtrading platform. However a large number of private, electronic systems are now available for bond trading. Broker dealers are regulated by SROs and by the SEC. There is no trade reporting requirement for bond trades (except for municipalities) but the NASD, at SEC instigation, is introducing a system for reporting of corporate bond trades. Settlement is DVP (DvP2 gross stock, net cash) and dematerialised. Clearing is effected by DTCC an industry-owned utility that has a limited banking license.
132.
133.
Subjects Examined
134. The discussions during the visit were extremely frank and wide-ranging. This report has focused on those topics that are of special relevance to the bond market. The topics examined below are: a. Market structure b. Posttrade transparency c. Regulatory structures d. Supervision and enforcement e. Public Debt Office f. Auction calendar g. Consolidation of government debt issues h. Other debt issues i. Participants j. Disclosure k. Short selling l. Settlement A summary of the key findings linking them to the recommendations for the Indian Debt market is presented on the next page. This is followed by a fuller discussion of the US and German situation in each of the topics examined.
135.
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Study Tour Summary of Findings

Issue Thumbnail overview Germany Large government debt market. Heavy issuance in the past and expected to increase in future but constrained by EU. Corporate debt issuance almost all by banks. Corporates rely on bank debt and international bond issues. Almost entirely negotiated OTC. Failed attempts at offering public order books. A number of proprietary electronic trading facilities including one offered by the Exchange. Minimal retail activity. USA Large government debt market. Heavy issuance in the past and expected to increase in future. Large corporate debt market at all credit qualities. India
Market Structure
Almost entirely negotiated OTC. Failed attempts at offering public order books. Many proprietary electronic trading facilities Minimal retail activity.
Post-trade transparency
No formal reporting or publication of trade details.
Regulatory structures
Regulation is functional (i.e. linked to economic activity rather than institution type)
No formal reporting or publication of trade details. Regulator have encouraged Nasdaq to develop a reporting system which will be mandatory for Nasdaq members Regulation is functional but fragmented between a number of entities.
Almost entirely negotiated OTC in both government and corporate and confined to Mumbai. Planned electronic negotiation system. Exchange order book has not attracted trading business. Recommend maintain negotiated markets but offer exchange systems to non-professional investment. Avoid market segmentation by post-trade transparency and arbitrage. Partial reporting of trades by exchange members. Reporting and publication not timely. Recommend - move to immediate post-trade publication to improve regulation and attract new entrants Clear demarcation lines based largely on institutional structure. Effect is significant gap especially affecting
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Issue
Germany currently fragmented but will be centralised into a universal regulator.
USA
Supervision and enforcement
Central government operated regulators operating through SROs where applicable. Regulators involved in setting principles and authorising SROs to carry out those principles. Obligation on SROs and firms is act in such a way and to set up systems that ensure they comply with the principles. The regulators and SROs have strong enforcement powers which they use and they are able to apply swingeing penalties. Relatively little oversight of trading in bonds - seen as a professional market and no SRO. Exception is US municipal market where there is retail involvement. However the SEC is showing increasing interest in bond trading.
Public Debt Office
PDO separate from central band and has remit to act independently as a pure price taker in auctions.
Debt management is delegated by the Treasury to the Fed. Fed acts independently as a pure agent and does not intervene in the
India transparency of trading. Recommend ideally move towards functional regulation but in short term address gap of regulating bank trading of debt. India tends to have more prescriptive and interventionalist regulation. This is characteristic of developing markets but must be changed if a market is to move to a more mature phase. Its staff resources are rotated through government departments which weaken its skill and credibility. Recommendations move to a less prescriptive regulatory structure but with stronger enforcement. SROs should be made clearly responsible for the quality of their markets requiring them to by police abuse and demonstrate strict enforcement. SEBI staffing policies should be modified to ensure adequate levels of specialist capital market skills to improve policy and gain credibility with the regulated entities. RBI has a history of intervention and is perceived as interventionalist. Recommend independent PDO with remit to accept market
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Issue Consolidation of Government Debt Issues
Germany market. Debt office attaches great importance to liquidity which it associates with size of issue. Management has concentrated debt into 38 issues with an average outstanding value of 9bn Euros.
USA Treasury attaches great importance to liquidity which it associates with size of issue. Management has concentrated debt into 124 issues with an average outstanding value of $16bn.
India clearing prices. Fragmented issuance of government debt some 112 issues with all bar 10 having a value below Rs100bn (approx $2bn) and an average of about Rs40bn. Recommend passive consolidation (through natural redemption) has reduced fragmentation but more active measures such as swap auctions or conversion offers are required to raise the average size of outstanding issues. India has a large number of state bonds. These are illiquid and some are of doubtful credit quality. There are also a large number of retail deposit bonds offered by prime lending institutions and also by corporates. No Recommendation There is no calendar for dated stocks which are issued by auction at about 1 weeks notice. This limits the ability of participants to plan investment cash flows. Recommendation - the DMO should issue an annual calendar showing its intentions, planned auction dates, amounts and maturities. This should be updated as the governments funding requirements change or are clarified. Main investment by
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Specialised instruments
Auction calendar
Pfanndbriefen issued by home finance banks attractive to international investors high rating and heavy marketing. Move towards larger issues jumbo pfandbriefen. Commitment to predictability and transparency of issuance. 3 month calendar giving auction dates, sizes and maturity. Indicative annual calendar.
Extensive issuance by municipalities. Attracts local retail and institutional interest. Illiquid except for the largest issuers. Specialised broker negotiated market. No attempt to time the market believes liquidity requires predictability of issuance. 6 month calendar soon to be 12 month. Variable to meet new demands but in practice variations are rare
Participants
Relatively light
Massive institutional
Issue
Germany domestic institutional involvement. Approximately 50% held by foreigners. Negligible retail involvement.
USA investment capacity mainly pension funds. Significant foreign interest at times. Small retail involvement.
Disclosure
Limited corporate bond market. Regulator sets disclosure requirements for public issuer. Requirements are consistent with international standards and are subject to EU oversight.
Large corporate debt market both public issues and private placements. Regulator sets standards for both public and private issues. Standards differ but common documentation. Standards not extremely demanding but backed up by provisions on fraud applying to both issuers and intermediaries.
India banks and state-owned insurance. Pension funds not developed and not truly funded. Little foreign interest. Growing mutual fund sector. Slight retail involvement. Recommendations Liberalise investment rules for banks, life companies and provident funds. Offer trading facilities to non-professional investors Review pension provision arrangements Allow foreign entities to become 100% owners of brokers/dealers Public issues are avoided by most corporates because of time/cost. Public issues are only made for retail bonds these are highly illiquid. Private placements dominant type of issue. PP terms are implicit especially regarding default. This limits liquidity since the instrument is imprecisely specified. Recommendations Streamline public issue procedures including removing need to redisclose public information for listed companies, reduce timescale and allow shelf registration. Institute standard of best practice for private placement documentation. Enforce through rules prohibiting
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Issue
Germany
USA
Settlement
Short selling
Practically total dematerialisation in government market. Depository accounts at credit institution (banks own most broking businesses) or broker level. DvP2 gross securities, net cash. German SE operates the clearing and settlement but can settle through Euroclear. Electronic funds transfer universal. No restriction on short selling seen as essential for secondary and primary market liquidity. Stock borrowing operated by depository (automatic or using a broker).
Practically total dematerialisation in debt market. Individuals can hold depository accounts but mostly at broker level. DvP2 gross securities, net cash. DTCC operates the clearing and settlement and has limited banking license allowing money transmission. Electronic funds transfer universal. No restriction on short selling seen as essential for secondary and primary debt market liquidity (up-tick rule restricts equity short selling but does not apply to bonds). Stock borrowing arranged through intermediaries.
India regulated entities from investing in placements with sub-standard documentation. Government stock dematerialised. Settlement is paperbased but change is planned. Sophisticated depository system increasingly used for corporate debt offers individual accounts. Limited electronic movement of funds. Recommendation remove paper element of government stock settlement as planned. Reappraise RTGS plans Prohibition on shortselling of government debt. Temporary ban on corporate debt. Recommendation Remove ban perhaps for primary dealers only in short term.
Market Structure 136. In both markets the trading was almost entirely OTC. The NYSE ran an open order book for on-exchange bond trading but has now closed this because of lack of business. The German Stock Exchange used to run such a system but withdrew it in the face of very limited interest. The reason given for the preference for OTC trading include: a. Low liquidity in most bonds means need for dealers and price negotiation b. Role of dealers in providing liquidity c. Technical nature of bond trading
137.
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d. The need for personal contact to support relationships and avoid risk of asymmetric information 138. 139. [It is worth noting that these are very similar to the arguments against order books for equities.] Both markets have however experienced considerable expansion in the number -of private electronic systems offered to dealers and other participants ECNs. Both markets allow relatively free entry of such systems (Germany as part of the EU could not stop them even if it wanted to). These systems offer a range on options including restricted access (i.e. limited counterparties) and specialized trading functionalities. Trading functionality is general quote driven or bilateral negotiation (which may or may not be anonymous). DBAG, the holding company that operates the Frankfurt SE has introduced its own ECN XETRA Bonds. This offers quote driven functionality with anonymity (quotes are ranked by dealers are not identified). Trades on XETRA Bonds are non on-exchange and are not published. Quotes are visible to subscribers who may or may not be exchange members. (In short XETRA Bonds is an ECN that happens to be owned by the entity that also owns the Frankfurt SE.) Reasons for the growth of ECNs (in terms of numbers of offerings rather than volumes which are not available) include: a. Cost b. Anonymity c. Straight Through Processing It is worth mentioning that the only situation of which we are aware where the government bond market is on-exchange is Italy where MTS has a dominant share. MTS which is jointly owned by Euro MTS is a quote driven market.
140.
141.
Summing up 142. Traditionally bond markets have been OTC telephone markets. Recent developments suggest a role for electronic systems. However attempts to force or attract bond markets on to open order books have not succeeded. Bond market traders seem more likely to be attracted away from OTC trading by systems that are quote driven or allow bilateral negotiation often, but not always, offering anonymity. It is not clear how successful such systems have been but the indications are that they attract more business than pure order books. The jury is still out on which systems will succeed best but the level of anonymity, ability to negotiate and post-trade transparency seem to be critical factors in defining an attractive bond trading system.
Post Trade Transparency: Trade Reporting and Publication 143. The German bond market has no formal reporting of trades and is almost entirely opaque. A very small part is done on the stock exchange and is published. Settlement may be through Clearstream or Euroclear so there is no central point even of settlement information. The Bundesbank has no clear idea of the total size
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of the market. Neither the Bundesbank nor BAWe saw this as a problem and there are no plans to change this. 144. [This is also true of the equity market where there is no publication of OTC (offexchange, telephone) trades. However there is a requirement to report these trades to BAWe.] The US system was similar in that for the bulk of the market there is no reporting or publication of trade reports. The NYSE offered a trading facility which was little used. The exception is the municipal bond market (which has significant retail participation). The municipal market has trade reporting and some publication. However the SEC has become concerned about this and believes an increase in post-trade transparency would be beneficial in terms of: a. Investor protection b. Audit trail [It is worth noting that the audit function could be achieved by regulatory reporting without publication.] The practitioners saw little possible gain from greater post-trade transparency. They argued that: a. Bond markets, being more technical and less momentum driven, would not gain much useful information from last trade publication b. It is an institutional market c. Many stocks are highly illiquid so prices mean nothing. d. Liquidity provided by dealers would be reduced if there was publication The Bond Market Association reported that: a. There was now reporting in the Treasury market for inter-dealer trades. b. At the instigation of the SEC, Nasdaq-R is developing a system for reporting and publication of corporate bond trades for implementation next year. The system will be mandatory for NASD members (pretty much all brokers). Reporting deadlines will be relaxed at the start (30 minutes) but the aim is to tighten them to the level of the equity market (90 seconds) eventually. c. Both systems are being or will be tested on large stocks to see if liquidity is aversely affected
145.
146.
147. 148.
149.
Summing up 150. Bond markets are traditionally opaque with little reporting let alone publication of trades. Incumbents like it that way. However their arguments are not entirely convincing and are often inconsistent. The sense from other markets is that incumbent intermediaries like opacity because their knowledge and relationships give them a comparative advantage over incomers and over investors. Empirical evidence for the effect on liquidity does not exist for bond markets. However evidence from equity markets is, without exception, that liquidity is not damaged by increased post-trade transparency.
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151.
152.
However bond markets are highly international so the threat of migration to less transparent venues is a credible threat so regulators have tended to be wary of mandating transparency for bond markets (they have been more willing to act in equity markets where national ties are stronger). The growth of ECNs described elsewhere is argued by some to lead to natural transparency. The argument is that trading systems will have an incentive to publish more as a form of advertising. The evidence for bond ECNs so far does not support this. Regulatory reporting even without publication will assist regulatory oversight.
153.
154.
Regulatory Structures 155. Both Germany and USA have integrated financial institutions. Germany has tended to always have considerable bank involvement in securities. Like India, German banks are heavy lenders to commercial companies the corporate bond market is underdeveloped (discussed elsewhere) but banks issue bonds to finance corporate lending. German banks also have substantial equity holdings in top companies though they are seeking to reduce this. US banks have long been legally excluded from direct participation in securities business but that has now been relaxed. The implications for regulation are that the traditional principals of institutionbased regulation do not work any longer i.e. where all business of banks is regulated by one regulator and all business of securities firms by another. Both countries have adopted functional regulatory philosophies with the effect that a single entity bank or securities firm is subject to more than one regulator. In both countries there is a recognition that the increasing scope of financial firms is making traditional distinctions not only between institutions but also between types of business less easy to sustain. There is a convergence of participants towards a single type of business model than offers a combination of bank and brokerage services. Arguably this suggests that functional splits between regulators will be less easy to sustain. The debate is whether this suggests a need for a superregulator that covers all aspects of banking, securities and investment management business under one roof. The UK has gone that way and legislation or such a regulator is scheduled in Germany. There was some agreement in the US that this would be a logical development. However the traditional fragmentation of US regulation (where securities and derivatives are separately regulated) means there was no expectation of a merger any time soon.
156.
157.
Summing up 158. The logic for functional regulation is unarguable for any financial system where there is a level of sophistication of players. Institutional regulation can only work in such a system if there are artificial restrictions on activities of different participants. Such restrictions are distorting, suppress competition and limit innovation.
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159.
Whether convergence of financial business models supports integration of regulatory functions remains debatable. The logic is strong: a. Less chance of regulatory overlaps or gaps b. Lower costs c. Less imposition on the regulated
But the institutional barriers may be formidable. Supervision and Enforcement 160. Both countries have central agencies which co-ordinate supervisory and enforcement efforts. These show significant similarities and differences: a. Both agencies are constituted by statute, are government agencies and are accountable to the Finance Minister. b. In terms of scale and experience, Germany is a relative newcomer to market regulation insider dealing was only made illegal in 1995. Its scale of operation is relatively small BAWe has only 138 staff (by contrast the SEC has 150 staff in its New York regional office) though it is growing. c. Both countries also use SROs as front-line enforcement agencies but BAWe is more involved in day-to-day market supervision than is the SEC. BAWe has a database of transaction and other market data which is interrogates on a routine basis seeking possible cases of insider trading or market manipulation. The SEC, in contrast, delegates that work to the SROs (NYSE and NASD). This difference has come about because of differences in the regulatory remit of SROs. Broadly US SROs have jurisdiction over the entire securities business of their members and so will be able to supervise (and penalise) infractions in OTC trading as well as on-exchange business. German SROs (Deutsche Brse and the regional stock exchanges) only have jurisdiction over the business transacted on the exchange. Deutsche Brse maintains an independent market supervision unit (which reports to the local state government) but its functioning is largely restricted to supervising the use of its trading system. d. Both BAWe and the SEC are responsible for issuer disclosure setting requirements and enforcing them. The SROs may admit securities to their markets or not on the basis of objective criteria (size, spread of holding etc). e. Employees of both agencies are government employees. Both, as is common elsewhere, have problems competing with industry salaries. Germany is new to the problem but the SEC has long experience in this. Its policy seems to be to maintain a critical cadre of experienced career officials there is little movement between the SEC and other government agencies. This provides the core for a fluid group of younger employees who see the SEC as a stage in their careers. SEC staffers are in constant demand by the industry and the more aggressively the staffers pursue their regulatory brief, the more in demand they are. This factor, together with the rarity of movements from industry to regulator, ensures that the regulators do not become captive to the industry. f. Both regulators are responsible for supervision and inspection of brokers. This involves regular on-site inspections. The SEC has structured these so that most time is devoted to potential problem firms. The inspections cover capital adequacy and also, importantly they cover the enforcement investor protection
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rules including suitability (know your client) and best execution rules, the compliance function and the record keeping. Inevitably the inspections focus on ensuring firms have procedures in place and that these are enforced rather than detailed inspection but the SEC inspection will involve on-site visits by SEC staff lasting several weeks. g. Both regulators, as noted earlier, have powers over all participants in the securities market including those such as banks that are also subject to other regulators. They control entry through competency requirements and can withdraw authorisation as a last resort. h. Both regulators are concerned by the increasing fragmentation of markets and the growth of cross-border business. However, in general their attitude to these developments was that they were a consequence of other beneficial developments and so should be accommodated rather than restricted. In the bond market both countries have seen a proliferation of bond trading platforms none of which is on a public exchange. This innovation has improved the quality of the market in the view of the regulators and so their policy has been no to discourage entry despite the regulatory complexities that follow. Summing up 161. Both countries have seen that strong regulatory agencies are necessary for the sort of clean markets that will attract business. In their operation practices they both have common features: a. They tend to see the role of the regulator as setting principles rather than specifying detailed rules and regulations. The SEC is particularly strong on this for example it has consistently refused to define best execution on the grounds that doing so would provide a safe haven in which poorly performing brokers could shelter. SROs are required to define their market structures in a way that conforms to these principles. Further, firms are expected to have compliance functions that ensure the firm operates in conformity with the principles. Firms, in turn, and especially the larger firms have developed a culture of compliance they know how to meet the needs of the regulator and are motivated usually (but by no means always) to follow good regulatory practice in order to preserve their reputations. b. While not prescriptive at the detailed level the regulators are fearsome at the enforcement and monitoring level. This applies both to firms and to the performance of SROs. Investigations are often protracted but pursued with determination and stiff penalties are enforced including exclusion from the business. In practice while regulators can pursue criminal cases this has not been a particularly successful aspect of the operation civil and administrative penalties imposed by regulators or SROs have been the main vehicles of enforcement. This attitude has, to a large extent, persuaded the larger participants that the costs both legal and reputational of non-compliance are too large to risk. c. They make changes in a highly deliberative manner publishing consultation documents, conducting hearings, taking submissions etc. The process is welldefined and while slow it does ensure that regulations are more likely to achieve their objectives, fit the needs of the market, are less likely to damage the
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market and by the time they are implemented a measure of consensus has built up. d. Being driven by principles rather than detailed regulations they can be tolerant of variations in market infrastructure and practice. Therefore innovation is encouraged since regulation is permissive rather than prescriptive. It is often argued that the SEC is still too prescriptive and restrictive but it is difficult to argue that innovation has been stifled in the US market. European regulators tend to be more permissive and more willing to tolerate diversity in the interests of competition. It is argued that the rapid evolution of European markets which are technically more sophisticated than US markets (though lack the massive volumes and resultant liquidity) - is a consequence of a regulatory climate that has responded to competition by becoming more sensitive to market needs. e. They have become more integrated with their industry in their staffing while still remaining civil service organisations. It is relatively rare for staff to move from other parts of the government sector into the regulator or vice versa. The interchange is more likely to be with capital market entities. This ensures staff are fully conversant with the capital markets and is a valuable both in setting policy and gaining credibility with the regulated. Such an interchange, of course, puts pressure on remuneration levels as neither regulator can compete directly on remuneration with investment banks. The SEC and other regulators have developed personnel management policies to allow them to attract the right staff within their financial constraints. 162. In fact neither regulator has a particularly large role in the bond markets. These are seen as largely professional markets (which in those countries they are). Their role is mainly focused on issuer disclosure. The regulations on securities trading apply to bond trading as well as to equity but supervisory and enforcement activity of the secondary market is light.
Public Debt Office 163. A number of countries (including Italy, Holland, UK, Ireland, Portugal, Finland, New Zealand) have moved the issuance of public debt function away from the central bank and into an independent agency. The reasoning behind this is threefold: a. Potential conflicts between the central bank as monetary authority and as issuer of debt introduce uncertainty into the market and this is reflected in a higher cost of capital for the government (and for commercial borrowers whose rates strike off the sovereign rate). In short the central bank is the ultimate insider. It is difficult for a central bank to convince the market that it does not abuse its power so even if it does not, the argument is, the uncertainty premium will remain. b. As the dominant issuer and dominant player the central bank might act in a way that distorted the market in its favour. For example it might decline to accept the market price and manipulate the supply (or the demand through reserve requirements for example) to ensure its view of the correct price prevailed. In short the central bank is the ultimate market manipulator. As it is difficult for a
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central bank to convince the market that it does not abuse its power and the uncertainty premium will remain even if the central bank does not use its market power. c. A more commercial issuer perhaps staffed by investment banking professionals would be a more effective issuer. Its market knowledge would improve the structure of issues employing more innovative techniques and instruments. Conventional central bank staff pay and reward structures do not allow employment of the type of staff required. 164. Germany has recently set up an independent agency to manage the government debt. The new Finance Agency is answerable directly to the Ministry of Finance. It is staffed by investment bankers though the staff members are government employees. Its role (defined by statute) is to finance the governments funding requirement at lowest cost. The implication is that lowest cost is a long-term concept. They also have an objective to maintain and expand the benchmark status of German government bonds. German bonds have long been the benchmark for Europe because of the strength of the Mark and the monetary stability provided by the Bundesbank. The effect is that the German government is able to achieve a premium price for its paper. Monetary union removes this competitive advantage and the German government is concerned to maintain its advantageous benchmark status. Reason 1 above is not relevant for Germany (or any other Eurozone country) since there is no possibility of a conflict of monetary policy and debt issuance, as they do not control their own monetary policy. Where countries retain control over monetary policy as do the UK and New Zealand the removal of potential or perceived conflicts was a major factor in the decision to set up an independent debt office. Reason 2 is important in countries that have a history of substantial fiscal deficits (and which are not benchmark issuers) and where there has been pressure to use the central banks power to push rates below their natural levels. Again this was a factor in the UK and also in Italy and Portugal (both Eurozone countries). The German government sees the potential loss of benchmark status as a major threat. It sees reason 3 need for more innovative issuance strategies as the main force behind its decision. The US Treasury has long accepted that its dominant position in the market could raise suspicions about its conduct with consequences for yields. Therefore the Treasury delegates the role of issuers to the Federal Reserve. The Fed acts purely as the Treasurys agent and is not permitted to do anything other than accept market clearing prices at auctions.
165.
166.
167.
168.
169.
Summing up 170. Removing the possibility of conflicts of interest removes uncertainty even if a central bank has never abused its position and reduces debt service costs. Where a
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central bank has attempted to disadvantage the market then setting up an independent agency is a speedy way of improving a central banks reputation when it decides to move to market rates. 171. The constitution of an independent debt agency need not exclude the possibility of intervention in the market for example to alleviate a liquidity squeeze. However the greater is the restriction on intervention and the more it is limited to defined circumstances the greater the reputational gain. Increasing competition for the investors dollar means issuers have to be innovative (or willing to pay more). Central banks are poorly equipped to compete with investment bankers in arranging issues of securities.
172.
Auction Calendar 173. The US Treasury attributed the liquidity of the US Treasury market to its being regular and predictable. The Treasury has a tradition of not trying to time the market it is a price taker. In line with this strategy it has for some years published a quarterly timetable of Treasury issues. In November 2000 this became a six monthly calendar and is planned to soon become a one-year calendar. In practice issuance is so predictable that the longer calendars do not add very much new information. The calendar gives information on the auction date amount and maturity of issues coupon is decided in the light of market conditions. The Treasury accepts that its stance means that it has effectively given up risk management but considers the gains from predictability amply justify that loss. The new German debt office (and the Bundesbank before) operates issues to a quarterly calendar which gives firm commitments on size, maturity and date of auction. There is also a provisional annual calendar which gives the same information but with a lower degree of certainty.
174.
Summing up 175. Importantly both the US and German authorities stressed that even a firm calendar can be flexible when necessity arises. At any time the calendar is the current best estimate of funding needs and issue features but both reserve the right to vary the calendar. They would, of course, fully inform the market of changes and the possibility of changes. The German Finance Agency however noted that changing the calendar did not enhance the reputation of the issuer so should be done sparingly. Both saw the commitment to an auction calendar as bringing benefits that outweighed the loss of operational freedom it implies. They saw the benefits as the greater ability of investors to plan their cash flows around the issue calendar which they clearly believed would increase the attraction of the issues and hence lower their cost of capital. They felt that the loss of freedom was illusory anyway. Since they had no special knowledge of the general prospects for interest rates the only way they could capitalize on the freedom to issue at any time would be to
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176.
manipulate the market which they saw as damaging to their reputation and the market and likely to raise issue costs. Consolidation of Government Debt Issues 177. Both the Bundesbank/Finance Agency and US Treasury/Federal reserve attached great importance to their benchmark status. A large part of this they attributed to high levels of liquidity. In turn this was supported by concentrating debt into a limit number of very large issues. This had been achieved by re-opening/reissuing and retirement of smaller, less-liquid issues. The US treasury issues of marketable, long-dated (over one year at issue) securities now number 124 with an average issue outstanding value of $16bn. The figures for Germany are 38 and nearly 9bn Euros.
Summing up 178. A fragmented government marketable debt stock is seen as a barrier to liquidity in the US and Germany. The expectation of the US and German authorities is that this would reduce secondary market liquidity and lead to higher yields at auction i.e. fragmented debt structures result in a higher cost of capital. Active policies are required to create and maintain large benchmark issues.
Other Debt Issues 179. 180. Both Germany and the US have specialised instruments in addition to government bonds: Pfandbriefe are issued in Germany by housing finance banks. The bonds are backed by housing loans. They offer a yield slightly above the Bund rate and are rated AAA though they do not have a sovereign guarantee. They are actively sought after by a wide range of investors both retail and institutional. Recently issuers have taken to consolidating the Pfandebriefen into so-called Jumbo Pfandbriefen with multi-billion Euro issues. There is a relatively active secondary market encouraged by the increasing size of issues. Municipalities in the US issue bonds. Typically these are linked to projects or functions though the bonds are not securitised. There are a very large number of individual issues since even very small municipalities will participate in the market. There is considerable local interest with local citizens and banks taking up issues. With the exception of the major municipal issuers such as New York, Chicago, Los Angeles the bonds are very illiquid. Trading in the municipal market is arranged by specialised brokers who seek out counterparties. Various US government agencies issue collaterised debt securities backed by for example housing mortgages (GNMAs), student loans (SLMAs), Small Business Administration (SBIs) loans (to local venture capital groups). These may or may
181.
182.
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not have government guarantees for example the SBIs do not and there were substantial defaults in the early 1990s. Participants 183. Neither Germany nor the US had requirements that investing or credit institutions should invest in government (or any other particular type of) securities. Corporate governance codes in the US would not accept heavy investment by banks or other corporates in government securities. German companies, including banks, have been investors in equity and hold large, strategic (i.e. non-tradable) stakes. They have sought to divest themselves in recent years as shareholders in German corporations (many of whom are now foreign) have begun to question the holdings. Difficulties with taxation have prevented this progressing as fast as shareholders would wish but the trend is to reduce strategic holdings. Both countries have been successful in attracting foreign participation in their government bond markets. Both were jealous to preserve their benchmark status. They saw this as enabling them to issue large amounts at finer rates. They saw their success as being a consequence of having large and liquid markets. They saw the size and liquidity of their markets as being largely a consequence of transparency, predictability and fiscal discipline. Pension provision is an important factor in development of capital markets. Pension provision is inevitably pay-as-you-go in terms of the real economy a pension means that output produced by the working population is diverted to a member of the retired population. The important question is how that transfer is effected. There are 4 possibilities: a. A social contract whereby the money to purchase resources is taken through the tax/social security system and passed on to pensioners (France, Italy). b. A business contract whereby an employer undertakes to allocate future cash flow to pay pensions for ex-employees (Germany). c. An individual investment arrangement whereby individuals invest directly in assets to fund their retirement. They may do this entirely independently or through an organisation that provides administrative and custodial support (increasingly USA). d. A collective investment arrangement whereby a group of individuals pool their investments in assets. The manger of the pool takes the investment decisions as well as providing administrative and custodial support (UK, Holland and Chile). Most economies will have a mix of types of provision but usually with a bias towards one or other. Countries that have type 4 or type 3 arrangements tend to have large well-developed capital markets. Countries that have arrangements of type 1 or 2 will tend to have less well-developed capital markets except to the extent that they are able to attract investment from pension funds in countries with type 3 or 4 arrangements. Thus Germany has a developed capital market with a
184.
185.
186.
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majority of the assets being owned and traded by foreign entities largely US and UK pension funds. 187. Arguably a well-developed capital market is essential for funded pension arrangements (types 3 and 4) to succeed. But equally the history suggests that pension funding is a major stimulus to the development of capital markets. This has historically been the case in the US and UK. More recently the development of capital markets in other countries has been stimulated by foreign investment i.e. from foreign pension funds. Pension funds have been the only investment vehicle that have successfully mobilised large sums of money from individual savers for investment in the stock and bond markets. Their size in the US and UK reflects their ability to mobilise funds of the broad mass of the working population, not just the richest. Mutual funds may also be important but they are small relative to pension funds and, since retirement is the main reason for savings, much mutual fund investment is really self-managed pension schemes. Successful pension funds need to reassure contributors that the long-term contracts will be honoured. In the US and UK there is no guarantee of investment returns (though defined benefit schemes do transfer the risk from the scheme-member to the scheme sponsor). Nor is there a guarantee against fraud. Regulation is through the normal fraud laws, through requirements for independent audit/trustees and more recently through Minimum Liquidity Requirements. These latter require that funds be in a position such that if they were liquidated then the proceeds would be sufficient, if reinvested, to meet future pension obligations. The USA has a large and highly developed pension fund industry offering a combination of company schemes (type 4) and privately managed schemes (type 3). The bulk of domestic investment in equity and bond is owned by these funds. ERISA requirements on company schemes have pushed fund mangers into foreign investment to diversify holdings Germany has a combination of state provision (type 1) and corporate provision (type 2). German corporates have typically been investors in equity of other corporates, as have banks though they are now seeking to divest. As in other countries with large sate schemes the pressures on those schemes are threatening their viability and encouraging a government-led push for private funding of pensions. The development of the German capital market really took off in the early 1990s when US managers adopted a higher level of diversification. The majority of holding of German equity and government bonds are in the hands of foreign investors.
188.
189.
190.
Summing up 191. Neither US of Germany requires their banks or corporates to invest in government securities. Traditionally German banks have had large equity and corporate bond holdings but these are now being reduced under pressure from shareholders.
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192.
Benchmark status attracts foreign participation in government bond markets which widens the market and reduces capital cost. Benchmark status requires a liquid market which in turn requires transparency, predictability and fiscal discipline. Funded pension schemes where there is competition between providers have proved to be a powerful force in the development of capital markets in other countries. Countries without funded pension arrangements tend to only have developed capital markets to the extent that investment from pension funds in other countries is attracted. While pension funds grew up at the corporate level with centralized investment strategies and corporate guarantees, the trend has been towards transferring the investment risk to the members. Inevitably this has led to a greater involvement of scheme members in the investment decisions. Pension funds can succeed only where they attract a large number of ordinary workers as members. This will happen only if state schemes do not offer returns which are inherently superior for the bulk of the working population. In order for them to earn a decent return, pension schemes must have freedom to invest. Their trust deeds may limit investment vehicles but that is a private matter for the fund. Competition between funds will drive down costs and force funds to hunt for better returns. Competition implies risk that the fund may not perform as well as claimed or expected. Government guarantees for private schemes are unworkable. The guarantee against fraud has to come from a regulatory structure involving extensive independent oversight.
193.
194.
195.
196.
Disclosure 197. The responsibility for enforcing issuer disclosure rest mainly with the regulators BAWe in Germany and the SEC in the USA. They are responsible for ensuring timely and fair disclosure by companies that make issues of securities. The patterns are similar in the two countries but the USA has a far more significant corporate bond market than does Germany and so is more relevant to this project. The SEC requires issuers of securities to register those securities with the SEC. To achieve registration issuers must comply with SEC requirements on disclosure. The procedure differs between bonds for public issue and those for private placement (the 144A market for professional investors). However, the documentation is standardised for all types of issue. In practice the disclosure levels for public and private issues are essentially the same. Investor pressure has forced greater disclosure. Issuers that have equity in public issue (i.e. traded on an exchange) can issue bonds using a short-form prospectus which only requires the information specific to the bond issue (terms, use of proceeds, trustee etc). Issuers can also gain approval for shelf registration programs giving the right to issue tranches of securities over a period with varying terms to suit prevailing market conditions at the time the tranch is issued.
198.
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199.
The regulatory specifications for disclosure are not particularly demanding. It would, in theory, be possible for an issuer to comply without disclosing significant information but the disclosure requirements are backed up by a number of regulatory provisions and commercial forces that would impose sanctions on an issuer that failed to disclose fully. These include: a. The general laws on fraud make it a criminal offence to issue securities where material omissions have been made in the disclosure. These laws are binding on issuers and also on dealers who can be prosecuted if they trade the issue knowing there are such material omissions. The SEC is responsible for bringing these cases and does so with vigour. b. Investors have certainty of timely and effective legal recourse against issuers in default. Where the default is purely commercial (i.e. no fraud) then the process allows rapid action to either reconstruct the company (chapter 11) or realise the assets. c. Issues must conform to required accounting standards US GAAP is becoming a global standard. d. Auditors putting themselves on the prospectus will put preservation of their reputation ahead of any short-term gains from non-disclosure. Increasingly audit business is concentrated in a small number of global firms. While this may be bad in some respects (such as raising the costs of issue) the big 5 are extremely protective of their reputations. e. Similarly, business is increasingly concentrated in a few global investment banks that have reputations to protect. The same goes for credit rating agencies. f. Investment banks have long-term relations with their customers so they scrutinise issues to ensure their customers are not sold bad stocks. g. Issuers themselves increasingly see the market as a repeat game they will be back so they want to ensure investors will welcome their next issue. h. In an institutional investor market, investors have considerable power and will blacklist issuers that do not conform.
Summing up 200. The US has a very active corporate bond market. In part this is historically a function of its relatively underdeveloped banking system but this has been driven also by a desire to novate and disintermediate. The result is a system that gives bond market access for corporates of most credit qualities. Many countries have sought or are seeking to emulate the US system for bond issuance (including the EU where smaller, more lowly-rated companies have little access to bond markets). [It is worth noting in passing that the US Small Business Agency has successfully mobilised seed capital debt finance for venture capitalists through securitisations backed by government guarantee.] Investors will only invest in smaller corporates if they have confidence in the level of disclosure and it is the success in fostering a culture of disclosure that the US has been most successful. This has, in the view of practitioners, been driven by regulators in setting basic standards but commercial pressures have reinforced the culture. There was agreement that without the regulatory requirements and enforcement the disclosure culture might not have developed.
201.
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202.
However, the important point is that there is now a regulatory underpinning and standardisation of documentation but that commercial relationships are the main enforcement mechanism for the big issuers. The provisions of the fraud laws etc are more likely to be applicable to the small, infrequent issuers and the SEC focuses its attention through reducing the regulatory effort needed for larger issuers by allowing short-form prospectuses and shelf registration. The key elements are therefore: a. Legal obligation to disclose b. Basic and standardised disclosure standards for all issues c. Clear legal recourse d. Focus on likely problem issuers e. Placing disclosure responsibilities on intermediaries f. Encouragement for growing professionalism among industry participants so that reputations become too valuable to risk.
203.
Short Selling 204. Neither country has restrictions on short selling. The US equity market has an uptick rule (prohibits short selling into a falling market) but there are no restrictions in the bond markets. As a point of policy the authorities saw short selling as a major contributor to liquidity in the markets both primary and secondary. In primary markets dealers especially and other investors also would make room for the new stock by shorting existing stock. Since dealers, in particular, do not want to take large exposures shorting for the auction allows them to use their capital more efficiently and so take up more new stock than they otherwise could. In the secondary market short selling allowed efficient arbitrage of price anomalies so assisting market efficiency. It also assisted liquidity in the corporate debt market by allowing credit arbitrage on the corporate yield spread. Both countries have efficient stock borrowing and lending facilities to remove the settlement risk inherent in short selling. In Germany borrowing may be arranged automatically through Clearstream Banking AG (the settlement agency and depository for German securities) or they may be negotiated directly between participants. The US system is more informal with borrowing being arranged through intermediaries.
205.
Summing up 206. Short selling is valuable in assisting in liquidity and permitting larger auction bids. Manipulative shorting is unlikely in large government bond markets. An efficient system of stock lending is required which may be formally offered by a settlement agency or may be informally arranged by market participants (informally in the sense that there is no central point but not informal in the sense that transactions are allowed to roll-over without settlement).
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Settlement 207. Government bonds are dematerialised in both US and Germany. Participants in both countries saw secure, efficient settlement as one of the hygiene factors without which no bond market could succeed. The German depository is run by Clearstream Banking AG (CBAG, a subsidiary of Deutsche Brse, the stock exchange) which also operates the settlement function. Settlement of securities is trade for trade (gross); settlement of cash is simultaneous but net (DVP2). Securities are held in collective accounts on behalf of credit institutions rather than in the names of investors. German government bonds can also be settled through Euroclear which interfaces on a net basis with CBAG. Germany is moving towards a system of pre-funding i.e. participants lodge deposits of stock and money and trade from these deposits (the nature of the German system as essentially an inter-bank market makes this more acceptable than it would be in a more broker-dealer oriented market) US government stock is held in dematerialised form in a depository run by the US Treasury. Individuals may open accounts with the depositary. Clearing is through DTCC. DTCC is a limited purpose bank (it can transmit money but not take deposits). Currently settlement is trade for trade with DTCC instructing each transfer in the depositary. There is a plan to move towards a system allowing DTCC to submit batches of transactions with net movements. Both countries have full EFT systems. These are long established and are integrated with the securities settlement systems.
208.
209.
210.
Summing up 211. India has sophisticated government securities depository functions to handle the stock side of transactions. The main weakness is the sequential nature of processing which limits short-selling (even if it were not banned). Its deficiency is on the cash side where there is an effective but limited EFT system. In Germany and USA the EFT systems were developed independently of the securities side which was a later addition. In fact the German system does not yet offer RTGS for securities settlement but this is planned for end 2002. Both countries have moved from paper, trade for trade settlement to dematerialised RTGS over a long period in a number of stages allowing participants to become familiar with the new technology in stages rather than through a big bang approach.
212.
Meetings and Participants

Dr J. Bhagwati (Head of Delegation) Joint Secretary (Capital Markets) Department of Economic Affairs Ministry of Finance
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Mr K.R. Ganapathy Mr P. Kar Mr R.K.N Kumar
Chief General Manager-in-Charge, Department of Information and Technology, Reserve Bank of India Executive Director Securities and Exchange Board of India Assistant Vice President Development Team National Stock Exchange Executive Director National Securities Depository Ltd Consultant, Project Team Leader International Securities Consultancy Ltd.
Mr G. Rai Mr S. Wells Dates 213.
The group visited Germany from 8 to 9 November and the USA from 12 to 16 November. The 12and 13 were spent in New York, the 14 and 15 in Washington and the team split between New York and Washington on the 16.
Meetings 214. Germany Deutsche Bundesbank Joachim Fuchs Senior Project Manager/ International Relations Gerhard Klopf Head of Dealing Section Bianca Schenfelder Payment Systems Oversight. Karl-Heinz Beckman Op. Manager, Trade Settlement and Custody Services Dr Stefan Markscheffel Technical Project Management RTGSplus Finance Agency David Derwis Press and Investor Relations Dr Carsten Lehr CEO BAWe Georg Wittich President Angie Reeh-Schild International relations Thomas Eufinger - Director, Directorate II (Market supervision and issuer disclosure) Dr. Holger Schaefer Asst Director, Div. for Rules of conduct and credit institutions. Deutsche Brse Dr Dirk Schloctermeyer Head of Market Policy Mr Achim Brosch Market Policy Marc Becker - Deutsche Brse Systems AG, Division Information Products
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215.
USA Lehman Brothers - New York Theodore Rooseveldt, Managing Director David A. Demuro, Managing Director, Global compliance and Regulation Salomon Smith Barney - New York Jeffrey Shafer Vice Chairman SSB International Geoffrey Hunter Managing Director, International Debt Markets Stephen Taran Managing Director, Corporate Bond Research Goldman Sachs & Co - New York Robert Hormats Vice Chairman Bond Market Association - New York Micah Green President V. Paul Chattergy - Director, Strategic Planning and Development Lori Trawinski Director of Research SEC NYC Office Robert Sollazzo Head of Broker Dealer Inspection Tim Hanson Enforcement Section Federal Reserve Bank NYC Office Lawrence Sweet Vice President Joel Stein International Affairs Dara Hunt Senior Vice President & Wholesale Payments Product Manager Om Bagaria - Senior Vice President, System Development Function Thomas Connolly Regional Check Manager US Treasury - Washington Timothy Bitsberger Deputy Assistant Secretary for Federal Finance Paul Malvey Director, Office of Market Finance Geetha Rao International Economist Nasdaq Regulation - Washington Mary Schapiro President Malcolm Northam Director, Fixed Income Securities Regulation Federal Reserve Bank - Washington Brian Madigan Deputy Director, Division of Monetary Affairs Jim Clouse Head of Section, Treasury Securities Market Securities Exchange Commission - Washington Robert Strahota Assistant Director, Office of International Affairs Stephen Weinstein - Assistant Director, Municipal bonds Section Ester Saverson - Assistant Director, Office of International Affairs Morgan Stanley New York Victor S. Garber, Managing Director
216.
In general the entire party attended meetings. The exceptions were: a. Only Mr Ganapathy and Dr Bhagwati attended the latter part of the meeting with the Federal Reserve in New York. b. Only Dr Bhagwati and Mr Wells attended the meeting with the SEC in Washington.
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c. Only Mr Kar, Mr Ganapathy, Mr Rai and Mr Kumar attended the meeting with Morgan Stanley. 217. The meetings with the US Treasury, Nasdaq-R and Federal Reserve (Washington) were accompanied by Dr Alok Sheel of the Indian Embassy in Washington.
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Volume 2 Analysis and Recommendations Chapter 3 Secondary Market Participants
Chapter 3 Secondary Market Participants

218. The Indian market, for both Government and corporate bonds, displays the main types of player that would be expected in a domestic, secondary bond market: a. Investors: banks, both deposit-taking commercial and development banks; institutions, insurance companies, pension funds (known as provident funds) and mutual funds; retail clients which includes corporate investors whose participation is very limited; and co-operative banks. b. Intermediaries: primary dealers in the Government securities market; brokers acting in their traditional agency role; and satellite dealers, who do not account for much volume. The Indian market is different from many other markets in two important respects: a. Banks and institutions all have varying degrees of state ownership. b. Foreign investors are almost entirely absent, although their participation is allowed; the relatively low sovereign credit rating combined with the barriers to full convertibility on the capital account have largely deterred them. This is despite the fact that they have been permitted to take forward cover for their debt investments.
219.
Common Barriers and Recommendations 220. In later paragraphs of this chapter we look at specific issues, barriers and recommendations for the various participating institutions in the market. In this section we examine some broad issues relating to the number, nature and background regulation of participants.
NARROW INVESTOR BASE/LITTLE DIVERSITY

221. The nature of the Indian market is unusual. It is a transition market moving from a highly state-owned and controlled structure to a more private enterprise structure. There has been a realisation that the old system did not deliver the levels of growth and development that India requires. However, unlike many transition economies, the previous system has not demonstrably failed or collapsed. Therefore, many of the old institutions persist in forms that bear strong similarities to those of the previous system but which are in the process of attempting to change themselves into genuine commercial players. Similarly, many segments where a state monopoly incumbent held undisputed sway have been opened up to new entrants. However, we caution that often state-owned/controlled entities retain a dominant market share (e.g in banking, primary dealer business, mutual funds and life insurance). These new entrants inevitably struggle, lacking the critical mass of customers and distribution networks of the incumbents, but are making some headway. The future development of the capital markets generally and the bond market in particular will depend upon the success of this transition process: i.e., will the
222.
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incumbents be able to develop commercial skills, and will the new entrants gain sufficient business? 223. Although the situation is changing, many of the participants that actively participate in the market are either fully or partly state-owned and the number of major participants is relatively low. For example, many corporate bond placings, even of relatively large size, are placed among no more than a dozen institutions at the outside. Secondary market activity is similarly limited in scope. Further, investment guidelines that apply to banks, insurance companies and pension funds often significantly restrict participation, discourage innovative behaviour, limit competition and reduce the returns to investors. In developed markets, and increasingly in India, there is generally a lack of confidence in the quality of state-owned or managed investment institutions. The world over, the more commercially oriented players consider that the market is held back by the lack of diversity of view, perverse incentives and lack of skill that is typical of state entities. Hence, the policy direction towards privatisation, with genuinely independent ownership of the major investment and financial institutions, is likely to be particularly beneficial. In interviews with market participants, we received comments that there needed to be more participant organisations (i.e. with more diverse investment requirements). We concur with this even though the direction of change is moving towards supporting competition. A number of institutions believed that, since Government stakeholdings in so many of the major investors remains so high, the trading of Government bonds, in reality, did previously amount to a zero sum game between the RBI and the leading investment houses. They also believe that, as the Government is gradually disposing of its stakes, it is becoming less so. The Government has a stated goal of reducing its shareholding in finance firms. However, in the case of banks, the existing policy regime envisages Government shareholding staying above 33%, and that banks would retain their public sector character. Even in those institutions where Government or quasi-Government stakes remain, it would appear that incentives to make profits are now taking over from acting merely as facilitators and developers. As more privately owned players enter the market, further real privatisations take place and a more competitive market spirit is achieved, the lack of diversity and its consequences on secondary market trading will further diminish. We are therefore inclined to agree with most interviewees who believe that while the Government bond business, in particular, could have been considered to be a zero sum game even a year ago, it is already going through a change process. However, in our opinion, this change process could be a more rapid one. Markets only work where there is diversity of view and objectives. Without that, the only event is the investment of new inflows. This is characteristic of the Indian bond market (and others) where the usual strategy of investors is to buy and hold.
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224.
225.
226.
227.
228.
This is not unusual with illiquid corporate bonds, but in India a buy-and-hold mentality permeates the entire corporate bond and Government bond market. While it is accepted internationally that around 70% of all bonds are purchased to hold to redemption, the pure size of Indian issues alone should leave open for trading far more volume than is currently evident. 229. Diversity is needed in: a. Risk appetite: some participants need to be risk seeking and others need to be risk averse. b. Investment strategies: some participants need active investment strategies, whereas others may adopt passive ones; this will reflect in the demand for stocks with large capitalisations and those with small capitalisations and other differentiating factors. c. Investment goals: some investors will look for growth and some for income, with many combinations. d. Investment horizons: some investors will require long-term investments (e.g. life insurance companies and pensions institutions), whereas others will require short-term investment (e.g. open-ended mutual fund managers). e. The participants tax situation: some will look for income and some for capital gains to minimise tax liabilities. Combined with differences in investment outlook, diversity in the above areas will make for an active market. In our view this is the key feature. It is possible to have active markets with diverse participants but poor infrastructure, though the reverse is not true. Some of this diversity is present in the Indian market for example, we shall see that there is a greater diversity of mutual fund types but too often we heard of a small band of participants all with similar objectives and outlooks. For example, while bond funds which invest in distressed debt are quite feasible, in practice all bond funds tend to be buyers of high-grade corporate debt. The market design should seek to avoid regulatory inconsistencies and tax anomalies, if these exist. For example, it is visualised that when order matching on exchanges comes about for Government bonds, banks might be prohibited from participating in it. Such inconsistencies produce artificial outcomes, which are not driven by economic efficiency. Trading driven by these factors aggravates inefficiencies, distorts investment flows and encourages abuse.
230.
231.
Recommendations 232. The general policy direction of the Government agencies charged with responsibility for financial markets should be to encourage greater diversity among participants. Some actions that will encourage this are: a. Divestment of state holdings in financial institutions as rapidly as is prudent: the upside for the Government is that divested entities are no longer the financial responsibility of the Government: b. avoidance (or removal) of policies designed to restrict entry other than where there is a genuine and demonstrable prudential need: one key lesson of modern finance is that size is no guarantee of probity or sustainability; and
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c. prudential controls on access should be based on regulatory compliance rather than relying purely on size. d. Removal of explicit guarantees from state-owned or other entities (even though very few of these remain): these distort the competitive framework and prevent new entrants from gaining access. e. Clarification of implicit guarantees: these similarly distort the competitive framework.
LACK OF BOND MARKET EDUCATION

233. Of the fund management groups that we interviewed, relatively few appeared to have investment strategies, other than buy and expect to hold to maturity. We noted a similar lack of awareness among intermediaries. It is clear that the market, and the regulators, could benefit from training in this area. Even if the fund managers are aware of bond trading techniques, the uses and advantages of employing such techniques will also need to be appreciated by the trustees of mutual funds, provident funds, insurance companies and charitable trusts. We also observe from interviews that retail investor education in bond trading and investing has not been a high priority. More generally, there is a failure to understand the nature of interest rate risk in bond trading, and we noted the tendency to believe that an investment through a state-owned or quasi-state-owned entity in equities was seen as more secure than an investment in a high-grade corporate debenture. Perhaps this is because this area is largely an institutional market and it has been felt unnecessary to educate professionals who could in turn educate and advise retail investors. However, it could be an area that would provide significant benefit.
234.
235.
Recommendations 236. Education is driven by: a. demand-side factors such as requirements that practitioners achieve a certain level of competence demonstrated by education and testing; and b. supply-side factors ensuring that the requisite courses are available. In our experience a regulatory push to install and enforce competency standards brings forth private sector suppliers. Our understanding is that the system of accreditation offered by the NSE will soon be extended to incorporate a bond market module. We see this as very positive and recommend that the market regulator take steps to incorporate this into the requirements for recognition of bond market practitioners. We recommend that a range of private suppliers be encouraged to develop teaching materials, etc., to support the accreditation. The regulator could and should do more in the way of publicising the risks and rewards of investment, especially bond investment. Interest rate risks need to be pointed out to investors, as does the fact that investment in medium/long-dated
237.
238.
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marketable instruments should be seen as a medium/long-term investment strategy, not a temporary home for surplus funds.
BANKS
239. Banks, particularly those that are privately owned, need to be competitive and efficient in order to expand and survive in their financial services activities. Although most banking regulation is based on the Prudent Man rule, there is a great need for banks to be innovative and to accept certain degrees of risk in their business. To this end, and in order to compensate for the inevitability of bad loans, it is necessary to generate extra profits, i.e. in excess of their asset/liability matches. Where reserve requirements are high, thus requiring large amounts of Government and other high-quality bonds to be held in the banking book, often to maturity, this reduces the potential for banks to secure such extra profit from the resources allocated to their trading books. Where the trading books can be utilised to generate new profitability, this permits the banking community to reduce margins on their lending portfolios and thus establish better lending rates for the industrial and public communities. As long as the supervision of such activity monitors the effectiveness of bank risk management policies and practices, this will encourage commercial development and offer new business opportunities, particularly in the small and medium enterprise sector. There are 106 scheduled banks in India (banks that can offer the full range of banking services nationally) as at 31 March 2000. Their ownership structure is shown in Table 3.1.
Table 3.1. Ownership structure of banks Ownership Number
240.
241.
State-owned Private domestic Foreign Total 242.
27 34 45 106
Banks are the largest group in terms of holdings, representing around 60% of all Government securities. In the 1999 RBI estimate of the balance, 18% was held by the LIC and 9% by the RBI itself, leaving only 13% for other holders. Banks are obliged to hold 25% of their deposits in eligible securities (the SLR requirement). Eligible securities are Government bonds, state Government bonds and Government-guaranteed municipal bonds. Yields on state and municipal bonds are higher, so banks hold a proportion of these. Also, although it was not stated explicitly, there seem to be serious doubts about the credit quality of some state and municipal issuers. In theory, these are both Government-guaranteed, but among participants there is considerable doubt as to whether the guarantee would be honoured and, even if it were, the costs of delays while claiming would justify a premium on the coupon rate.
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243.
The SLR requirement has been progressively lowered from 38.5% in 199192 to 25% now, but in practice most banks continue to hold more than the minimum (excess SLR). Between 199798 and 19992000, banks held an average of 30% of their net deposit and time liabilities in Government securities. The RBI Credit Policy of April 2001 reports the banking system holding 35% of net demand and time liabilities (NDTL) in Government securities. The reason given is that corporate and other lending is more risky, and that demand for commercial credit is sluggish in the current economic conditions. Banks hold a substantial stock of corporate bonds issued by highly leveraged parastatal finance companies (the All-India financial institutions, or AIFIs), since these have been deemed eligible for reserve requirements of banks. Apart from this, banks tend to hold only small amounts of corporate bonds, usually acquired through underwriting commitments, and are not active investors or traders in this market. There is little incentive for officials of state-owned banks to take additional risk. A failure or loss will lead to career damage, whereas a success will bring little reward. It is far easier to maintain a high proportion of Government bonds with zero risk of default. Since most state banks operate an investment policy of buy-and-hold, they have tended to concentrate on default risk. The incentive structures of state bank officials do not reward successful risk-taking; whereas in the private and foreign banks sector, staff remuneration is more likely to be linked to profitability. Private and foreign banks also have much greater flexibility in hiring and firing. Larger banks now trade their excess SLR portfolio in particular, the Bank of Baroda, Bank of India, Canara Bank, Central Bank of India, Punjab National Bank and State Bank of India (largest by an order of magnitude). This has developed over the last three to four years. Our estimate is that scheduled banks represent up to a third of all Government bond trading (c.f. holdings of 60% of all Government securities). Banks are also allowed to hold repos as part of their SLR requirement. Thus, in theory, the whole of their SLR portfolio is tradable, but our understanding is that most, although not all, limit their trading to the excess SLR holding. For regulatory and valuation purposes, banks holdings of Government debt securities are divided into three classes: a. held to maturity or permanent; b. available for sale; and c. held for trading. Those in the held to maturity category are not marked to market but held at book value. They cannot exceed 25% of the investment portfolio of any bank. It has been proposed that they be marked to market, but the banks have a number of bonds in their portfolio that would show a substantial capital loss at current valuations. The modern approach to valuation and reporting has a strong bias in favour of complete marking to market. Accounting measures yield inaccurate information about the
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244.
245.
246.
247.
248.
249.
liquidation value of a finance company (e.g. a bank) if any subset of its assets or liabilities is not marked to market. Once the held to maturity part of the portfolio is marked to market, there would be incentives to trade the bonds. Practitioners seem to think that securities held owing to SLR requirements are generally not traded. It is not clear whether this is a rule of thumb used by firms with weak IT systems, or whether there are other aspects (such as hidden losses on the held to maturity bonds) which make this an optimal policy. 250. The available for sale category bonds must be marked to market at year-end, or more frequently if the bank so decides. Gains and losses do not accrue to the income (P&L) account. The held for trading category must be marked to market at least monthly. Regulations in this area significantly lag those found in Indias mutual fund industry, where valuation is calculated daily, exploiting computers which are now ubiquitous. Trading profits/losses appear on the income account, as do unrealised gains or losses. RBIs valuation norms sometimes involve a value which is the lower of book value, market value or the cost of acquisition. This is inconsistent with the marked-to-market approach, where the only regulatory concern should be to require valuation using sound models when secondary market liquidity or transparency is suspect. Banks have passed through a significant process of evolution in terms of progressive stringency of prudential norms, phased programs of marking to market, etc. The categorisation of investments into three groups, (held to maturity, available for sale and held for trading), the norms for valuing the portfolios and the frequency at which they are revalued, requires banks to be concerned with interest rate and price risk, in addition to default risk. The concept of risk in a Government securities portfolio is increasingly well understood. Banks today do a significant amount of trade using excess SLR holdings. However, the majority of Government stock is locked away in holdings that cannot be traded or is only traded by the more adventurous/skilled banks. This freezing of stock is a factor which inhibits the development of a liquid secondary market.
251.
252.
Recommendations 253. We recommend that the Government develop a plan for disinvestments in public sector banks. Currently, one factor which is a significant barrier to active portfolio management among banks is a lack of skills and incentives at the staff level. Incentive and career structures in state banks do not encourage or reward dealing success, so it is unlikely that there will be any great increase in trading from this source unless the ownership, skill sets, employment structures and cultures are changed. Private sector enterprises typically have better performance incentives for employees, which result in better motivated staff. There are two aspects to the question of incentives which are relevant for market liquidity: efficiency and the enforcement against market misconduct. There is a passive aspect where employees may not put in their best effort when poorly incentivised, and also a more profound problem where employees may engage in actions which are explicitly against the interests of their shareholders.
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254.
We consider that investment guidelines, such as the SLR requirement, are generally not conducive to market development. The current situation is that despite high Government bond issuance, the banks still retain 60% of the issuance (LIC, which is similarly constrained, has a further 18%). Whatever their original reason, we came to the opinion that their retention owes much to the desire to have a ready market for Government debt. (It is, of course, arguable whether forcing state-owned entities to hold sub-optimal portfolios helps the Governments overall fiscal position and benefits the economy). The RBI has encouragingly reduced the SLR requirement. However, as we have noted, banks choose to hold more Government debt than they are obliged to. Whether this will change as the economy turns and demand for credit increases is an open question, and much will depend upon the culture of the banks and their desire to increase profitability. A reduction in the SLR would, at the least, remove a potential obstacle. It would also remove an excuse for not expanding corporate lending activity and be a further signal of the move towards a more market-driven financial sector. We recommend an extension of the requirement to mark to market to all bank holdings. This could be an incentive to trade to prevent the occurrence of capital losses under the cover of book values. It also makes prudential sense, since the objective of reserves is to secure a bank against a run on deposits. Therefore, knowing the true value that banks can raise from their security portfolios has more prudential value than knowing what they paid for them or what they would be worth at maturity. RBI should be careful to require valuation using the zero coupon yield curve when the secondary market is non-transparent or illiquid, as is the case with the existing secondary market. Marking to market might put pressure on weaker banks by revealing their lack of capital. Arguably this would not be a bad thing, since it would force a contraction of weaker banks relative to stronger ones. However, in the current situation, it would be prudent to have a phased programme working towards a full mark to market regime. State-owned banks do not have incentive structures that enable them to retrain staff of the skill and quality required for successful bond market operations. The problem has been seen in other markets were even private sector commercial banks have not been able to retain staff in competition with investment banks. This is an even more acute problem with state-owned Indian banks where rigid salary structures prevent rewards based on success. The state-owned banks have, according to the RBI, suffered extensive poaching of staff by private sector participants. For state-owned banks to participate successfully in the longer term in bond market trading they will have to make major changes to their personnel policies including changes to salary structures, bonus incentives and dismissal, If banks are able to work their Government bond portfolios more profitably, then this will generally enhance their profitability or allow them to reduce costs to
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255.
256.
257.
258.
259.
borrowers and increase returns to depositors. If firms do not have in-house skills or lack the organisational structure for a change in the style of doing business, both of which are true for many banks, they could successfully outsource fund management. (Banks, in the main, currently outsource order execution to brokers.) Therefore, we recommend that banks be allowed to outsource management of their portfolios to professional fund managers. 260. The simplest way of doing this would be to allow banks to hold gilt mutual funds in place of Government stock in their SLR. (Currently, banks can hold their excess SLR in gilt funds but not the core SLR.) Since these funds have daily NAV calculations, the value of the SLR holding would be known. Banks could profit from the enhanced returns that professional fund managers could achieve on their gilt portfolio. Naturally, there would have to be regulation of diversification to ensure that banks invest prudently. Investing in gilt funds would imply marking to market, since NAVs (which are derived from the regulatory regime for mutual funds) are purely market value-based. Gilt funds have SGL accounts, so the RBI would continue to know precisely what was happening to the banks holdings. An impediment to development of a repo market is the shortage of potential borrowers. In other markets, the main borrowers would be primary dealers seeking to cover short positions. However, Indian primary dealers are not permitted to have short positions. We recommend here (as elsewhere in the report) that this barrier be removed.
261.
MUTUAL FUNDS
262. From 1964 until 1987, the mutual fund industry was confined to a single player, the UTI. In 1987, public sector banks and insurance companies were permitted to set up mutual funds; and since 1987, six public sector banks have set up mutual funds. Also, the two insurance companies the LIC and the General Insurance Company of India (GIC) have established mutual funds. In 1993, SEBI formulated the Mutual Fund Regulations, which for the first time established a comprehensive regulatory framework for the mutual fund industry. Since then, several mutual funds have been set up by private and joint ventures. The industry also has a trade association, the Association of Mutual Funds of India (AMFI).
263.
Unit Trust of India 264. UTI was established under the UTI Act 1963 as a public limited trust which manages the funds mobilised from the public through various schemes (each of which is like a mutual fund scheme). Subsequent mutual funds are regulated by SEBI under the SEBI (MF) Regulations 1996 (originally, 1993). All mutual funds, except UTI, are under the regulatory purview of SEBI. The Income Tax Act does not provide Indian mutual funds a pass-through status that exempts them from income tax (under Section 10(23)D) unless they are registered with SEBI under the SEBI (MF) Regulations 1996.
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The SEBI (MF) Regulations do not supersede the UTI Act 1963, which is not yet repealed. As long as the UTI Act holds, UTI is required to be regulated under the provisions of the UTI Act. Recently, however, UTI has voluntarily subjected all its schemes, except Unit Scheme 1964 (US-64), to SEBIs regulatory purview. These schemes comply with the SEBI (MF) Regulations as prescribed for other mutual funds. 265. The assets under management of UTI can be divided broadly into two categories: a. the US-64 scheme; and b. other schemes which are run like mutual fund schemes. The US-64 is different from other mutual funds in the following respects: a. US-64 holds the initial capital contributed by UTIs promoters (IDBI, LIC and nationalised banks). b. US-64 holds UTIs assets in other subsidiaries and fixed assets through a specially created Development Reserve Fund (DRF). c. US-64 can invest in loans and also borrow in the market. Other mutual funds have to invest in marketable securities, and have limited powers to borrow (restricted to 30% of NAV for a tenor not exceeding six months).
266.
MUTUAL FUND SECTOR DEVELOPMENT

267. The state of the industry at the end of year 2000 is shown in Table 3.2.
Table 3.2 Indian mutual funds Type of organisation Number
UTI Bank-sponsored Institution Private-sector Indian Private-sector joint venture (mainly Indian) Private-sector joint venture (mainly foreign) Total 268.
1 6 4 6 7 10 34
The 34 funds offer a wide range of schemes, totalling 643. Gilt schemes specifically for investment in Government securities were introduced in 1999. The main differentiating features of the existing funds are shown in Table 3.3.
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By structure
Table 3.3 Differentiating features of mutual funds By objective By specialisation
Open-ended Closed-ended Interval
Growth Income Balanced Money market Gilt Assured return
Tax saving Index-based Sectoral
269.
Using the categorisation of schemes defined by the AMFI, most schemes are openended. Income and growth schemes make up the largest groups, and 70 gilt schemes are offered. A breakdown of the number of schemes in each category is shown in Table 3.4.
No. of schemes 148 116 46 57 2 70 20 5 34 17 2 67 59 643
Table 3.4 Breakdown by category Scheme type No. of funds offering Open-ended (income) 25 Open-ended (growth) 25 Open-ended (balanced) 22 Open-ended (liquid) 19 Open-ended (money market) 2 Open-ended (gilt) 16 Open-ended (Equity Linked Savings Scheme) 16 Open-ended (assured return) 2 Closed-ended (income) 6 Closed-ended (growth) 7 Closed-ended (balanced) 2 Closed-ended (Equity Linked Savings Scheme) 17 Closed-ended (assured return) 2 Total
270.
Mutual fund assets under management have grown rapidly, particularly in 1999. UTIs assets have grown also, but at a slower rate. The new mutual funds have made significant inroads into UTIs market share, and the industry now has a more competitive structure compared with before. The growth in mutual fund assets is shown in Table 3.5.
Table 3.5 Mutual fund assets
Year
1996
1997
1998
1999
2000
UTI Others Total UTI%
535 127 662 80.8
544 107 651 83.5
582 106 688 84.6
584 137 720 81.0
679 317 996 68.2
Figures at end-March (Rs. bn). Note: UTI figures at book value, whereas the others at market, so the figures are not strictly comparable and only indicative. Source: Mutual Funds Yearbook 2000, UTI Institute for Capital Markets.
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271.
Since 1999, the tax status of investments in mutual funds has changed. All dividends paid out by mutual funds are tax-free in the hands of all classes of investors (including companies). However, mutual funds themselves are subject to a dividend distribution tax and are required to pay 10% tax (in addition, there is a 10% surcharge on the 10% basic rate, raising this figure to 11% effectively) on dividends distributed by them. (This rate was 10% in 1999, was raised to 20% in 2000 and restored to 10% in 2001.) The above tax system creates tax arbitrage for all investors subject to a marginal rate of tax above 10%. If such investors invest directly in debt securities, the interest they earn is subject to income tax. Instead, if they invested in a mutual fund that invests in debt securities, and if the mutual fund distributes interest that is earned, such income is only subject to the dividend distribution tax and is tax-free for the investor. This has created a growing demand for debt, gilt and liquid funds. Corporates have tended to use mutual funds as treasury management tools because of the tax break on mutual funds, buying and selling mutual fund units as their short-term cash needs dictate. This accounts for the unusually high churn rate in mutual funds (purchases and redemptions compared to total asset values). Figures from AMFI (shown in Table 3.6) put purchases plus sales of units at 195%. Figures for mutual funds, excluding UTI which has a lower churn rate, are 467%. This churn rate is probably indicative of the growing use of mutual funds by corporates as a short-term investment avenue.
Table 3.6 Sales and redemptions by Indian mutual funds, 200001 (Rs. bn) Sales Redemptions Net assets Net sales Churn rate (%)
272.
273.
All UTI Other
929 124 805
838 121 717
906 580 326
91 3 88
195 42 467
Churn rate = 100(Sales + redemptions)/net assets. Source: AMFI.
274.
Corporate treasuries can no longer invest in call money markets. Therefore, they are increasingly parking their short-term surpluses with mutual funds, which in turn are investing in the money market and call money market instruments. Mutual funds are substantial investors in Government bonds and corporate debt. Debt funds in 2001 are around 60% of the mutual fund industry assets. Table 3.7 shows the mutual fund holdings of debt securities as at the end of March for a five-year period.
275. 276.
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Table 3.7 Mutual fund holdings of debt securities (Rs. bn) 1996 1997 1998 1999 Central and state Government securities
2000
UTI Others Total UTI Others Total
62 11.6 2 1.3 64 9.6 181 33.8 31 1.6 212 32.0
45 8.3 0 0.2 45 6.9 197 36.2 34 1.7 231 35.5
25 4.3 3 2.7 28 4.1 218 37.4 32 1.6 250 36.4
53 9.0 9 6.9 62 8.6 216 37.1 44 2.2 260 36.1
51 7.4 54 17.0 104 10.5 248 36.5 74 3.7 322 32.3
Corporate bonds and debentures
Italics show % of total assets. Note: UTI figures at book, others at market, so figures are not strictly comparable. Source: Mutual Funds Yearbook 2001, UTI Institute for Capital Markets.
Recommendations 277. The size and positioning of UTI casts a shadow over the industry. Despite inroads made by new entrants, UTI retains about 60% of the total assets under management by mutual funds. Of this, US-64 represents 12% of the entire industrys assets under management. A significant growth in debt funds and a high churn ratio would translate into a higher level of trading activity by mutual funds in the secondary debt market. In the case of UTI, though, it is seen that inter-scheme transfers are a significant proportion of sales/purchases of schemes. In 2000, for instance, nearly 80% of the profits from sale of securities of all schemes came from inter-scheme transfers. The presence of UTI in the debt market is therefore, relatively, quite limited. Like the LIC, UTI has a reputation as a safe investment among retail investors. Surveys show that its funds are viewed as comparable to Government debt in terms of the level of risk. Of the 75 funds managed by the UTI, 45 invest in bonds but adopt various scenarios of low/medium- and high-risk profiles. However, the vast majority of such funds are closed-ended, and therefore UTI has relatively less motivation to trade frequently. Thus, they settle for asset/liability matches to meet their funds redemption dates. It is also accepted that most of UTIs funds are so large, hence with such large holdings, that it is most difficult for them to switch investments on a regular basis. UTIs dominant position would be a concern, but market trends (growth of private mutual funds) and regulatory/Government policy towards UTI (not fully underwriting US-64 losses and converting it to an NAV fund) suggest that its dominant position will not be sustained.
278.
279.
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280.
The tax concession for mutual funds has probably been an important driver for fund growth. While we would generally urge fiscal neutrality, this would appear to be the wrong time to do something that might destroy a significant part of their business. But in the longer term, mutual funds would seem to be the preferred and more plausible home for retail fixed income investment. While the spur for growth has been corporate treasury, it is more likely that servicing small individual investors will be the more natural and sustainable path for mutual fund development. Institutional investors, especially the larger ones (e.g. UTI and LIC), have opportunities for cross trading between different funds under the same house. This is attractive as it saves commissions, although these are not high in India, and saves on the market impact costs especially for illiquid stocks. Currently, funds have no obligation to transact through the market. They are obliged to ensure the price of the exchange at market prices. A large number of transactions between institutional investors tend to happen on a negotiated basis, outside the markets. SEBI has mandated that such transactions in equity shares be reported to the exchange. We recommend that it should be mandatory for debt trades to be reported, both within funds across schemes and across funds and institutional investors, on exchanges. Fund management and pensions reform go together. In the paragraphs in this chapter related to pension funds, we discuss the proposed scheme to offer pensions to those outside current schemes. The issues regarding mutual funds, which have to be discussed and reviewed in this context, are: (a) bond funds have grown and become a substantial players in the debt markets; (b) tax arbitrage; and (c) their NAV and liquidity needs are different from other investors because the relative size of these funds could be very different from what has been seen in the industry so far.
281.
282.
INSURANCE COMPANIES
283. Insurance companies were nationalised in 1972 and only two companies were licensed to operate, General Insurance Corporation (GIC) and Life Insurance Corporation (LIC). In 1999, the law was changed, permitting competition in the insurance industry. Since 2000, new entrants, including foreign joint ventures, have been permitted in both life and general sectors. The change in the law also set up the Insurance Regulatory and Development Authority (IRDA) as the regulator. IRDAs role is licensing and supervision of the new entrants, as well as the LIC and GIC. LIC remains the dominant player in life insurance with close to 100% of the market, although the year 2000 saw the entry of six foreign insurers (as joint ventures). Entry requirements are not unduly onerous and focus mainly on assets. LIC is constituted by statute, which specifies prudential investment norms. It is required to hold a large proportion (75%) of its portfolio in Government securities and the rest in high-quality corporate debt. Its holding makes up 18% of all
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284.
285.
286.
Government securities. Given its size, ownership structure and the duration of its liabilities, LIC tends to follow a buy-and-hold strategy. On occasions, the RBI has made special issues of Government stock solely to meet the investment needs of LIC, and LIC has taken the whole issue. 287. LIC does trade, but tends to trade large amounts. Its actions are closely followed by other market participants, since its actions are likely to move the price. When LIC is in the market, it will execute an order over several hours and the normal practice is to front-run the orders. It has been observed that a competitive market for life assurance helps in the development of a secondary debt market, as this will provide an incentive for life companies to trade bond portfolios to achieve higher returns. For the same reasons, it will encourage them to participate in repo/stock lending, in the process improving liquidity and also reducing costs in those markets. As with state banks, the issue becomes one of how to free up the holdings of LIC. There are a number of impediments: a. Although LICs market share will be eroded as other parties are free to enter the life business, the recent evidence is that the insurance sector is slow to open up to competition from both domestic and foreign insurance companies. b. LIC is a Government entity and therefore is perceived as being free of default risk i.e. it has an implicit Government guarantee. This is a strong competitive advantage and will slow down the erosion of LICs totally dominant share.
288.
289.
Recommendations 290. LIC is obliged to invest heavily in Government bonds. While Government bonds may often be a good investment for a life company, at other times they may not be. While there may be concerns at the RBI about losing a captive buyer, the investment norms should be relaxed. LIC is in some ways like the banking sector. It has a huge holding of Government stocks that it cannot trade aggressively. While in the banks, one problem is that of expertise and incentive, LIC is constrained by its very size. If it tries tactical trading, then the combination of market movements and front running will erode away any additional return it can achieve. If LIC were to become a set of smaller competing companies, that would address both the incentive and the size problem. LIC is legally constituted, and to privatise or restructure it would be a lengthy undertaking, if it were feasible at all. The alternative is to encourage LIC to split its funds and operate them separately in competition with each other. The lack of impact of a similar attempt at UTI is not promising, but if there was genuine separation it should allow LIC to operate as a more nimble player in an increasingly competitive industry. The same effect could be achieved by allowing LIC to outsource fund management, either by purchasing mutual fund units or by inviting external fund management companies to run different parts of its portfolio. We recommend this should be explored.
291.
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292.
The perception of LIC as being safer than private life companies will tend to deter all but the most wealthy or most adventurous from using private life insurers. There is a widespread perception in India that LIC is somehow Government backed and supported. In other markets it is usual for there to be some kind of guarantee against loss through default or fraud covering licensed life companies. These can be self-funded, although administered by the Government/regulator. They do require the regulator to monitor companies to ensure solvency and probity, something that is required of IRDA. Guarantee funds imply the risk of moral hazard, i.e. that unreasonable risks may be taken with the secure knowledge that someone else will pick up the tab. However, the guarantee suggested here is not a guarantee of investment performance but of transparency, honesty and solvency. Regulatory supervision can effectively contain that sort of risk. A reasonable compromise might be to limit cover to perhaps 80% of loss. This raises the question of who would pay for the self-funded guarantee fund. A system based on market share would currently make LIC responsible for nearly 100% of any losses. Therefore, the fund would need careful structuring to ensure that the smaller (and therefore inevitably more risky) life companies paid an appropriate amount. The IRDA has taken a role in licensing individual products of insurance companies. Aside from the delays that this implies, it is also a barrier to innovation. While the insurance regulator is outside our terms of reference, we do see this as a potential barrier to the development of life products and hence as a potential barrier to the development of the secondary debt market.
293.
294.
295.
PENSION FUNDS
Current Provision 296. In most developed debt markets, both Government and corporate, pension funds of one type or another are major investors and major traders. The very lack of participants in the Indian debt market discourages trading, encourages buy-andhold strategies, and reduces the attraction of public offers vis--vis private placing. Pension provision is poorly developed in India. No more than 10% of the total workforce is covered in any formal way. There is no state scheme covering workers in the non-state sector. Existing pensions provision falls into a number of categories, as shown in Table 3.8.
297.
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Type of worker
Table 3.8 Analysis of existing pension provision Pension provision
Number covered (mn)*
State employees, including Central Non-contributory, defined benefit, and state Governments, armed forces, indexed pension funded entirely railways and post office from the Government Private sector salaried employees in sectors Mandatory Employee Provident covered by Employees Provident Fund & Fund or Employee Pension Scheme
Miscellaneous Provisions Act 1952 mandating pension provision (in one of 117 notified sectors and employing more than 20)
11 23
Other private sector employees Self-employed Casual/contract workers Total
No provision No provision No provision
13 166 97 310
* Figures from 1991 Census (latest). Source: National Project to Devise a Pension System for India, Project OASIS (Old Age and Income Security), January 2000.
298.
In addition to the schemes described in the table, Government employees also contribute 6% of their wages into a provident fund scheme. The pension scheme is unfunded and has become very expensive. The dependency ratio among Central Government employees is 66%, i.e. two pensioners for every three contributors, and is expected to continue to rise sharply. There is also a residual scheme for the destitute elderly, offering a pension of Rs. 75 per month. Industries and establishments in notified sectors and employing more than 20 people are mandated to subscribe to the Employees Provident Fund Scheme (EPF) and Employees Pension Scheme (EPS). Currently, the schemes cover 177 industries and at April 1999 had 23.1million members. The schemes are managed by the EPF Office (or various specialised agencies for certain industries such as coal mining). All employees in these establishments, except those earning over Rs. 5000 per month, are obliged to participate and contribute. Employees and employer make equal contributions totalling between 20% and 24% of salary and the Government adds a further 1.16%, making a total of 25%, which is high by international standards. Contributions are tax-free up to Rs. 1,20,000 crore p.a. In 1998, establishments were permitted to manage funds on behalf of their employees and many now do so, but they are still obliged to follow the investment guidelines set down by the EPF Office. Mutual funds are also permitted to offer pension schemes but are subject to the same investment guidelines. In practice, investment is mainly in Government securities or fixed-rate Government deposits. The growth or return rates on provident funds are mandated in the Union Budget and guaranteed. The 2001 Budget reduced the guaranteed rate from 12% to 11%. It is not completely clear who would meet any shortfall, but the assumption is the
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299. 300.
301.
302.
Central Government rather than the employer. The investment policies mean that the schemes are not really funded, since their assets are mainly Central Government obligations. 303. On reaching retirement, funds accumulated are paid out to the individual employee for the purchase of annuities. Provident fund members may withdraw funds before retirement for housing, marriage, education of children, medical expenses, unemployment, etc. These withdrawals are not taxed, but pensions are taxed. There is thus an incentive to withdraw funds prematurely and terminal accumulations are small, an average of Rs. 25,000 in 199798. The administration costs of the system are said to be high. Alternatively, employees may be covered by the EPS, which offers a defined benefit pension up to 50% of terminal salary. Contribution rates vary across industries and classes of establishment despite a standard benefits package. The schemes follow the same investment guidelines as provident funds and are mainly in Government securities and deposits. There are no available actuarial calculations showing the solvency or otherwise of these schemes, and one is led to suspect this could be a problem in the future. The unorganised (unsalaried) sector was offered access to the Public Provident Fund (PPF) in 199899. This scheme offers 15-year individual accounts with tax exemption for contributions and withdrawals. Partial withdrawals are allowed after five years. The scheme has only attracted some three million contributors and is believed to be mainly used by the relatively well-off as a tax shelter. The Government is considering implementing a proposal to offer contributory, defined contribution pensions for the unorganised sector (farmers and selfemployed), known as the OASIS project. This envisages using private fund managers to invest the contributions collected through the retail network of banks and post offices. The proposal involves limiting the number of fund managers that are franchised to operate the scheme and basing the selection on an auction of fees. Fund managers would offer a number of standardised investment packages with varying degrees of risk. The proposal is attractive from a bond market point of view in that, if successful, it will bring new investment funds to the market. The use of private sector fund managers is also beneficial for the scheme and sets a useful precedent for outsourcing of fund management by other institutions. The proposal to limit the number of managers that can operate the scheme appears less beneficial, as this would be an unnecessary limitation on competition.
304.
305.
306.
Provident funds 307. Provident funds have proved relatively poor at generating reasonable pensions. The early withdrawal provisions means that they are used as tax-free savings vehicles, rather than for long-term build-up of capital for retirement. They offer guaranteed rates that are set by the Central Government. Their trust agreements generally require board of trustees approval for investment. Hence, they tend to buy when
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cash flow dictates and hold to maturity. They are generally regarded as actuarially insolvent, and it is not clear who would step in if there were to be a failure. 308. Problems with provident funds related to their possible actuarial insolvency and the problem of early withdrawal limit their effectiveness as pension providers but are outside the scope of these terms of reference. The problem from a market development point of view is that they are currently required to follow restrictive investment guidelines, while their investment decision-making is slow and inflexible essentially they are confined to buying and holding a limited range of securities. Most provident fund monies are invested by a single fund manager (State Bank of India) following guidelines laid down by the EFP Office. The guidelines require: a. 25% Central Government securities (including promissory notes); b. 15% in Central and state Government-guaranteed securities; c. 40% in public sector utilities or public sector financial institutions (including the IDBI and the Industrial Credit and Investment Corporation of India Limited (ICICI)); d. 10% in highly-rated corporate bonds (optional); e. balance (10%) spread over top three categories; and f. no investment in equity or foreign securities. However, liberalisation alone would bring new risks. Provident funds are ill equipped to adopt a more active investment policy. Their managements lack the skills required, so there is a serious risk of a scandal such as followed the liberalisation of US savings and loan associations. The savings and loan associations adopted aggressive investment policies when their choice of investments was widened and they moved heavily into high-yield, high-risk investments. They lacked the skill to manage such investments. At the same time, the increased demand for these assets drove down the yields and attracted even more risky issuers so that the higher yields that previously had compensated for the higher risk no longer did so. The result is well known: the US Federal Government eventually had to bail out the savings and loans associations at large cost to the taxpayer. It is all too easy to see a similar situation arising in India if provident fund investment guidelines were liberalised with the current level of expertise. Provident funds are also based at the enterprise level. While there are many large enterprises, there are also many small and medium ones. Small and medium enterprises do not have the size necessary to support qualified investment expertise. Nor do they have the size to operate successfully in competition with other larger investment institutions their unit costs will be too high. This is not a situation unique to India; in other markets where private pension provision is significant (and India is ahead of the game in this respect), the trend has been to move away from investment management at the enterprise level and outsource the portfolio to professional fund managers. There is an increasing supply of such fund managers in India among the private sector mutual funds and there will be a further influx from the insurance companies. These offer economies of scale allowing them to employ skilled fund managers while keeping management costs low.
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309.
310.
311.
312.
However, managing the fund managers requires a measure of skill in itself and provident funds would need to acquire that if they are to be successful in using external managers. In other markets there is a whole industry to support pension fund outsourcing decisions, but this does not exist in India. Accordingly, there is still a need for caution to avoid the risk of relatively inexperienced provident funds being seduced into committing their members retirement savings into a narrow range of fund managers or fund managers whose risk profile is inappropriate to the needs of the provident fund members.
Recommendations 313. In developed markets, the trustee role is to set the parameters for investment selection to be carried out by the fund managers and not to make the individual selections themselves. Markets move too quickly for this, and trustees, in any market, rarely have the skills required for active investment management. Our understanding is that, in the case of provident funds, trustees often make the investment decisions themselves. While this may be acceptable where investment consists of no more than pushing cash flows into Government securities, it is unlikely to be appropriate in a faster-moving investment environment. We recommend that the regulations governing provident funds and their articles of association be altered to allow delegation of investment decisions, subject to trustee oversight. We do not see it as likely that the provident funds themselves will always have the requisite investment management skills in-house, and so we recommend that provident funds be permitted and encouraged to use external fund managers. However, a number of limitations and constraints should be imposed, as follows: a. Delegation could only be to institutions subject to SEBI monitoring and approval for their investment management functions, regardless of whether another authority actually licenses the organisations per se. b. The concept of investment guidelines should not be entirely abandoned, only eased; the Dave Committee on Pension Reform (OASIS) proposed a classification of funds as shown in Table 3.9, and it would seem prudent to oblige provident funds to concentrate their investments into the balanced income funds, perhaps requiring two-thirds to be in such funds.
Table 3.9 Investment guidelines as proposed by the Dave Committee Safe income Balanced income Growth (%) (%) (%)
314.
315.
Government paper Corporate bonds Equity Of which foreign equity 316.
>50 >30 <10
>30 >30 <30 <10
>25 >25 <50 <10
Funds would also need to be obliged to spread investments across mutual funds (say, not more than 3035% with any one manager). This would ensure that belowaverage performance by one fund manager did not drag down the benefits of the
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fund members too far, although some risk is inevitable (see the paragraph on impediments below). Provident funds would have a free choice among the full range of mutual and other fund managers. 317. There are three major impediments to the proposal to outsource fund management that are built into the structure of provident funds and will need to be addressed if use of external fund managers is to be feasible: a. The residual responsibility for the solvency of funds needs to be clarified. The current situation where the Government sets investment guidelines and implicitly underwrites the funds is an accident waiting to happen. We would like to see these organisations put on independent commercial footings such that the so-called guarantee requirements are removed. Each of these funds and trusts should set their own investment policies within a prudent framework established by regulation. Under such circumstances, it is advisable that the framework is indicative and not prescriptive. b. Provident funds offer a guaranteed return and the return is set by the Central Government. While this is not incompatible with the use of external fund managers, it does highlight the question of who pays if the fund performance does not support the guaranteed rate. We have asked this and there seems no clarity in the answers. However, it is clearly unsustainable in the present situation for funds to realistically guarantee performance to fund members unless some other entity underwrites the fund. One of two things must happen: either provident fund members must accept more risk in exchange for the possibility, but not certainty, of higher returns; or someone else must pick up the bill if returns are inadequate. It is worth noting that in other markets the fund returns have been substantially higher when investment guidelines are removed from pension funds. We recommend that the guaranteed returns be removed. Pension packages then become part of the contractual relationship between employers and employed (subject to some acceptable minimum level of coverage). c. Provident funds are not required to mark all their investments to market, and there is a strong likelihood that were they to do so substantial losses could be realised. These might compromise the actuarial solvency of the funds. Clearly, external fund managers will not accept the mandate to manage funds of a provident fund at book value but only at market value. A transition program would be required to ease those funds with unrealised losses into a more realistic position before they could use external managers. We recommend provident and pension funds should be subject to regular actuarial solvency audits. The OASIS proposal, while visionary in concept and potentially very beneficial for capital market development, risks losing something by restricting the number of providers and possibly setting unreasonably low fees for fund managers. This restriction is proposed despite widespread and predictable criticism from fund managers. The shortage of motivated participants has been a limiting factor in bond market growth, and to introduce a limitation on a potentially huge new source of investment, and investment aims, would seem a retrograde step.
318.
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319.
To be successful, pension provision must start when workers are relatively young. In order to attract the younger participants, governments generally offer tax breaks on pension savings. The motivation, aside from a desire to see the elderly well catered for, is to enable them to downgrade state provision and remove a future liability from their balance sheet. The provident schemes do offer tax breaks indeed, Indian pension provision has greater tax advantages than in many other countries. It is common elsewhere for contributions to be tax-free and also for infund income to be exempt. However, Indian provident funds allow withdrawal of the lump sum at retirement, or partial withdrawals before retirement, without any tax liability. Nor are Indian pensioners obliged to invest the lump sum in an annuity. This applies to provident funds and pension funds run by mutuals. There is scope to attract the better-off into self-funded schemes that would supplement and eventually replace the inadequate provident funds (and their assumed guarantee) by removing the investment restrictions on pension funds. The US 401k plans are a relevant model, but because of their investment freedoms, not their tax advantages. The barrier is the investment restrictions on private pension funds, which should be removed; although, as for provident funds, limitations to ensure prudent investment should be imposed.
320.
RETAIL INVESTORS
321. 322. The tables below give an overview of the level of affluence of the retail population and their current investment preferences. Some 12.1 million households are direct investors in equity shares. Table 3.10 gives an indication of the income distribution and shows that they come from a wide band of monthly incomes. Equity investment has not solely been the preserve of the very affluent. As would be expected, the lowest income group that makes up the vast majority of the population is not much represented among equity investors. However, penetration in those income groups above the lowest is relatively low. These results suggest there is a substantial group with income to invest in more risky assets, but that most have not yet done so.
Table 3.10 Distribution of investor and non-investor households by income Monthly income (Rs.) All households Investor households Million % Million %
Up to 2500 25015000 500110,000 10,00115,000 Over 15,000
72 57 32 6 3 169
42.5 33.5 18.8 3.4 1.8 100.0
0.9 3.1 5.5 1.7 0.9 12.1
7.3 25.9 45.7 13.9 7.2 100.0
Source: Survey of Indian Investors, SEBI/National Council for Applied Economic Research, June 2000.
323.
Probably a majority of households use some kind of formal savings vehicle. Predominantly these are deposit-based vehicles, as shown in Table 3.11. Again,
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these users of savings vehicles are predominantly not those in the lowest income group.
Table 3.11 Household investments Number and % of households with investments in: Million %
Banks/Post office Government undertakings Non-Government companies Non-bank financial institutions Term lending institutions Equity Mutual funds
77 30 29 12 4 12 15
43.31 17.95 16.88 7.02 2.15 7.16 8.88
(Some investors will have investments in more than one asset type.) Source: Survey of Indian Investors, SEBI/National Council for Applied Economic Research, June 2000.
324.
However, most equity portfolios remain small in value terms, with about 85% below Rs. 25,000 (about US$500), as shown in Table 3.12.
Distribution by size (Rs.) Table 3.12 Household equity portfolios Number of households ('000) % of households
Below 5000 50009999 10,00024,999 25,00049,999 Over 50,000 Total 325.
1811 3232 5084 1513 448 12.10
14.97 26.71 42.02 12.5 3.7 100.0
They are also highly undiversified and therefore carry significant stock-specific risk. Few portfolios have more than five stocks, as shown in Table 3.13. Most stocks are purchased from initial public offerings. Conventional finance theory suggests that portfolios with fewer than ten stocks will carry significant, but unrewarded, specific risk. This pattern is typical of markets with a large number of new shareholders.
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Table 3.13 Diversification of equity portfolios Number of companies Number of households ('000) in portfolio
% of households
1 2 3 4 5 6 7 8 9 Total Competing Assets 326.
2,840 4,623 1,709 1,779 594 346 56 100 54 12,100
23.47 38.21 14.12 14.7 4.91 2.86 0.46 0.83 0.45
Retail investors already face a wide range of relatively attractive and simple investment opportunities, as shown in Table 3.14.
Table 3.14 Investment opportunities for retail investors Approx. current yield Tax status
Investment type
Post office accounts deposits term three years Bank deposits nil notice Unit trust bond funds up to seven years, but redeemable and tradable (all listed) Provident funds
Guaranteed 9.5%
Tax-free
Corporate term bonds Bank term bonds Government bonds Corporate bonds Equities Recommendations 327.
44.5% Taxable Variable, but trend of falling Tax advantage gains taxed rates has made capital gains inat lower CGT rate recent years Guaranteed 9.5% Taxable, but pension contributions are from gross income and funds can be drawn down for housing purposes 11% unsecured Taxable 11% unsecured, but implicit Taxable Government guarantee 9% Taxable 10%+ unsecured Taxable Variable Taxable
We are unsure of the potential of the retail investor. On the one hand, they have become a dominant force in the equity market. There is also considerable demand for fixed income investments there are a large number of deposit accounts and interest in fixed term deposit bonds issued by development banks and corporates. These are entities that have, thus far, been considered to pose no problems of clearing or settlement risks to a retail investor. Two reasons for doubting the retail
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investor potential are: (1) Currently, we see no examples among global economies of markets where retail investors are major investors or a significant source of liquidity. (2) The volatility in bond markets is lower than in equities, making bonds less attractive as speculations (though more risky as savings vehicles than fixedterm deposits). We have also looked at the data on retail portfolios, which generally remain small too small for the current costs of bond trading to be cost-effective. However, there will be affluent, and, indeed, less affluent, individuals who will want to access bond markets. 328. We concluded, after much deliberation, that it would be too risky to come down firmly one way or the other on retail investors in the bond market. There is certainly some potential, although it is very difficult to quantify. Our recommendation, therefore, is that whatever decisions are taken should certainly not preclude retail involvement. Indeed, generally, we believe that efforts should be made to encourage retail participation in bond markets where bonds are suitable investments.
PRIMARY DEALERS
329. The ownership structure of primary dealers is shown in Table 3.15.
Table 3.15 Ownership structure of primary dealers Ownership Number
State-owned Private domestic Joint ventures Total 330.
8 3 5 16
The primary dealer network now stands at 16. The RBI will accommodate more if there are further applicants, perhaps to a level of about 25. Currently, four applications are being processed. (They have in-principle approval.) Primary dealers are required to have net owned funds of Rs. 50 crore. Primary dealers have obligations to underwrite auctions and submit bids, but do not have sole access, although there is a widespread expectation that the RBI will move towards exclusivity when it judges there are enough dealers to take up issues. A figure of 25 is the expectation. We note, however, that state-owned primary dealers dominate the market with a market share of trading in excess of 90%. Primary dealers are assessed by their performance at auctions; their target is a 40% success rate in dated securities and 40% in T-Bills. Primary dealers have access to limited cheap funds through the RBIs repo auctions (the Liquidity Adjustment Facility, or LAF). Like all other participants who have access to LAF, primary dealers access to funds is unlimited as long as it is collateralised by Government bonds or T-Bills. They also have unlimited access to funds from the RBI at market rates. They have obligations to make two-way prices on enquiry. The market view is that this obligation is not adhered to or enforced, and quotes are often wide or not available.
331.
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332.
The main reason for being a primary dealer is access to low-cost RBI funding, as well as a strategic need: To be anybody significant in the bond market, it is necessary to be a primary dealer. The limitation on short-selling and intra-day trading makes it hard for primary dealers to make markets, since often they can only quote one side. Primary dealers typically hold large positions of stock obtained in auctions. We heard various estimates of the holding period, but two to four weeks did not seem unusual. Our understanding was that foreign (joint venture) dealers held for a shorter time than domestic dealers. Such a long holding period is unusual among world markets. Usually, primary dealers aim to flip stock very rapidly to investors; indeed, in other markets, primary dealers bids include client orders. This makes them highly susceptible to changes in funding costs in the call market, as the cost of carry is a critical determinant of their profitability. (The LAF only offers limited funding.)
333.
Recommendations 334. The recommendations that affect primary dealers are covered in other sections as referenced and are accordingly only summarised here: a. Remove the regulation banning short-selling of Government bonds and so permit intra-day trading by primary dealers. b. Enforce the obligations of primary dealers to make a firm two-way quote on demand. c. Remove underwriting obligations from primary dealers. d. Move the RBI issuance function to an independent debt office so that auction prices clear the market.
BROKERS
335. Brokers play a significant role in the Government bond market. They are also active in corporate bonds, but to a much lesser extent. This is unusual in international terms, as in most primary dealer markets the primary dealers want to get as close as possible to the ultimate investors. Primary dealers do this for the following reasons: a. Dealing with known counterparties reduces settlement risk. Restricting their dealing to holders of SGL accounts at the RBI reduces the delivery risk, although it does not eliminate it. b. The direct contact allows the dealer to reduce the risk of unknowingly facing asymmetric information (an informed trader). The nature of Government securities means there is little chance of inside information (except from the RBI), but there is a risk of dealing with a counterparty holding a large, unrevealed position that might subsequently depress the market. Investors tend to concur with this situation because they can build relationships with primary dealers. This benefits them for the following reasons:
336.
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a. Building a reputation as a trustworthy counterparty, i.e. not bringing orders that cause the primary dealer to lose money, means the dealer quotes will be better. Trading is a repeating game, so reputations are carefully built up and nurtured. b. Being a regular customer means the primary dealers call when attractive opportunities present themselves, and this might include access to auction stocks. 337. The relatively small number of participants in bond markets reduces the value of the broker in seeking out prices and information, so the result is that brokers tend to be excluded from most institutional trading that is transacted on a principal-toprincipal basis. There are believed to be around 40 to 50 brokers active in the Government bond market, with 15 taking the bulk of the business. Evidence of growing use of the WDM operated by the NSE, which is only available to brokers, suggests that brokers may be gaining in importance. This segment now represents 6065% of transactions. The practice seems to be for brokers to take a first sounding of the market. They establish the current levels of trading and where the business is being done. (Typically, there is a large order that is making the market on any particular day.) The brokers then contact a primary dealer to negotiate terms. Of course, there is nothing in that for the broker, but investors will route some business through the broker as a reward for his or her services as an information gatherer. Brokers also do some research on fundamentals of bond portfolio management and trading. Brokers can simultaneously hold proprietary positions while matching deals for clients, which can potentially be the source of considerable conflicts of interest. Banks and mutual funds are prohibited from routing more than 5% of their total Government securities business through any one broker. Breaches of this rule require notification and explanation to the trustees, and the sense we have is that this rule is strictly adhered to. Therefore, in the scenario described above, an institution would have to distribute its rewards to brokers over a number of firms even though it may have had significantly better service from some than from others. Anecdotal evidence suggests that some institutions reward the brokers offering better service by routing business through other brokers with instructions to share the commission with the preferred broker. Primary dealers tend to see brokers as not bringing much value, and variously described the market as over-brokered or leaky because of brokers. The interpretation we took was that brokers would use the information they got from dealing for investors to benefit their other clients or their personal trading accounts, i.e. front-running orders or counter-positioning themselves to profit from a primary dealers position. The 5% rule has the effect of maintaining the number of brokers and probably prevents the emergence of larger, more integrated and possibly more professional firms. Broking commissions are negotiable; therefore, there are no scales. We were quoted several rates, but all at or below 0.5 paise per Rs. 100 of nominal value, i.e. half to one basis point or less. On a Rs. 5 crore lot, the commission would not be
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338.
339.
340.
341.
more than Rs. 2500. On an average daily transaction number of 400, the total daily brokerage revenue will be less than Rs. 1 million (assuming all trades go through brokers, which they do not), and no broker can receive more than 5% of the total. Mumbai brokers are subject to a maximum stamp duty (state tax) of Rs. 1000 per transaction, and all brokers must also pay a revenue-based SEBI levy. 342. Looking at the commission figures, it is hard to see gilt business being profitable for brokers unless they use the information they acquire. This will be to the disadvantage of primary dealers and investors. The NDS system which the RBI is proposing to introduce could threaten the role of brokers, since it is designed to allow direct interaction between participants. However, our understanding is that participants do not intend to change their trading practices in the short term at least. Brokers are required to report to the stock exchange, which in practice means the NSE. The reporting obligation is same-day. NSE publishes the reports as it receives them. All trades (broker and non-broker) are reported to the RBI-SGL system for settlement and are published next day.
343.
Recommendations 344. The future for brokers in Government securities could be threatened by the NDS if they are not permitted to trade on this system, and there seems less and less prospect of them being viable without their having greater recourse to information gained from trading. We therefore recommend that the larger, more professional broking firms should be encouraged by increasing the 5% threshold. Larger, more professional firms would be able to gain from economies of scale and to bring a research expertise to the market. As the market matures and the value of fundamental analysis of interest rate trends becomes more useful, this might enable brokers to add value and so earn a return over and above the pure transaction execution fees they earn now. If the hoped-for growth in retail and corporate use of the debt securities market occurs, then there will be a need for brokers to manage this retail order flow, offering execution services (order entry and management) and advice and research. Firms serving retail clients should have strictly enforced regulations governing their treatment of clients, and this is more likely to be complied with in large, professional firms than in small, marginal operations.
345.
FOREIGN SECURITIES HOUSES

346. Foreign investors are largely absent from the Indian bond market. This is linked to Indias low sovereign rating and capital controls. However, international securities firms have entered the market as primary dealers and in fund management roles. Currently, they are only allowed in as joint venture partners with a maximum holding of 25%. This restriction is worrisome, as it requires the foreign firms to commit without having control. Our sense was that the foreign firms were biding their time in case the market took off, but had no deep roots in India, to a large extent because of the joint venture requirement.
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Recommendations 347. Accordingly, we would recommend that, in addition to an increased pace of disinvestments, the authorities could consider removing a potential barrier by liberalising their approach to encouraging foreign joint venture businesses into the Indian market. Many developing markets require foreign firms to establish their local market subsidiaries by residence in the local market (i.e. they must have a local registered address) and hence be subject to local rules and taxes. Often the main concern of developing market governments, as regards letting in foreign firms, is the potential for foreign subsidiaries merely to repatriate profits and effectively suck money out of the local system. The foreign firms, on the other hand, are more concerned that such governments could nationalise such businesses without paying reasonable compensation and thus they could lose their investment. What typically happens in practice is that most such foreign firms, particularly when they are also in developed markets, are seeking long-term relationships in these places. As a consequence, they would tend to employ local staff, pay local taxes, transfer know-how in the process to their new staff, and reinvest profits in the business in order to develop it. We are aware that in India there is also a culture problem, not appreciated in many other jurisdictions, that business can often only be initiated on the basis of personal introduction i.e. individuals will only do business with people they know or who are known to close associates, or where strong personal recommendations are given. Hence, in order for such firms to be successful in this market, it is paramount that they take on locals who appreciate these sentiments, otherwise their lead-time to profitability could be prohibitive. As a quid pro quo for this, international firms will only be prepared to enter the market if the entry requirements are reasonable. Thus, we would also recommend that the Government establish encouraging entry programmes that would not be viewed as either overly bureaucratic, unnecessarily delayed or restrictive.
348.
349.
350.
CREDIT RATING AGENCIES

351. There are four domestic credit rating agencies, all of which have joint venture operations with international agencies. Each agency was originally established by a different sponsor bank or institution. Two of the agencies are reported to be substantially larger than the other two. The Credit Rating Information Services of India Ltd (CRISIL) is the largest and is regarded as the most prestigious. It rates approximately 110 issues, including commercial paper, fixed deposits and nearly 350 corporate debentures. The agencies use rating scales that follow the style of the major international agencies. However, it should be noted that, in common with other national agencies, the Indian credit rating agencies rate companies relative to their market. For example, CRISIL rates from AAA down to D. However, from an international perspective, the national ratings are factored down by the sovereign rating which
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352.
on Standard and Poors (S&P) rating is BB (foreign currency rating). Therefore, all but the best Indian corporations are sub-investment grade to an international investor. Recommendations 353. We were impressed in our dealings with the credit rating agencies by their commitment. However, we were surprised that a market that is relatively small could support four agencies. While our view is that competition is desirable, there is always a concern that rating agencies will lower standards in order to attract custom if competition is too fierce. We have no evidence to suggest this is the case, since the market seems only to be receptive to AAA corporations most of the ratings obtained are AAA, as few others bother to apply. It is possible that there are some regulatory barriers to consolidation, such as the requirement for three ratings for provident fund investments. These should be removed and then the viability of the existing rating agencies will be clearer. State entities are not generally required to have ratings. This is not a regulatory issue so much as a market preference, since in the private placement market issues by state entities have no rating. This appears to be another symptom of the way in which the Indian market retains links to the previous system of administered markets. The status of sovereign guarantees for anything other than Central Government debt is not clear. Thus, while state Government issues and public sector undertakings are treated as Central Government-guaranteed, this is not unambiguously the case. We recommend that as part of the standardisation of private placement documentation proposed in Chapter 4 (on Issuance and Instruments), there should be a requirement that all issuers, including state entities, should seek a credit rating.
354.
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Volume 2 Analysis and Recommendations Chapter 4 Issuance and Instruments
Chapter 4 Issuance and Instruments

355. The Reserve Bank of India is the issuing authority for the Government of India. It has issued a range of debt securities at varying maturities, including T-Bills for less than one year and dated Government bonds. The dated bonds have more than one year to maturity at the date of issue. There are 110 of these dated securities in issue with a total value of Rs. 4.3 trillion, or roughly 21% of GDP. The bulk of these instruments are coupon-bearing bonds. The RBI has experimented with zerocoupon bonds and index-linked bonds. These experiments have failed owing to problems connected with institutions and market design. Zero coupon bonds generate a certain lumpiness of expenses on the budgets of the Government, which does not yet use accrual-based accounting. Certain tax clarifications for indexlinked bonds were not given in time. Market perceptions about ambiguities were not decisively resolved, which led to participants taking the cautious approach of avoiding these products. Issuance is by auction (single price for 91-day T-Bills, multiple price for dated securities). Primary dealers and others (banks and mutual funds) can participate in the auction. Primary dealers are expected to underwrite auctions and bid for stock. They are assessed on their bidding performance. T-Bill auctions are conducted in a regular cycle, but auctions for dated bonds are announced about a week ahead. Corporate bonds are mainly privately placed. Public issues are rare and confined to a few issuers. Public issues are regulated by SEBI, which conducts document examinations, etc., and all are rated by at least one agency. The public issuance process is long and imposes risks on issuers and investors as well as substantial costs. Unlike many other markets, most issues, including those that are privately placed, are listed on a stock exchange. The issuance market is confined to topquality Indian corporations, as most investment institutions, e.g. mutual funds, provident funds and insurance companies, who are the main holders, cannot hold sub-investment-grade bonds. Issues are mainly in the form of secured debentures, though these may well have unusual term structures including zero-coupon and irregular payments. Failure is not infrequent and is usually resolved by negotiation since legal redress is possible but slow.
356.
357.
358.
GOVERNMENT SECURITIES
359. The Government of India has been a major issuer of securities. Growing fiscal deficits combined with a policy of not monetising the deficit have obliged the Government to rely on market borrowings. Table 4.1 shows the growing demands upon the market through issuance of dated securities.
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Volume 2 Analysis and Recommendations Chapter 4 Issuance and Instruments Table 4.1 Issuance of dated securities by issuance type (Rs. bn) Auctions Private Tap/ placements flotation
Year
Total
199596 199697 199798 199899 199900 200001
154 9 189 9 270 8 435 16 611 21 795 25
55 3 0 0 110 3 300 11 270 8 180 5
175 8 90 3 54 2 103 5 21 1 27 1
385 20 279 12 434 13 838 32 901 30 1002 31
Note: Numbers of issues of each type in italics.
360.
Since 1991 there has been a programme to reform the Government bond market. Historically, the Government relied upon mandatory investment holding by stateowned financial institutions. Increasingly the RBI, acting as the Governments agent, has sought to move towards market borrowing to fund the deficit. This has been made easier by the declining trend in interest rates as inflation has been brought under control. The reforms have led to two major developments: a. T-Bills and dated securities are generally issued through an auction process; prior to that either the debt was monetised without issue of Government stock or stock was merely allocated to the banks. b. Primary dealers have been established; they are required to bid at auctions and provide a focus for the secondary market in exchange for access to the RBI funds. Government bonds can be issued in three ways: a.auctions; a. private placements, where the RBI takes the entire issue and sells at the best available price; the expectation is that the stock will be sold relatively quickly, although this has often not been the case; and b. tap/flotation issues, where the RBI also takes the entire issue and sells to the market at par; this is intended to be a slower release of stock. Table 4.1 above shows that auctions have become the dominant method in recent years. Where an auction does not clear the market, stock may devolve on to the RBI. The RBI sells the stock in the same way as a private placement, i.e. by feeding the stock into the market. During 200001, 17.4% of the total issue was placed with or devolved on to the RBI. The comments and recommendations we make below recognise the enormous strides that have been made towards developing a truly market-based system for
361.
362.
363.
364.
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issuing Government securities. However, our research indicates that there remain non-market elements in the issue process. These residues of the previous system act as a limitation on the development of the market. This is more true of the secondary market where participation is voluntary, so that while the primary market is able to handle large volumes of issuance, the secondary market remains relatively underdeveloped. 365. The Government bond market also provides the key benchmarks for other debt, including the corporate bond market. Our contention is that the residues of the previous system not only restrict the full development of the secondary Government bond market but also limit the development of both primary and secondary markets for corporate bonds.
Absence of Independent Pricing

366. The RBI has adopted an auction for issuance of T-Bills and dated securities. However, the auction process is not straightforward and does not necessarily clear the market. Prior to the auction, primary dealers are invited to bid to underwrite the auction. They receive a fee for this and it is expected that they will bid. However, auctions are often not fully underwritten. Bids are then submitted to the auction by primary dealers and others. For T-Bills the stock is allocated at the auction cut-off price; for dated securities, stock is allocated at the bid price. Unsold stock devolves to the underwriters and then to the RBI if the auction was less than 100% underwritten. Devolvements to the RBI are not uncommon, as the figures above illustrate. In 200001, just under 10% of the total issued was taken up by primary dealers through underwriting commitments. The Government of India can also effect a private placement of an issue with the RBI. The stock is allocated to the RBI and then sold through open market operations. At any time the RBI is a substantial holder of Government stock. The RBI considers that it could not entirely commit itself to auctions it feels it needs the flexibility to be able to hold back a portion if it believes that the market is temporarily distorted. Its experience is that it has done this and been able to sell the balance through open market operations shortly after the auction. The reason the RBI gives for not relying entirely on auctions is that the trading, profitability, and therefore bids, of primary dealers are heavily dependent upon the call rate. This is because primary dealers typically hold auction stock for an extended period, rather than flipping into the secondary market very quickly. They finance these positions with call market funds (since primary dealers cannot manage their overall exposure by short selling of other government securities). (Their access to cheap finance through the LAF is limited, and further funds, from the RBI or the market, are only available at market rates.) The call rate is volatile because the RBI uses the call rate to smooth short-term fluctuations in the US dollar exchange rate. This is not currency support, since the RBIs currency target is for a steady depreciation over time, but smoothing. The aim is to limit speculation and speculative damage. Therefore, the RBI perceives that the shortPage 94
367.
368.
369.
term interest rate volatility will cause auctions to mis-price periodically and it acts accordingly. 370. The RBI is therefore certainly not a price taker in the debt market, but seeks to influence the level of yields along the entire yield curve (rather than just at the short end where most central banks conduct monetary management). The view in the market is that the RBI has the power to control the yields on Government securities and uses that power to reduce its debt costs. Since this effectively means that prices are distorted (upwards to the detriment of investors), this represents a significant barrier to growth of the secondary market. Primary market participants, by and large, are obliged to participate, but secondary market participants are not. Inevitably, this affects the perceptions of market participants. A primary dealer, for example, knows that its profitability in auctions will be determined almost solely by the RBIs actions, either in stopping the auction short of the clearing price or through its actions on the call rate, or both. Whichever, there is relatively little point in studying fundamentals of interest rate determination; all that matters is second-guessing the RBI. This imparts significant uncertainty to the market, which will be reflected in the yields at auction. Thus while the RBI is trying to reduce its debt costs by managing the market, the effect is to add an uncertainty premium which raises the debt cost. In addition, the uncertainty is a major factor in the failure of the secondary market to develop liquidity and so the debt issues will also carry an illiquidity premium. There is also a possibility that the RBI is facing a conflict of interest in its twin roles as debt manager and monetary authority. The market will always suspect that a central bank might be manipulating monetary policy to benefit its funding needs. Even if it is not true, the suspicion remains and will be stronger where a central bank, such as the RBI, is actively moving the call market in pursuit of exchange rate objectives. The RBI indicated that it does not have a large inventory of debt stock, but it also indicated that it too could hold securities against its asset/liability matches. However, the markets perception is that this may well mean that the RBI holds inventory on what banks call their back books (i.e. technically, off-balance sheet) where securities are actually held for the Government. This general view results in a market perception (and here such perception is more important to market confidence than any reality) that there exists a huge overhang of potential supply of Government securities that inevitably tends to hold down actual bond prices. Figures for March 1999 from World Bank sources indicate that around 25% of Government debt issuance was held by the RBI. The current figure is lower but could easily rise again if borrowing conditions tightened. The RBIs actions are a barrier to the development of secondary trading because of the uncertainty they cause and because their actions limit diversity. For secondary
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371.
372.
373.
374.
375.
376.
traders the only game in town becomes central bank watching, and every little nuance of the RBI is watched for possible signals as to the future course of policy. This limits the possibility of diversity of view, which is one necessity for an active trading market. (The other is diversity of portfolio objectives, which, since banks and the LIC take up most Government stocks, is also absent.) 377. The experience of the RBI is not unique; other central banks have found that the role of monetary authority and debt manager introduces costly uncertainty into the market. They have sought to reduce this by committing themselves to accepting auction-clearing prices rather than setting target cut-off rates. One particularly effective way was followed in the UK where the DMO was removed from the Bank of England to become a part of the Treasury (Finance Ministry). The objectives were pertinent to the Indian situation: to ensure that debt management decisions could not be influenced by inside information on interest rate decisions, and to increase transparency in debt and cash management operations. 378. It is important to note that the level of devolvement has been reduced recently though the level of private placements remains high (see Volume 1 Table 1.6). In the current fiscal year (2001/02) the RBIs figures put devolvement at Rs679crore (I devolvement) and private placements at R225,000crore (5 placements) out of a total issue of RS95,000crore. We would argue however that: a. It is not possible to be slightly interventionalist the market perceives that the RBI intervenes and it acts accordingly. b. The high volume of private placements indicates that the RBI is not willing to trust the auction process. This implies that it continues to attempt to manage the market and the level of government bond prices. But the relevance of the proposal is greater, since there is clear evidence that the RBI does not accept market-clearing prices and there is a wide perception of a conflict of interest between its debt management and monetary management roles. The UK DMOs objective is solely to carry out the Governments debt management policy of minimising its financing costs over the long term taking account of risk. This is consistent with the aims of the RBI, but the UK DMOs operational guidelines, which are published, explicitly prevent it from being anything other than a pure price taker save in the most exceptional circumstances. In other words, although The Bank of England retains monetary responsibility, a view has been taken that: a. the lowest funding cost will be obtained by allowing the market to clear freely without intervention; and b. the DMO, since it has no special information or control, is not in a position to judge or play the market. (This will be important in the discussion of auction timetables below.)
379.
380.
381.
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382.
The Chief Executive of the UK DMO is only answerable to Parliament, and then only for the efficient operation of the DMO and the efficient selling of securities, i.e. meeting the DMOs annual remit. Neither it nor the Bank engages in any significant open market operations in Government securities, short-term monetary management being entirely conducted through the repo market. As a practical matter, the transfer to the Treasury involved no disruption since the existing staff and premises were retained. The staff has expanded since the separation but remains small at about 30. This is sufficient to manage the auction process, which, in the UK, remains manual and hence relatively inefficient. Since the UK DMOs formation in 1998, the UK Government has been in the comfortable position of fiscal surplus; indeed, a substantial surplus in the latest year as a result of the sale of the third-generation mobile phone spectrum. The DMO sees its current task as maintaining the Government bond market in the face of net overall surpluses. Forecasts suggest the UK Government will become a net borrower during the next two or three years, so it is important to maintain the market by refinancing and converting debt. No changes in the current structure or staffing are expected when the Government reverts to its more normal position as a net borrower.
383.
384.
Recommendations 385. It is recommended that the Indian authorities should abandon the practice of intervening in the auctions of dated securities. Auction prices should clear the market. The current practice of intervening and selling devolved debt later unsettles the market. The central bank is only likely to achieve a better price consistently if it knows that rates will decline, i.e. it knows the price will improve. Therefore, the market participants will assume, correctly, that they are dealing with an informed counterparty and adjust their bids accordingly they will bid lower to offset the risk of loss if the RBI takes a devolvement and manages rates downwards to sell the devolved stock. The expectation is that if the RBI were to operate as a pure price taker in the auction, then this uncertainty premium would disappear and average funding costs would be lower. It would also mean that prices would more accurately reflect the markets expectations of economic fundamentals, which would benefit the secondary market. Many central bank issuers have sought to become price takers, e.g. Korea and Australia. The problem is how to convince the market, which naturally fears that the central bank will revert back to its interventionalist ways. The quickest and most definite way to remove this uncertainty is to establish an independent DMO, which we recommend, as a way of establishing the credentials of the noninterventionalist policy. The move to price taking by the RBI, reinforced by a move to an independent office, would significantly improve the quality of the primary and secondary markets by making them truly price driven. It would also remove uncertainty in the market and lead to a reduction in borrowing costs. It is worth noting in the context of cost of funding that the UK DMO saw an immediate
386.
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reduction in its borrowing cost of some 40 basis points following the announcement of the move to an independent debt office. 387. We understand that the situation in India is complex in that the Government of India is a substantial net borrower. Whether it remains so will depend upon progress in enacting and implementing the Fiscal Responsibility Bill (see Chapter 9 under Macro-economic Issues). Successful implementation of the bill will require a medium-term debt management plan to achieve the targets. An environment of declining borrowing would offer a prime opportunity to move to independence for debt management by providing a less fevered need to issue debt. We understand there are also staffing issues, the RBI's Debt Management Cell having a substantial staff. This should be seen as a separate issue. It may need to be resolved at some future date, but since the move to an independent debt office is a move within the public sector there is no immediate need to restructure the office (merely change its reporting line and objectives), though greater efficiency through restructuring may be a longer-term objective as part of a general quest to reduce Government spending.
388.
Lack of Transparency and Predictability in Issuance

389. There is seasonality in the private sector demand for credit. For reasons originally linked to the agricultural cycle, but still persisting, the private sector is a more active borrower in the winter (October to March). This pattern has continued. The RBIs borrowing pattern sought to avoid conflict with the private sector market. The RBIs borrowing pattern has been to raise the bulk (about two-thirds) of its budgeted issuance during the AprilSeptember period. (The budget year is April to March.) The smaller share of the budgeted borrowing is then raised in the second half of the year when corporate issuance is higher. Any excess funding is also raised towards the end of the financial year. In recent years, the borrowing need of the Government has exceeded plans, so there has been recourse to the market over and above that announced in the Budget. It is difficult for market players to anticipate this additional supply of securities for the following reasons: a. While expenditure and deficit figures are available, they are considerably delayed the market will be aware of an overshoot but not its magnitude. b. The method of funding and the maturity structure of dated security issues is not known. c. The RBI may opt to take the stock as a private placement or a devolvement, and so the timing of its impact on the market is uncertain.
This adds further to the uncertainty premium on the auctions. 390. The absence of an auction calendar for dated securities (T-Bills are issued to a calendar) adds further uncertainty in that the future supply of dated securities is largely unknown: first, because a primary dealer cannot be sure that there will not be another auction in similar maturity while he is still distributing stock from the last auction; and secondly, because the total supply during the year is unknown.
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391.
Uncertainty (and uncertainty cost) can also be reduced by improving the transparency of the process. Auction calendars are the most visible part of this, but there should be a whole process of continuous updating for the market. This should start with the budget remit (and the earlier the budget financing projections can be published before the start of the Budget year the better), indicating the expected level of finance together with whatever indications the debt office has regarding the maturities at which stock will be offered. The UK DMO Financing Remit gives the split between conventional and index linked, the number of auctions planned and the approximate maturity bands of the auctions. These figures are updated throughout the year as new information becomes available on the borrowing requirement during the period of the remit. Thus, at any time the market knows roughly as much as the DMO about the likely supply of Government stock.
Recommendations 392. The DMO should adopt a policy of maximum transparency with auctions. The current situation, where the market is only aware of an issue and its details a week ahead, adds uncertainty and cost to the market. Other markets have found it beneficial to the market, and hence to funding costs, to keep the market informed. Inevitably any information that the DMO shares with the market will always be provisional since it is subject to changing circumstances, but if the market is as well informed as the DMO then a considerable source of uncertainty is removed. It should also consult with the market on the most desirable structure of maturities and timing. There is already a calendar for T-Bills, but not for dated securities (which make up the bulk of issuance). However, publishing a calendar is only a part of transparency. Information on the plans for issuance should be published as soon as information becomes available i.e. general statements of the pattern, size and timing of issuance should be made available as much before the start of the year as the budget process allows. This should then be firmed up through further information releases to the market and continuous consultation with primary dealers. Where revisions are necessary as spending/expenditure plans are varied, the calendar (which is always provisional, being the best estimate based on current knowledge) should be adjusted and the market informed. The transparency policy should become a continuous interaction between the market and the issuing authority involving a two-way flow of information.
393.
Cumbersome Issuance Procedure

394. The current procedure is a two-stage process as described above. Primary dealers bid for underwriting of the auction and then bid for stock in the main auction. Both processes require paper bids to be submitted to the RBI in Mumbai. Primary dealers do not have exclusive access to the auction. The underwriting bidding is particularly problematic since primary dealers are being asked to underwrite the issue at an unknown price, as the RBI has a cut-off price that is not announced to the market. Primary dealers receive an underwriting fee for the amount they offer to underwrite, decided by the underwriting auction
395.
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and reflecting the amount they underwrite (rather than what they may actually take up). It is not clear how the dealers determine their bids, since the underwritten price is unknown. 396. There are two possibilities: a. the primary dealers underwriting bids include a premium to cover them for the uncertainty; or b. the RBI is able to drive out any uncertainty premium from the dealers bids and so the underwriting fees do not reflect the risk they bear. Either possibility is bad for the development of the market, since the first means there is a cost borne by the RBI for the uncertainty that it is creating, and the second that the primary dealers are receiving uneconomic fees. Since there is no obligation for the underwriting to cover the whole auction in dated securities (as there is in T-bills), it is not obvious what the RBI gains from the procedure in return for the fees (Rs. 833 million in 199899). In other markets that use underwriting of Government issues, such as Korea, the underwriting is for 100%. Electronic auctions reduce the time between closure of the auction and notification of results. The Australian debt office reduced the time from 29 hours to 1.25 hours. The period after closure of bids is a period of considerable uncertainty when primary dealers and other bidders are at risk but unable to adjust their positions with certainty. Electronic auctions also potentially widen the audience for Government securities, since it is no longer necessary to deliver a physical bid. Electronic auctions may be open (bidders can see other bids) or closed (like sealed bids). The trade-off is possibly better information in open auctions against the possibility of gaming through spurious bidding and a tendency for bids to be delayed until the last moment. When-issued or grey markets assist price discovery through allowing trading in the run-up to the auction. If the auction stock is a reissue, then this happens anyway, so it is only important for new lines of stock. Markets where grey trading is allowed typically converge towards the auction price, so the distribution of bids is reduced and the willingness to commit to bidding is increased.
397.
398.
399.
400.
Recommendations 401. The underwriting procedure is costly and gives relatively little reassurance since the RBI has historically received large devolvements of non-underwritten debt. Our sense is that the market is now sufficiently well-developed with well-capitalised primary dealers that underwriting adds little in the way of additional certainty or security. If an issue is genuinely attractive it will not need underwriting and if it is unattractive then the fees will result in a transfer from the RBI to the underwriters sufficient to offset the unattractive terms of the issue. So the RBI probably gains nothing. We would recommend a discontinuance of the underwriting procedure even though the RBI has modified the system from fixed fees to auction-based fees.
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If, as we recommend, the RBI were to move to a fully price-based auction, given credibility by the establishment of an independent debt office, then the issue would not arise. 402. The RBI is introducing the Negotiated Dealing System, which will include functionality for an electronic auction. This will increase the efficiency of the process, though there is no indication that the process is unduly long under the current system. Electronic auctions will also allow nationwide access and potentially wider participation in the auction process. However, since the new auction will replicate the functionality of the existing manual procedure, while desirable just on grounds of efficiency and better record-keeping it will make little real difference to the issuance process. The high level of opacity is likely to be a deterrent to wider participation, since potential participants cannot see the current level of bids. On the other hand, experiments with transparent auctions have had mixed results. The RBI should explore the possibility of increasing transparency, but cautiously and in consultation with current market participants. We do not recommend that primary dealers should be given exclusive access to dated security auctions. The current system allows non-primary dealers to participate directly in the auction. The practice in many markets is to grant primary dealers exclusive access to the auction. However, the existence of one additional layer of intermediation is contrary to the modern trend of utilising technology to obtain disintermediation in financial markets. The commercial position of primary dealers depends upon a balance of privileges and obligations. Exclusive access to the auctions (i.e. an entry barrier which prevents final investors from disintermediating primary dealers) is usually one of the privileges of being a primary dealer. We asked a number of Indian primary dealers what they saw as the advantages of being a primary dealer. The main response was access to the interbank money market and the, albeit limited, access to cheap funds at the RBI, plus the fact that in order to be a significant player in the market one had to be a primary dealer. Our sense was that the economic balance was quite fine, and the strategic and reputational advantages were dependent upon an assumption of growing profitability that may be unfounded. However, the rapid and continuing growth in the number of primary dealers suggests that the balance is still positive and we saw no reason to change the balance at this stage. When-issued or grey markets, as noted, can be beneficial. However, we would caution that grey market trading requires trading skills that are still poorly developed in the Indian market. A too rapid move towards grey market trading might be destabilising rather than stabilising, and our feeling, on balance, is that the introduction of grey market trading should be postponed for some time to allow the markets to develop the necessary skills.
403.
404.
Fragmentation of Gilt Issuance

405. The Government has made efforts to consolidate debt issues, but the market remains characterised by a large number of issues, many of them relatively small. Graph 4.1, drawn from data at end-2000, shows there were some 112 issues with
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only some ten issues exceeding Rs. 100 billion, representing 29% of the outstanding.
Graph 4.1 - Size Distribution of Government of India Dated Securities

Value of Issues 150 100 50 0 Individual issues
406.
Graph 4.2 (each segment in a bar represents a stock) shows that for short- to midrange maturities, the liquidity is often split between four or five stocks of a similar size. The effect of this is to fragment liquidity.
Graph 4.2 - Government of India Bonds by Maturity and Amount Outstanding
Amt Outstanding Rs bn
500 400 300 200 100 0

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 Years to maturity U
407.
As a comparison, the UK DMO has also been through a process of consolidation with the aim of concentrating liquidity in a small number of benchmark issues. It has reduced the number of issues from 96 in 1992 to 66 at the end of 2000 (of which 21 are rump issues that are very small and have little liquidity). Liquidity has been concentrated in the major issues, so that of the 66 issues, 40 are over 1.4 billion (approximately Rs. 200 billion), representing 97% of the outstanding. Graph 4.3 shows the comparative results of issues by maturity for the UK. Aside from the general shape of the curve (the UK DMO has a legacy of relatively short-
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term bonds), the contrast is that in many maturities there is only one or two stocks (usually one index-linked and one conventional).
Graph 4.3 - UK Government Bonds by Maturity and Amount Outstanding 30 25 20 15 10 5 0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 U
Years to maturity Amt Outstanding bn
408.
The Australian debt office went through a similar process to the UK and has reduced its number of issues from 128 to 15 benchmark issues as at 2001. These benchmark issues make up 95% of the total issued value.
Recommendations 409. The need to consolidate has been recognised by the RBI and passive steps have been taken through reopening of existing stocks: The size of the gross borrowing requirement and the market's absorptive capacity at any particular point in time has put constraints on the size of individual issues and accordingly has increased the frequency with which the Government enters the market to raise resources. Efforts were made to accommodate a series of new issuances within a narrow 10-year maturity band in order to prevent a bunching of repayments, but loans became fragmented as a result, and this impinged upon the liquidity of the Government securities. Loans therefore need to be consolidated to improve the fungibility and liquidity of securities and to pave the way for introducing STRIPS in the GSM. The reopening of existing stocks marks a first step toward passive consolidation. (Usha Thorat, Indias Debt Market: A Review of Reforms, in Building Local Bond Markets: An Asian Perspective, IFC, September 2000.) 410. The passive process of loan consolidation that the RBI has followed has yielded some positive benefits. First, the total number of outstanding issues has increased only marginally since 199899. Secondly, of the 116 outstanding issues as at the end-March 2001, 18 (comprising less than 16%) accounted for 43% of the total outstanding amount.
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411.
However, given that issuance is targeted at longer-dated stocks, this method of consolidation will not help for stocks with shorter maturities and will only have a slow effect in the longer-dated market. More active steps towards consolidation are most required in the two- to 15-year maturities (assuming that shorter-dated stocks will be nearing/passing redemption by the time a process of consolidation gets under way). The Public Debt Office (PDO) should aim to reduce the number of issues in the three- to 15-year maturities to one or two main issues per maturity. If implemented in full, this would imply reducing the number of stocks in total from 112 to about 54. However, there is relatively little to be gained from consolidating some very small stocks; the main gains will come from combining medium-sized issues to make large issues. We accept that this will not be a trivial process. There are, for example, legal obstacles in the way of consolidating loans issued prior to 1992 with those issued post-1992. Also, in the absence of call provisions, investors can be given an option to redeem their bonds. However, there is no guarantee that the entire outstanding amount of a security would be extinguished as a result. Given a choice between swapping a holding in an illiquid stock into a consolidated and therefore more liquid stock, few investors are likely to refuse, but some rump of the old stock will inevitably remain in issue.
412.
Restricted Repo Market

413. Repos can be executed either as inter-bank deals or by any permitted entity with RBI as the counterparty. Banks and primary dealers are permitted to undertake repos and reverse repos. Rollover repos are not permitted. Currently, while a market exists, it is restricted and small. In view of the continuing demand from market participants to widen the scope of repo transactions, a report was prepared by a sub-group of the RBI Technical Advisory Committee on Government Securities. The report, submitted in April 1999, covers all aspects of repo transactions, including legal status, regulatory framework, standardisation of accounting and risks involved. The recommendations include widening of the participant base, and expansion of the list of eligible instruments, removal of restrictions on maturity of repos, and market processes such as exchangeability of collateral, subject to the creation of market infrastructure which allows for (a) dematerialisation of all securities involved in repos and (b) innovation at the clearing corporation. As the CCI project falls into place, the development of a modern repo market would be a central area of attention on the part of CCI.
414.
Recommendations 415. The remaining recommendations of the RBI Technical Advisory Committee should be accepted. In particular: a. Widen the participant base by allowing all SGL account holders to conduct repos. With the RBI Credit Policy of April 2001 having laid down a timeframe
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for making the call money market a strictly inter-bank market, it would become imperative for non-bank entities to use the repo market for fund management. b. Widen the list of eligible instruments. Repos are currently allowed in Central Government securities (T-Bills and dated bonds). State Government securities are eligible instruments for repo transactions with the RBI. The sub-group had recommended widening the list of eligible instruments to State Government securities, corporate and PSU bonds, and bonds issued by financial institutions. c. Specify uniform repo accounting standards. Since only buy/sell-back repos are allowed, most entities treat them as an outright sale and an outright purchase, while a few treat them as collateralised borrowing in the money market. d. Introduce greater flexibility by allowing rollover repos. 416. Reduce settlement risk for repos. Settlement of repos is currently through the RBIs Delivery versus Payment end-of-day system. This involves a level of counterparty risk. The implementation of the Clearing Corporation will address this. CCI will act as a legal counterparty to all transactions and set collateral requirements for all participants. This will be more important when more instruments are allowed, since SGL accounts held with RBI only hold Government securities.
CORPORATE DEBT SECURITIES

417. Corporate debt may be issued through a public offer or through private placings. The former involves gaining SEBI approval for the issue documents and then offering the stock to all potential investors at a fixed price. Private placings involve a book-building exercise among institutional investors and dealers. The market is segmented in that the investors in private placings do not subscribe for public offers and the subscribers to public offers are usually retail investors without access to placings. The corporate debt market is overwhelmingly a private placement market (92%). In the latest year only two companies have made regular use of public issues. As Table 4.2 shows, the number and value of private placings has increased steadily while the value of public offers has been volatile but has seen little growth.
Table 4.2 Private placements: Historical number and proceeds Private placings Public issues Total Number Rs. bn Rs. bn Rs. bn Private placings (%)
418.
Year
199596 199697 199798 199899 199900
73 204 252 445 711
100 184 310 388 547
29 70 19 74 47
130 254 329 462 594
77 72 94 84 92
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419.
Private placements are made by a range of different types of issuer, as shown in Table 4.3.
Table 4.3 Private placements by issuer type, 19992000 Issuers Issues No. % No. % Value Rs. bn
Issuer type
All-India fin. institutions and banks State-level financial institutions Public sector undertakings State-level undertakings Private sector Total 420.
44 6 18 48 117 233
18.9 2.6 7.7 20.6 50.2
256 36.0 9 1.3 49 6.9 73 10.3 324 45.6 711
145.4 26.1 84.4 165.3 125.9 547.1
26.6 4.8 15.4 30.2 23.0
The continued importance of the public sector in the Indian economy is reflected in the fact that 77% of the total issue value was by public sector entities. Industrial and commercial enterprises took 61% of the total proceeds, banking and other term lending institutions 31% and financial services companies 8%. Private placements varied in size, as shown in Table 4.4, but included 150 issues over Rs. 1 billion that made up the bulk of the total proceeds. However, the majority of issues were for less than Rs. 250 million; the largest issue was for Rs. 26 billion and the ten largest issues totalled Rs. 191 billion, or 31% of the total
Table 4.4 Private placements by value, 19992000 Total value Average value per issue Issues Rs. bn Rs. m
421.
Value range (Rs.)
Up to 100m 100m to 250m 250m to 500m 500m to 1bn Over 1bn Total 422. 423.
309 106 91 55 150 711
12.4 20.5 39.2 40.7 434.2 547.0
40 193 431 740 2,895 769
The average duration of the issues was five to six years, with very few for over ten years. Table 4.5 shows the rates of private placements during 19992000. A most striking feature of the issuance was the predominance of very highly rated corporates (though it should be noted that Indias relatively low sovereign rating would make many of these barely investment grade for international investors). State entities often do not have a rating, as investors see them as guaranteed. But of the 354 that had known ratings, 331 were AAA or AA.
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Table 4.5 Private placements by rating, 19992000 Rating No. of issues
AAA (+/-) AA (+/-) A (+/-) Other Not rated Not known Total 424.
194 137 19 4 247 110 711
The private placement market is apparently only available to the most highly rated issuers. This was confirmed in our discussions with investors who, without exception, said they would not consider anything below a local rating of AA.
Lack of Access to Debt Market for Corporates

425. In most markets private placements are used by smaller or less highly rated companies, but in India the mechanism is used for issues by the largest corporates. Table 4.6 shows the three main types of corporate issuance in India.
Table 4.6 Types of corporate issuance in India Explanation
Type
Public offers
Private placements by highly rated corporates Private placements by less highly rated corporates
General offers made in compliance with SEBI rules for public issues and open to all investors. There are few of these, largely, we understand, because of the cost and length of the process to meet the requirements. This is discussed later in this chapter. These are the main types of issue for large, Indian corporates. SEBI regulations limit private placements to a maximum of 49 investors, but that is sufficient for most issues. Regulation is light and the procedure for issue is very rapid and cheap. These are similar to the private placements found in other markets for smaller or riskier companies. The cost of investor duediligence means that investment is only viable where the investing institution takes a major stake, so the issue is very tightly held (one investor in the extreme). The nature of the issuer generally also forces the investor to take an active supervisory role with the company and/or impose restrictive covenants.
426.
Tables 4.7 and 4.8 show a stylised contrast in structure between a generic corporate bond primary market and the Indian corporate bond market. Issuers are subdivided by rating quality, a high rating being AA (or equivalent) and above, a medium rating being lower but still investment grade and sub-investment grade. The horizontal dimension indicates the size of the issuer, relative to the market. The model splits issue type into public issues (wide distribution), limited issues (private placements by large corporates) and conventional private placements (by smaller, riskier companies).
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Volume 2 Analysis and Recommendations Chapter 4 Issuance and Instruments Table 4.7 Generic bond market Large Medium
Issuer
Small
High rating Medium rating Sub-investment grade

Issuer
Public Public/PP Public/PP
Public/PP PP PP
N/A PP PP
Small
Table 4.8 Indian bond market Large Medium
High rating Medium rating Sub-investment grade 427.
Public limited PP PP
PP PP PP
N/A PP PP
The shaded cells identify the differences shown between the two market models, illustrating the two distinguishing features of the Indian corporate bond primary market: a. Large corporate issues, which in other markets would be more likely to be done as public issues with a wide distribution, are issued as private placements to a limited investor group. b. Mid-sized corporates and/or those with ratings below AA or the equivalent are largely confined to private placements in the usual sense of the term, with their issues generally made to a very small group of investors, often purely bilateral deals.
Secondary market impact 428. A liquid secondary market is heavily reliant upon an active and diverse primary market. This is especially true with bonds, where much secondary trading is concentrated in the newly issued stocks. The unusual nature of the Indian primary market has two consequences for the secondary market: a. Issues that, in other markets, would be widely held and so tradable, are usually issued to a small number of holders. (The maximum permitted for private placements is 49, but the norm is far fewer, usually below ten and often below five. b. Smaller, less highly rated issuers have access only to a very small number of specialised investors, which severely limits the potential for trading. In other markets there will be reasonable liquidity in the public issues, depending upon the size and possibly a formal or informal market for privately placed issues. In India there is no market for any but the bonds of the largest, most highly rated corporates, since these are the only ones where the spread of ownership approaches that for a reasonably liquid and efficient market. Referring to the model used earlier, Tables 4.9 and 4.10 show the contrast in tradability between the generic market and the Indian market. The heavily shaded cells show where reasonably active trading might be expected, and the lighter shaded cells where some trading might be expected. In the Indian model, trading is limited to a single cell and even that is only likely to see some trading.
429.
430.
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Volume 2 Analysis and Recommendations Chapter 4 Issuance and Instruments 4.9 Generic bond market Large Medium
Issuer
Small
High rating Medium rating Sub-investment grade

Issuer
Public Public/PP Public/PP
Public/PP PP PP
N/A PP PP
Small
4.10 Indian bond market Large Medium
High rating Medium rating Sub-investment grade 431.
Public limited PP PP
PP PP PP
N/A PP PP
The full range of corporate finance options available to Indian corporates is beyond the scope of this project. However, on enquiry we were told that all bar the top corporates are excluded from the bond market. Their main source of finance is the development banks, as commercial banks do relatively little corporate lending since they lack the skills for assessing corporates. The development banks have emerged from the state-owned development banks but are now aggressively private and dominate corporate lending. They finance themselves not through deposits, which they generally are barred from taking, but through debt issues. The development banks are active in the private placement market, borrowing wholesale to lend on to smaller corporates. They have also sought to tap the retail market through public issues of bonds. The section above described the feature that bond issuance, either through public issues or private placement, tends to be confined to the top corporates. It was noted that medium-sized or medium-rated corporates tend to issue very limited private placements, often to a single holder, frequently a development bank, where in other markets they might make public issues or private placements to a larger number of investors. Several possible reasons were examined: a. crowding out; b. falling interest rates; c. pricing; d. tax volatility; and e. lack of investment demand.
432.
433.
Crowding out 434. While this is outside the terms of reference of the project, it is quite likely that the very high level of Government borrowing is crowding out private sector issuance. Crowding out drives out corporate bond issuance through a combination of high and volatile interest rates. Real interest rates are high in India the rate on Government of India issues is currently about 9% compared to a current inflation rate of 4% (which is projected to fall). Interest rates are volatile because the size of the states demands is the main determinant and this is unpredictable
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435.
The long-term downward trend also discourages issuance, since corporates are reluctant to risk issuing medium/long-term bonds with fixed coupons. (We note later that Indian private placings are frequently renegotiated to accommodate changes in interest rates.) In such macro-economic circumstances, corporations will opt for equity finance where the return is linked to profitability rather than current interest rates. Until the recent market decline, Indian corporates were significant issuers of equity. Some 9000 companies are listed on stock exchanges, illustrating that corporates tend to see the equity market as the vehicle for public capital raising. Where equity is unsuitable or unavailable, corporates will tend to opt for short-term variable-rate finance such as bank overdraft finance. Crowding out is something of a misnomer, since it neglects the fact that it is always possible to borrow at a price, so corporates will continue to borrow even with very high levels of Government borrowing. In fact, Indian corporates have increased their borrowing alongside the growth of Government borrowing, as Graph 4.4 illustrates.
Graph 4.4 - Issuance of dated securities and corporate bonds
1000 Issuance Rs Bn 800 600 400 200 0 1995/96 1996/97 1997/98 1998/99 1999/00
436.
437.
Corp bonds
Dated secs
438.
However, Indian interest rates are certainly higher than they would be if the level of Government borrowing were lower. Investment projects that are not profitable at current rates would be undertaken if rates were lower. India does have a reasonably high rate of investment and it may be argued from this that there is no crowding out by price. However, it is difficult to pull apart the state and non-state parts of investment in the current Indian economy, and so it is hard to be sure that all the investment is decided on grounds of profit potential. The most plausible conclusion is that private sector investment would be higher if interest rates were lower; and as the economy continues to transform, this will become increasingly significant.
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Recommendations 439. As already noted, macro-economic policy, and particularly the level of Government borrowing, is beyond the terms of reference of the project. However, it is obvious that a large and growing Government deficit is incompatible with an active primary and secondary market in corporate debt. The Government of India has itself recognised that the burden of debt is not sustainable in the longer term and has introduced the Fiscal Responsibility Bill with the intention of sharply reducing Government borrowing by 2005 (see discussion in Chapter 9 Macro-economic Issues). While accepting that the level of Government borrowing is beyond the terms of reference, the fact that the Government has already accepted the need for greater control is itself enough to make the point. However, we would make some comment on the implementation, given that the objective is accepted. If the bill is enacted and the timetable is followed, then a significant barrier to development of the corporate debt market will have been removed. However, a structural change of that magnitude is very large and difficult to achieve, so there have to remain doubts as to whether the timetable will be met. The credibility of the policy could be enhanced if, after enactment, the Government of India were to publish a strategy for medium-term policies to achieve the goals of fiscal responsibility. Such gains in credibility would bring shorter-term rewards, in that corporates would be more willing to enter the bond market in anticipation and expectation of greater, lower-cost liquidity in the primary market.
440.
441.
Falling rates 442. Indian interest rates have been on a downward trend through the late 1990s. Traditionally, issuers have avoided issuing bonds in falling interest rate periods, fearing being locked into the prevailing high yields. However, most bonds currently being issued have call provisions or other features designed to minimise the risk to the issuer. Inevitably, callability raises the cost, as investors seek to be rewarded for granting an option to the issuer, but that is a fair response to the issuers needs. While issuance is currently lower than it has been, the view is that this is a consequence of uncertainty in capital markets linked to the Indian equity markets, rather than because issuers are holding off until interest rates bottom out.
Pricing 443. An effective corporate bond primary and secondary market relies on the sovereign debt market for its pricing baseline. The sovereign yield curve is the benchmark for issuance and trading. The Indian Government debt market has a history of administered prices. It is now far more liberated than it was, but there is still significant intervention from the RBI to set rates, in its view to stabilise the economy and avoid unacceptable fluctuations in interest rates, etc. This is discussed elsewhere in this chapter, and recommendations are made to improve the pricing of Government bonds. If prices in the sovereign market are to an extent administered, or are perceived as administered by the market, then the sovereign yield curve will
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not provide a reliable benchmark and will be a barrier to development of the corporate bond market. This remains the case in India. 444. An important part of price formation is the ability of intermediaries to arbitrage anomalies. This ensures that assets stay in line and eliminates pricing anomalies. It tends to be the function of intermediaries rather than investors, since intermediaries have better access to the market, giving lower transaction costs and enabling them to exploit smaller arbitrage channels. Intermediaries try to minimise their risk and maximise the efficiency of their capital usage. This usually involves them arbitraging through offsetting transactions in different assets. The usual pattern for corporate bond traders is to trade the corporate bonds one way and offset this with transactions in Government bonds (trading the risk spread). This often means buying the corporate and selling the sovereign. However, their need to work their capital and minimise risk means they will buy the corporate and short the sovereign. This is not permitted in India, so an important force for better price discovery is lost.
Recommendations 445. Improve pricing efficiency in the sovereign debt market, as described later in this chapter. Specifically, take measures to remove the RBIs influence on Government bond prices and reduce uncertainty in the issue process by better timetabling and information dissemination. Permit short-selling of Government securities, as recommended in Chapter 5 on Trading.
446.
Volatility of Tax Environment

447. Evidence is that the investment tax environment has been volatile in recent years. Examples that have affected bonds include changes to dividend taxation, the taxation of mutual funds, and the (beneficial) abolition of stamp duty on transactions in dematerialised securities.
Recommendations 448. Define a medium-term strategy for investment taxation as recommended in Chapter 7 on Taxation.
Lack of Investment Demand

449. Lack of investment demand appears to be a significant barrier to bond issuance. There is an appetite for corporate paper, and most interviewees said they were buyers whenever there was availability of acceptable paper. This is borne out by the relatively low yield spread of corporate debt over Government debt - about 100 basis points is the norm. This has reduced as investment institutions have sought higher yields and bid up the price of corporate debt. But crucially, most Indian investment institutions largely or exclusively confine their investments to AAA, or possibly AA, bonds. While institutions that will take sub-investment-grade debt are
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rare in any market and probably confined to the US and one or two other mature markets, there is usually a debt primary and secondary market for middlerated/sized issuers. The reasons for this conservatism in India are varied: a. Statutory guidelines: These apply to provident funds, which are prohibited by regulation from investing in more lowly rated bonds. b. Trust deed restrictions or similar: some entities, including some mutual funds, have restrictions that were imposed when the entity was set up and are included in the trust deeds or other governing documentation. c. Self-imposed guidelines: several interviewees remarked that they confined their investment to AAA bonds or similar. 450. In the past, institutions have experienced relatively high levels of default (or renegotiation, since formal default is rare see below) even among supposedly secure issuers. The reason given is that the Indian economy has undergone a profound change as a consequence of opening its markets to imports (though this process is far from complete). Companies that appeared entirely secure within an Indian context proved to be weak when faced with foreign imports. There is therefore a great caution among investors. (This is as true of retail investors, where an equity-based but implicitly Government-backed fund was seen as less risky than a high-quality corporate debenture, as it is of institutions.) But the conclusion of the research was that the most telling reason was that, whatever the restrictions, formal or informal, most investment institutions lack the special skills required for investing in more risky bonds. The approach of most institutions was to invest and trade for yield alone and not for credit risk. Investing in more risky bonds requires an entirely new skill set. Bond investors face considerable downside risk because of the possibility of default. The risk is compounded by the fact that the bond issuer will generally be better informed about the default prospects than potential investors (asymmetric information). Borrowers may also be tempted to act against the interests of, or to defraud, lenders (moral hazard). Investors in more risky bonds seek to mitigate these risks through due diligence and covenants. They may be assisted in this by external organisations: a. Rating agencies assess issuers and issues, rating them according to a scale of riskiness. There are various ratings systems indeed, India has four agencies but the principle and approach is the same (though reputations may vary). b. Stock exchanges admit companies to listing if the company provides sufficient current information and undertakes to supply future information. As a rule, stock exchanges do not make any comment on the creditworthiness or otherwise of the issuer, merely that sufficient information is available for investors to make an informed decision. Larger companies are more likely to be listed and have ratings. Therefore, the effort required for due diligence is less than for smaller companies, since the information and extensive analysis is already available. Bond investors seek further protection through imposing covenants. Covenants restrict the actions of borrowers by:
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451.
452.
453.
a. requiring regular reporting of performance against key measures, typically related to profitability and interest cover (maintenance covenants); b. requiring borrowers to gain specific permission from bondholders for actions such as acquisitions, capital changes or distributions (occurrence covenants); or c. requiring the investor to have a close relationship with the running of the company, at least in strategic decisions that might affect the bondholders. d. The due diligence and covenant negotiation are expensive processes. These costs naturally affect the size and distribution of issues. Essentially, a lender must be offered sufficient yield to cover his cost of capital, the default risk (ratings will be a guide, but should be supplemented by research), and the costs of assessing and monitoring. 454. Costs of assessing and monitoring tend to be relatively fixed with respect to issue size, so the smaller the issue the more narrow is the base over which to spread those costs. This has two consequences: a. There is a practical minimum size for an issue: smaller issues would involve very high costs, which would mean that prohibitive yields would be required to compensate investors. b. The smaller the issue, the smaller will be the economic number of investors. This, among other things, makes a liquid secondary market difficult to achieve. The final element in the tool-kit for investment in more risky bonds is the workout skills, i.e. how much the investor can recoup in the event of a default. It is said that the workout is critical to the profitability of investing in more-risky bonds; aside from the investment decision, it is the main control point for the investor. More mature markets will have specialists in distressed debt who take these issues from other investors and extract the maximum value. Successful workouts require special skills and also very clearly defined procedures for initiating default procedures. If bankruptcy procedures, etc., are fuzzy, then a good workout is difficult to achieve. Indian investing institutions, currently, would have difficulty in following the requirements for due diligence, monitoring and workout of defaults: a. Due diligence: Indian investing institutions do not have skills in assessing default risk. As mentioned, their skills, such as they are, are in trading and investing on a yield basis. Historically, there has been little need for these skills as so much of the economy was Government-owned or guaranteed that credit analysis was redundant. Recent experience has awakened them to credit risk, but lacking the tools to address it they opt to play safe and invest in low-risk bonds. b. Monitoring: for similar reasons, investing institutions lack monitoring skills. Past experience suggests also that the information provided by companies to bondholders may be insufficient for proper monitoring. Investing institutions are certainly not equipped to take an active interest in or a more hands-on approach to the companies in which they invest and so are dependent upon public information that has proved deficient. c. Workout: the skills are lacking and there are difficulties in bankruptcy/default procedures. The research has not been able to investigate the detailed causes, as
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455.
456.
these are embedded within the legal and political system, but the clear impression is that triggering bankruptcy is not something an investor should attempt. Closure of failing enterprises has proved politically difficult and the process of seeking legal redress is extremely long. Reports of cases dragging on for a decade or more are not uncommon. The norm is for the issuer to offer renegotiation. Investors accept this, as the alternatives are even less attractive. But as the borrower is able to offer a take it or leave it option, the investors have little control of the outcome and so workout success is in the hands of the issuer. 457. The Indian investor situation is similar to the situation of many Western European banks that had long traded Government stocks, basing their trading on the sovereign yield curve. With the advent of the single currency, these banks found that the national Government bond markets had largely vanished and the scope for trading at the European level was not sufficient to support the current number of players. They wished to move into corporate bonds, but this was only economic if they traded the risk spectrum of corporate bonds. However, they lacked the skill set, since credit analysis had not been a skill they had required. The failure of investing institutions to develop the necessary skills reflects the historic lack of competition in the investment market institutions have not had to compete hard for the investors rupees and have tended to follow easier, safer options. In a competitive market, investing institutions compete to outperform and attract investors. Faced with a drying-up of profitable investment opportunities in the top-rated debt (Government and corporate), they would look around the market and purchase/develop the skills needed to offer attractive investment products using more risky bonds. This has not happened on any scale as yet, though institutions are facing declining relative returns on top-quality corporate debt (and in some cases squeezed by statutory guaranteed return requirements). However, in Chapter 2 of this report, under the heading Participants, the growth of new institutions is documented, mutual funds already and insurance companies in the near future. The same chapter also makes recommendations for improving the investment performance of provident funds.
458.
Recommendations 459. A number of factors are supporting greater investment in corporate bonds: a. Our research found a desire to invest in corporate debt albeit only of the highest quality. The declining yields on Government debt are pushing institutions towards higher-yielding paper in order to meet their commitments. Many institutions have a fixed commitment to members or policy-holders. For example, the provident funds are obliged to achieve a rate that is set by the Finance Minister, and the UTI has a commitment to give returns that are detached from investment performance on its large US-64 fund. Both of these have invested in corporate bonds for a higher yield. The result has been a demand that has outstripped supply. The spread of AAA corporates over Government is below 100 basis points the lowest spread ever known.
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b. Other investors are beginning to feel the force of competition if they are incumbents (UTI, LIC) or are aggressively seeking to enter the market (the new insurance companies). They will have to seek higher returns through investing more in corporate bonds, but may be disappointed by the declining spread unless there is an increased issuance of debt securities. c. The equity market that has been a focus for much retail investment is played out for the moment. Recent months have seen large inflows into bond mutual funds. Shortages of high-quality paper, together with low yields, will push them towards higher-yielding, lower-rated bonds 460. These pressures are pushing investors towards investment in lower-rated corporate bonds, but they face a major obstacle: lack of regulation of issues. The current private placement market suits the current players, both issuers and investors. However, the low levels of disclosure and informal nature of the contract are only sustainable with high-quality issuers essentially where there is enough public information available and governance issues are less (by Indian standards). Such an informal arrangement can only work for smaller companies if the investors are willing to devote considerable resources to due diligence, have the requisite credit analysis skills and are willing to become directly involved in the issuers (since the cost of due diligence can only be recovered by taking a large stake). Current investors are not in that position and so are unlikely to be successful investors in smaller issuer private placings. This suggests that their investments will be more like conventional portfolio investments and they will not be able to do the research themselves unless there is an increase in public information about the smaller issuers. This suggests that public issues, rather than private placings, are the most appropriate avenue for issues by second-tier corporates. Currently, public issue procedures are not satisfactory and are used only in special circumstances. We recommend below that these procedures be reformed to reduce the cost and time taken. The reluctance of investors to commit to less highly rated corporates in some cases reflects statutory or quasi-statutory restrictions. In particular, provident funds are restricted to AAA investments. These sorts of restrictions perpetuate the exclusive focus on the highest-quality issuers, as well as denying the stakeholders in provident funds the possibility of superior investment returns. We recommend that restrictions of this type be relaxed, but with caution. Throughout the report, as a sound principle, we recommend measures to continue the process of promoting competition in investment. This will lead to the development of the skill set required for handling a wider range of corporate bonds. This has proved to be the case in Europe, where the squeezing of Government bond markets as trading and investment vehicles has spawned the development of highyield markets, securitisation, etc. Competition will also encourage the emergence of specialist managers. We see this as an important development that will allow current fiduciary managers to bypass their own lack of investment skill by handing their investment portfolios to specialist managers.
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461.
462.
463.
464.
Lack of Specificity in Terms of Private Placements

465. The corporate bond market uses the terminology of public and private issues, but their meaning, in practice, is different to that used elsewhere. a. Public issues are essentially term deposit instruments aimed at retail investors. They are notionally tradable, but the issue documents give terms for early redemption. Trading would be difficult, so the sensible option would be to redeem with the issuer. They are constructed as bonds because the main issuers (the development banks) are not permitted to accept large-scale retail deposits. b. Private placements are essentially syndicated loans. There is seldom any clearly defined procedure for winding up the norm is for the terms to be renegotiated if circumstances change. This applies even to changes in the underlying interest rates if rates fall (as they have), issuers would go for a renegotiation (probably with a negotiated penalty) to reduce the coupon rate. Certainty of terms at the outset is one of the crucial features of a bond, and Indian private placements do not have that certainty. Therefore, they are not really bonds. This is a barrier to the broadening of secondary market trading, as it is difficult to price something that does not have certain terms. The original holders are comfortable with the situation since they are used to the renegotiation, but a wider group of potential investors would be deterred by the lack of certainty.
Recommendations 466. Moves towards a tighter structuring of bonds is a precondition for development of the market. Without it the market will remain limited to the current issuers and investors who trust each other to renegotiate. This can come about in two ways which we would see as desirable: a. Tightening of the documentation for private placings. We would urge a standardisation of documentation, but we believe this will only happen from a regulatory initiative the current players are happy with things as they are by SEBI in conjunction with the exchanges that trade corporate debt. b. Reducing the burdensome nature, but not the valuable information content, of the public issue process. Respondents commented that the tendency to renegotiate private placings, while sometimes a response to changing external conditions, was often a response to insolvency, i.e. a renegotiation of a default. The current bankruptcy procedures were deemed too slow to be useful. We therefore recommend improving bankruptcy and default procedures to give bondholders a realistic chance of obliging companies to honour their commitments, so shifting the balance of power back towards bondholders. The recommendation to force an improvement in private placement documentation is not in line with global norms. There are strong reasons for the recommendation that reflect the uniqueness of the Indian situation. As described private placements have become the dominant method of issuance for corporate debt. We have already described improvements to the public issue process in particular reducing the
467.
468.
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time taken to inspect prospectuses and reduce prospectus disclosure for issuers that are already well-known to the market through their equity issue. 469. In most markets there is little regulation of private placement documentation (in the US for example they are covered by the requirement not to offer fraudulent prospectuses but without prescription of content.). However the situation as it has developed in India is that private placement documentation is often unspecific about what happens in the event of a failure. The practice in a default is for the bond-holders to renegotiate terms with the issuer (we have noted elsewhere that the prospect of legal recourse is remote because of the lowness of the legal process). This limits participation to investors that are of sufficient size to be a part of that renegotiation process and forces them to take relatively large stakes in order to justify the costs of such renegotiation. Others would not be willing to purchase the bonds because they would be unable to price them accurately since they would have little or no involvement in any subsequent renegotiations. This represents a barrier to broadening of the market. It would be addressed by improving the quality of private placement documentation particularly in the area of default procedures. However to mandate this would require major changes to primary legislation which is unlikely. It is therefore suggested that the same effect be brought about by: a. Producing a model issue document for private placements. This would require comprehensive description of default procedures among other things. This could be produced by a trade association or a regulator. b. Requiring those regulated by SEBI and the RBI (by rule issued by those regulators) to only make investments in stocks that adhere to the model documentation. It is likely that market forces will reinforce this (with finer rates for placements that adhere to the code) but the nature of the Indian market suggests regulatory reinforcement would be necessary. There are precedents for this sort of action for example the RBIs requirement that banks only invest in dematerialised stock.
470.
Cumbersome Process for Public Issues

471. Since issuance is also largely confined to highly rated corporates, the dominance of private placings is surprising. In other markets, private placements are the preserve of smaller companies, where the small size of an issue means that only by taking a large stake can an institutional investor justify the cost of the due diligence examination. Private placements in other markets also include covenants and similar controls to ensure that the investor is able to have a measure of direct control over the company. Larger companies use private placements on occasions when they wish to move quickly or to sell an issue with special features; but in the main, large companies tend to favour public offerings, as these result in a finer price and the information disclosure required is not much of a burden.
472.
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473.
In India this is not so, and we were tempted, at first, to suspect that the limited number of market participants was the driving force. The thinking was that since the main investors were few anyway, there would be little to gain from a public issue in terms of reaching a wider market. However, we found this not to be the reason indeed, almost the opposite. It is possible to raise larger amounts through placements than through public issues. It appears that the main investors also prefer private placements and tend not to subscribe to public issues. Interviews with practitioners suggest that while the issuer could raise about Rs. 500750 crore from a public issue, amounts of Rs 1500 crore can be easily raised through private placements. Currently, only two issuers make regular public offers and the belief is that this is for balance sheet reasons rather than a preference for public issues. In fact, many of the issues are only bonds in name. They are highly specialised retail instruments that in most markets would be offered as deposit instruments. They are certainly not intended to be traded, and most buyers hold them to maturity. The preference for private placements raises two issues for the secondary market: a. Regulatory/disclosure concerns: private placements are subject to a lower disclosure requirement. This may make them unsuitable for public trading. However, in the Indian case, most of the companies making placements are well known to the market and very likely have equity listed, so the additional information that a public bond offer document could convey must be slight. b. Placements tend to be tailored to the needs of the small number of investors. This means that they are small (relative to public offers, although in India this is not true) and held by a few buyers. Trading is therefore difficult and potentially high in cost. Buyers invest usually with the intention to buy and hold, and any trading that does take place is by block negotiation between major investors. The main cause of the preference for placements appears to lie in the complexity, cost and time involved in making a public issue. Most investors we spoke to said they felt there should be more public issues, but that issuers were deterred. An essential prerequisite for a more active corporate bond market is a larger number of public issues. Accordingly, our recommendations focus upon the difficulties, perceived or otherwise, of making public issues.
474.
475.
476.
477.
Recommendations 478. Disclosure: The information we have suggests that the SEBI disclosure requirements for public issues of debt contain much duplication of material that would have been provided for previous issues or when seeking a listing of equity. We have wider questions about some of the disclosure standards that are addressed in the Regulation and Enforcement chapter (Chapter 8), but the point here is about unnecessary duplication. Each issue requires full disclosure of the companys activities and business. There is no provision for shelf-registration (where an issue is registered once and then issued in tranches as market circumstances allow) or
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medium-term note programmes that allow tranches of an issue to be sold as the market allows and with variations in the terms to meet current conditions. 479. It should then not be necessary for such disclosure elements to be required against each type of new security once such measures are made by the companies, rather than be specific to the security issues. Thus, this should allow all new bond issues to be made against a short form prospectus, regardless of whether they were being presented as a public or private placement where an equity issue already exists in public form. Hence, the only time a bond issue would require a full prospectus and initial (and subsequent continuous) disclosure requirements would be if the equity was not already quoted on a public market. While the disclosure requirements for public issues appear excessive, those for private placements are not regulated at all. While we would not wish to stifle the private placement market with burdensome disclosure requirements, some improvement is appropriate. We recommend that SEBI require, in agreement with the exchanges, that the standard of issue documents should be improved and that private placement offering documents should be standardised, albeit at a lower requirement level than for public placements. Time taken: The length of time it takes to get corporate debt issues to market would appear, from our research, to be the main impediment to the use of public markets for initial purposes. Several respondents suggested that it could often take between four and six months for a public placing to be achieved. Whilst some corporate treasuries will plan financing 12 months or so ahead, most, particularly for cash flow needs, will be working on a single quarterly basis. Hence, this sort of lead-time is unacceptable to them. In order to encourage the use of public placements, this lead-time must be reduced. Therefore, if the regulatory aim is to improve the percentage of new debt issues that are to be publicly offered, which from the point of transparency and reduced interest rates clearly should be a strong aim, then a number of necessary action points need to be addressed. We highlighted above that the disclosure regime has got to be efficient, whereas today it is seen as overly bureaucratic, duplicative and, consequently, inefficient. There is a significant need in this area to streamline the processes without losing any of the detail of disclosure and due diligence that currently exists. To achieve this, we would make a number of recommendations. The approval of new issues should be delegated to stock exchanges within an updated set of disclosure requirements produced by SEBI. This would reduce one level of duplication. Moreover, this exchanges approval should be recognised as meeting the accepted Indian standards by any other Indian exchange on which the issuer wishes to have his or her issue listed. This saves further current duplication. The approving exchange must have in effect an announced timetable process, from initial request to approval for listing, which is no longer than eight weeks. SEBI
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480.
481.
482.
483.
484.
485.
should remain responsible for monitoring and ensuring that the exchange meets not only this timetable but also the accepted standards for the approval process. Each issuer, since they technically are not members of the exchange, should appoint a sponsoring member firm of the exchange (probably its corporate finance adviser and possibly also its lead underwriter) to act as guardian for the issue. This member firm would have to accept legal responsibility for the accuracy and validity of information disclosed and, accordingly, would have to fulfil the role of due diligence on behalf of the exchange. 486. These areas of responsibility should be written into the rules of SEBI and the exchanges, and breaches would thus be civil offences, i.e. subject to financial penalties by the relevant exchanges and their members. SEBI or the RBI would consequently also regulate each of the members, and hence breaches of these proper practice rules should thus raise question marks about the firms ability to retain their respective licences. The use of diverse Government departments for approval of values, particularly in respect of assets that are to be used as collateral for these debt instruments, must also be streamlined. Our recommendations in this area are made below. Interest rate risk exposure: Since Indian regulations do not permit grey market trading, this means that for corporate bond issues, where registration is not dematerialised, no one is permitted to deal, following agreeing to either underwriting commitments or acceptance, until being in receipt of an allotment letter. We have been informed that, due to the inefficiencies of the registration system, this can lead to interest rate risks much longer than would be accepted in developed markets. In fact, we were given one example where an acceptor had been kept waiting more than three months from acceptance to receiving an allotment letter, and even the norm is apparently two to three weeks, leaving the investor at risk for an unacceptable period. It should be noted, for example, that many UK and US institutions are not even prepared to accept such interest rate risks against underwriting commitment acceptance across a weekend. Hence, most new issues need to be placed on a Tuesday, and dealing commences at the latest by the Friday of the same week. Clearly, dematerialisation could reduce this risk, but for certificated issues this concern needs to be addressed as a matter of urgency. This should be seen by the regulators as a particular issue that should be addressed within a very short period of time, since it represents a failure to meet moral hazard obligations to the financial community. It would not be our opinion, at this stage, to propose acceptance of grey market trading. There is insufficient market expertise for this, and certainly insufficient regulatory monitoring systems to provide effective control over it. Consequently, we believe the answer to this problem area is again to address the inefficiencies of the structural systems.
487.
488.
489.
490.
491.
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492.
We would propose that the accepting, or receiving, bank (i.e. the body which processes commitments and cash applications) should accept responsibility for issuing allotment letters, in the case of certificated issues, or allotment approvals, in the case of dematerialised issues. On behalf of the issuing company, this bank should ensure that such allotment confirmations are readied within the timeframe and structure of the new issue process. It should ensure that the allotment allocation process is completed within 24 hours of the closing of acceptance and that the permissions, or allotment letters, are released no later than 24 hours thereafter (i.e. 48 hours after the close of acceptances). This whole procedure should form part of the exchanges rule requirements for their new issue processes. This would mean that the exchange must provide a timetable that restricts the time span between the last day of acceptance and the first day of dealing, which, at the longest, could be three days. Every applicant must be in a position to know the extent to which his or her acceptance has been granted, or otherwise, and be able to trade such securities within this timeframe. We would suggest that where such timetables fail to be met, then the investors should have their funds returned, with interest, unless SEBI can justifiably declare that no investor has been disadvantaged by any timing slippage. Costs: Another area that came in for much criticism from respondents was the cost of public, compared to private, placements. It was suggested that the costs for a public issue could be around 44.5% of the proceeds. Public issuance costs vary quite dramatically across international markets, but our view would be that this is at the high end of the spectrum. The costs include brokerage and incentives, printing and stationery, marketing (advertisements in print and electronic media), issue management and trusteeship fees, and costs involved in setting up bank collection centres. By comparison, costs of a private placement are reckoned to be 0.10.15% of the proceeds. We do notice that two sets of fees need to be paid by those issuers whose headquarters are not based in Mumbai should the issuer want his bonds traded on one of the Mumbai exchanges. This would appear to be an unnecessary duplication of cost, but we would expect fees to fall anyway if more issues were actually publicly issued. We also note that NSE listing fees are very low, but the benefits of this are lost if companies are forced to list on other, more expensive, exchanges. This is an area that came in for much criticism from practitioners; criticism that we believe is well justified. For a developing market with sophisticated exchange systems, the costs of public issuance are clearly prohibitive in a number of aspects. Much of the costs for the public issue process are a result of duplication. A number of the processes, even where required from a regulatory viewpoint, should be done in parallel and not in series. Thus, for example, SEBI and the relevant exchange, if it is really necessary for both to partake in this process, which we find dubious, should both work on the material at the same time and liase over any overlapping factors. As previously indicated, it is our view that where the equity of a company
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493.
494.
495.
496.
497.
498.
is already listed, then the due diligence and prospectus requirements should be considerably reduced. It should only really be necessary to announce the use of the money and the application and allocation process where this is the case. This would further reduce the printing costs that are a significant part of the total.
Requirements for Multiple Credit Ratings

499. Many respondents were critical of the requirement for issuers of larger-size issues to obtain a credit rating from more than one agency per issue. Indeed, it was suggested that provident funds must have three ratings in order to buy corporate paper. Clearly, this adds to the issuers cost. However, under the present circumstances, we would view two such ratings as a prudent requirement, but three appears to fuel unnecessary costs. One of the general difficulties for credit rating agencies in gaining credence is that they are usually an unregulated industry and they are in competition with each other. (In India, however, they fall under the SEBI (Credit Rating Agencies) Regulations 1999.) However, it should also be appreciated that rating agencies can only survive if they are competent and provide accurate evaluations. To this extent, it should be said that either the market trusts them or it does not. Whilst we would not necessarily like to be the cause of reducing competition, we do consider that the requirement by provident funds for multiple ratings is not only excessive but adds unnecessary costs for issuers.
500.
Recommendations 501. Accordingly, we would strongly recommend that it should be considered as an unreasonable and unfair practice for any investors to insist that an issuer must gain more than two such credit ratings, unless the two provided differ by more than one rating grade. In other words, if the two agencies chosen give the same grade or only one grade apart, then issuers should not be subject to the cost of any further rating requirements. This ruling should perhaps be a fundamental condition for exchange listing rules and should be adopted by any institutional trade associations. It should also be borne in mind that foreign investors would only be content with international agency ratings, which would take into account Indias country rating. We would also recommend that where a recognised international rating agency provides a rating, only one rating should be a necessary requirement. Whilst this may also harm domestic agencies in the short term, it would be likely to lead to a potential association for some of the four main Indian agencies with these international concerns. This would have the effect of increasing the rating standard used by the market.
502. 503.
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Approvals and Verifications of Security Values

504. Another area which came in for much criticism was the number of Government or quasi-Government agencies (every respondent mentioned the stamp duty office) needed to give approvals, particularly for valuing assets used as collateral against debt issues. This adds to the amount of bureaucracy and costs and, even worse, it certainly adds to the time taken for the whole process. It is far more usual in developed markets that the company directors take full personal financial liability for ensuring that assets are reasonably valued. We see it as irrational that Government departments should be involved in valuing collateral. This takes commercial judgement, not an area usually covered in the training and experience of Government staff. Since most of the assets used as collateral will either be land, buildings, company shareholdings or other marketable property, we would expect to see such valuations performed by professional practices involved in those specific assets. For example, most developed market issuers would obtain real estate valuations from a specifically licensed commercial real estate business that would employ architects and surveyors. For other non-regularly tradable assets, such issuers would tend to use reputable accountants, auditors or stockbrokers research departments who would be better qualified for this purpose.
505.
506.
Recommendations 507. Our recommendation here would be that SEBI should build and operate a register of all such firms prepared to follow their trade association guidelines for valuations, and be prepared to supply a list of all such approved firms to the issuers sponsoring brokers and/or underwriters. This, of course, means that agreements on standards requirements would need to be agreed by SEBI with these associations prior to this methodology being introduced. Accordingly, we, again strongly, recommend that collateral valuation requirements are removed from Government departments and placed in the hands of commercial independent valuation firms. Since these firms will expect to charge for their services, they will only be successful if they provide accurate and trusted results and within short periods of time. Further, we recommend that this part of the due diligence process should subject the issuers company directors to personal financial liability and they should sign a declaration to this effect, copied in the short form prospectus.
508.
Sinking Fund Requirement

509. Further, we find that the legal requirement for all bonds with more than 18 months maturity be obliged to have debenture redemption reserves (i.e. sinking funds) to be outdated and unnecessary. Many developed markets have dispensed with this requirement. This also adds too significantly to the issuers costs during the early life of the bond. The slight reduction in yield permitted by the market for using a
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sinking fund is not balanced by the ultimate cost, particularly in a market with relatively high levels of inflation. The risk threat of not being repaid the capital element is substantially reduced by inflation, particularly against the almost certain increase in the assets used as security. 510. This is because the purchasing power of the repayment amount, assuming the business has grown over the life of the bond and in any case the value of the secured assets are likely to have grown, is substantially lower than at issue. Consequently, the issuer will often merely replace the borrowing with a further borrowing tranche at redemption, where even the same amount of borrowing will represent a smaller proportion of the secured assets, which the long-term savings media are usually most happy to see.
Recommendations 511. We recommend that the requirement for all bonds with more than 18 months to maturity to have a debenture redemption reserve be removed.
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Volume 2 Analysis and Recommendations Chapter 5 Trading
Chapter 5 Trading
512. In order to support financial stability, the trading of fixed income securities, both Government and corporate, must be conducted in markets that are efficient, liquid, orderly and resilient. In general, these market qualities are defined as: a. Efficient: prices balance underlying supply and demand; prices reflect fundamentals; informational efficiency holds; prices react rapidly when news breaks. b. Liquid: transactions are executed rapidly without unduly moving prices. c. Orderly: equivalent orders are executed at broadly equivalent prices. d. Stable and resilient: the market continues to operate in an efficient, liquid and orderly manner during times of uncertainty and market stress. However, these objectives need to be tempered by the reality of bond markets. Secondary debt markets are almost always relatively illiquid outside the top few issues. In both corporate and Government bond markets, trading is concentrated in a few newly issued and/or very large issues, the runners. Other issues, the rump issues in both Government and corporate markets, are inactive and difficult to trade.
513.
CURRENT SITUATION GOVERNMENT DEBT

514. Trading in Government debt is almost entirely through telephone negotiation between participants that have SGL accounts at the RBI. These are accounts for holding dematerialised Government securities. They are maintained by banks, financial institutions, primary dealers and mutual funds. The NSE has a debt market segment known as the Wholesale Debt Market, which offers trading and reporting facilities for all types of Government securities, including Government dated securities, T-bills, and bonds issued by public sector undertakings and other firms. The negotiated market segment of the WDM is used for the reporting of negotiated trades involving NSE brokers. The NSE also offers a facility for order book trading through the continuous market segment of WDM, but this is very lightly used. The secondary market (except for trades executed through the continuous market segment of NSE-WDM) is currently confined to Mumbai by the settlement process, which requires physical exchange of transfer forms. Primary dealers are required by the RBI to make two-way quotes. Conventional brokers are active (as agents only), but there are no specialised inter-dealer brokers. There is no fixed income derivatives market, although forward rate agreements (FRAs) are allowed and the RBI is active in the repo market. However, FRA volumes are very small and nearly all repos have the RBI as the counterparty.
515.
516.
517.
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518. 519.
Volumes are relatively low, some 700 to 1500 trades per day. The normal market lot is Rs. 5 crore (Rs. 50 million) nominal. All transactions (except those executed on the continuous market segment of the WDM) are reported to the RBI on the settlement day. There is no obligation for timely reporting. Aggregate volume figures for each stock are published next morning for stocks settled the previous day. Hence the figures published will include trades for yesterday for T+0 settlement (but not those for T+1, etc.), trades for the day before for T+1 settlement and so forth out to T+5. The NSE rules require same-day reporting of corporate debt transactions involving its members. Reports are verified by NSE and published. Observation suggests that brokers tend to report corporate debt trades in slack periods of the day, so there is a concentration of reports at the middle and end of the day. Published reports are thus not timely, nor are they in time sequence. Participants attach little if any value to them. The RBI is committed to introducing an electronic Negotiated Dealing System in the near future. This is intended to offer an alternative to the negotiated, telephone market for the full range of Government and state securities. The latest schedule for the implementation of NDS involves acceptance testing of phase 1 during November and December 2001. We have not been able to obtain documents giving detailed specifications or unambiguous descriptions of the operation, functionality or regulation of the system. Conversations suggest that its trading elements are a replication of the current telephone market with through-the-screen negotiation. The practical difference would be that trades would be reported immediately the negotiated deal was entered into the system. The negotiating parties would know each others identities during the negotiation.
520.
521.
CURRENT SITUATION CORPORATE DEBT

522. The SEBI has mandated that trading in listed corporate debt, other than trades for spot settlement, shall be transacted on an exchange. Trading in unlisted stocks and trades for spot settlement (the bulk of the inter-bank market) may be traded offexchange by telephone negotiation. Both NSE and the BSE offer order-matching trading for corporate debt, but, as in Government debt, the facilities are little used. Most on-exchange trading is negotiated by telephone and reported after the trade has been agreed. This is true for both BSE and NSE, but BSE sees very little reporting of corporate debt trades. Corporate debt may be listed (multiple listings are permitted) and traded on any one of the other 21 exchanges in India. While there is some residual listing on these other exchanges, there is practically no trading. At the end of March 2001 the numbers of corporate debt issues eligible for exchange-based trading were 1588 on the NSE and 799 on the BSE.
523.
524.
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525.
The SEBI requirement that all non-spot trading in listed stocks should be onexchange (reporting pre-negotiated trades qualifies as on-exchange) excludes spot, inter-bank trades. There is a relatively significant inter-bank market that is not traded on or reported to an exchange. In addition, many corporate debt issues are not listed and so trading in these issues lies outside of SEBIs remit. Accurate figures on the extent of this trading are not available since there is no reporting, but anecdotal evidence suggests it is of a similar order of magnitude to the exchangereported trading. SEBI rules permit mutual fund and other fund managers to move securities between funds, rather than selling and buying on the market, provided they do so at the market price. Given the relative lack of liquidity in the secondary market and the consequent high search costs, this mechanism is used by most mutual funds. Often these are affected through exchange brokers, as a means of validating prices, so are reported and published (without a special marker) but there is no requirement to do so. There are several elements of a regulatory regime designed to ensure fair pricing of inter-scheme transfers, at prices which are close to normal market prices. All inter-scheme transfers have to be reported to SEBI. In addition, they are scrutinised by auditors. The corporate debt market is between investment institutions, including banks and primary dealers, who operate in both the Government and corporate bond markets. Brokers are often, but not always, used to seek out potential counterparties. However, for the reasons discussed in Chapter 4 on Issuance and Instruments, most issues are privately placed and are distributed among relatively few holders. This makes for little trading of those issues. With more widely held issues some merchant banks take on a market-making role for specific issues, but they do not offer continuous quotes and the price is not a firm commitment to trade. Rather, they are acting as collection points for expressions of interest and may facilitate trading by taking positions if they wish. Some banks operate active corporate bond trading desks, but much of their business is associated with the primary market, i.e. the distribution of new issues. Public issues, as explained elsewhere, are generally retail deposit substitutes (i.e. they are redeemable before maturity) and there is little, if any, trading. There is no retail involvement in the secondary market. This, given that most issues are privately placed with unregulated disclosure, is fortunate. But this retail exclusion, which is desirable given the nature of the issues, is more an accident of the nature of settlement. Easier settlement (which is planned) could allow retail investors to enter the market for corporate debt.
526.
527.
528.
529.
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CURRENT MARKET MODEL RESTRICTS ACCESS

Participants
530. 531. Both Government and corporate debt markets are entirely, or almost entirely, negotiated, telephone markets with limited trade reporting and publication. The RBI is intending to introduce NDS, a screen-based system, which will essentially replicate the current telephone trading system for Government debt, but with potential efficiency and transparency gains. NDS will be open to any participant with an SGL account. There are expected to be eventually some 300 participants, including primary dealers, banks, mutual funds and large institutional investors. Brokers will not be members, since they act purely as agents and so do not have SGL accounts. Both NSE and BSE have sought to extend their electronic order books into corporate debt trading, with negligible success. The current telephone-based systems, while adequate for current participants, are seen by regulators and policy-makers as excluding potential participants. These include participants located outside Mumbai, who cannot participate directly because of settlement constraints, and what we have called second-tier participants, which are smaller institutions, corporate users and large retail investors. The route for such participants should be through the stock exchange systems, or through existing participants for both corporate and Government debt, as it is not proposed to make NDS available to them. Improved settlement procedures discussed elsewhere in this report, including dematerialisation and improved post-trade transparency, recommended later in this chapter, may encourage new participants, and indeed the Indian market has a problem with lack of participants. However, in spite of this, there seems relatively little prospect of a large influx of liquidity from retail or corporate investors. a. Retail interest in equity among the Indian population is largely speculative. The size and shape of portfolios is shown in Chapter 3 on Secondary Market Participants. Most retail investor portfolios are below Rs. 25,000 (US$500) in value and comprise fewer than four issues. This is not a criticism of the equity market, nor is it unusual, but it leads us to question whether the speculative attractions of equity can be translated into bonds. Profitable bond trading is far more technical than profitable equity trading, unless an investor is betting on major interest rate moves. The trading gains come from spotting anomalies in the pricing structure. Typically, these anomalies are small and can only be profitably exploited by trading in large sizes. Our expectation is that the attractions of equity trading for retail investors will not carry over into bonds. Retail bond investment will be driven by different priorities and expectations. b. Indian retail savers have shown a desire for savings vehicles, particularly deposit-type instruments (including bond issues by banks and corporates that are better described as term deposits). While these offer some of the
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532. 533.
534.
c.
d.
e.
f.
g.
characteristics of bonds, being fixed income instruments, they do not involve capital risk and can be redeemed on application to the issuers (albeit with a predefined penalty). There is a poor appreciation among investors and potential investors of the capital risk of bonds that suggests that, if retail investors were attracted, they would generally hold to maturity. Desirable as this would be for the bond primary market, it will not assist in developing liquidity in the secondary market. Retail investors, after experiencing equities, tend to find bond markets boring and the product (bonds) unexciting. With the exception of individual pensioners, private investors only tend to consider bond products for their minimum risk balancing effects on portfolios, and then only really in the case of high net worth individuals. We have been told that, in the 1970s (i.e. before the equity culture boom), many high net worth individuals traded Government bonds. However, when the banks were nationalised this changed and money was switched to a deposit base, but this too faltered with controlled rates. By the early 1990s, banks needed to give market deposit rates, but their reserve requirements only received low-level rates in comparison. Some observers therefore believe that a more liquid bond market would encourage these high net worth individuals back to the bond markets. While we agree that it is possible, we do not see it as a given; nor do we see it as a major source of new liquidity. In all bond markets, the vast bulk of trading is between professionals. Even where there is substantial retail (i.e. not dealers and investing institutions) interest, it remains a small percentage of the market. It is stated correctly that about 50% of NSEs equity trading is retail and that if it were able to duplicate that in bonds then there would be major gains in liquidity. That would be true, but it would still leave the secondary bond market small by any of the usual measures. The real need is for a major expansion of trading involving institutional investors. They will have the resources to make a significant impact in the market and they are likely to be in a position to trade actively. The only occasion, to the knowledge of the consultants, where retail interest has been of importance has been in recent years in Germany. However, there it occurred for three main reasons specific to the German situation at the time: Following the unification of Germany, the federated nation had become a huge Government borrower of cash to fund development and cater for the imbalance of the previously un-unified Mark exchange rates. There was a general public dependency on banks and bank products, particularly resulting from the fact that Germany has no history of development of intermediaries other than banks. It had, and still has today, a very under-developed equity market and no real equity market culture among the public, although that is improving. India, on the other hand, although the Government is a huge borrower, already has a significant equity culture and its people are not dependent on bank-only intermediaries. Corporate treasurers do indeed have cash to invest. However, the pattern in most markets is generally that corporate treasurers focus on short-term, highly liquid assets. Arguably, if they have long-term money to invest, then they should, as a matter of rational finance, either invest it in their own business or
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distribute it to shareholders. There may, of course, be obstacles to this (such as taxation), but generally companies (other than those whose business is bond investment) do not have specific expertise in bond trading or investment and would tend to suffer shareholder dissatisfaction if they were to engage in it to any degree. If shareholders wanted bond investments, then there are easier ways for them to gain access to bonds than by investing indirectly through equity. (In the Indian context, there is actually a tax disadvantage to such indirect investment through a corporate in comparison to a mutual fund.) Therefore, while corporate treasurers could be more substantial players in money markets, their involvement in secondary bond (longer-term debt) markets will not be large. Indeed if it were to become large it would be a warning that something was lacking in corporate governance and the market for corporate control or that there were serious tax and/or regulatory distortions allowing or encouraging corporates to become market speculators. h. We note in Chapter 3 that tax advantages to mutual funds have encouraged corporates to effectively outsource their treasury operations to mutual funds. While this tax advantage persists (and we do not argue for its withdrawal in the short term because of the damage it would do to the emerging private mutual fund sector), the direct involvement of corporates will remain small. 535. Looking at these points, the initial conclusion of the international consultants was that the most plausible market model was a largely professional market dominated by investing institutions and dealers. At the same time, there is an argument that the potential for retail (defined as individuals plus non-financial corporates) involvement in this market was large and that retail investors could be major contributors to liquidity. The main arguments are based on: a. the experience of the equity market in India: there retail participation has been a major engine of growth to the point where there are: four million depository account holders, who are mainly retail investors; trading on NSE of 500,000 bargains per day, again mainly driven by retail investors; 10,000 trading terminals throughout the country serving mainly retail investors; b. corporates have significant money to invest though, as discussed in the previous paragraphs, this raises governance issues; c. the mutual fund growth, especially of bond funds in recent months, reflects a retail interest in bonds, although this may not transfer into direct participation; d. the clear appetite for fixed income investments among retail customers, although to date all of this is buy and hold; and e. it was very much the case that exactly the same arguments as given above against a retail bond market were made against retail participation in the equity market in the early 1990s; in retrospect they were wrong, it is argued, because of the unique features of the Indian situation. We concluded that there could be no certainty either way and that it would be excessively risky to form policy and recommendations on an assumption of certainty. Accordingly, our recommendation accepts this and stresses the need to enhance retail access to the bond market while also serving the current participants.
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536.
537.
We also expect to see growing retail participation through managed funds and other collective schemes. Pension funds and life insurers are natural investors in debt and, given the nature of the Indian financial system, we would expect banks to continue to be large holders and increasingly traders of debt.
Market Structure
538. India has an impressive trading market infrastructure developed to support the equity market. This allows cheap and easy access, low entry barriers, settlement security, and low or zero intermediation costs. SEBI has shown a strong preference for trading through the electronic infrastructure of exchanges to the extent that it has prohibited equity trading away from exchange trading systems. Correctly, it believes that the greater transparency and audit trail make supervision easy and fraud less likely. However the Indian bond markets have largely ignored the infrastructure of electronic exchanges, although it is available to them. (When SEBI mandated that equity market trading should all be through exchanges, a large part of the trading was already on exchange, in contrast to the bond market situation.) Indian markets are not unique in this. Typically bond markets remain negotiated markets and efforts to draw or push them on to electronic order books have generally proved unsuccessful (see Chapter 2 Study Tour Report for a discussion of the experiences of Germany and the USA). One significant exception is the Italian government bond market which is mainly concentrated on a central electronic trading platform but, in general, bond markets remain resolutely OTC. Electronic systems have made some headway in bond markets, especially in the USA, but, by and large, these have been dealers own internal systems (for routing and matching customer orders in house) or inter-dealer systems (used to unwind positions). The public limit order books that have become he dominant trading mechanism for equities throughout the world have almost universally failed to attract wholesale bond business. We believe this would be the case in India also, indeed the failure of the NSEs WDM to attract significant execution (as opposed to reporting business) supports this. Hence our recommendation that the negotiated wholesale market should continue but alongside facilities that offer order matching functionality for retail and other non-professional clients. Indeed it might be that, in time, institutional investors will find the public order book and attractive way of executing orders and some or all of the wholesale business will migrate from the negotiated market. But we have not yet heard any indication from current participants that they intend voluntarily to move away from negotiated trading. Dealers tend to favour negotiated markets and direct contact with counterparties over firm quote or order exposure. In the experience of the consultants, they give a number of reasons for this, all of which are applicable in the Indian context. Table 5.1 sets out the reasons given and their justification.
539.
540.
541.
542.
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Table 5.1 Reasons for OTC trading of bonds
Dealer minimises counterparty risk.
Dealer minimises the risk of dealing with a betterinformed counterparty.
There is scope for price improvement for the investor.
Long-term relationships are valuable.
Demand for immediacy in size means that quotes are unique to the order. Trading is infrequent and orders may not be current.
Diversity of instruments and settlement options require customised quotes. 543.
Dealers prefer to trade with known counterparties to avoid the risk of settlement failure (or easy resolution in the event of bad delivery). This is less important in the Government bond market but is vital in corporate bonds (see Settlement). Planned development of the Clearing Corporation will eliminate settlement risk for Government securities. Dematerialisation of corporate debt and settlement through the clearing houses/depositories will also allow reduction of settlement risk in this area. Dealers fear asymmetric information trades. Direct negotiation allows them to probe the reasons behind the order (reinforced by relationships see below). Asymmetric information is quite likely in corporate bonds. It is less so in Government bonds, though there is a risk of inadvertently dealing with a competitor with a large (but unannounced) position. The probing described above gives scope for price improvement dealers will make an initial quote that assumes asymmetric information and improves as the probing reveals the counterparty has no private information (or if he has, is unwilling to share it with the dealer). Dealers typically build relationships with customers. This is advantageous to the customer since the relationship means better prices, and for the dealer since it gives him a sanction against a customer, i.e. withdrawing the favourable terms in future if the customer cheats by bringing informed business to the dealer. Different size, different quote. In liquid markets there is little variation with respect to size (unless the order is very large), but in less liquid markets size does influence price. The dealers initial quote will be for a normal lot. Infrequent trading in an instrument imposes a risk on a dealer that his quotes will be stale and so risk being traded against at disadvantageous prices. Consequently, if a dealer does make continuous quotes, these will be set wide enough to offer protection against being caught with stale quotes. Infrequent but large trades also make it more practicable for dealers to rely on negotiation. In practice, orders tend to standardise to attract liquidity e.g. the Government securities market can trade T+0 to T+5, but most (80%) are T+0.
The NDS for Government stock will be an electronic replication of the current negotiated market, along with other features designed for the primary issuance of Government securities and for settlement. It will not involve a requirement to
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maintain continuous quotes, nor will orders be publicly exposed. In that way it is more likely to meet the needs of current participants. A plausible scenario is one where market participants negotiate by telephone for the foreseeable future, and use the NDS for settlement. Of course, experiences in other markets suggest that the situation may change, and change rapidly (the near catastrophic loss of German Bund business by LIFFE2 over a period of months is a recent example where liquidity has migrated) once a new dealing system gains acceptance. But that point seems a long way off in the Indian Government debt market. 544. Similarly, the corporate bond market now faces a choice between continuing with negotiated dealing, or moving on to anonymous order matching. If negotiated dealing were to dominate, then the WDM offers trade reporting facilities, which should be made mandatory with a very short delay between trade and report. Alternatively, nationwide anonymous order matching is an important alternative channel through which market liquidity and participation could grow. There is a strong policy aim that bond markets should be more accessible to retail and corporate investors. We have already accepted that retail investors may have bond market potential as bond market investors. To accommodate and encourage this, the market structure used in the Government and corporate markets should allow for easy, cheap and secure nationwide access for retail and second-tier participants. The NSE and BSE trading systems, based on anonymous order matching, already offer scope for such access and, combined with dematerialised settlement and a clearing system for Government bonds, may well attract a wider range of participants. If retail and other second-tier investors choose to participate, then well and good; if they do not, then the cost of offering access would be small as the trading systems in the stock exchanges already exist though they are not used. Trading in multiple venues, wholesale (OTC) and retail (on-exchanges), raises important structural and regulatory issues. There is a risk of price fragmentation if the venues are segmented, and there is a risk that users of one venue will feel disadvantaged if there is access from one venue (usually wholesale) to the other (usually retail): a. If prices are fragmented, then the retail users will lose confidence that the retail venue is offering them best execution. b. If the wholesale venue participants can access the retail venue, then this will ensure prices stay in line, but there is the risk that orders exposed on the retail venue will become stale and so be hit by participants from the wholesale venue. Retail orders will only be executed when the market has moved against them (i.e. buy orders will be hit when the market has fallen, and vice versa). c. Either way, the retail venue will not gain users confidence and so will not attract business. For the retail order book to attract business, users must be convinced that the retail order book prices will be in line with the wholesale segment prices. This can be
545.
546.
547.
London International Financial Futures and Options Exchange Page 134
achieved by requiring that all orders go through the order book, and so wholesale orders interact with any other orders (retail or wholesale) that are exposed on the book. In practice, where this is required, wholesale traders continue to negotiate privately but put the resulting cross trade (the original order plus the counterparty order they have negotiated) into the book. 548. This may be unattractive to wholesale players, as it may mean blocks are split by small retail orders and become unattractive odd lots. Odd lots may be hard to trade in the OTC market and may be more costly to settle (at least in terms of back-office processing even in a dematerialised environment). If short-selling were restricted (as in the Indian Government bond market), then a dealer with a long odd-lot position cannot sell a round lot but must try and buy the shortfall in the market to make a round lot. A simpler alternative, which is the norm in most other markets, is to rely on market forces to integrate the two systems through arbitrage. This works best if there are firm and public quotes so that any discrepancy is immediately traded out. However, in India there will not be firm and public quotes in the wholesale Government or corporate segment, so a weaker alternative is to require immediate publication of trades in the wholesale venue. As well as having benefits for the market generally, such transparency at least gives users of the retail order book a chance to see that their orders are out of line with the wholesale prices and to act accordingly. Transparency is discussed in more detail below. However for transparency to work in maintaining common pricing between various trading platforms it is necessary that at least some significant players can access both platforms to arbitrage any price anomalies that occur. At the moment this is not possible. Non-professional clients do not have direct access to the wholesale market (nor probably should they have) since the wholesale market is only open to SGL account holders. Conversely banks which are currently the main players in the wholesale market cannot access the retail market. This is because: a. Currently, banks are not allowed to open depository participant (NSDL) accounts, since their transactions in Government securities are settled directly through their SGL accounts held with the RBI. b. An RBI circular issued in September 2001 (that consolidates all guidelines related to classification, valuation and operation of investment portfolios) prohibits banks from settling their transactions through brokers. The consideration amounts in respect of each trade are settled through current accounts held with the RBI, with brokers receiving only their brokerage amount from the counterparties. For banks to be able to trade on the exchange, it would be necessary to allow banks to settle through brokers (intermediaries). There is a further issue that would require clarification. The clearing organisation for the exchange would designate only a select set of banks as clearing members with whom other banks would have to open current accounts. The implications of this for CRR obligations for the former i.e. whether the amounts held in such accounts would be categorised as inter-bank liabilities and hence be exempt from CRR obligations would need to be clarified.
549.
550.
Recommendations
551. We recommend that SEBI and the RBI recognise the needs and preferences of wholesale participants in both Government and corporate markets by allowing negotiated dealing to continue. SEBI should continue to take a pragmatic approach with the corporate debt market by permitting negotiation but requiring timely reporting (though the current requirements are too weak, as will be discussed below) and immediate publication of trades. Price integration between different trading platforms requires arbitrage which in turn requires that a significant group of participants have access to both platforms. Banks, the main whole sale players, are currently barred from participating in the exchange market (and so from arbitraging) by regulations that prohibit them from settling government bond transactions other than through the RBI. It is recommended that these restrictions be withdrawn so that banks can carry out arbitrage (and other ) transactions on-exchange The exchanges should continue to provide retail/second-tier participant functionality through order books. Mandating interaction between OTC and retail order book has attractions, but it adds complexity (especially with two order books operating at different exchanges) and would appear perverse given the almost complete lack of business on the order books. Also, the trend in global markets is against mandating interaction and instead placing reliance on arbitrage to prevent fragmentation. Therefore, mandatory interaction is not recommended, though we make strong recommendations on transparency that are discussed below. SEBI should permit and encourage exchanges to develop electronic systems to support wholesale bond trading. We would expect the most successful solutions would be those recognising the negotiated nature of the wholesale market and involving some kind of electronic negotiation.
552.
553.
554.
LACK OF TRANSPARENCY
555. Trading transparency is affected by pre-trade and post-trade transparency. Pre-trade transparency enables investors to know, with some degree of certainty, whether and at what prices they can deal. Post-trade information is related to the prices and the volumes of all individual transactions actually executed. Ensuring timely access to information is a key to the regulation of secondary market trading. Timely access to relevant information about the secondary markets trading allows investors to better look after their own interests and reduces the risk of manipulative or other unfair trading practices. There has been a long debate on post-trade transparency in many markets. The point, which is relevant to India, is that in a dealer market where positions are being taken by dealers who must liquidate those positions in the near-term (i.e. they are not long-term holders), publishing trades may reveal the position of the dealers and allow others to trade against them. Dealers, it is argued, will therefore be less
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556.
557.
willing to provide liquidity by positioning stock and the cost of liquidity will rise. While the debate continues and has spawned a number of mechanisms for delaying publication or otherwise protecting dealers, the balance of the argument is coming down in favour of high transparency. The case for a bias towards high transparency is supported by: a. the lack of empirical evidence demonstrating that liquidity has been harmed by increased transparency. In the cases where liquidity has shifted away from markets, a number of factors, other than transparency, have been responsible; b. the lack of evidence that business has been driven to other, less transparent markets purely because of increased transparency requirements; c. many exchanges worldwide have voluntarily mandated high levels of transparency; d. global best practice leans towards transparency e.g. IOSCO Principles of Securities Regulation, Principle 27 states that Regulation should promote transparency of trading; e. many regulatory authorities worldwide are insisting on increased levels of transparency; and f. users, and especially new participants entering from other markets, are increasingly inclined to be wary of exchanges they see as opaque, and user pressure appears to be towards greater trade transparency. 558. Both the Government and corporate debt markets in India are very opaque. There is no pre-trade transparency, as quotes or orders are not publicly disseminated (except for the few orders on the NSE order book). Post-trade transparency is also absent. As described, NSE trades in Government debt are subject to a same-day reporting requirement and so trade reports are published with considerable delay and out of sequence; non-NSE trades are published in aggregate on the day after settlement. In corporate debt the NSE trade publication is subject to the same limitations. In addition, a significant, but unquantified, part of the trading takes place away from the exchange and so is never reported, i.e. the spot transactions between banks that are not covered by the SEBI requirement to trade on an exchange. We see the lack of post-trade transparency as potentially a most serious barrier to market development. Pre-trade transparency is important, but in the experience of the consultants it is difficult to mandate standards of pre-trade transparency. This is partly because the precise nature of transparency is part of the competitive positioning of a trading system and mandating levels would remove this competition. But a more significant difficulty arises because it is very difficult to insist that pre-trade quotes actually form the basis of trading. As mentioned above, price improvement through negotiation is normal in dealer markets and so whatever the regulators decree, the quotes will never truly be more than indicative. Post-trade transparency is a different matter. It is possible for regulation to substantially raise the level of post-trade transparency without the negative effects on competition or innovation that would arise from enforcing rules on pre-trade transparency. While there may be enforcement difficulties, which are discussed below, regulation and enforcement of timely reporting and publication can improve
559.
560.
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market quality and market integration where there are multiple trading venues as well as giving confidence to existing and potential participants. 561. Trade data published late and in a random sequence, as in the Indian debt markets, makes it impossible for investors and market participants to discover what is actually going on in the market and all but eliminates any realistic possibility of investor price discovery. Therefore, we are recommending that trade reporting rules and procedures be tightened to ensure timely publication of anonymous details of all trades in Government and corporate debt securities. Publication will be through the trading systems and we are not advocating a consolidated tape. Modern technology makes it easy for any participant to see a virtual consolidated tape, and any advantages of a formal consolidated tape system are likely to be offset by its cost and inflexibility. We do, however, consider it vital that qualifiers are attached to published trade reports to show trades where the price is not to be regarded as the current price. Examples include: a. late reports; b. reports of trades done out of the normal context of trading, e.g. cum coupon trades in the ex period; c. trades resulting from options exercise if allowed; and d. cross trades and asset swaps (see below). The future trading structure will, we recommend and expect, continue to offer a variety of trading mechanisms for Government and corporate bonds. For both markets, an order book will be offered but will not be mandatory, i.e. it will be possible to trade through bilateral negotiation. In other markets this arrangement, which is realistic and feasible given the nature of the market, has raised the possibility that reporting of bilaterally negotiated trades will not be timely. As a consequence, action will be required to enforce the trade reporting obligations and ensure a high level of post-trade transparency. Dealers have an incentive to delay reporting, as delay enables them to reverse positions before the market has become aware of the position and hence avoid adverse price movements. Indian dealers that we have spoken to have not expressed any objection to post-trade transparency, but in our experience increased competition and tougher market conditions increase pressure on dealers margins. When margins are under pressure, dealers have more incentive to try and delay trade reporting. Therefore, we would expect some dealer resistance and hence the need, if the necessary increase in transparency is to be credible, for active monitoring and strong enforcement by regulators, as described below.
562.
563.
564.
Transparency government securities market 565. The future trading system will combine: a. the NDS system for wholesale participants (those with SGL accounts). We are not sure of the configuration and functionality of the NDS, as these have not
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been published, but it is described as allowing two-way negotiation between known counterparties; b. the NSE system, which will offer order book functionality that may be used by participants without SGL accounts, particularly retail/corporate investors. (Wholesale traders are not excluded and may come to prefer the anonymity of the order book, but in the near-term they are not expected to use the NSE); and c. the NSE reporting facility, which allows negotiated trades to be reported to the exchange. Some of these trades may potentially also be reported through NDS. 566. The order book presents no enforcement problems, as trades are executed through the system and the report is created at the same time. The other two trading venues present an enforcement challenge. The enforcement challenge arises because much trading will continue to be by telephone negotiation, so there is a potential risk of delay in reporting. If NDS were to be used for through-the-screen negotiation, then the problem would not arise. However, there is a strong possibility that dealers will continue to negotiate by telephone and then enter the details into the NDS as a confirmation/trade report. Reporting will not be automatic and may not be timely.
567.
Transparency corporate debt market 568. The current situation for corporate debt allows a large part of the market to avoid reporting requirements. This is potentially even more of a barrier than for Government debt since transactions are relatively fewer, so the loss of pricing information is greater. We recommend that SEBI require reporting of all corporate debt transactions, including those currently entirely OTC, unreported transactions that do not involve exchange brokers, transactions in unlisted stock and spot transactions. This may imply mandatory listing for all issues. We therefore recommend that the reporting rules for corporate debt should be tightened to reduce the time between trading and reporting. Our recommendation is that as an initial step this should be reduced to 30 minutes with a program of reductions aiming at five minutes or less within two years. At current volumes or foreseeable volumes, these targets should not be too challenging for competent and well-equipped brokers/dealers.
569.
Regulation and enforcement 570. The possibility that bonds can be traded in multiple venues and by participants that have different regulatory responsibilities presents a regulatory challenge. This arises because of the need to ascribe responsibilities for trade reporting and publication in situations where exchange and non-exchange parties are involved so as to ensure that every trade is reported but to avoid multiple reporting of trades. The nature of the Government settlement process suggests that NDS should be the primary reporting mechanism for Government security trades, so the exchanges should waive their reporting requirement where a trade is reported through NDS.
571.
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572.
For corporate debt the reporting requirement would be more complex. However, a regulation should establish a reporting requirement as follows: a. Where a transaction takes place through an automated trading facility operated by an exchange, then the exchange accepts responsibility for its publication. b. Where a transaction takes place off-exchange and one party involved in the trade (including the broker) is an exchange member, the exchange member reports to the exchange for publication. c. Where a transaction is off-exchange between two non-exchange members, the selling non-member reports to a central authority. Ideally, the authority should be SEBI, who should then arrange for publication of their reports along with those of on-exchange trades. However, SEBI may not wish to become a recipient of substantial numbers of reports. (The Financial Services Authority in the UK has sought to deter market participants from reporting trades direct to them rather than through an exchange or other self-regulatory organisation.) A regulation such as this would also prevent multiple reporting. For example, trades in Government stock could potentially be reported once to the NDS and also to the NSE if an NSE member is involved in the trade. (The norm is for brokers to seek out counterparties and then step aside from the trade but retaining a responsibility to report.) Since multiple reporting is as misleading as inadequate reporting (most markets, including India, have rules to prevent deliberate multiple reporting), it is highly important that it is prevented. Where there is publication of trade reports, there is an element of automatic detection of possible breaches. Market participants are, in our experience, quick to challenge trade reports that appear out of sequence. The market regulators should ensure these are reinforced by tools enabling them to examine trade reports for suspicious patterns, e.g. the clustering of trade reports at the end of the day. However, suspecting and proving are different things. It is hard to prove that a trade report was delayed from the trading system alone. Proof of abuse requires a comparison of the trade report with the firms own dealing records. Dealing records can, of course, be falsified, so in other jurisdictions firms are required to make and retain tape recordings of dealers telephone calls for inspection by regulators. This implies visits to firms offices to examine records and construct cases. We understand there is a reluctance to incur the expense of recording. There is also the problem of use of mobile phones. However, without recording there can be no enforcement of timely reporting, and without enforcement of timely reporting there is no transparency. This enforcement machinery may appear intrusive, and it calls for a significant regulatory capacity. However, it is an essential ingredient for improving the transparency of an innately non-transparent market design founded on OTC contracting. Greater transparency would generally enhance the quality of regulation in the Indian market. History has shown that:
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573.
574.
575.
576.
577.
a. Indian firms and institutions have poor internal structures to bind the incentives of employees to the goals of the organisation. The lack of high-quality human resource processes, including performance measurement, bonuses, stock options, and dismissal, implies that individuals working in the financial sector may only loosely align their actions with corporate objectives. These agency conflicts have played an important role in every financial scandal in India in the 1990s. b. Once fraudulent activities take place, Indias regulators are weak at post-hoc investigation and enforcement. The scandals of the 1990s have generated highly limited successes of post-hoc punishment. 578. Greater exposure of trades to public scrutiny has elsewhere been found to restrict fraudulent activities by ensuring that abusive trading becomes more visible and known to other market participants. While there is no intention of identifying participants in published trade reports, experience in other markets indicates that, with greater transparency, the market becomes more aware of the sources of abusive behaviour and tends to avoid having them as counterparties. It would also aid transparency and price quality if intra-fund manager trades were reported and published. Fund managers are obliged to trade assets between funds at prices that are fair to fund holders, and so they often use a broker to validate the price. Such trades are reported, but it would be beneficial if this were made a comprehensive requirement. Experience elsewhere suggests that, in illiquid stocks, publication of a validated price, even if only for an intra-fund transfer, encourages further trading as investors take the opportunity of a good price to transact business. It is worth pointing out that the recommendation for greater post trade transparency in both government and corporate bond markets is at odds with normal global practice. While regulators have tried to increase transparency in bond markets (for example the efforts by ISMA to improve transparency in the Eurobond market) the norm in developed markets is negotiated trading and very little post-trade transparency. There are strong regulatory reasons to increase transparency but our decision to diverge from global practice derives from two aspects of the Indian market: a. There is a policy objective to broaden the market both by increasing the number of participants by attracting retail and corporate direct participation and by raising the range of institutions that participate. b. The alternative sources of price information such as derivatives markets or swap trading are largely absent in the Indian market. Our opinion is that opacity of current price information acts as a powerful deterrent to wider participation. Current participants generally have a good feel for the current level of the market through their interaction with other participants if asked they will sat that everybody knows where the market is. In fact what they mean is that the inner circle of current participants knows but potential entrants do not. New entrants would be severely disadvantaged and would find it very difficult
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579.
580.
581.
582.
to make headway in an opaque market. In most developed markets there is no particular desire to increase participation it is judged to be adequate for the needs of the market. This is not true in India new participants are needed and they will, in our view, only be attracted to participate directly in the market if there is a higher level of post-trade transparency. Recommendations 583. Timely reporting requirements for trades in Government securities should be imposed. These should include provisions to ascribe reporting responsibilities, prevent multiple reporting and provisions to flag trades that are not part of the normal flow of business and whose prices might therefore be misleading. Timely reporting requirements on all trades in corporate debt should be imposed. These should specifically include unlisted debt, spot transactions and any other transactions that are currently not reported. These should also include provisions to ascribe reporting responsibilities, prevent multiple reporting and provisions to flag trades that are not part of the normal flow of business and whose prices might therefore be misleading. Timely reporting requirements should also be imposed on intra-fund transfers of Government and corporate debt securities. As of today, it appears that these can be reported on an end-of-day basis. With improvements in technology in the future, this delay can be shortened. Operators of trading systems should be required to ensure that trade reports received by them are published with all speed. Trading system operators should be required to install simple analysis routines to identify patterns suggesting delay of reporting, e.g. the present tendency for reports to cluster at midday and before the close. Trading system operators should be required to retain trading reports for a number of years adequate to cover the length of investigations into malpractice, etc. Mechanisms should be developed for enforcement of trade reporting requirements. These will include mechanisms to: a. collect and investigate market complaints about out-of-sequence or otherwise suspect reports; b. conduct on-site investigations where breaches of the trade reporting rules are suspected; and c. tape telephone conversations to provide conclusive evidence of breach or otherwise of reporting requirements3.
584.
585.
586. 587.
588. 589.
In many jurisdictions there are, quite rightly, legal protections against telephone recording. It is therefore necessary that employees consent is obtained through the contract of employment allowing monitoring of calls (it is common in the call-centre business to record and monitor calls). Page 142
There is relatively little experience with the supervision and regulation of OTC trading in India. While SEBI has considerable experience in coping with the highly active equity market, it has avoided confronting the enforcement complexities of an OTC market by prohibiting OTC contracting. Given that OTC trading is the dominant form of market design on the fixed income market, a new regulatory capacity will need to be created in India, on the lines described above.
Corporate Bonds
Lack of regulated trading venue for corporate bonds 590. Two points have concerned us about the regulation of the corporate bond market: a. Unsophisticated investors are not prevented from investing in private placements where the level of disclosure is deemed by SEBI to be inadequate for retail participation in the primary market. b. There is a lack of supervision of the OTC market where corporate bonds are traded. This is additional to the concern about reporting and transparency, and although we have wider concerns about market regulation in the Indian market, our focus here is on how those concerns affect the bond market.
Lack of a public trading venue for private placements 591. The majority of corporate debt in India is currently issued via private placement, with the trading in private placements taking place in an unregulated, off-market environment. However, while the market is mostly OTC, it is not entirely so and there is some trading on the order book. This may increase if retail and corporate interest is stimulated and settlement is improved. This would be highly inappropriate, since the nature of the issuance process for private placements means that the information divulged by the issuer is limited. While we would accept, indeed argue strongly, that the process for public issues is unduly burdensome, we do accept the motivation to prevent unregulated issues with light disclosure being bought by non-professional investors. As things are at present, there is nothing, except very low liquidity, to stop a retail or other non-professional investor from purchasing privately placed stock in the secondary market. If retail interest in the debt market does develop, and the electronic order book systems and expected improvements to settlement are certainly facilitatory developments, then the risk of unsophisticated investors investing in private placements increases. Because of the significantly lower disclosure levels of private placement issues and the corresponding higher trading risk, most markets that permit the trading of private placement issues require that participation in the market be limited to qualified investors. These are market participants who by virtue of their capitalisation and trading expertise are deemed capable of effectively managing the risk associated with private placements. It is recommended that a distinct private placement segment be created within the stock exchange trading systems. The segment could be easily defined by setting a high minimum order size. The electronic trading systems currently operated by the
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592.
593.
BSE and the NSE are functionally capable of supporting trading in a private placement segment, and development effort would be minimal. The basic functional mechanics are currently contained in these systems, and the majority of work required to support the electronic trading of private placement issues would involve the incorporation of regulatory requirements and testing. Recommendations 594. 595. 596. The regulatory procedures for initial public debt offerings should be simplified and streamlined (see Chapter 4 on Issuance and Instruments). Timely trade reporting and publication of corporate debt trades should be made mandatory (see above). Both BSE and NSE should be required to create a regulated private placement segment on the market if they wish to permit trading of these securities. This would involve separately identifying the trading system applicable to privately placed stocks. (The current systems are the same for publicly issued debt, Government debt and privately placed debt.) Participation by non-professional investors in the private placement segment should be prevented by applying a substantial minimum order size.
Market Supervision of Secondary Corporate Debt Market

597. It is not clear to the consultants that there is an appropriate level of regulation of the secondary corporate debt market. The current situation is that trading takes place in an OTC environment but with trade reporting, mainly to the NSE. We have already said that we consider negotiated trading to be an appropriate structure for bond trading in line with general international norms, although we have recommended implementation of rigorous trade reporting rules to ensure a measure of transparency. Multiple venue trading would be a regulatory challenge in itself. A recent report produced by the London School of Economics for the UK Financial Services Authority (of which one of the consultants was a co-author) concluded that where trading venues were in competition for trading in the same assets, there would be a tendency for the trading venues to reduce their regulatory effort. This is not an argument about a race for the bottom (i.e. investors opting for the least regulated market and so sparking a competitive lowering of standards). Nor is it an argument based on the difficulty of supervising across multiple markets. This is indeed a challenge, but one that is not insoluble through information sharing agreements, analogous to the memorandum of understanding that most exchanges have with their foreign counterparts. Rather, it is a conclusion based upon the economics of trading systems. To maintain a fully-fledged surveillance and enforcement effort is very expensive in terms of human and system resources. By definition the manipulative and other abuses that occur are skilfully concealed by the perpetrators and therefore hard to
598.
599.
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identify. It is, for example, hard to spot them using automatic systems. Such systems can be programmed to produce alerts where there is a suspicious set of trades, for example, but generally they produce a large number of false alerts for each genuine case of abuse that they detect. It is a complex job to sift among the many alerts to identify the likely ones. Various exchanges in other markets have experimented with highly sophisticated computer techniques for example, using artificial intelligence concepts but these have not proved sufficiently accurate as yet. Surveillance thus remains a labour-intensive, and more importantly, a skillintensive activity. The requisite level of skill is only achieved through training and, more importantly, extensive experience. Ensuring that skilled staff are not attracted away from the regulator or exchange by the higher rewards offered by the industry requires imaginative human resources policies and competitive salaries. 600. Given the high cost, the London School of Economics study, mentioned above, concluded that competitive pressures on trading system operators will encourage them to limit their expenditure on regulation. Trading system operators will continue to regulate: a. the conduct of its members/users in relation to each other and the use of the trading system (including trading halts); and b. the integrity of its settlement process, e.g. margins and large exposures. The regulation and surveillance that they will tend not to do relates to general market quality and market confidence in particular, control of market abuse and insider dealing. Evidence of this, or at least of the tension that it creates in incumbent trading systems, can be seen in European and US markets. It is considered by the consultants that a similar situation exists in India. The exchanges do offer regulation and surveillance in the two areas mentioned above, trading system and settlement. But the surveillance efforts of the exchanges on market abuse are relatively modest. This is not a judgement on the exchanges, but merely a comment that they are acting rationally in a situation where surveillance will not earn a commercial return. Inevitably, market abuse is more of an issue in equity markets. Bond markets are less subject to abuse. This is because the price volatility of bonds is lower than that of equities, and so the scope for reward from abuse is less. And the illiquidity of bond markets again limits the scope for profiting from abusive trading. However, the instruments are still susceptible to abusive behaviour: a. The relatively small, tightly held and illiquid issues usual in bond markets offer potential for squeezes and similar manipulative behaviour. b. The possibility of inside information exists as to the ability of an issuer to repay or service the debt. Given the possibility of abusive behaviour and the relatively low level of surveillance effort, we are concerned that the negotiated corporate bond market will be inadequately regulated. This introduces the possibility that investors may be
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601.
602.
603.
604.
605.
disadvantaged, or that they will perceive that there is a possibility that they will be disadvantaged. Either way they will keep away from the market or limit their trading, as they do now, to a limited set of counterparties and a limited set of issues. This represents a barrier to development of an active secondary market for corporate bonds. 606. The recommendation here goes beyond the needs of the corporate bond market. Indeed, the low volumes of the corporate bond market would not themselves support even the most modest surveillance effort. There is a need for a national surveillance and enforcement strategy. This would define the responsibilities of the exchanges and SEBI, where at present the responsibilities seem unclear. Our sense is that the current situation involves SEBI in initiating investigations, but since they lack the front-line capabilities they are dependent upon others to point to possible examples of abuse. The exchanges do not generally identify cases for investigation. Their current systems will shut down the market, or parts of the market, in certain circumstances, such as when price parameters are passed but do not spark an investigation. The problem of regulating multiple trading venues that SEBI is facing, while its origins are uniquely Indian, is similar to that faced by other regulators in Europe and the US. In those jurisdictions, the pressure, which it has to be said some national regulators are resisting, is towards greater centralisation of the surveillance effort, with the national regulator increasingly setting the framework and then delegating implementation and data collection to the exchanges. SEBI could learn from their experiences and their strategies for the future evolution of market regulation.
607.
Recommendations 608. SEBI should, drawing upon experiences and responses in other jurisdictions, develop a plausible, feasible and sustainable regulatory strategy for a situation where there are competing trading venues. In particular, SEBI should draw up plans to ensure that: a. responsibility for first-line identification of possible abuse is clearly defined; in all likelihood the exchanges will be the first-line and their licensing should be dependent upon adequate fulfilment of this role; b. adequately trained staff are available to carry out the surveillance activities wherever that activity is located (at SEBI or at the exchanges); c. the enforcement staff are adequately empowered and have sufficient operational independence, etc., to carry out their surveillance/enforcement duties; and d. adequate and appropriate technical resources are available to the surveillance staff. A number of software packages that carry out the basic alert-generation functions are available at a range of prices, depending upon the degree of sophistication. It is not recommended that the Indian market opt for the most sophisticated, since the cost would not be justified because of lack of skilled staff to get the full benefit from the high level of functionality.
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GOVERNMENT SECURITIES MARKET

Negotiated Dealing System
609. The RBI is planning to implement the NDS to supplement or replace the current telephone trading. There are a number of significant concerns about the implementation, operation and regulation of the NDS that collectively represent significant risks to the Government securities market and, in turn, to the corporate bond market that relies upon an effective Government market for pricing.
Lack of information on the NDS 610. There is currently no announced live date for the NDS. It has not proved possible for the project team to obtain detailed information on the operation, functionality, regulation or business parameters of the NDS. A limited summary is given in Box 5.1 below. Market participants have similarly not been offered detailed documentation and, as a result, are less than clear as to what is being offered and what they are required to do to be able to use the NDS. The impression we gained was that market participants see the NDS as being important to settlement processes but not as a replacement for using the telephone for OTC contracting. In discussions with the three largest dealers in the Government securities primary market we heard that the dealers did not have any significant amount of information on the NDS, nor had beta testing commenced at any of the firms. It is disconcerting that as of June 2001 beta testing had not begun for a market-critical electronic trading system that was scheduled for live operation in July then September of 2001 then January 2002. there is currently no official live date. The RBI states that, Right from the conceptualisation of NDS in RBI, market participants have been involved at each stage of development through several meetings of all SGL account holders and presentations by vendors at each stage. Several groups of market participants have been formed to assist the RBI and the vendors in the development of the system. More than 100 market participants have participated in the hands on system in LAN environment created by the RBI. Presentations have been made in various for a such as FIMMDA-PDAI annual meetings, Seminar in 2000, Business Asia Seminar on debt market in Mumbai for companies, mutual funds and depositories. The functionality of the NDS as it has emerged with the active involvement of the users at each stage, is being put on the [RBIs] website for wider dissemination. However, despite considerable effort we were unable to obtain comprehensive documentation on NDS. Our discussions with participants suggested that while they had seen the presentation described they did not have comprehensive documentation (or indeed any significant documentation and believed that it did not exist. Our discussions did not suggest that practitioners were adequately familiar with the functionality of NDS. Additionally they had little confidence in target
611.
612.
613.
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delivery dates and planned to spend little time and effort in preparing in advance of implementation. 614. Since also the attendees at meetings, seminars and conferences are unlikely to be the people who actually implement the system within the firm, it is essential that there is adequate documentation for lower level staff to work from. It is also hard to see how a presentation could encompass the required level of detail for building a system to use the NDS facility. In order to provide an electronic trading mechanism with a reasonable chance of success, the design and implementation of an electronic trading system should be transparent to professional participants in the marketplace. It is extremely important that business and technical design of a system such as NDS be validated prior to implementation by neutral parties having a strong business interest in the operational viability and success of the system. These should include trading firms, investors, exchanges and SEBI. It is not recommended that the RBI, which is responsible for the construction of the system, perform the assessment. It is recommended that on completion of the assessment the RBI consider implementing changes to the system that it deems appropriate for the orderly and secure conduct of business in the market.
615.
616.
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Box 5.1 Negotiated Dealing System: Summary of Functionality
The salient features of the NDS are: a. Banks, primary dealers and financial institutions having SGL and current accounts with RBI will be eligible to become members of the system. b. The system will facilitate submission of bids/applications for auctions/flotations of Government securities through pooled terminal facility located at regional offices of the PDO across the country and through member-terminals. c. The system can be used for daily repo and reverse repo auctions under the LAF. d. It will provide an electronic dealing platform for primary and secondary market participants in Government securities and also facilitate reporting of trades executed through exchanges for information dissemination and settlement in addition to deals done through the system. e. Government dated securities, T-Bills, repurchase agreements (repos), call/notice/term money, commercial paper, certificates of deposit, forward rate agreements/interest rate swaps, etc., will be the eligible instruments. f. NDS will be integrated with the Securities Settlement System of PDO of the RBI to facilitate settlement of deals done in Government securities and T-Bills. g. It will facilitate dissemination of information relating to primary issuance through auction/sale on tap and underwriting apart from secondary market trade details to participants.
Source: Monetary and Credit Policy for the year 20012002, Statement by Dr. Bimal Jalan, Governor, Reserve Bank of India on Monetary and Credit Policy for the year 20012002, Reserve Bank of India, April 19, 2001, Mumbai. The information contained above represents the total amount of documentation available to the project consultants.
RBI's lack of experience as the regulator of a secondary securities market 617. The RBI does not have any discernible experience as the regulator of a secondary securities market. Therefore, the RBI should take all steps necessary to acquire the expertise to meet its regulatory, operational and technical responsibilities as the primary regulator of the secondary market in Government securities. In consideration of the time required to internalise the expertise required and to avoid undue delay in the implementation of the NDS, it is recommended that the RBI devise an interim plan to acquire the expertise necessary to provide for the market regulation. This will probably require assistance from other regulatory entities.
618.
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RBI's lack of experience as the operator of an electronic trading system 619. Secondary markets in Government securities differ significantly from primary markets in their structure, regulation, participants and operation. The differences also apply to the electronic trading systems that support the markets. Although the RBI does have a considerable amount of experience with the operation of electronic systems, especially in the clearing and settlement area, it does not have any experience with the operation of electronic trading systems that support trading in a secondary market. The RBI, through its Request for Proposal process, has engaged the services of a system services provider to build and test the NDS. However, it must be noted that the expertise required for the design and testing of an electronic trading system differ significantly from the expertise required to operate the trading system on a day-to-day basis. The expertise required to sustain the operation of an electronic trading system is not purely technical in nature. The operational expertise required is a combination of technical, business, regulatory, surveillance and compliance skill sets that is normally acquired, over time, as the result of practical application. In consideration of the time required to internalise the expertise required and to avoid undue delay in the implementation of a secondary market, it is recommended that, as with regulation, the RBI devise an interim plan to provide the expertise necessary to support the ongoing operations of the market by outsourcing NDS operations and technical support. It is strongly recommended that the outsourcing provider chosen under an interim plan be qualified by virtue of the providers performance in providing operational and technical support to a successful electronic secondary market. It is also strongly recommended that the outsourcing provider chosen be an entity whose primary business is in the securities market.
620.
621.
622.
623.
Recommendations 624. The RBI should publish and disseminate information on the NDS to enable the user base to validate the functionality and to inform the user base as to what is required of them in order to be able to use the system. The RBI should acquire the expertise necessary to effectively regulate the secondary market in Government securities. An interim plan is required to bridge the gap, which will involve use of external resources to provide surveillance functions. The RBI should acquire the technical expertise necessary to effectively operate the NDS. An interim plan is required, probably involving outsourcing of operations to an entity with a track record of performance in running critical systems and experience in the securities industry.
625.
626.
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Prohibition on Short-Selling
627. Short-selling of Government stock is prohibited by the RBI. (SEBI has also imposed a temporary ban on short-selling of equity and corporate debt following recent cases of market manipulation.) The prohibition has a number of negative effects for the Government bond market which spill over into the corporate bond market. Primary dealers are not able to make two-way quotes when they do not have stock. They have an obligation to make quotes, but the prohibition on shorting gives them inconsistent regulation. In practice, the requirement to make quotes is widely regarded as not enforced. The perception of market participants is that most primary dealers will not make firm quotes in normal size. In other markets, primary dealers run their business on the smallest possible positions, since positions are expensive to maintain. Indian primary dealers seem to hold auction stock for longer than do primary dealers in other markets, but in other stocks they hold relatively flat positions. This inhibits their ability to place buy orders on the market. This reduces the value of the primary dealers to the market, since they are constrained in acting as market makers. Further, the ban on shortselling inhibits their ability to place sell orders on the market. Putting these two aspects together, the liquidity provision by primary dealers is constrained. The ban is expressed in terms of a ban on selling stock that is not in the SGL account. This means that intra-day trading is prohibited (even if for different settlement dates) since a purchase of stock will not be reflected in the SGL account until the end of the daily settlement process. An offsetting sale will not be seen as such but as a short-sell and will be rejected. Even without the ban on selling stock not reflected in the SGL account, intra-day trading would be difficult because of the way the SGL system works. The SGL processes transactions one by one in no particular sequence. Therefore, it is not necessarily true that a trade done early in the day will be processed before one dealt later. A primary dealer who buys stock and then sells it has no guarantee that the buy will be processed first. If the sell is processed first, then it will be rejected as a short. This would severely disrupt the settlement cycle. The impossibility of intra-day trading severely restricts the ability of primary dealers to perform their role as market makers and indeed to trade actively at all. Intra-day trading is only possible for large net holders of Government stock (such as banks and the LIC, and to a limited extent, the large primary dealers). The prohibition on shorting also rules out a number of other trading strategies. For example, bond traders will trade to arbitrage what they see as discrepancies in the credit spread. If they see the credit spread on a stock as too large, anticipating a correction, they will buy the stock. Since they do not want to take a view on rates generally, but only on the selected stock in relation to risk-free investments, they will seek to offset the position, i.e. sell Government securities short, so their only exposure is to the credit spread. This and a number of other strategies relying on
628.
629.
630.
631.
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Government stocks as the base measure are not possible. Failure to trade out arbitrage opportunities reduces pricing efficiency in the corporate bond market. 632. Many countries, after initially negative experiences with unregulated short-selling, have adopted standard regulatory measures to facilitate short sales, including securities lending and/or repo markets, rules and practices for delivery fails, and special security lending and/or repo facilities through which the authorities can provide the securities in short supply. It is unfortunate that many newer markets did not address the requisite regulatory issues related to short-selling, and as a result unregulated naked short-selling became common. The trading firm defaults, investor losses and market disruption caused by naked short-selling subsequently led many markets to prohibit any form of short-selling which, in turn, reduced liquidity in the market at a time when increased liquidity was required. It is important that market regulators consider rules and regulations related to shortselling and securities borrowing/lending in an objective light. It is equally important for market regulators to review the experience of those markets where naked short-selling is illegal but a well-regulated and supervised environment supports legal short-selling. The restriction on short-selling in India is maintained not to limit speculation but in order to guarantee the integrity of the settlement process. Very few trade failures in the Government market occur on the stock side; almost all are on the cash side. The RBI have said they have no objection to short-selling provided there was an adequate system to ensure stock could be borrowed to cover shorts. By this they mean that short positions would automatically be covered by borrowing within the settlement system. It is not absolutely clear why it is necessary to have automatic borrowing, as many markets operate with less formal arrangements whereby money brokers or similar arrange stock loans. However, there is a deep concern at the RBI about settlement integrity and the possibility of abuse of informal systems in particular, those for stock lending. (There is a history of abuse of informal systems.) But whatever the reasoning, the settlement problem should be resolved when the clearing corporation is implemented. The precise timetable for this is unclear, but current thinking is for operation in January 2002. A clearing process has two advantages over the current system: a. The process works out daily settlement net balances, rather than balances trade by trade. This would allow intra-day trading, as these would appear as net zero balances on the day. CCIs initial efforts seem to be based on batch-mode processing, and real-time operation is still some distance away. b. The process could be integrated with a securities borrowing functionality to support short-selling. It appears that the economic efficiencies associated with the clearing corporation will be substantially limited insofar as netting will only take place on the funds
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633.
634.
635.
636.
637.
side. It is important for this to be changed to full-fledged netting on both funds and securities for the market to obtain the full gains from having a clearing corporation. CCI should also move on to rapidly become a genuine real-time system. 638. There are a number of issues relating to the take-up of the clearing corporation and how it relates to the existing RBI settlement process. In particular, the lack of documentation means that key market participants are unaware of its advantages and may not use it at the outset. However, the facility to borrow, sell short and trade intra-day should encourage use and a rapid migration to the clearing corporation (assuming other issues relating to margin cost are addressed see Chapter 6 on Clearing and Settlement). It is necessary nonetheless that short-selling be allowed only in a regulated environment. In order to safely legalise short-selling in the Indian debt market in a manner that is reasonably compliant with generally accepted global standards, it is recommended that market regulators, exchange management and market participants undertake a study of short-selling operations in comparable markets, such as Hong Kong, and as a result of the study design and implement regulations that will permit short-selling in a safe and orderly manner. Following the 1998 financial crisis, regulators in Hong Kong began to review the supervision of shortselling and the securities borrowing and lending markets. A number of legislative changes have been proposed to enhance the transparency of the short-selling market, as well as measures to improve the regulatory regime for securities borrowing and lending.
639.
Recommendations 640. Prohibitions on the short-selling of Government debt (when covered by borrowing) should be removed. This has been under consideration for many years and is a recommendation of previous reports. Primary dealers are the most affected by the restriction (other participants tend to have stock), so it would be a reasonable interim step to remove the prohibition for primary dealers first, with others to follow once the RBI had become comfortable with short-selling. The advantage of restricting the benefit to primary dealers is that they are more directly under the control of the RBI (as indeed are banks and gilt mutual funds). In practice, there is little a regulator can do in the longer term to stop primary dealers using their stock borrowing and short-selling privilege to facilitate short selling by clients but this is only an interim step so that need not matter so much. This should not be done until the clearing corporation is operational and effective, and robust stock borrowing is in place. Automated stock borrowing will only be available for business settled at the clearing corporation. Short-selling should therefore only be permissible for users of the clearing corporation. The introduction of short-selling should be done in a regulated way. The overall implementation of short-selling regulations should be undertaken as a structured project for regulatory development with specific performance deadlines and accountability.
641.
642.
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Lack of Hedging Mechanisms

643. Primary dealers incur risk positions and need mechanisms to allow them to lay off the risk. The Indian market has forward rate agreements and swaps, but these are only traded OTC and only lightly used. There is no futures or other organised derivatives market. Our sense is that the lack of sophisticated participants in the market is restricting use of forward rate agreements and swaps. The equity derivatives market has now proved to be quite successful in terms of attaining high liquidity, but the participants continue to suffer from a variety of constraints in engaging in arbitrage, which inhibits market efficiency. A valuable hedging mechanism in many markets is the ability to lay off positions with other primary dealers. This allows them to take larger positions than they can support themselves, or positions that do not match their portfolio objectives, secure in the knowledge that they can fairly rapidly spread the position across the market. Inter-dealer trading therefore increases the liquidity of the market by allowing primary dealers to accommodate larger orders. It improves price formation through the constant testing of current prices and trading. It also improves market integration by providing a forum where the primary dealers, which are each individual markets, can exchange (through trading) information about current prices. In other markets, primary dealers use inter-dealer trading above and beyond their needs to lay off positions. (This is analogous to trading in the forex market where inter-bank trading is vastly bigger than the underlying trading.) To illustrate the importance of inter-dealer trading in Government bonds, in 2000 the average daily volume in US Treasuries was $207 billion, of which $99 billion was interdealer trading. However, it is important that the process of laying off risk does not involve revealing a position to other primary dealers, as a dealer with an unbalanced or exposed position is vulnerable to spoiling behaviour from competitors. In the experience of the consultants, primary dealers will rarely trade directly with competitors because they fear exposing the temporary weakness in their trading situation. Without specialist intermediaries, primary dealers in the Indian Government bond market have no easy way of laying off positions with other primary dealers. Conventional brokers currently perform this role, but conversations with primary dealers suggest that there are justified fears that the information on the dealers position leaks out to other clients of the broker. Brokers are not permitted to take principal positions themselves, but principals in the firm or major clients are believed to use the information gained from executing inter-dealer orders. Since brokers cannot be principals and do not have SGL accounts, settlement takes place directly between the primary dealers. Since most Government bonds are settled T+0, this means the dealers know each others identity very soon after the trade, so there is no anonymity. The mechanisms for inter-dealer trading in other markets usually involve dedicated intermediaries, usually known as inter-dealer brokers. IDBs have traditionally
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644.
645.
646.
647.
relied on voice broking. The usual procedure has been to allocate an individual broker within each IDB to each primary dealer. These individual brokers maintain telephone contact with the primary dealers, and deals are negotiated across the desk at the IDBs office between the individual brokers at the IDB. The negotiations, and hence the identities of the counterparties, are not visible to the primary dealers. All they are aware of is the messages passed back to them from the IDB. 648. The IDBs broking function is usually supported by screens that attract the attention of primary dealers by announcing expressions of interest. Increasingly, IDB-like functions are being performed by pure electronic systems. The most successful of these have negotiation functionality (rather than pure order-book systems), but allow the primary dealers to interact anonymously. (Note: NDS does not, we believe, allow anonymous negotiation.) In order to maintain anonymity, IDBs often trade with both sides as a principal so that anonymity is retained throughout the settlement period. At the same time, it is important that IDBs are seen by primary dealers as neutral players so they are not themselves allowed to take positions. Thus all their trades will be on a matched principal basis, i.e. the simultaneous matching of buy and sell orders. They are rewarded by a (usually small) commission paid by the aggressor, i.e. the primary dealer that takes up the offer. The initiator is rewarded for being a liquidity provider by paying no commission. Commissions are added to the price paid or subtracted from the price received. Primary dealers also tend to be concerned about information leakage, and the tendency has been for IDBs to be specialists who only offer their service to primary dealers. An IDB with a relationship to another investor would raise concerns about the possibility of the IDB encouraging the customer to front-run the primary dealers. Exclusive access to IDBs is also used as an additional incentive to become a primary dealer. IDB services are specialised in their nature and there are a number of global firms that offer IDB services in a range of different national and asset markets. Remaining specialists enables primary dealers to have confidence that IDBs are not passing information on to related businesses that deal with investors. The nature of the business tends towards monopoly, as the market share tends to attract more market share. However, the primary dealers tend to favour competition (to keep commissions down) and so spread their business among the IDBs. The London gilt market started with six IDBs but has now stabilised at three.
649.
650.
651.
Recommendations 652. We recommend that the RBI develop a framework for supporting IDBs in the Government bond market. This requires three developments: a. Rules for IDBs: the current London Stock Exchange rules are relatively short (two pages) and the main points are: IDBs do not take principal positions; IDBs maintain anonymity of counterparties; and
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IDBs do not deal with non-primary dealers. b. The development of regulatory monitoring systems and procedures to ensure that IDBs adhere to the rules: in particular that the IDBs do not hold positions and maintain proper separation from other businesses so that confidentiality and anonymity are not compromised. 653. The provision of SGL access for IDBs. This will be a limited form of access to the settlement system, since IDBs will not hold stock but merely pass it through. Current regulations require stock to be in the SGL account at the start of the settlement process if it is to be sold, and so effectively prohibit intra-day trading. This will need to be waived for IDBs. Alternatively, if the restriction on shortselling were removed, then it would be easier to accommodate IDBs. IDBs would stand to gain most from the clearing corporation since, as non-position takers, they would only ever be takers of cash (commission payments). The fee structure of the settlement system would need to recognise the relatively low burden that IDBs, as non-takers or deliverers of stock, place on the system. It is possible for IDBs to be regulated by contractual agreement rather than by formal rules. This is the case in the US where the service contract between and IDB and a primary dealer prohibits the IDB from exposing business to non-primary dealers. We did not feel this approach was appropriate for India and felt the regulatory approach would be more easily enforced and more likely to be trusted by primary dealers.
654.
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Volume 2 Analysis and Recommendations Chapter 6 Clearing and Settlement
Chapter 6 Clearing and Settlement

655. India has made substantial progress in automating and improving its settlement infrastructure. However, the inauguration of industry automation with the creation of the National Stock Exchange and its associated depository the National Securities Depository Ltd (NSDL) was not preceded by the necessary fundamental infrastructure changes to legacy business mechanics. In particular, the system of account period settlement was retained. Therefore, although activity in the Indian securities markets has increased significantly in recent years, the failure to effect business changes has appreciably impacted the marketplaces ability to attract investor capital and to compete with newer markets that have developed since 1990. The major impediment to the efficient and cost-effective settlement of debt securities in India has been the presence of an archaic and fragmented post-trade processing infrastructure. In order to support a viable secondary debt market it is recommended that the post-trading infrastructure in India be simplified, standardised and upgraded. Much new infrastructure is planned, as is described below. In addition, recent announcements by the SEBI and others have signalled the end of the account system and related badla carry-over procedures. In many ways, Indias settlement processes will, if these changes are carried through, be in line with world standards. However, many things in the proposals remain unclear or uncertain. Much of the comment that follows reflects not an obvious failing in the Indian settlement infrastructure, but rather a lack of clarity, or a concern that beneficial change will not be carried through or that it will be incomplete, leaving pockets of weakness in the settlement of debt securities.
656.
657.
CURRENT SITUATION
Government Securities
658. The RBI acts as the issuer and manager of public debt. As a depository for public debt, it supports and manages holdings in all types of Government securities in paper and dematerialised form. The holdings in dematerialised form are maintained in the RBIs SGL accounts. The RBI has announced its commitment to the operation of payment and settlement systems, especially a Real Time Gross Settlement system, that are compatible with global norms. An SGL account is provided to all scheduled commercial banks, financial institutions and some co-operative banks having a current account with the RBI. Participating institutions may settle their trades for securities held in SGL through a
659.
660.
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DVP mechanism, which ensures the simultaneous movement of funds and securities. Since not all investors in Government securities have access to the SGL accounting system, RBI has permitted such investors to hold their securities in physical stock certificate form. 661. Participants may also open a Constituent Subsidiary General Ledger (CSGL) account. This allows them to offer SGL functionality to any entity. The National Securities Depository has a CSGL account through which it settles Government stock transactions, thus giving access to Government of India (GOI) bond settlement for NSDL account-holders. Trading in Government securities is almost exclusively conducted between participants with an SGL account, over the telephone. At a point where agreement is reached as to the details of the trade, the seller will create a type of trade contract document known as a Form-3. The Form-3 must contain all trade details and be signed by the seller and buyer before settlement can begin. In most cases, the buyer sends the signed Form-3 to the seller, who counter-signs it and presents it to the RBI for settlement. The settlement infrastructure is electronic insofar as physical securities do not move in the system. However, it is not electronic insofar as instructions are moved on physical forms. This is in contrast with (say) equity settlement at NSDL, which is capable of fully electronic operation using the Internet for communicating instructions. Market participants have stated that trades executed over the phone can be settled the same day (trade date) if the necessary paperwork is completed and submitted at the RBI offices before 2:30pm. The practice seems to be that trades struck before 1pm are settled on T+0 and those after 1pm are settled on T+1. Most trades are settled T+0, with a small proportion settled on T+1. Settlement may take place up to T+5, but this is rare. Discussions with market participants provide evidence that the current settlement methodology works well, although there have been relatively frequent problems with gridlock associated with sequencing difficulties of settlement instructions, necessitating a high level of manual intervention and consequent delays. The RBI puts the responsibility for resolving the gridlock problem on the participants, who sometimes have to cancel trades. Recently, the RBI has instituted a special emergency credit facility (called the Special Liquidity Facility) to ease the temporary funds shortages that cause gridlock. However, participants are required to pay interest on the emergency funds provided. The fact that the current arrangements are generally regarded as acceptable by participants is, in large measure, because of the low volume of settlement transactions as well as the emergency credit facility. It may also reflect low expectations on the part of the fixed income community, who do not easily visualise the possibility of sophisticated settlement infrastructure (such as that found on the equity market). Trades executed on the NSEs Continuous Market (CM) are settled through the NSDLs CSGL account.
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662.
663.
664.
665.
666.
667.
Current settlement activity is averaging between 700 and 1500 transactions per day in all Government securities instruments, with a significant concentration in dated securities.
Corporate Debt Securities

668. The settlement of corporate debt instruments in India is fragmented, with settlement occurring in multiple venues with varying settlement cycles. Corporate debt securities are held in dematerialised form and physical holdings. The settlement cycle for corporate debt varies according to an issues dematerialisation status and/or whether the trade is settled at the BSE depository (Central Depository Services Ltd CDSL), NSDL or inter-office. Discussions with participants in the debt market indicated that only 4060% of trades are executed on-exchange. On-exchange includes negotiated trades that are subsequently reported to an exchange. Settlement of trades in corporate debt issues may occur in any of the ways described below: a. NSDL: Trades on the WDM segment of NSE are settled on a trade-for-trade basis, i.e. each transaction is settled individually with no netting. Each trade has a settlement date that is set at the time the trade is executed. The NSE allows settlement periods ranging from same day (T+0) settlement to a maximum of six days (T+5). The actual settlement of funds and securities is effected directly between participants, usually via a custodian for physical stock and by depository instructions for dematerialised stock. The members and participants report the settlement details to the exchange. The NSE produces settlement instructions on the due date and monitors that settlement actually takes place. The depository does not guarantee these trades or take a margin. NSEs CM offers an order book for corporate debt. These trades are settled in the same way as equities i.e. cleared by the National Securities Clearing Corporation Ltd (NSCCL), which is the NSEs clearing house. Such trades are margined and guaranteed by NSCCL. Volumes on the CM are very low. b. CDSL: Trades on BSE in corporate debt settle in an account settlement period environment in which all trades on all days within a specific time period (Wednesday to Tuesday) settle at the same time, seven days after the end of the account period. The settlement is trade-for-trade and effected directly between participants. Currently, very little use is made of the CDSL facility for corporate debt. The depository does not guarantee trades or take a margin. c. Inter-office settlement: It is also common for participants in the debt market to trade away from the stock exchanges and make their own settlement arrangements outside the depositories. Such trades are settled inter-office by exchange of certificates and cheques often involving a custodian.
669.
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REGULATORY DEVELOPMENTS AFFECTING SETTLEMENT

670. Two significant regulatory developments relating to settlement have occurred during the course of the project: a. a move towards rolling settlement; and b. the SEBI/RBI regulations regarding the dematerialisation of corporate debt.
Move to Rolling Settlement

671. The Indian equity market has traditionally worked on an account settlement basis trades during a week-long trading period are all settled on account day. Account settlement days varied between exchanges but were about seven days after the end of the trading period. Account settlement allows investors to open and close positions during an account and only settle their net gains/losses on account day, but involves significant extra risk of settlement loss and scandal. The account system was supplemented by various carry-over systems that allowed investors to roll positions from one account to the next. Some of this was conducted through exchange systems and some was conducted OTC. The various exchanges in India have different account periods, i.e. they do not match. This allows investors to extend positions by moving them from one exchange to another. Corporate bond trading is generally not for account settlement. BSEs system for corporate bonds uses account settlement, but its volumes, as noted, are very low. On May 14, 2001, SEBI announced major changes to the post-trade processing environment. With effect from July 2, 2001, all major stocks have been traded for rolling settlement and all new carry-over has been discontinued. Existing carryover positions in those stocks were unwound by September 3, 2001. Other stocks will move to rolling settlement in January 2002. This is a positive move for the Indian equity market and, to the extent that bond trading is or could be for account settlement, also positive for bonds.
672.
673. 674.
675.
Dematerialisation of Corporate Bonds

676. Most corporate bonds are held in physical form. SEBI has previously mandated dematerialisation for a small number of issuers. The Finance Bill 2000 exempted corporate bond trades from stamp duty if the trade was done in dematerialised stock. Stamp duty is a significant cost. It is a minimum of 50 basis points but varies from state to state. The duty is complex, being based on location of the issuer rather than location of the trade. In the credit policy announcement of April 2001, the RBI has made dematerialisation mandatory for fresh investments of banks, FIs and primary dealers. It also required that all outstanding bonds held by RBI-regulated entities should be dematerialised by June 30, 2002. This is irrespective of whether the
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677.
bonds are Government bonds or corporate bonds, publicly issued or privately placed. This action has greatly spurred the process of eliminating physical paper from the bond market. 678. This will now require institutional holdings of corporate bonds to be dematerialised (or sold). The dematerialisation process for corporate bonds is different from the process for equities. For equities, SEBI published a list of stocks to become mandatorily dematerialised and ran the timetable. For bonds, there is no SEBI involvement in the process. NSDLs website contains the procedure and the forms required. The cost is low, especially for issuers that already have equity issued. It is not clear what will happen as a result of the RBIs announcement. To be in compliance, all banks and primary dealers will have to hold corporate bonds only in dematerialised form by the deadline. The hope seems to be that investor pressure will drive issuers to dematerialise their bonds, which would be a positive development. RBI-regulated entities are important as holders of corporate bonds, so this should serve to force all issuers towards dematerialisation.
679.
INFRASTRUCTURE DEVELOPMENTS AFFECTING SETTLEMENT

680. Three systems infrastructure developments are taking place or planned: a. the development of the Clearing Corporation of India; b. the development of a Real Time Gross Settlement System; and c. the development of an interim settlement system.
Clearing Corporation of India

681. A clearing system for Government securities is being developed. The responsibility for the development lies with the Ministry of Finance rather than the RBI. The system will offer clearing and settlement guarantees and will link to the NSEs depository, NSDL. NSDL, in turn, operates a constituent SGL account. Like NSCCL (the NSEs clearing system), CCI will interface with the NSE so that trades on the NSE can pass seamlessly to the CCI. The CCI is intended to be operational by January 2002. The project consultants have been unable to obtain documentation on CCI. It is not clear how the CCI will relate to the current RBI settlement system for Government securities. It is intended that the CCI should be attractive to current SGL accountholders, and this may be true since it will offer attractions including partial netting, which is currently not possible. CCI membership will also be wider than current SGL membership.
682.
Real Time Gross Settlement

683. The RBI is in the process of constructing a new money transmission system that will facilitate RTGS. Documentation is not currently available to provide a realistic assessment of the proposed systems capacity and suitability. Discussions with
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management of the RBIs IT Department did reveal that the earliest possible live date for the new RTGS system would be 1518 months after delivery of the new NDS trading facility. Based on this projection (NDS roll-out due to commence January 2002), the RTGS system would be available sometime around late 2003. 684. We now understand that a development contract has been awarded and that this requires the system to be delivered in 20 months. However there remains a total lack of published detail and plans. We remain concerned about the project and the lack of published documentation, plans and specifications does nothing to alleviate our concern. Implementation of RTGS is a very complex and risky undertaking. We have attached an appendix to this report on RTGS systems architecture and operations. For the interested reader. One important point is that the basic central system is only a part of the RTGS structure. As important are the clerical and computer systems of the participants. We are concerned that the lack of published plans, design documentation, roll-out plan etc. will compromise the RTGS development in India. Implementation of RTGS in other countries has been preceded by white papers subject to expert reviews before the system-build contract was awarded and we are concerned that this does not appear to have happened in India
685.
Interim Settlement System for Government Stock

686. The NDS is discussed in Chapter 5 on Trading and will allow electronic entry of details of Government stock trades, i.e. it will replace the current Form-3 transfer document. This requires the development of an interim settlement system to operate for the period between the introduction of NDS and the full redevelopment of the settlement system required for the implementation of RTGS.
Recommendations
687. We recommend the publication of comprehensive design, testing and implementation and business documentation for CCI, RTGS and the interim settlement system. In the course of the project, requests were made to the RBI for documentation related to the design, development and implementation of the interim settlement and RTGS systems. The total amount of documentation received, at the time this report was drafted, was the one-page Annexure 3 attached to the RBIs 2001 Annual Policy Statement and a generic outline presentation on NDS prepared by the RBIs Public Debt Management Cell. Without access to detailed documents and expert evaluation of the market design of NDS, there are significant risks that the system may suffer from significant design flaws. Similar attempts were made to assess the operational viability of the proposed CCI. However, as with the interim settlement system and the proposed RTGS system, the absence of comprehensive documentation made such an assessment impossible.
688.
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689.
The absence of design, developmental and implementation documentation on such market-critical components constitutes a potential impediment to the development of the secondary debt market in India for two reasons: a. In order to ensure that the rules, regulations and operational structure of marketcritical components are fully understood by market participants, it is necessary to publish and circulate relevant documentation. In many cases the publication and circulation of regulatory and systems documentation prevents implementation of market regulation or system components that would place unreasonable participation burdens on market participants. Additionally, the vetting of requirements helps in eliminating regulatory and operational inefficiencies in the marketplace by considering the results of market participant review. b. The design, development, testing and implementation of critical market components without the structure, direction and control provided by appropriate documentation could lead to major regulatory and operational gaps in market structure. The development of complex and critical market components cannot be left to chance nor conducted in a random design-as-you-go fashion. The development of regulatory and operational components should be conducted in an orderly manner, in order not to compromise confidence in the safety and reliability of the post-trading processes.
690.
INTERNATIONAL STANDARDS
691. In order to identify impediments in the current post-trade processing environment and to recommend specific solutions, the Indian post-trading processing environment is measured against the 18 IOSCO Settlement Principles.4 For each principle, the current Indian debt market situation is summarised and compared to the IOSCO principles. This leads to detailed proposals for solutions.
Legal Framework
692. The legal framework includes the laws, rules and procedures that support the holding, transfer, pledging and lending of securities and related payments, and how these laws, rules and procedures work in practice. It is critical that under the legal framework system, operators, participants and their customers can enforce their rights.
IOSCO Principle 1. Legal Framework Securities settlement systems should have a well-founded, clear and transparent legal basis in the relevant jurisdictions. Current Environment Impediments The legal basis for guaranteeing the finality Currently there are no actual or potential of settlement is well founded, clear and impediments to the development of the transparent. Legal authority of infrastructure secondary debt market.
4
Objective and Principles of Securities Regulation, pages iiv, International Organization of Securities Commissions Secretariat, September 1998, Montreal, Canada. Page 163
IOSCO Principle 1. Legal Framework organisations is well established. Recommendations Recommended solutions are not required. The Indian environment is reasonably compliant with generally accepted global standards.
Trade Confirmation
693. The first step in settling an executed trade is to ensure that the buyer and the seller agree on the terms of the transaction. The agreement process is referred to as trade confirmation. Where market participants execute trades on behalf of indirect market participants, trade confirmation usually occurs in two separate parts: a. confirmation of the terms of the trade between the direct participants (trade confirmation); and b. confirmation of the terms between each direct participant and the indirect participant (trade affirmation) for whom the direct participant is acting. Trade confirmation and/or trade affirmation should occur as soon as possible so that errors and discrepancies in the settlement process can be discovered as early as possible.
694.
IOSCO Principle 2. Trade Confirmation Confirmation of trades between direct market participants should occur as soon as possible after trade execution, but no later than trade date (T+0). Where confirmation of trades by indirect market participants is required, it should occur as soon as possible after trade execution, preferably on T+0, but no later than T+1. Current Environment Impediments Confirmations for trades executed through A large proportion of secondary debt exchange facilities are issued no later than market trades are not executed through or trade date (T+0). reported to exchange facilities and, as a result, confirmations are not generated in a timely manner by exchange systems. Recommendations Rules and enforcement mechanics for mandatory trade reporting of executed trades in debt issues be established (see Chapter 5). Rules to include enforceable time reporting requirements (see Chapter 5).
Settlement Cycle
695. 696. The Bank for International Settlements recommends that rolling settlement be adopted in all securities markets, with final settlement occurring no later than T+3. The longer the time period from trade execution to settlement, the greater the risk that one of the parties may become insolvent or default on trades, the larger the number of unsettled trades outstanding, and the greater the opportunity for the prices of traded securities to move away from the contract prices which, in turn, will increase the risk that non-defaulting parties will incur a loss when replacing securities in unsettled contracts.
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697.
As far back as 1989, the Group of Thirty (G30) recognised that to minimise counterparty risk and market exposure associated with securities transactions, same-day settlement is the final goal. Currently, the global securities industry is actively pursuing implementation of T+1 by mid-2004.
IOSCO Principle 3. Settlement Cycle Corporate Debt Rolling settlement should be adopted in all securities markets. Final settlement should occur no later than T+3. The benefits and costs of a settlement cycle shorter than T+3 should be assessed. Current Environment Impediments Account period settlement was the norm for There is a lack of clarity on SEBI equity. BSEs system for corporate bonds requirements for corporate debt settlement. uses account settlement but volumes are low. SEBI has now mandated a rapid move to rolling settlement for equity. Recommendations Specific inclusion of corporate debt instruments in SEBI regulatory changes. Implementation of standardised rolling settlement for all corporate debt trades. Corporate debt recommendations 698. The key to eliminating the current impediments lies in the adoption of a proactive approach by SEBI to the implementation and enforcement of the regulatory components contained in its mandate of May 14, 2001. Historically, SEBI has adopted a reactive approach to market regulation, with the implementation and enforcement of regulation occurring as an after-the-fact reaction to specific marketrelated problems. Regulatory efforts in the Indian marketplace have tended to focus on the formulation of market regulation, with a limited amount of effort devoted to on-going compliance enforcement. The primary focus of SEBI regulation on rolling settlement has been equity. The circular does not specifically mention corporate debt issues, and it is not possible to determine with any certainty the inclusion or exclusion of corporate debt issues in the proposed changes. It is therefore recommended that SEBI specifically include corporate debt issues in these regulatory changes. In order to minimise investor risk and to standardise the markets trading and posttrading mechanics, it is recommended that rolling settlement be mandatory for all trades in corporate debt executed on all exchanges or reported through all exchanges. To conform with the Government debt market and the trend in international markets, the settlement period should be set at T+1.
699.
700.
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IOSCO Principle 3. Settlement Cycle Government Debt Rolling settlement should be adopted in all securities markets. Final settlement should occur no later than T+3. The benefits and costs of a settlement cycle shorter than T+3 should be assessed. Current Environment Impediments Trade date (T+0) and T+1 settlement is The processing capacity of the CCI is currently the norm for Government debt. unknown. Implementation of the RBIs new NDS will The processing capacity of the interim increase the geographic scope of trading and settlement system is unknown. will establish T+1 as the national settlement standard. The interim settlement system will be utilised until the implementation of the RBIs settlement interface with RTGS. The CCI is being established for the settlement of secondary market trades in Government debt. Recommendations Publication of capacity details for the interim settlement system and CCI. Government debt recommendations 701. Discussions with RBI revealed plans to implement an RTGS system approximately 1518 months after the launch of the NDS. In order to support post-trade processing in the NDS environment, the RBI plans to implement interim connectivity between the NDS and the current SGL/current account systems. Based on the RTGS implementation experiences of markets in Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States,5 the most likely and practical implementation timeframe for RTGS in India is 2430 months after the launch of NDS. The timeframe will require that the interim post-trading connectivity within the NDS have a utility life span of 2430 months. It is recommended that a thorough review of the NDS interim post-trading connectivity be conducted to determine the processing capabilities of the interim connectivity and the ability of the interim connectivity to sustain the post-trading needs of the NDS for a period of 36 months, should this proves necessary. Attempts were made to assess the operational viability of the proposed CCI, but this was not possible due to the lack of documentation and information. Consequently, we also recommend that details of the processing capacity of CCI be published.
702.
703.
704.
The Structure of Government Securities Markets in G10 Countries: Summary of Questionnaire Results, Study Group on Market Liquidity of the Bank for International Settlements Committee on the Global Financial System, September 1999, Basel, Switzerland. Page 166
Central Counterparty
705. A central counterparty is defined as an entity that interposes itself between the counterparties to a securities trade, acting as the buyer to every seller and the seller to every buyer. The use of a central counterparty has generally been adopted in most global securities markets. In netting underlying trade obligations, the use of a central counterparty reduces both pre-settlement replacement cost exposure and principal and liquidity settlement exposure. The use of a central counterparty concentrates risk, which is reallocated among the central counterpartys membership through its policies and risk management procedures. The ability of the central counterparty to withstand the default of individual participants is vital and depends crucially on the risk management procedures of the central counterparty and its access to resources to absorb financial losses. The failure of a central counterparty would have serious systemic consequences, especially where multiple markets are served by one central counterparty. Furthermore, there must be a sound and transparent legal basis for the netting and financial support arrangements. Netting must be enforceable against participants in bankruptcy, and it must be clear when and under what conditions the central counterparty interposes itself between its participants. The central counterparty must also be operationally sound and must ensure that its participants have the incentive and ability to manage the risks they assume.
706.
IOSCO Principle 4. Central Counterparty The benefits and costs of a central counterparty should be assessed. Where such a mechanism is introduced, the central counterparty should rigorously control the risks it assumes. Current Environment Impediments Central counterparty facilities are The lack of central counterparty facilities operational in the equities market but not in for settlement of Government debt trades the secondary debt market. Corporate debt and an unclear business case for CCI. trades are settled on a bilateral basis, outside The lack of central counterparty facilities central counterparty facilities except for for settlement of corporate debt trades NSE-CM trades. traded OTC. CCI intends to offer central counterparty for Government securities. Recommendations Clarify and publicise the business case for the implementation of CCI. Clarify and publicise the business case for offering central counterparty facilities for dematerialised corporate debt. Government debt recommendations 707. It is recommended that a clear and transparent business case for the CCI be prepared and published. This should be subject to scrutiny by potential users of the system and amendments made accordingly. The CCI is proposing to introduce a central counterparty functionality to the Government securities market. However, it is not clear as to how the CCI will relate to the existing settlement system operated
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by the RBI. Current SGL account-holders will be eligible to become members of the CCI, but it is not absolutely clear that they will wish to do so. 708. The advantages of CCI to the current Government securities trading community are: a. Guaranteed settlement: although current participants only deal with known counterparties and therefore the value of a central guarantee may be reduced. b. Intra-day netting: however, the lack of intra-day functionality is only a problem while short-selling is prohibited. c. Third-party repos become possible: this is expected to pave the way for removal of restrictions on repos and produce an active repo market. d. No gridlock costs: currently, dealers incur overdraft costs if the RBI emergency facility is used and these would be removed with the implementation of CCI. e. CCI will access funds from several banks, not just (non-interest-bearing) RBI accounts: however, most players keep minimal excess balances with the RBI. Preliminary discussions with the RBI, CCI designated personnel and market participants indicate that there may not be compelling financial and operational advantages associated with CCI membership. It was put to us by a practitioner that the saving of overdraft costs, when there is gridlock in the RBI settlement system, was the only genuine benefit. Practitioners have observed the functioning of NSCCL, and seem to be concerned about the capital requirements of the clearing corporation, which might be a significant cost to them. It will be important for the clearing corporation and regulators to use sophisticated models of price risk and liquidity risk, so as to avoid rules of thumb which will inevitably involve large safety factors and hence wasteful over-collateralisation. There are cost disadvantages to current SGL account-holders: a. the cost of changing to an alternative system; b. the cost of paying a margin; c. the cost of the guarantee fund; and d. the charges per transaction charged to current account-holders. The margin and guarantee fund policy, which will be adopted by CCI, is unclear, but it should involve: a. a variation margin to cover losses/gains though the importance of this will depend upon the settlement cycle, i.e. the variation margin will be nil if all trades are settled T+1; b. an initial margin to cover the current day (or the settlement day if T+1); and c. a guarantee fund to cover the first day before any margin is paid (T+0). Variation margin and initial margin costs depend upon the level of trading. They also offer value to users that is proportional to the level of trading. The guarantee fund is, however, a fixed cost, since a participant pays it whether or not they trade. The guarantee fund will be initially based on some proxy for expected turnover. It
709.
710.
711.
712.
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is critical for the CCI that the guarantee fund costs are not set at levels or calculated in such a way as to deter participation by current major players. 713. One solution put to us was for the banks excess SGL holdings to be pledged to the guarantee fund, so eliminating the cost to banks. But primary dealers do not have such holdings and will incur a cost. Banks could subsidise the primary dealers by allowing them to be exempt from the guarantee fund cost, but it is not obvious why they should wish to do so. There is therefore a risk that the CCI will fail to attract primary dealers and thus not succeed. The fact that banks and primary dealers are shareholders in the CCI will not guarantee that they use it, as their commercial interest in trading is likely to exceed their commercial interest as shareholders. Automated trading systems in Europe have found repeatedly that having large investment banks as shareholders does not mean the investment banks will use them for trading. CCI may find the same. It is envisaged that non-SGL account-holders will access CCI through clearing members and execute their trades on NSE. Alternatively, they may continue to access the market through current SGL account-holders operating CSGL accounts and have their trades executed in the wholesale market. Which one they choose to do will depend upon the success of NSE in attracting Government securities business away from the current participants. This will depend upon the interest among other participants in the Government debt market, the relative costs of the systems, and the degree of integration between the NSE and wholesale market.
714.
715.
Corporate debt recommendations 716. There is no central counterparty function for corporate debt and trades are settled trade-by-trade either through NSDL, CDSL or inter-office via custodians. This is expensive and risky. Current participants deal only on a known-counterparty basis to eliminate the possibility of settlement risk. For the market to attract a wider range of participants and for existing participants to be willing to trade with them, it is essential that central counterparty functionality be provided. A central counterparty can only operate properly in a dematerialised environment and most corporate debt is not dematerialised at present. There is a movement to oblige banks and primary dealers to hold only dematerialised stock, and this may force dematerialisation of corporate debt, but there is a lack of any clear, coordinated strategy for achieving this (see Principle 6). With dematerialised corporate debt, the functionality of NSCCL/NSDL would be capable of providing a central counterparty function for corporate debt. Two business actions would be required before that could be undertaken: a. Development of a risk management system for corporate debt: the risk profile of debt is different from that of equity; the debt market involves larger trades but with less volatility. Therefore, the parameters for the risk management system should be specific to corporate debt and separate and distinct from the equity risk management system.
717.
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b. Development of a business plan for a central counterparty in corporate debt: the issues of cost and advantage raised above in relation to the CCI are equally relevant in corporate debt. Current participants may see little advantage and some disadvantage in moving away from the current system. The business case should examine those issues. It should be published for feedback and adjusted accordingly. Currently, the BSE/CDSL facility sees little business. However, the BSE is planning a new trading facility for corporate debt and, if this attracts business, then the BSE should also produce and publish a business plan.
Securities Lending
718. Legally sound and well-managed securities borrowing and lending programmes, including repurchase agreements and other economically equivalent transactions, improve the functioning of securities markets. Securities lending programmes support market functioning by allowing sellers ready access to securities needed to settle transactions where those securities are not held in inventory, by offering an efficient means of financing securities portfolios, and by supporting participants trading strategies.
IOSCO Principle 5. Securities Lending Securities lending and borrowing, repurchase agreements and other economically equivalent transactions should be encouraged as a method for expediting the settlement of securities transactions. Barriers that inhibit the practice of lending securities for this purpose should be removed. Current Environment Impediments Securities lending programmes in the equity The ban, imposed by SEBI, on securities markets have been banned by SEBI. Prior to lending programmes. this ban, securities lending programmes The traditional structure of securities were modified carry-forward schemes and lending as modified carry-forward schemes. not standard securities lending programmes. The lack of securities lending programmes There are no securities lending programmes for Government securities. for Government securities. Recommendations Implementation of a securities lending programme for the secondary debt market. Legalisation of short-selling in the secondary debt market for liquid securities (see Chapter 5). Recommendations 719. In order to create and implement a securities lending programme, it is recommended that market regulators, exchange management and market participants undertake a study of the programmes that are operational in comparable markets. It is also recommended that the overall implementation of a securities lending programme be undertaken as a structured project with specific performance deadlines and accountability. The development of such a market-critical component
720.
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cannot be left to chance nor allowed to drift into oblivion. In order to achieve success in a timely manner, the project must be organised with implementation proceeding according to a well-defined schedule. 721. The implementation of a securities lending programme requires the active participation of representatives from market regulators, infrastructure organisations and market participants. It is strongly recommended that representatives from all of the market entities necessary to the programmes success be constituted as a working committee with implementation accountability to the Ministry of Finance. It is recommended that the securities lending programme to be implemented be a true securities lending programme. It must be designed to support the finality of settlement and must not be constituted as carry-forward schemes or modified carryforward schemes, as has been the case, until very recently, in the Indian capital markets. The design of the securities lending programme should include, but not be limited to, the elements listed below: a. participant eligibility; b. issue eligibility; c. collateral requirements; d. collateral eligibility; e. master agreements; f. loan enforcement; g. risk management; h. regulatory oversight; and i. financial requirements.
722.
Central Securities Depositories

723. The immobilisation or dematerialisation of securities and their transfer by book entry within a Central Securities Depository (CSD) significantly reduces the costs associated with securities settlements and custody. Generally accepted global standards for post-trade processing recommend that securities should be immobilised or dematerialised in CSDs to the greatest extent possible to reduce transaction costs in the marketplace and to facilitate shortening of the marketplaces settlement cycle. The maximum benefit of a CSD is directly connected to the level of immobilisation and dematerialisation of securities certificates in the general marketplace.
724.
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IOSCO Principle 6. Central Securities Depositories Securities should be immobilised or dematerialised and transferred by book entry in CSDs to the greatest extent possible. Current Environment Impediments Government securities are dematerialised. There is a lack of regulatory clarity on A dematerialisation programme for equities corporate debt dematerialisation due to a has been underway since 1994, with lack of operational and enforcement detail complete dematerialisation of equities, in dematerialisation regulatory mandates. mandated by SEBI, by early 2002. NSDL has well-functioning systems for dematerialised stock settlement. Recommendations Formulation and publication of comprehensive regulations relating to the dematerialisation of corporate debt issues. Recommendations 725. In order to provide the debt market with a reasonable level of operational efficiency, cost-effectiveness and safety in post-trade processing, it is recommended that the activities, listed below, be undertaken to formalise the situation with regard to corporate debt. It has proved difficult to determine the status of corporate debt issues in SEBIs dematerialisation efforts. SEBI has produced a significant number of dematerialisation mandates since 1996. However, the inclusion or exclusion of corporate debt issues in dematerialisation regulations is extremely difficult to determine. We have noted the RBI requirement that entities it regulates shall only hold corporate debt in dematerialised form. There is therefore a significant lack of clarity in the policy on dematerialisation of corporate debt. In order to firmly establish the dematerialisation status of corporate debt issues and the eligibility of such issues for inclusion in CSD processing, it is recommended that SEBI formulate and publish rules and regulations specifically related to the dematerialisation status of corporate debt issues. This should include plans to encourage rapid dematerialisation of corporate debt. It is also recommended that SEBI include private placement issues in its corporate debt regulatory formulation and publication efforts. Due to the lack of on-market activity in corporate debt issues and the preponderance of corporate debt issuance being concentrated in private placements, SEBI has failed to specifically address the status of corporate debt issues in its dematerialisation efforts.
726.
727.
728.
Delivery versus Payment

729. The settlement of securities transactions on a DVP basis ensures that the risk of securities being delivered but payment not being received, or payment being delivered and securities not being received, is eliminated. The provisioning of such
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a settlement guarantee is critical to establishing and maintaining investor confidence in a securities market. IOSCO Principle 7. Delivery versus Payment Securities settlement systems should eliminate principal risk by linking securities transfers to funds transfers in a way that achieves DVP. Current Environment Impediments Exchange-operated CSDs have the capacity There is a lack of DVP for corporate debt to settle equity trades on a DVP basis. securities. However, corporate debt trades are usually settled on a bilateral basis. Settlement mechanics for trades in There is a lack of clear settlement Government securities executed through procedures for exchange trades in exchange facilities have not been Government debt settled through CCI. established and are not operational. There is an unrealistic implementation timetable for RTGS. Recommendations Mandatory DVP settlement for corporate debt trades. Publish settlement procedures for CCI. Review RTGS implementation schedule. Recommendations 730. It is recommended that SEBI, in conjunction with the CSDs, formulate and publish a regulatory mandate requiring that the settlement of trades in corporate debt take place on the basis of DVP. At present, settlement regulation specific to corporate debt trades is ill defined and difficult to discern. Although assumptions as to settlement requirements generally held by market participants may very well prove to be true, it is not prudent to operate a market on unsupported assumptions, no matter how strongly and widely held. It is critical that the SEBI remove any ambiguity from the marketplace by formulating and publishing clear, comprehensive, and concise rules and regulations governing the post-trade processing of corporate debt trades. Interviews with market participants, infrastructure organisations and designated CCI personnel give the impression that all of the necessary business and operational details will, in time, fall into place. The development of a marketcritical component such as CCI in an ad-hoc manner, with expectations that all of the necessary details will, in time, fall into place is not conducive to the development of an investor-attractive secondary debt market. As previously mentioned, in order to attract and retain the amount of investor capital necessary to support a secondary market, the rules, regulations and operational mechanics of the market must be clear, understandable and acceptable to a diverse investor base. In order to clarify settlement through CCI, we recommend that the RBI and SEBI jointly (though with clarity as to ultimate regulatory responsibility) formulate a regulatory regime for trading and settlement of Government securities.
731.
732.
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733.
The design, development, testing and implementation of an RTGS system is a highly complex and difficult undertaking. The impact an RTGS system has on a countrys financial markets and national payment systems is considerable. Safe and efficient payment and settlement systems are critical to the effective functioning of a countrys financial system. These systems are the means by which securities transactions are settled and funds are transferred between banks. The systems are also a major channel by which shocks can be transmitted across domestic and international financial systems and markets. Robust payment and settlement systems are therefore a key requirement in maintaining and promoting financial stability. Considering the impact an RTGS system has on securities markets and financial systems, the margin for implementation error is extremely small. It is recommended that a complete disclosure review be conducted by a qualified, independent entity to assess the viability of the RBIs design, development, testing and implementation plans for the proposed RTGS system. It is also recommended that the RBI modify its plans, as and if required, in order to ensure the credibility of the securities markets and the safety of the financial system.
734.
Finality of Settlement
735. The completion of the settlement process by the end of the agreed upon settlement day is deemed to be a minimum standard in the global marketplace.
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IOSCO Principle 8. Finality of Settlement Final settlement on a DVP basis should occur no later than the end of the settlement day. Intra-day or real-time finality should be provided where necessary to reduce risks. Current Environment Impediments Equity trades settle DVP by the end-of-day The majority of corporate debt trades settle on settlement day (T+5). outside the CSDs on a bilateral basis. Trades in corporate debt settle ex-CSD on The lack of DVP settlement for corporate a bilateral basis. debt trades. Regulatory requirements for settlement of The ill-defined regulations and operational corporate debt are not clearly defined. mechanics for settlement of secondary Regulatory requirements and operational market trades in Government securities mechanics for settlement of secondary through CCI and the lack of business and market trades in Government securities operational plans for CCI post-trade through CCI have not been published. processing. Recommendations Mandatory CSD standardised rolling settlement for secondary debt market trades. Formulation and publication of comprehensive regulations and operational requirements for settlement of corporate debt trades. Formulation and publication of comprehensive business and operational plans for CCI post-trade processing. Recommendations 736. It is recommended that SEBI create and publish a body of clear and understandable regulations specifically governing the settlement of corporate debt instruments. For the benefit of domestic and international investors, it is also recommended that the corporate debt settlement regulations be in reasonable compliance with generally accepted global standards. It is recommended that comprehensive business and operational plans for CCI posttrade processing are formulated and published. This recommendation has been made previously in this document. It is repeated in this section to emphasise the importance of establishing regulatory and operational transparency in the secondary Government securities market.
737.
CSD Risk Management

738. Risk controls are required for deferred net settlement systems where final settlement of transfer instructions occurs on a net basis at one or more discrete, prespecified times during the settlement day. When a deferred net settlement system is used, a failure of a participant to settle its payment obligations could result in significant liquidity pressures on other CSD participants.
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IOSCO Principle 9. CSD Risk Management Deferred net settlement systems should institute risk controls that, at a minimum, ensure timely settlement in the event that the participant with the largest payment obligation is unable to settle. In any system in which a CSD extends credit or arranges securities loans to facilitate settlement, best practice is for the resulting credit exposures to be fully collateralised. Current Environment Impediments Current CSDs possess risk controls that are There is a lack of settlement procedures and compliant with or better than generally risk controls for trades executed on or accepted global standards. reported through the NSD. CCI settlement procedures for settlement of There is a lack of settlement procedures and secondary market Government securities risk controls for CCI. trades executed on or reported through exchanges have not been established. Risk controls for trading through NDS have not been established. Recommendations Formulation, publication and implementation of risk controls for NDS. Formulation, publication and implementation of risk controls for CCI. Recommendations 739. It is recommended that risk controls for settlement positions resulting from NDS trades are formulated, published and implemented. In order to ensure that participants in the secondary Government securities market have the ability to honour execution contracts, risk management controls must be operable within NDS. The risk management controls recommended include, but are not limited to: a.creation, monitoring and enforcement of participant specific position limits; and b.creation, monitoring and enforcement of margining procedures. As NDS direct participants enjoy liquidity facilities through their RBI accounts, the maintenance of a guarantee fund is not required for trades settling directly at the RBI. It is recommended that risk controls for CCI are formulated, published and implemented. In order to inspire investor confidence and to ensure orderly posttrade processing, it has been agreed that the CCI will novate all trades settled through CCI facilities. The novation of trades settled through CCI facilities will also be supported by a settlement guarantee fund. In order to avoid undue financial risk on the part of the CCI, it is recommended that the initial size of the settlement guarantee fund be governed by the Bank for International Settlements Lambufsey Rule. The Lambufsey Rule requires that the minimum size of a settlement guarantee fund be established at a value equal to the aggregate amount of a CSDs largest participants settlement obligations on an average settlement day.
740.
741.
742.
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743.
Since the Lambufsey Rule is recommended as a minimum, it is further recommended that the CCI investigate the economic practicality of establishing the size of its settlement guarantee fund at a value equal to the aggregate amount of a CCIs three largest participants settlement obligations on an average settlement day. It is fully realised that the size of the CCIs settlement guarantee fund will, out of necessity, initially be based on projections of transaction volumes and values. The financial sustainability of the CCIs settlement guarantee fund is critical to the stability and safety of the market. It is recommended that the CCI investigate the practicality of diverting a small portion of each transactions processing fee(s) to the settlement guarantee fund. The support of the fund by means of a fee-sharing scheme provides for the continued growth of the fund and will, over time, transition the support of the fund from participant contributions to transaction fees. In considering a transaction fee support scheme, the CCI should be careful to separately maintain participation contribution amounts from transaction fee contribution amounts. The contribution segregation is recommended to provide for instances where a participant in CCI has contributed directly to the fund but subsequently wishes to withdraw from CCI participation. The withdrawal of a participant would require CCI to refund the withdrawing participants contribution to the fund. It is also recommended that the CCI consider allowing participant contributions to be maintained at a number of CCI-approved commercial banks in a pledged or escrow account. The adoption of such a plan would allow CCI participants to receive interest on their fund contributions. However, in considering such a possibility the CCI must be careful to determine the availability of the contributory monies and the stability of banking institutions permitted to hold such funds. In considering way in which to reduce the financial impact on participants, it is recommended that the CCI consider the possibility of allowing participants to pay their fund contribution in approved Government securities. In such a scheme the participants contributions, in the form of approved Government securities, could be held in the participants accounts at the RBI but pledged to the CCI. Alternatively, the contribution in securities form could be actually transferred from the participants accounts at the RBI to the CCIs account at the RBI. In considering such an option, the CCI should carefully take into account the payment of interest on approved Government securities held/pledged as fund contributions. It is important that such interest be paid to the beneficial owner and not to the CCI. It is also recommended that the CCI consider establishing lines of credit in order to obtain capital beyond the participant contributions to the fund. This would be similar to lines of credit that have been established at NSCCL. In considering such an option, the CCI should be very careful as to the financial stability of the commercial banks at which the lines of credit are maintained and the immediate availability of funds.
744.
745.
746.
747.
748.
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IOSCO Principles 10 to 17
749. These relate to a number of important issues relating to the operation, security and governance of settlement systems: a. cash settlement assets (Principle 10); b. operational reliability (Principle 11); c. protection of customer assets (Principle 12); d. governance (Principle 13); e. access (Principle 14); f. efficiency (Principle 15); g. communications (Principle 16); and h. transparency of cost and risks (Principle 17). Our assessment is that current settlement entities are entirely compliant with these principles. However, the lack of detailed and specific information about the two new developments, the interim settlement system and the CCI, have prevented any assessment of these new systems. We have no reason to believe they will not be compliant, but we are not in a position to judge. We strongly recommend that both the interim settlement system and the CCI should publish detailed documents showing their approach to the above eight principles.
750.
Regulation and Oversight

751. In the global marketplace, securities regulators and central banks share the common objective of promoting the implementation of measures that enhance the safety and efficiency of securities settlement systems. The primary responsibility for ensuring the settlement systems general compliance with global standards lies with the designers, owners and operators of the systems. Regulation and oversight is needed to ensure that designers, owners and operators fulfil their responsibilities. In the global marketplace where a central bank operates a securities settlement system, the central bank generally ensures that its system is compliant with global standards. It is general practice in global markets that the objectives and responsibilities, as well as the roles and major policies, of the securities regulator and the central bank are publicly disclosed. This is to enable designers, owners, operators and participants of securities settlement systems to operate in a predictable environment and to act in a manner that is consistent with publicly disclosed policies. The objectives and responsibilities, as well as roles and major policies, of SEBI and the RBI need to be publicly disclosed. This will enable designers, owners, operators and participants of Indian securities settlement systems to operate in a predictable environment and to act in a manner that is consistent with those policies.
752.
753.
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IOSCO Principle 18. Regulation and Oversight Securities settlement systems should be subject to regulation and oversight. The responsibilities and objectives of the securities regulator and the central bank with respect to securities settlement systems should be clearly defined, and their roles and major policies should be publicly disclosed. They should have the ability and the resources to perform their responsibilities, including assessing and promoting implementation of these recommendations. They should co-operate with each other and with other relevant authorities. Current Environment Impediments Regulatory policy for the settlement of The lack of clearly defined policy regulating corporate debt at exchange-operated CSDs the settlement of corporate debt trades. and clearing corporations is not clearly The lack of information related to defined. regulatory policy governing the settlement Regulatory policy for the settlement of of secondary market trades in Government Government securities trades in the securities. secondary market through the interim settlement system or at the CCI is not available. Recommendations Establishment of regulatory jurisdictions for the secondary market in Government securities. Establishment of regulatory jurisdictions for the secondary market in corporate securities. Recommendations 754. Regulatory jurisdiction in the Indian marketplace is allocated between the RBI and SEBI. In the area of the secondary debt market, the demarcation lines are not clearly drawn. In the past there have been areas of, possibly inadvertent, regulatory conflict between the RBI and SEBI, where SEBI has issued equity market participation rules and the RBI has effectively exempted market participants under its supervision from compliance with those rules. The continued absence of clear-cut regulatory authority and the failure to establish practical regulations in the secondary market in Government securities will cause confusion on the part of potential investors. This may result in investors being reluctant to commit their capital in a market where participatory regulation and investor protection are ill defined. The primary sources of the regulatory confusion are: a. the settlement and trading of Government securities conducted outside of the RBI-operated NDS; and b. the settlement and trading of corporate debt by entities that are regulated by the RBI. We recommend that a clear demarcation be agreed that clarifies the regulation of trading and settlement of Government debt securities traded outside the NDS. We recommend a similar clarification of regulatory responsibility for off-exchange corporate debt trading.
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755.
756.
757.
Volume 2 Analysis and Recommendations Chapter 7 Taxation
Chapter 7 Taxation
758. This chapter examines those features of the Indian taxation system that may be a barrier to the development of the secondary debt market and makes recommendations for removing such barriers or ameliorating the effects. The discussion begins with an overview of structural problems with Indias taxation system. These issues affect the debt market but have a wider resonance to the capital markets more generally and, indeed, to the whole economy. After that, a number of specific issues are examined. In the main, these reflect specific instances of the structural issues.
INTRODUCTION
759. Indias federal Government structure operates by devolving the powers of taxation down to the various levels of the national hierarchy, so that the right to levy taxes vests with the Central Government, state and local authority level, with diminishing relative powers to derive revenues. For example, the Central Government can levy both direct and indirect taxes, state governments mainly levy indirect taxes, and local authorities have restricted powers of tax collection. Direct taxes, such as income and wealth taxes, are administered by the Ministry of Finances Central Board of Direct Taxes (CBDT) in the Department of Revenue. Indirect taxes, such as customs duties, excise (production) levies and sales service taxes, are levied by the central and/or state authorities. In terms of overall tax revenue composition, nearly two-thirds of total tax revenue is derived from indirect taxes (see Table 7.1). However, the proportion of the total tax revenues contributed by direct taxes is growing, largely as a result of the measures introduced since the mid-1990s to widen the tax base. Of the total direct tax revenues, about three-quarters of them are derived from corporation tax. Therefore, the individual taxpayers contributions through direct taxes make up a mere 8% of total tax revenues, including taxes on wages/salaries and taxes on investments. It has also been reported that 40% of Indias tax revenues are generated from Mumbai (which is estimated to handle half of Indias trade), demonstrating the concentrated nature of Indias tax base.
760.
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Tax Direct taxes: Corporation tax Personal income tax Agriculture tax Others
Table 7.1 Level and composition of taxes in India Percentages 197071 198081 199091 199596 21.3 16.4 14.0 20.4 7.8 6.6 6.1 9.4 10.0 7.6 6.1 8.9 2.8 1.0 0.9 0.8 0.7 1.2 0.9 1.3
199697 20.5 9.3 9.1 0.6 1.5
199798 23.6 9.4 12.6 0.6 1.0
78.7 83.6 86.0 79.6 79.5 76.4 Indirect taxes: Customs 11.0 17.2 23.5 20.4 21.4 18.0 Union excise duties 37.0 32.8 27.9 22.9 22.5 20.9 Sales tax 16.6 20.3 20.8 20.4 21.1 21.2 State excise duties 4.1 4.2 5.7 4.9 4.5 5.0 Others 10.0 9.1 8.1 10.9 10.0 11.3 Total tax GDP % 11.0 14.6 16.4 14.4 14.2 14.6 Source: Public Finance Statistics (various issues): Government of India, New Delhi, as compiled by M. Govinda Rao in his paper, Tax Reform in India: Achievements and Challenges, Asia-Pacific Development Journal, 7(2), December 2000.
761.
Foreign investors in the Indian capital markets can be broadly classified into two categories: a. Foreign financial institutions (FIIs) who registered with SEBI and invest in the Indian capital markets. These are subject to tax on income and capital gains, as per the Indian income tax rules. (These are 10% on income, and 10% on longterm capital gains. Capital gains realised within the year are taxed at 20%.) b. Foreign investors who are registered in Mauritius and invest in the Indian capital markets. The presence of a Double Taxation Avoidance Agreement between India and Mauritius enables tax arbitrage by these FIIs. (The rates of taxation on income can vary between 0% and 35% in Mauritius. Capital gains are not taxed in Mauritius.)
FORMS OF TAXATION IMPOSED ON INVESTORS

762. Investment income in the form of interest and capital gains is subject to tax. The rates of tax, however, vary across instruments and participant (see Table 7.2).
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Table 7.2 Taxes applicable to capital market transactions in India

Categories Capital asset Withholding tax Long-term capital gain Total income Rs. 60,000 >150,000 150,000 22% 23% 11.5% Short-term capital gain Total income Rs. 60,000 >150,000 150,000 22% 34.5% 22% 34.5%
Shares in an Indian company, debentures Applicable tax 11% issued by an Indian company which is not rate private, deposits placed by an Indian company (not private), security issued by Central Government, any other notified asset acquired, purchased or subscribed to in convertible foreign exchange. Bonds/shares of Indian company issued 11% 11% under a notified scheme or on bonds or shares of a public sector company sold by the Government and purchased in foreign currency. Non-residents Other bonds/shares/ securities. Applicable tax 22% rate 11% 11% Bonds/shares of Indian company issued under a notified scheme or on bonds or shares of a public sector company sold by the Government and purchased in foreign currency. Other bonds/shares/ securities. Applicable Tax 22% Rate Companies Bonds/shares/securities if held as 0 22% Domestic investments (capital asset and not trading asset). Foreign In case of a non-resident foreign company 10% 10% bonds/shares of an Indian company issued under notified scheme or on bonds or shares of a public sector company sold by the Government and purchased in foreign currency. 10% 10% Units of specified mutual funds and of UTI purchased in foreign currency by offshore funds (including funds, institutions, associations or bodies established under laws of a country outside India). Other bonds/shares/ securities. Applicable tax 20% rate 0 10% FII Securities (including shares/ bonds) other than units purchased in foreign currency. Tax rate under double taxation agreements in case of FII situated in: Cyprus, Indonesia, Korea,Shares/bonds/securities 0 0 Mauritius, Nepal, Tanzania, Thailand, UAE, Zambia Belgium, Czech Republic, Bonds/securities 0 0 Denmark, France, Germany, Hungary, Indonesia, Israel, Netherlands, New Zealand, Norway, Russian Federation, Singapore, South Africa, Spain, Sri Lanka, Switzerland Source: Deutsche Bank Global Markets Research, The Indian Bond Market, May 2001, Table [Y]: Level and Composition of Taxes in India (percentages).
Individuals Residents Non-resident Indians
Bonds/shares/ securities
11.5%
22%
34.5%
23% 11.5%
22% 22%
34.5% 34.5%
23% 23% 10%
22% 38.5% 48%
34.5% 38.5% 48%
10%
48%
48%
20% 10% 0 0
48% 30% 0 0
48% 30% 0 0
763.
Though interest income received from investments in debt securities is subject to income tax, a number of exemptions are available to certain classes of investors and certain types of debt securities. We discuss the exemptions in detail in a later section.
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764.
Capital gains from the sale of securities are generally subject to tax, depending upon the period of holding (though corporate bonds are treated differently, as described below). In the case of capital market securities (as defined by the Securities Contract Regulation Act), holding periods beyond 12 months are considered as long-term. Short-term capital gains are based on sales within 12 months. Short-term capital gains are taxed at 20%, while long-term capital gains are taxed at 10%. Long-term capital gains, however, enjoy the benefits of indexation. Before ascertaining the amount of capital gains, the acquisition cost of the security is adjusted for inflation, based on an index published by the CBDT. Primary and secondary market transactions in securities are subject to stamp duty. Stamp duty is payable on every transfer of a security from one entity to another. The rates vary across states. However, the Government has granted a waiver of stamp duty for secondary market transactions in dematerialised stocks.
765.
766.
STRUCTURAL ISSUES
767. The Indian tax system suffers from a number of general structural features that represent potential barriers to the development of capital markets in general and the secondary bond market in particular: a. Complexity: tax structures are characterised by a multiplicity of differential rates and exemptions. The investment and trading behaviour of market participants is driven by these differences. The result is distortions in returns on securities. The complexity has arisen as taxation policy has been modified to achieve specific political and economic aims. However, in other economies the experience has been that taxation complexities lead to unpredictable changes in behaviour (as well as to an industry of tax planners) which often, in their cumulative effect, are at variance with the objectives of the policy-makers. Accordingly, the trend in other countries has been towards greater simplicity in tax structures and to avoid using taxation to manage the micro-economy (except where a very clearly defined aim can be achieved by a very direct fiscal method of achieving it). In India this has proved difficult, both economically and politically, and tax structures remain complex. b. Volatility: the tendency in India to use taxation policy as an instrument of micro-economic management means that there are often changes in the tax structure. Tax volatility makes it difficult for economic agents to plan ahead, since their net income stream is uncertain. This is particularly true of taxes on financial investments, since returns and risk depend upon projections of future income streams. c. Inconsistency: differential tax treatments exist without there being any clear apparent rationale, which inevitably leads to tax arbitrage. This implies that the behaviour of market participants is affected more by tax policies than by other economic factors. d. Regional variations: different states in India are allowed to impose certain local sales taxes as well as taxes on capital transactions, e.g. stamp duties.
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Regional variations tend to lead to avoidance behaviour that distorts economic and investment decisions. 768. The current trends in other economies are aimed at removing fiscal distortions to economic decisions and tend to favour: a. Simplicity: collection and enforcement costs rise exponentially with the complexity (i.e. the number of rates, allowances and exemptions). So rationalisation to a limited number of rates enables significant reductions in costs of administration. b. Stability: tax uncertainty deters investment and encourages short-term behaviour. Increasingly, the aim is to set tax rates for the medium term and to avoid frequent tinkering with structural components. c. Economic consistency: inconsistency causes distortions, so the aim is for similar activities to be taxed in similar ways irrespective of the nature of the participant. Direct taxes are a small part of total Indian Central Government revenues (see Tables 7.1 and 7.3), and taxes on investments are a small part of direct taxes. The Indian Government has historically used tax incentives to direct investments into sectors that it wants to promote. Investments in new enterprises, mutual funds and insurance schemes have been specifically identified and encouraged at different points in time. Recently, the Government has used tax incentives as a part of a bailout package for institutions in distress. All this suggests that taxation of investment incomes is driven by such considerations, rather than purely revenue raising in an economically efficient manner.
769.
770.
Table 7.3 Tax as a proportion of Government revenues Rs. crore Rs. crore Rs. crore % of total % of tax revenue revenue Total receipts 3,38,487 Total tax revenue 1,46,209 Direct tax 52,331 Of which personal income tax 11,816 3.5 8.1 Of which corporation tax 40,040 11.8 27.4 Indirect tax 93,878 Of which excise duties 36,947 10.9 25.3 Of which customs duties 53,572 15.8 36.6 Non-tax revenue 57,464 Of which interest receipts 36,721 10.8 Source: Central Government receipts (from RBI Handbook of Statistics on Indian Economy); 200001 Budget estimates (all net of states share).
771.
Recognising the problems caused by the complexities and inconsistencies of taxation, the Planning Commission has set up an advisory group on tax policy and tax administration. The terms of reference of the advisory group are: to examine the structure of personal income tax and recommend means of expanding its base, in particular, by streamlining tax incentives; and to examine the structure of corporate tax and recommend means of expanding its base and simplification of the
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overall structure as specified in the current law. This appears to be a positive sign. Recommendations 772. The Government should build upon the Planning Commission advisory group report of May 2001 by explicitly aiming to rationalise the tax structure applying to the capital markets with the aim of achieving neutrality between different investments and market participants. Tax neutrality should be the driving principle, except where such neutrality explicitly and demonstrably conflicts with clearly defined social or micro-economic aims. The Government should commit to the principle of stability for investment taxation and phased change. Such commitment would allow investors to make longer-term decisions and reduce excessive short-terms arising out of fiscal incentives (which is a feature of Indian markets). Introducing changes in a number of stages allows the capital markets to build the change into their expectations and reduces discontinuities. To avoid reintroducing inconsistencies, any future proposals to change taxes relating to the capital markets should automatically be subject to examination by an expert committee. Their aim would be to move to or maintain tax neutrality, and their specific brief would be to ensure that: a. the proposed tax changes are supported by a clearly argued case addressing the reasons for the change and the likely effects on the markets; and b. the impact on capital markets of the proposed change would not be to introduce distortions or inconsistencies that are disproportionate to any gains that might be achieved.
773.
774.
SPECIFIC ISSUES REQUIRING ATTENTION

775. There are a number of specific issues relating to Indias current tax system that require attention. We address these below and make specific recommendations.
Distorting Effect of Income Tax

776. Income from investments in debt securities in the form of interest is added to the gross total income of an assessee, and is taxable at the applicable marginal rate of taxation (the maximum rate is 30%). However, there are a number of exemptions and concessions, which can be broadly classified under two main headings: a. Interest incomes that are completely exempt from tax (Section 10): RBI relief bonds; Government promissory notes; Post Office savings bank deposits; 16-year Public Provident Fund (PPF) schemes; and notified bonds of municipal corporations.
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777.
b. Interest incomes that are exempt up to a certain limit (Section 80L): small savings schemes have deductions of up to Rs. 15,000; National Savings Certificates; Post Office time and recurring deposits; and Post Office Monthly Income Scheme. 778. In addition, the following are exempt from income tax: a. payments received from insurance, except an annuity, are tax-free for an individual, under Section 10D; b. dividends on shares and mutual funds; and c. some specific retirement monies. Some types of income are eligible for deduction from gross total taxable income. There are also deductions of up to Rs. 15,000 from taxable income for interest from small savings schemes. Section 80L of the Income Tax Act covers National Savings Certificates, Post Office time and recurring deposits, and the Post Office Monthly Income Scheme. Rebates are given under Section 88 of the Income Tax Act. A rebate is a deduction from tax payable. For instance, an individuals contributions to eligible investments can be made out of income chargeable to income tax, and then contributions qualify for deductions from tax payable at a flat rate of 20% of the contributions made. The ceiling is normally Rs. 60,000, rising to Rs. 80,000 for infrastructure-related investments (except for authors, playwrights, artists, musicians, actors, sportsmen or athletes, for whom the qualifying ceiling is Rs. 70,000 and the tax rebate is 25%). The following are the major distortions created by tax incentives on income from debt securities: a. Many tax concessions are linked to locking-in investments for a pre-stated period (e.g. infrastructure bonds cannot be sold before three years). This structurally inhibits secondary market trading in these bonds. b. The return from bonds is different for different entities, depending upon the tax treatment. This artificially segments debt market participants. c. Benchmark yields and returns are difficult to compute. When debt securities are structurally differentiated by a tax incentive, the effect is similar to having an administered interest rate. d. Since fiscal incentives distort returns from competitive investment avenues, corporate bonds compare unfavourably in this context. e. Investors in bonds are subject to tax on interest income, while dividend income is not taxed. This has created an interesting tax arbitrage. Investors buy bond funds, which invest in debt securities. The interest earned by bond funds is passed on to investors as dividend, which is exempt from tax. With a few exceptions, conventional corporate bonds are not eligible for any concessions, nor are bank deposits or fixed deposits with corporations. Thus corporate bonds are disadvantaged in comparison to many other investment media, including equities.
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779.
780.
781.
782.
783.
Provident funds have a particularly favourable treatment. There are two types of provident fund that have substantial tax advantages: a. Statutory provident funds under the Provident Fund Act 1925. The funds are administered by Government and quasi-Government organisations, and by local authorities, universities, airlines, railways, etc. Everything is exempt from tax, including the employers contribution, investment returns and benefits paid. b. Recognised provident funds covered by the Employees Provident Fund and Miscellaneous Provisions Act 1952 are applicable to firms with 20 or more employees, or, on a voluntary basis, by smaller firms. Employees contributions are covered by Section 88 of the Act, and there is no ceiling on voluntary contributions. Employers contributions in excess of 12% of an employees salary, as well as any interest paid which exceeds 11%, is charged to tax. After five years of pensionable salary, the accumulated balance in the fund is payable exempt of tax. Provident funds allow early withdrawal for a range of lifetime events such as marriage, property purchases, illness, etc., and the withdrawals are tax-free. India has an unusually attractive tax regime for pension contributions since contributions, fund earnings and final lump-sum pay-outs are all tax-free. The tax exemption of pay-outs is unusual and in practice means most money is drawn down before retirement. In effect, the provident funds have become tax-exempt vehicles for other, non-pension, saving.
784.
Recommendations 785. There is a good case to reduce and remove the existing exemptions, deductions and rebates applied to income tax on investment income. Exceptions should be made where the tax advantage is providing a demonstrable social or economic benefit, such as pension contributions, but in general the aim should be to remove the biases and distortions that have been introduced over the years. To avoid instability, as well as being consistent with the need for stability and predictability in taxation, the removals should be phased over a period of three to five years. The presence of tax-free bonds distorts returns from bonds of issuing entities of similar credit quality. Special structural concessions to PSUs in the form of such bonds should be withdrawn. The other bonds in this category, such as the RBI relief bond, should be phased out, so that interest from debt instruments is not structurally designed to be exempt from tax. The special tax treatment of investments in a number of debt instruments with administered rates (National Savings Certificates, Post Office Savings Scheme, etc.) should be removed. These schemes should gradually move to marketdetermined rates, and interest incomes should not receive specific tax exemption. All investments where Government policy is to increase attractiveness through tax incentives (pension, infrastructure, etc.) should be brought under a single incentive structure, such as the Section 88 rebate. The amount of investments eligible for
786.
787.
788.
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rebate, and the qualifying investments, can be expanded if policy requires but there should be no other special treatment of investment in debt instruments. 789. The linking of tax concessions to holding period should be removed. A higher short-term CGT is a more effective and uniform tool to encourage longer holding periods.
Income Tax and CGT Distortions

790. 791. There are a number of inconsistencies between income tax and CGT that affect the development of a secondary bond market. There are different effective tax rates for the various participants in the corporate bond market. Table 7.2 above illustrates the range of CGT treatment rendered by differing situations and the fragmented approach to this form of revenue. Taxadvantaged participants such as pension funds, mutual funds and other funds registered under Section 10(23D) of the Income Tax Act pay no tax on either longor short-term capital gains. These differentials appear to have no special rationale.
Recommendations 792. Over a predefined period the authorities should implement a programme moving towards a unified, harmonised system with one rate of tax for income, short-term and long-term capital gains applicable to all investors. As before, the aim should be to reduce the biases created by the interaction of differential taxes. Again, as before, to maintain stability the programme should be phased in and preannounced.
Anti-Bond Bias in CGT

793. Capital gains are taxed either as long-term or short-term. With securities, as defined by the Securities Contract (Regulations) Act 1956, investors normally have the option of paying long-term CGT either at the rate of 20% of long-term capital gains with indexation, or at 10% without indexation. However, this choice is denied to investors in bonds and debentures, and long-term capital gains are taxed on the basis of 20% of original cost. This represents a clear disadvantage to tax-paying corporate bond investors.
Recommendations 794. There is no rationale for disadvantaging bond investors in such a specific and obvious way; this looks almost accidental, or as if a review of the discrepancy has been overlooked. It should be remedied either by allowing the indexation option for bonds or perhaps, given the commitment to low inflation, by removing the indexation option altogether.
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Other Distortions in CGT

795. The offset of capital losses is segmented so that losses may not be set off against income under any category other than capital gains, either short-term or long-term. Therefore, long-term capital gains are typically computed by deducting from the full value of the consideration any expenditure incurred in connection with the transfer, the indexed cost of acquisition and the indexed cost of improvement. The assessee will not get any deduction under Sections 80L or 80D, or the rebate under Section 88 for capital gains. For corporations, this reduces the effectiveness of a financial management tool that is sometimes used to enable the volatility in earnings within the corporate group or over different tax periods to be levelled out. As with income tax, there are exemptions to liability for CGT. For instance, the National Highway Authority of India offers privately placed seven-year bonds, which are available on tap throughout the year, and which are exempt from longterm CGT under Section 54 of the Income Tax Act.6
796.
Recommendations 797. Disallowing capital losses to be offset against other income results in an asymmetry of treatment. Investors will, on occasions, be paying tax on gains but be unable at other times to offset losses against tax. In practice, one suspects that tax planners will get around this, so the current situation looks like an anomaly without a purpose. It would be simpler, and probably make no revenue difference, if capital losses could be offset against any income/gains. The CGT structure lacks consistency and logic. It gives the impression of having been incrementally developed without major consideration being given to the overall effect of the reforms made at each stage. The serious discussion of the possibility of allowing the IDBI (which is a commercial entity, albeit with a large Government stake, in competition with other commercial entities) to have a special dispensation allowing it to offer a CGT-exempt bond illustrates that ad-hoc adjustments continue to exist. We cannot emphasise strongly enough that this sort of process leads to tax structures that are complex, unpredictable and give rise to market distortions. Therefore, it is recommended that: a. the CGT regime should be simplified wherever possible and, over time, the trend should be towards a unified, harmonised system with one rate of tax for income, short-term and long-term capital gains applicable to all investors; and b. the approach to tax policy needs to change so that the tax system should not be seen and treated as a mechanism for achieving short-term policy fixes.
798.
Distortion and Bias Against Bonds in Mutual Fund Taxation

799.
6
Dividends from mutual funds (including bond and gilt funds) are tax-free to investors. This exemption was promulgated by the 1999 Finance Act. The
Bonds issued on or after April 1, 2000 by the National Bank for Agricultural and Rural Development (NABARD) and National Highway Authority of India (NHAI), with a lock-in of five years, are exempt from CGT under Section 54EB. Page 189
exemption applied, and continues to apply, to all mutual funds. It is not surprising, and is probably even desirable from a market development perspective, that individual investors have chosen this route into the market. However, it would have been preferable if the decision to use asset managers was based on fund management skills rather than on the availability of tax breaks which, to a certain extent, take the pressure off the fund managers. This is because the returns on taxadvantaged funds should always beat fully taxed returns on comparable direct investments. 800. This exemption structure has led to a distortion, since corporations have chosen to invest their surplus cash not in the money markets but in mutual funds. A major part of the significant growth in private sector mutual funds was, we understand, as a consequence of corporate money being invested in mutual fund units. Such an investment strategy has attendant potential liquidity and capital risks, as there is scope for a diminution in value of the investment and a clear possible mismatch of assets and liabilities, which could result in cash flow difficulties. Also, the decision to invest in mutual funds may not be in the best interests of shareholders given that corporations currently have no obvious advantage over the shareholders themselves when making long-term bond investments. Mutual funds do pay a dividend distribution tax amounting to 11% on their distributions. However, the dividend tax is not payable by all mutual funds. There are specific exemptions for: a. US-64 (the UTIs largest fund); and b. open-ended mutual funds which have 50%-plus equity. These two categories make up the largest part of the market. The tax situation, whereby dividends paid by a select group of mutual funds (i.e. US-64 and certain equity funds) are tax exempt, has two distorting effects: a. There is a clear bias embedded in the tax system against bond funds, since they will be subject to a 22% tax (as will money-market funds). b. Corporations are offered a tax incentive to invest their surplus cash in the equity market through the mutual funds.
801.
802.
Recommendations 803. The scheduled withdrawal of exemptions for US-64 and for equity funds in March 2002 should be supported. This is to be welcomed because it will correct the antibond bias inherent in the current structure. Inevitably, there will be pressure to extend the exemption and this should be resisted firmly. It is recommended that the tax treatment of corporate earnings should be neutral between in-house and externally managed funds.
804.
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IMPACT ON TRANSACTIONS AND PROVISION OF SERVICES

Stamp Duty
805. Indian stamp duty is complex. There is a national system set down in the Indian Stamp Act 1896. The rate is currently 0.5% on securities. The Act sets out seven instruments for which the national rate will be the only stamp duty charged. These include equities, bills of exchange, cheques, receipts and proxy forms, but not corporate bonds. Seven states have their own Stamp Acts and impose their own rates on instruments outside the seven that are reserved for the Central Government. Corporate bond transfers may, therefore, be subject to the national stamp duty and to state duties. Transfer duty is payable according to the state where the issuers registered office is located. There are differences between states with respect to the rate charged on different securities. Some states levy substantial stamp duties on corporate bonds. This could represent a significant barrier to trading, and one might expect a market solution to emerge with issuers locating their head office in states where transfer taxes were lower, though given the low turnover, issuers might not wish to undergo the cost and inconvenience. However, Maharastra and Gujarat (the main states where issuers are located) now have low or zero stamp duties. In addition, the Stamp Act was amended to implement a waiver of stamp duties for transfers of dematerialised stock. Currently, most corporate bonds are held in physical form, but this is likely to change as: a. SEBI has encouraged dematerialisation of a limited number of issues; b. SEBI has mandated a move to rolling settlement which, if applied to bonds, will increase the attraction of dematerialising; c. in the near future the RBI will require those it regulates (banks and primary dealers) to hold bonds only in dematerialised form; and d. dematerialisation of corporate bonds is relatively simple, as it is by arrangement between the issuer and a depository.
806.
807.
Stamp Duty and Special Purpose Vehicles (SPVs)

808. Stamp duty was an issue for SPVs, as the transfers in and out of the SPV were seen as transactions subject to stamp duty. This was a potential barrier to the development of securitisation. The liability to stamp duty remains the case, but the main states where issuers are located have now reduced the stamp duty to a nominal amount so it is no longer a barrier.
Recommendations 809. To at least reduce, and ideally eventually eliminate, transfer stamp duty, as this is a barrier to trading. Evidence from other markets suggests that the elasticity of
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demand for trading is high, so that reductions in transaction costs lead to proportionately larger increases in trading volumes. 810. However, evidence from other markets also suggests that the revenue losses from abolition can also be significant and this might deter complete abolition, as it has in the UK. The situation in India is different in that, by-and-large, equity transactions are free of stamp duty, since most are in dematerialised form. Therefore, the revenue effect of total abolition would not be great. In one regard, stamp duty has an important beneficial effect by adding to the pressure for dematerialisation of corporate bonds. As that would undeniably be a good step for the market, the recommendation is to leave transfer stamp duty unchanged for the present but to formalise the waiver for dematerialised holdings.
811.
Service Tax on Financial Intermediaries

812. In summer 2001, it was announced that the invoices of merchant bankers, foreign exchange brokers, asset management and advisory service providers, and hire, purchase and lease rentals will be subject to a 5% service tax. However, asset management companies of mutual funds will be exempt. Fees received in convertible foreign exchange for services rendered in India, and which will not be remitted out of India, are also exempt.
Recommendations 813. It is not obvious why mutual funds should be exempt but asset managers are not. This is a substantial tax burden and will seriously distort the asset management market. It is recommended that the exemption for mutual fund asset managers be extended to the provision of all asset management and advisory services.
OTHER GENERAL RECOMMENDATIONS

814. Earlier research into Indias tax system has advocated the need to maintain ongoing development/implementation of the policy under which revenues are collected, to reform the administration and collection of taxes, and to make refinements to the legal process of hearings/appeals. These are all initiatives aimed at achieving a tax system that will minimise tax-induced distortions and provide a system that will be simple, transparent, administratively feasible and politically acceptable, and result in a broader tax base which yields an enhanced revenue productivity. We support these initiatives, as they should help to produce an efficient and equitable tax system in which both domestic and international investors can have confidence. The changes affecting the capital markets should be incorporated into a broader overall review of Indias taxation system to ensure that a coherent and comprehensive system is developed and that inconsistent/conflicting regulations arising from piecemeal regulatory amendments are avoided. In order to inform the markets and to canvass opinion from the market practitioners, who will be instrumental in determining whether Indias secondary
815.
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bond markets are a success, a series of public consultations and explanations need to be undertaken prior to any proposed tax changes being implemented.
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Volume 2 Analysis and Recommendations Chapter 8 Regulation and Enforcement
Chapter 8 Regulation and Enforcement

816. Regulation is an integral part of any successful capital market. A number of regulatory issues, relating to participants (Chapter 3), issuance (Chapter 4), trading (Chapter 5) and settlement (Chapter 6) have been discussed previously. In this chapter we bring together some over-arching regulatory issues that represent significant barriers to market development. A number of these apply to the market generally, rather than just to the secondary debt market, but their importance in moving the entire Indian market forward means that the debt market would benefit significantly from their resolution.
INDIA'S CURRENT FINANCIAL REGULATORY STRUCTURE

817. Indias financial markets are regulated by a hierarchy of different institutions, which derive their authority and power mainly through legislative statutes.
Economic and Fiscal Management

818. The countrys economic and fiscal management falls under the remit of the Ministry of Finance, which formulates the Union Budget used to plan economic development and produces the economic surveys used to gauge the countrys performance. Macro-economic policy is managed by the Ministry via the Department of Revenue, the Department of Expenditure and the Department of Economic Affairs. The RBI has day-to-day responsibility for exchange rate and interest rate management.
Banking Sector
819. The Reserve Bank of India Act 1934 was passed by the Indian parliament to create the RBI as an autonomous central bank. It was the Banking Regulation Act 1949 that vested the RBI with its sole powers of regulation and supervision over Indias banking sector. The RBI has responsibility for Indias commercial banks (both those listed in the second schedule of the RBI Act of 1934, and those deemed to be non-scheduled), and for its co-operative banks, financial institutions and non-bank financial companies (NBFCs). In addition to its role as the main regulator of the banking sector, RBI acts as banker to the Government with the responsibility for the issuance of the Government of Indias sovereign debt obligations in both the money market and securities market.
820.
821.
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Capital Markets
822. In 1996, in a move designed to bolster secondary market trading, the RBI created the position of primary dealer to act as underwriters in primary treasury auctions, and as market makers in the secondary debt market. There are currently 16 such primary dealers licensed by the RBI in accordance with the Public Debt Act 1944. (Four more have approval in principle.) Plans have been announced in the 2000 Union Budget for this Act to be replaced by the Government Securities Act. Most other issues relating to the debt and equity capital markets are controlled by SEBI, the primary securities regulator that was created in 1992. The exchanges do, however, also come under the purview of the Stock Exchange Division of the Ministry of Finance, which has regulatory powers stemming from authority delegated to it by the Securities Contracts (Regulation) Act 1956 and the Securities Contracts (Regulation) Rules 1957. SEBI has supervisory responsibility for Indias 24 stock exchanges, although the exchanges are all SROs. Secondary debt trading is currently executed through the NSE-WDM, the BSE or the OTC markets.
823.
824.
Financial Services Industry

825. The RBI has established a Board of Financial Supervision to supervise banks, financial institutions and NBFCs. Daily administration of Indias banks is undertaken by the RBIs Department of Banking Operations, while the merchant banking subsidiaries of commercial banks are supervised by the Department of Banking Supervision, and the financial institutions (e.g. development organisations) are supervised by the Department of Banking Supervisions Financial Institutions Division. NBFCs are handled by the Department of NonBanking Supervision. In addition to statutory regulation, there are a number of professional practitioner bodies or groupings serving the interests of their members. For example, the Institute of Chartered Accountants of India represents the accounting community. (We cover issues relating to financial accounting standards in India later in this chapter.) In addition, a number of trade associations represent intermediaries in the market: the Fixed Interest Market Derivatives Association, the Fixed Interest Brokers Association and the Primary Dealers Association. The Association of Merchant Bankers of India represents the investment banking industry. Other similar organisations include the Indian Banks Association and the Association of Mutual Funds of India.
826.
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GENERAL REGULATORY ISSUES

Too Much Control, Not Enough Regulation
827. Experience in other markets suggests that developing financial markets go through three phases of state intervention in markets: a. Phase 1 Ownership: participants are mainly state-owned and activity is largely directed by administrative edict. Prices are set and there is little marketdetermined price discovery. Secondary activity is very low, since there is no motivation to engage in such activity that is highly restricted by the authorities. There is neither private sector involvement nor foreign involvement. b. Phase 2 Control: private sector entities begin to participate alongside the public sector. However, their activities are highly circumscribed by controls. Licensing of participants is required, and rules are highly specific as to the roles and functions that a participant can undertake. Private involvement improves price discovery, and there is some secondary activity, but development of innovative instruments, etc., is restricted by the slow speed with which the licensing authority can move. The tight system of licensing and controls restricts competition and new entrants. There is a tendency for monopolistic structures and the need for frequent direct government intervention to prevent disorderliness or to deal with scandals. Some foreign entities enter the market in anticipation of future development, but their participation tends to be minimal. c. Phase 3 Supervision: entry into market is relatively easy, and private sector entities become major participants; state entities may remain, though their longterm future is less assured. Regulators set principles and require SROs to ensure compliance. Front-line regulation is delegated to SROs. There is little or no direct government involvement, and authority is delegated to the national regulator except possibly in the most extreme cases. Participants themselves take an active interest in ensuring they comply with regulation, because the potential gains from abuse are outweighed by potential loss of reputation and, consequently, of customers. Price discovery is entirely market-determined though the central bank will set macro-economic controls. Intense secondary market activity improves price determination and setting of benchmarks. Competition among participants leads to innovation, lower costs and improved service quality. There is active foreign involvement. Since the start of the reforms in 1992, India has moved from the ownership phase and is approaching the supervision phase, through the implementation of a series of reforms in the financial sector. An important requirement for effective regulation is the development of a compliance culture. It is not possible for regulators to be effective without the tacit consent of the regulated they lack the resources, both human and capital, to detect wrongdoing and abuse on their own. In a compliance culture, participants tend to comply with the spirit and intention of regulation rather than with the letter of the law. Naturally, even in markets with strong compliance cultures, there are rogues, but they are the minority and are ostracised by the major part of the participants
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828.
829.
(i.e. the so-called cold shouldering approach), which means they cannot trade easily. 830. The situation in India is not one of a compliance culture. It is one where the regulator attempts to anticipate potential wrongdoing and regulates largely singlehanded. Inevitably, serious scandals happen. The legacy of the licensing regime means that politicians are unwilling to delegate fully to the regulators. There is a lack of the complete authority to regulate, and multiple regulators with overlapping mandates exist. The result is that regulators are generally responsive rather than proactive, and their short-term responses can often be damaging to the development of the market. This is not to say that regulators do not get it right. SEBIs recent far-sighted regulations requiring rolling settlement and prohibiting roll-over were excellent examples of a regulator leading the market, against considerable opposition, towards highly desirable changes. The issue in that case was that SEBI needed to lead on a matter that should have been market-driven.
Recommendations 831. Responsibility for surveillance and enforcement should be clearly delegated to the SROs such as the exchanges. The exchanges, for example, have extensive rules but these are, to a large extent, aimed at reducing settlement risk or controlling the interaction of members with the trading systems. Where the rules operate against market abuse, it is not clear that they lead to sanctions. Stopping trading or even cancelling trades is not a valid enforcement mechanism, since they do not punish but only prevent it getting worse. Recent developments suggest that SEBI initiates investigations and requests data from the exchanges. This will not work, as SEBI is too remote from the day-to-day trading and probably lacks resources. SEBI needs to make very clear to exchanges that their continued authorisation depends upon demonstrating their abilities to fulfil the front-line regulatory responsibility. SEBI should state and promulgate regulatory principles. These are different from the regulations themselves, which become the job of the SROs. As an example, cornering and bear-hammering are abuses that should be outlawed by regulatory principles, but short-selling is a technique that can be used abusively. However, short-selling, of itself, is not an abuse. Therefore, a decision on shortselling should be taken by the SRO on the basis of its proven ability to regulate short-selling so that it cannot be used abusively. Areas where regulatory principles are needed include, but are not limited to: a. Client money: evidence from the recent problems with manipulation and badla suggests that strict segregation of client money (which is admirably enforced in the settlement system) is not enforced at the firm level. b. Conduct of business and suitability: there seems to be very little regulation and practically no enforcement covering the treatment of clients. Given the predominantly retail nature of Indias equity market and the desire to expand retail access to the debt market, this is particularly worrying. It is apparent that clients have been advised in ways that were unsuitable and which in other jurisdictions would have resulted in investigation followed by sanctions.
832.
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c. Promotional material and marketing: much current material is truly misleading, especially with respect to risk, with investments that involve significant risk being marketed as risk-free. 833. Participants must develop compliance functions and this must be mandated. A compliance culture implies that firms monitor themselves. To do this they need to have designated compliance functions with specific and individual responsibility for compliance. These functions need to have access to the highest management of the firm, since it is at that level (if anywhere) that a commitment to reputation, as opposed to short-term gains, will be strongest. The function is best staffed by compliance professionals, since, like auditors, they have a professional reputation to uphold which makes them more tenacious in resisting commercial pressures. The best participants may already have this function, but a requirement and enforcement by the national regulator will be needed to force the less compliant. Inevitably, two issues will come up opposing such a requirement: a. Cost: for small firms this can be significant. However, it is absolutely essential that the requirement is universally enforced. It may be hard, but if a firm cannot afford to monitor its compliance with regulations, then it should not be in business. b. Human capital: skilled compliance professionals are scarce in India. They were in other markets before there was a requirement creating a demand. It would be hard to believe that India, with its highly educated and sophisticated workforce in the capital markets, could not respond to a need for compliance officers. If there is no requirement, then the supply will certainly not materialise, but in other markets the demand led to a rise in salaries for compliance staff which brought forth the supply. Trade associations should be supported and encouraged. These are important networks supporting the development of a regulatory culture. Inevitably, they tend to reflect the culture of the leading firms and these are the firms most likely to view a regulated market as essential for their business success. They are also important in standard setting and in addressing industry human capital shortages through organising/stimulating the development of training programmes. The debt market already has a number of trade associations in the form of the Fixed Income Money Market and Derivatives Association of India (FIMMDA), the Primary Dealers of India Association (PDAI) and the Indian Banks Association (IBA). Trade associations also act as lobby and/or consultation groups, and the regulators could raise and strengthen their profile by ensuring they are involved in consultations on regulatory developments. This makes them attractive to smaller participants whose voices otherwise do not get heard. There is quite some distance for the trade associations to go, in order to grow from a lobbying function (e.g. the Federation of Indian Chambers of Commerce and Industry, FICCI) into a regulatory function (e.g. like NSE). While such a transition is desirable, it is not yet in sight. Regulators and policy-makers should be cautious about prematurely placing regulatory roles on trade associations which have as yet not developed governance, regulatory capacity and reputational capital.
834.
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835.
There should be a move away from institutionally based regulation towards functional regulation. Most regulation is at the level of the institution, so most participants only have one regulator. This is increasingly not the pattern elsewhere. Institutionally focused regulation raises difficulties when activities are undertaken by more than one type of participant or when a participant wishes to enter new activities. We note below that the apparently clean split between SEBI and RBI actually has led to gaps, which are a consequence of an institutional approach. There may be an argument that this may mean that some participants have two regulators and this might lead to cost and confusion. However, cross-institution overlaps are likely to be increasingly the case as the financial sector develops and participants move into new areas of activity (as they will need to if they are to compete globally anyway). It is worth noting that this is now common in other markets and is achieved with little real problem. The regulatory boundary between SEBI and RBI should be revisited with a view to ensuring not only that there are no gaps, but also that the structure is sufficiently flexible to accommodate crossinstitutional overlaps.
Regulatory Overlap
836. The jurisdiction for regulating the debt capital markets appears to be divided between the RBI and SEBI (largely through its responsibility for corporate debt issuance, and secondary market activity in debt securities), depending upon the type of instruments traded and/or where the instruments are traded. The current situation has RBI licensing the firms that will trade on the WDM, but SEBI governing the way in which they trade. It is understandable that as financial markets develop in their sophistication, situations can arise whereby organisations engage in various types of financial business. In India, this stage has already been reached and it was formalised with the passing of the Insurance Regulatory and Development Authority Act 1999. This has enabled banks to participate in the insurance sector; however, only those banks deemed by the RBI to have sufficiently strong balance sheets are allowed to enter on a risk-participation basis as opposed to a pure agency role. Hence, a dual approval from both the RBI and the IRDA is required.
837.
Recommendation 838. Consideration needs to be given to exploring the scope for streamlining the regulatory processes and, where possible, assigning the responsibility for regulating particular aspects of the market or areas of business to a single regulator. (For example, the IRDA should determine which organisations are suitable to write insurance business.)
Gaps in Surveillance Responsibility

839. In most capital markets, responsibility for the regulation of the trading in Government securities tends to become somewhat blurred. However, in the Indian
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marketplace there appears to have been a serious attempt by the RBI and SEBI to establish a practical demarcation line. Responsibility is delegated to the RBI in relation to any contracts in Government securities, money market securities, goldrelated securities and any securities derived from these securities, and in relation to ready forward contracts in bonds, debentures, debenture stock, securitised debt and other debt securities. 840. SEBI further specified that contracts for the purchase or sale of Government securities, money market securities, gold-related securities, ready forward contracts and debt securities to be entered into the recognised stock exchange shall be entered in accordance with the rules or regulations or the by-laws made under the Securities Contracts (Regulation) Act 1996, or the Securities and Exchange Board of India Act 1992, or the directions issued by SEBI and the rules made under the Reserve Bank of India Act 1992, Banking Regulation Act and the Foreign Exchange Regulation Act 1973 by RBI. However, while various standing committees of RBI and SEBI do work to coordinate regulation two areas are not clear: a. On-exchange trading of government debt is subject to both RBI and SEBI regulation. Currently RBI regulated entities are not permitted to undertake exchange trading in government debt, but if they were to (which we recommend elsewhere) it is not clear how SEBI would execute its authority over trading. While exchange trading is clearly within SEBIs purview, Currently, there is very little of this, but if the retail interest that is hoped for materialises, then there will be a significant volume of trading for which regulatory responsibility is unclear. b. Corporate bond trading on a spot basis is not regulated by SEBI. This includes most of the trading between banks which seems not to be regulated directly by the RBI or SEBI. This is a significant part of the corporate bond secondary market estimates say around 50%. The practical impact of this is that the SEBI rule that all business must be on-exchange (or OTC but reported) does not apply to a large part of the market which is thus entirely opaque.
841.
Recommendations 842. As a practical matter, SEBI already regulates other exchange business, and reflecting its greater experience in retail investment, we recommend that SEBI might be the most appropriate regulator for trading of Government bonds on organised trading systems and exchanges. We see the lack of transparency in spot trades of corporate bonds as a serious barrier and have discussed this in Chapter 5. Our preference again would be for SEBI to undertake the regulation. Once this is done, the entire corporate bond market would move to a transparent, exchange-traded market design with transparency, a lack of entry barriers, and competition.
843.
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Lack of Regulatory Development Structure

844. Financial markets are innovative, and changes to products, styles and practices occur quite frequently. The regulator thus usually tends to be reactive. There is often a fine line between reaction and over-reaction, as indeed there is between regulation and over-regulation. It is important, if the market participants are not to see the regulators as over-reacting or over-regulating, that full justification for such actions is given publicly. Otherwise, the market will lose confidence in the regulator, seeing it as exerting excessive control. The strength of the regulatory authority, either domestically or internationally, is an important element to investor confidence. While regulators are expected to act responsibly and swiftly in times of crisis, this can only be achieved with careful and purposeful planning. Our experiences in this field have shown us that quick fixes do not provide optimum solutions. Most of our research suggested that Indian regulators were moving in the right direction and that they are perceived as improving in their handling of market situations. However, there was a significant, and informed, body of opinion that that there is an element of over-reaction to some, often high-profile, problems. For example, as a result of the alleged activities of one stock exchanges chairman, SEBI very properly reacted swiftly in suspending the individual pending an official investigation. However, in the same decision it was decreed that all exchange directors who were employed within brokerage firms must immediately be disenfranchised from holding such offices. Since there were no other immediate announcements of alleged wrongdoings against such other brokerage principals, who were also exchange directors, the market could not see the justification for this reaction. Consequently, within the brokerage community, this action was perceived as not only heavy-handed but also as a centre control issue in pushing stock exchanges towards demutualisation and independent governance. It is important that regulators establish a reasonable balance between the levels of regulation, the cost of that regulation and the benefits that are achievable from that regulation. The US market regulators are often accused of over-regulation, which is seen by the better-quality market participants as being equally as bad as too little regulation. For the market development to succeed, particularly from a regulatory and compliance perspective, it is vital that there is effective and valued communication and co-operation between the regulators and the regulated. This does not happen in either over-regulated or under-regulated markets.
845.
846.
847.
848.
Recommendations 849. We would recommend a more structured approach to developing a regulatory framework than seems to be the case at present. We would advise regulators to adopt a more measured approach, avoid rapid responses, seek genuine consultation and be willing to listen to practitioners. We would strongly recommend that the
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regulators address their policy-making systems and establish firm protocols for damage limitation and risk assessment scenarios against their statutory and moral obligations.
Lack of Enforcement Against Brokerage Firms

850. It does not matter what laws, regulations and rules exist unless these are effectively (and publicly) enforced. It is estimated that there are in India more than 2000 brokerage firms of a widely varying nature. The licensing requirements for these firms are newly established and are not as comprehensive as international standards. However, even within the existing standards of legislation, regulation and rules, there is sufficient scope for SEBI to take action against more licensed firms than currently appears to be the case. Most of these broking firms will not be much involved in the debt markets, since there is little retail interest. However, if retail interest does develop, then the apparently low level of supervision and enforcement applied to most broking firms could be a barrier. In our experience of working with regulatory organisations in developing markets, it is the private investors who need the most protection and who make the most official complaints.
851.
Recommendations 852. SEBI should consider taking very strong regulatory action with particularly meaningful penalties against relevant firms for breaches of rules and regulations. We have found from experience in other markets that this provides a shock tactic for all licensed firms that breaches will not be tolerated. The outcomes tend to include: a. a reduction of licensed firms, some for cancelled licences and others which simply resign their licences, realising they cannot make legitimate profits; b. a combining of resources of better-quality firms, often through a trade association, to ensure more disciplined procedures and encouraging the fulfilment of higher standards; c. more business moving on to exchange platforms to ensure clearer regulatory treatment; and d. a significant improvement in investor confidence. While this may appear to be a drastic action, the results in terms of increased awareness of regulation and the consequence of non-compliance will be beneficial to the market. The realisation that compliance is not optional and the consequently greater emphasis on in-firm compliance monitoring will be a sustainable benefit to the market as a whole. Participants will come to appreciate that regulatory sanctions will hurt those that receive them. This should only need to be a one-off measure taken after considerable planning and executed with concerted action.
853.
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Low Level of Skill and Competency in Brokerage Firms

854. We have remarked in Chapter 2 on the level of understanding of bond investment and trading. We reiterate here the need for regulations to ensure competency of practitioners.
Recommendations 855. SEBI should consider individual licensing competency testing. This competency testing should include examining: a. brokers for understanding of products, regulation, exchange systems, investment analysis and advice, and application of knowledge; and b. fund managers for their product base, regulatory knowledge, investment analysis and portfolio management skills. Once this has been established, SEBI could also consider requiring a process of continued professional development. Such a complete process would ensure only adequately trained personnel could give investment advice to the public and that only suitably qualified personnel could manage portfolios for the public. This need is particularly apparent in bond markets, where the level of expertise among many participants is seriously deficient. Experience in other countries suggests that once the regulator has set the standards, a host of private sector training suppliers will emerge to fill the requirement.
856.
857.
Lack of Encouragement of Competition

858. Regulators should be mindful of the beneficial effects of competition between financial service providers. As well as leading to greater efficiency and innovation, competition when combined with transparency often reduces the need for prescriptive legislation. Regulators in Europe are coming to realise that competition from alternative trading systems, far from being a threat to regulation, is a benefit, as national regulators have to spend less time concerning themselves with the detail of exchange rules. (Indian regulators have long experience of competing exchanges, so they would perhaps be less surprised at this finding than their European counterparts.) In a truly competitive market, informed consumers will shun those providers that offer unfair or unattractive terms. The job of the regulator becomes more one of ensuring that fair competition can flourish and that consumers can make informed choices, rather than micro-managing the participants. It is important for successful capital markets that there be freedom of choice, and that this choice is based on quality, price and variety of product. In the financial market, there is a need for significant diversity of product range to satisfy the different planning, taxation, and flexibility and risk requirements of the range of investors.
859.
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860.
However, before this can even be considered, there is a need to encourage competition to exist in the first place. For example, we have had informal feedback that suggests that when order-matching for bonds commences on electronic exchanges, banks would be prohibited from participating in this. Such barriers, which are not justified by sound economic arguments, are anti-competitive. Competition should also be improved by bringing in a wide range of participants, and moving away from the narrow set of RBI- and SEBI-regulated entities that currently dominate the market. While regulation is vital, it should not stifle the benefits of competition. As a principle, it should not restrict new entrants unless there are sound and demonstrable regulatory grounds for doing so. Similarly, regulation should not restrict the development and innovation of new products. Regulators cannot and should not protect people from making what turn out to be wrong decisions, as risk is an inherent and necessary part of investing. Indeed, they should robustly rebut any suggestion that there should be recompense or regulatory action where investors losses are a consequence of free and informed choice. At the same time, regulators have a duty to protect against false or misleading claims. Informed consumers are able to make sound choices between competing products only if they are well informed. Financial products are notoriously susceptible to misinformation because of their complexity, duration and volatility. At the same time, the critical nature of decisions that affect long-term savings makes it all the more important that decisions are made with full and fair presentation of the facts. One of the key marketing tools is league tables of past performance. In terms of financial product choice, this is often the main plank for marketing and selling such instruments. Although, past performance is no guarantee of future performance (and many regulators require a statement to that effect), investors will often look at performance tables before deciding on a particular product provider. Independent fund managers are therefore particularly aware that out-performance against, for example, index benchmarks and their competitors is vitally important and can be the major reason for increases in new business. To this end, we see it as a regulatory role both to educate the public in the unavoidable risks of investment and to set strict standards for the use of performance criteria and statistics. The public and professionals would gain confidence from the validity of data published under the regulatory standards set and appreciate the value of the products (i.e. from investor education).
861.
862.
863.
864.
No Review of Infrastructure System Developments

865. In traditional, non-electronic markets, all material changes in trading procedures and the operations of market participants were subject to regulatory review and approval by the market regulator. The move to electronic markets has changed the method of trading and settling, but not the need for regulators to review significant changes affecting those operations.
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866.
In order to ensure that electronic trading systems are operated in the best interests of investors and market participants, regulators in many global markets have implemented Automation Review Policy (ARP) procedures. These procedures require that market regulators review and approve all segments of electronic trading systems operated by organisations under their jurisdiction. The purpose of the ARP is to continually ensure that public markets for the trading of securities are operated in a manner that is: a. consistent with the written policies of the market regulators; and b. sufficiently robust to accommodate increased volume levels. This issue is particularly relevant after problems at the Calcutta Stock Exchange in March 2000. At the Calcutta Exchange, a settlement crisis arose apparently as a result of a flawed software package that enabled brokers to take large positions without the trades showing up for the purposes of margin money calculation.
867.
Recommendations 868. In order to reassure itself that system changes initiated by exchanges and other infrastructure providers do not compromise the integrity or the operational robustness of the markets, SEBI should instigate a procedure to review material changes to trading and other systems. Operators proposing changes should be required to submit the changes to SEBI for assessment (within a specified time period) and approval where those changes are likely to affect the integrity of the market or the business of participants.
Poor Disclosure
869. One of the most fundamental elements of success for any capital market is the extent and depth of disclosure and transparency. Both these elements are vital for both primary and secondary markets and we have made strong recommendations about transparency elsewhere. In order to achieve suitable internationally acceptable standards issuers need to make relevant and regular disclosures of all pertinent facts and activities and the directors have to be accountable to shareholders. Financial service providers and participants must likewise make necessary disclosures about their products and services, and be accountable to their stakeholders and regulators. Accounting principles and practices used must provide a fair and true picture of all financial statements. Our research on this area indicates that there is considerable scope for improvement in terms of the standards for disclosure. Even though the initial and continuing issuer disclosure standards required by the recognised Indian exchanges are adequate, accounting practices themselves can be of a better standard. Private placements, which account for over 95% of the private sector bond issuance, are not subject to any specific disclosure standards. The memorandum that is circulated to the qualified institutional buyers has evolved from market
870.
871.
872.
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requirements and is not a SEBI-approved format. In January 2001, it was notified that all private placements made to a set of investors larger than 50 (few, if any, are) will be deemed to be a public issue, and therefore subject to SEBI supervision. 873. In addition to considering the process through which company announcements are made to the investing public, we raised the question of accounting standards with credit rating agencies and others.
Recommendations 874. Our recommendations here are given in Chapters 4 and 5.
Indias Accounting Standards

875. The financial reporting requirements for companies incorporated in India are set out in the Companies Act 1956 and in subsequent amendments to that Act which took effect on October 31, 1998. The new regulations require companies to comply with the accounting standards that are being established by a new National Advisory Committee on Accounting Standards. Accounting standards specified by the ICAI must be followed until the National Advisory Committee has addressed the issue. The ICAIs Accounting Standards Board also takes into consideration international accounting standards when developing and publishing its standards. While many of the Indian accounting standards conform in most material respects to international accounting standards and USGAAP (Generally Accepted Accounting Principles), those on segment reporting, consolidation of accounts, treatment of research and development, foreign exchange, borrowing costs and business combinations do not. Table 8.1 highlights areas where Indias accounting standards differ from international ones.
Table 8.1 Differences between Indian and international accounting standards (IAS)
In one key area, the absence of Indian rules may lead to important differences from IAS requirements:
876.
877.
parent enterprises are not required to consolidate or equity account any investments, and no detailed rules are yet in force regarding consolidation procedures and accounting principles applicable to consolidated financial statements published on a voluntary basis
IAS 27; IAS 28
Indian accounting may also differ from that required by IAS because of the absence of specific rules in the following areas: IAS 31 accounting for joint ventures IAS 22.31 the creation of provisions in the context of business combinations accounted for as acquisitions IAS 36 impairment of assets IAS 17.12 the capitalisation of leases IAS 37.45 discounting of provisions IAS 19.64/78/83 the methods to be used when accounting for employee benefit obligations IAS 12 accounting for deferred tax
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Table 8.1 Differences between Indian and international accounting standards (IAS) There are no specific rules requiring disclosures of: a primary statement of changes in equity the fair values of financial assets and liabilities, except for quoted investments related party transactions discontinuing operations segment reporting cash flow statements, except for listed companies IAS 1.7 IAS 32.77 IAS 24 IAS 35 IAS 14 IAS 7.1
There are inconsistencies between Indian and IAS rules that could lead to differences for many enterprises in certain areas. Under Indian rules: IAS 22.8 the classification of business combinations as acquisitions or merging of interests is not based on the ability to identify an acquirer IAS 21.15 exchange differences arising on foreign currency liabilities related to the purchase of fixed assets are used to adjust the fixed assets rather than being taken to income IAS 38.42 certain research costs can be capitalised IAS 38.56 certain expenditures on intangible items that are not assets can be capitalised IAS 16.29 revaluations of assets do not need to be kept up to date IAS 17.25; SIC 15 operating lease payments are generally recognised on the basis of legal arrangements rather than straight-line, and there are no specific requirements on the treatment of lease incentives IAS 11.12 the completed contract method may be used to recognise revenues on construction contracts IAS 37.14 provisions can be created when there is no obligation IAS 10.11 proposed dividends are accrued IAS 32.18/23 an issuers financial instruments are generally accounted for on the basis of their legal form, and compound instruments are not split into liability and equity components IAS 33.10/11/20 the calculation of earnings per share may use a variety of bases Source: Summary prepared by International Forum on Accountancy Development based on data collected by the International Accounting Standards Committee.
878.
Listed companies are also required to comply with rules and regulations contained in regulatory releases issued by SEBI. In July 2001, SEBIs Accounting Standards Committee (in close consultation with ICAI), under the chairmanship of Y.H. Malegam, provided some recommendations on issues relating to accounting standards and financial reporting, which included moves towards consolidated accounts, segmental reporting, deferred taxes, the highlighting of related party transactions, and the definition of earnings-per-share calculations. The ICAI President has mentioned that standards have been issued for these areas and the ICAI will be issuing accounting standards in respect of other areas, such as Intangible Assets, Impairment of Assets, Discontinuing Operations, Accounting for Investments in Associates, etc., by December 2001. Additional disclosures were also required regarding the quarterly reporting by companies. It is important to note that accounting standards issued by ICAI are not mandatory, but only prescriptive in nature.
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Recommendations 879. SEBI should initiate and lead a review by the stock exchanges of the existing disclosure requirements in these areas on an international market-comparative basis and to provide proposed changes which would make them more compatible on the world stage. The standards have been gradually improving in this area domestically but could also benefit from the establishment of a corporate governance code for issuers. SEBI issued regulations on corporate governance, which have been enforced for a certain class of firms from March 31, 2001 onwards, and will be extended to most firms from March 31, 2002 onwards. It is imperative that the international market should view the Indian market positively, and this will only stand a chance of happening when such disclosure standards are met. [Move number to the left] The Indian Accounting Standards Committee (IASC) should move as rapidly as possible to ensure compliance between Indian accounting standards and international best practice, especially in the areas of research and development, foreign exchange, borrowing costs and business combinations. With particular reference to the bond market they need to move towards IAS standards on bond valuation, repos and market transactions. The current differences matter less in the current climate, where the market involves a limited number of sophisticated investors (who can make adjustments) and a host of unsophisticated retail investors (in the equity market). However, if the market is to become broader and if, in particular, it wishes to attract foreign investor interest, conformity to international standards will become more pressing. We note that a number of top-rated companies, including those that have sought listing overseas, already produce accounts that comply with international standards.
880.
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Volume 2 Analysis and Recommendations Chapter 9 Macro-economic Issues
Chapter 9 Macro-economic Issues

INTRODUCTION
881. Macro-economic policies and the macro-economic environment are critical for bond markets. Indeed, as far as the Government bond market goes, they are the only fundamental information that is relevant. Other investments are more susceptible to the fortunes of corporate entities, although even they are subject to the macro-economic climate because of its effect on interest rates (alternative investments) and on corporate profitability/viability. It is not within the scope of this project to attempt a detailed critique of Indian macro-economic management, nor would we wish to do so. However, insofar as the policies of management affect the bond market, it would be irresponsible to omit a discussion of macro-economic management and would damage the external credibility of the report. Much of what follows is by its nature anecdotal and based on interviews with market participants. We make no apology for this, since it is sadly true that the perceptions of market participants are more important than the reality. If participants see the market as risky, they will behave as if it was risky and their actions may well make the market risky and will certainly make it illiquid. We also bring experience of macro-economic policies from other markets. As the Indian economy becomes more open and is increasingly subject to the forces that drive the global economy, its macro-economic policies will come under greater international scrutiny. The international environment is very unforgiving and is not tolerant of diversity. As a consequence, countries whose macro-economic management tends to diverge from what the global market sees as the prudent norm tend to be punished or ignored by global financial players. This is unfair and sometimes unjustified, but it is a fact the price of participation in the global economy is conformity to global norms. We focus the discussion on two specific aspects of policy the fiscal deficit and the variability of policy which, in our opinion and in the opinion of those we have met during the project, affect the attractiveness of the Indian bond market.
882.
883.
884.
POLICY EFFECTS
885. The macro-economic policies followed by Governments may affect their domestic market in two ways: a. By their magnitude: the tax burden may be too high, for example, or the exchange rate may be supported at an unsustainably high rate (neither of which is true for India). b. By the method of implementation, which may be destabilising: policy may be subject to volatility, or there may be a lack of clear objectives, or conflicting
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objectives, or the objectives may lack credibility, all of which unnerve financial markets.
MAGNITUDE
886. The main macro-economic issues affecting bond markets in India are the Government deficit and the continued dominance of the state in all aspects of the economy and financial system. The Government is running a large fiscal deficit and has a high debt burden. (The Budget projects that over 40% of Government revenues are spent on interest payments, though some commentators expect over 45%.) The deficit is now accommodated by funding rather than monetisation, so inflation is reasonably under control, but there are fears about the ability of the Government to continue to service a growing debt. Government, or centre, dominance continues. Relatively little divestment has occurred and, while the licence Raj7 has passed, the role of the state remains massive and its ownership of financial institutions dominant. Standard and Poors rate the Indian Rupee sovereign debt as BBB and its foreign currency sovereign debt as BB. Other countries with similar ratings include Colombia and Morocco. By comparison, the Philippines is BBB+/BB+. Table 9.1 shows the full list of ratings.
Table 9.1 Standard and Poors ratings, April 6, 2001 Domestic currency ratings Sovereigns
887.
Rating
AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+
Australia, Austria, Canada, Denmark, France, Germany, Isle of Man, Liechtenstein, Luxembourg, Netherlands, New Zealand, Norway, Singapore, Sweden, Switzerland, United Kingdom, United States. Belgium, Finland, Iceland, Ireland, Japan, Spain, Taiwan. Bermuda, Chile, Italy, Portugal, Slovenia. Barbados, Cyprus, Czech Republic, Hong Kong, Israel, Malta. Botswana, Hungary, Kuwait, Poland. Greece, Korea, Malaysia, Tunisia. Egypt, Estonia, Latvia, Qatar, South Africa, Thailand. Croatia, Lithuania, Mexico, Oman, Philippines, Slovak Republic, Trinidad & Tobago, Uruguay. China, Colombia, India, Morocco. Jordan. Belize, Brazil, Costa Rica, El Salvador, Panama, Peru. Bolivia, Kazakhstan, Papua New Guinea. Bulgaria, Lebanon, Paraguay. Argentina, Jamaica, Pakistan, Senegal. Cook Islands, Indonesia, Mongolia, Romania, Suriname, Turkey. Russia. Ecuador.
Licence Raj is a term used to describe the Indian economy in the 1970s/1980s. Then it was a largely command-driven economy with high levels of bureaucratic intervention and requirements for permits/licenses to conduct many economic activities. Page 210
Volume 2 Analysis and Recommendations Chapter 9 Macro-economic Issues Table 9.1 Standard and Poors ratings, April 6, 2001 Foreign currency ratings Sovereigns
Rating
AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ BBB2
Austria, Denmark, France, Germany, Isle of Man, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Switzerland, United Kingdom, United States. Australia, Belgium, Canada, Finland, Ireland, Japan, New Zealand, Spain, Sweden, Taiwan. Bermuda, Italy, Portugal. Hong Kong, Iceland. Botswana, Cyprus, Greece, Kuwait, Malta, Slovenia. Barbados, Chile, Czech Republic, Hungary, Israel. Estonia, Poland, Qatar. Korea, Latvia, Malaysia, Oman, Tunisia. Croatia, Egypt, Lithuania, South Africa, Thailand, Trinidad & Tobago, Uruguay. El Salvador, Mexico, Panama, Philippines, Slovak Republic. Belize, Colombia, Costa Rica, India, Morocco. Brazil, Jordan, Peru. Argentina, Bolivia, Bulgaria, Dominican Republic, Lebanon, Papua New Guinea, Senegal. Cook Islands, Jamaica, Mongolia, Paraguay, Turkey, Venezuela. Indonesia, Kazakhstan, Pakistan, Romania, Russia, Suriname. Ecuador. China.
888.
According to S&P, Indias ratings remain constrained by its: a. High fiscal burden: general Government debt (excluding guarantees) is likely to reach 66% of GDP, higher than the median level for similarly rated countries. Interest costs are likely to consume over 45% of the Central Governments revenues this year (2001/02), one of the highest levels of any rated sovereign. b. Pervasive and largely unreformed public sector: the borrowing requirement of all levels of Government and their enterprises consumes nearly 40% of the annual flow of savings in India, and the inefficient use of much of the countrys resources will continue to constrain growth and development prospects. On a more positive note, S&P also stated that The ratings are supported by comfortable external liquidity. Foreign exchange reserves, which exceed 300% of short-term debt, mitigate the risk of a sudden drop in external confidence. The recent liberalisation of rules for foreign direct investment, along with the rising number of Indian companies raising equity abroad, should sustain external liquidity even as imports rise with the removal of import quotas next year [2001]. It should be noted that there is a clear difference between interpretations of domestic rating agencies compared with their international counterparts. The domestic agencies tend to adopt the same notation style (i.e. AAA to BBB- is considered investment grade, and BB+ and below are considered sub-investment grade). However, it must be acknowledged that international agencies (i.e. S&P, Moodys, etc.) consider Indias country rating to be BB+ (although local agencies,
889.
890.
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of course, work from a sovereign rating of AAA), which therefore represents subinvestment grade on an international basis. 891. Accordingly, even though India is a very large and important economy, many financial institutional investors from the leading international investing nations (i.e. the US, Japan, Germany and the UK) will not currently be permitted, under their own countrys regulations and trustee protocols, to invest in Indian debt instruments until such time as the national rating improves, at least to BBB, with those rating agencies. Whatever the underlying fundamental economic facts, and whatever the local rating agencies may say, international investment will not happen to any great extent until the international rating agencies revise their ratings. This means that it is unlikely that India will see significant foreign investor involvement in its debt market until the perception of the deficit and of the role of Government changes. The Government is aware of both these macro-economic problems. It continues to strive towards state disinvestment and encouraging private entrants, especially, into the financial sector. It is also addressing the deficit problem through the Fiscal Responsibility Bill, currently before parliament. The bill requires, as general principles, that the Government: a. ensures intergenerational equity in fiscal management, i.e. it does not incur current expenditure deficits for future generations to repay; deficits may only be used to fund investments; and b. ensures long-term macro-economic stability by: achieving sufficient revenue surplus; eliminating the fiscal deficit; and removing fiscal impediments to the conduct of monetary policy, i.e. excessive borrowing demands. The bill also requires: a. prudential debt management consistent with fiscal sustainability through limits on Central Government borrowings, debts and deficits; and b. greater transparency in fiscal operations and in conducting fiscal policy. Operationally, the bill requires: a. presentation of a medium-term fiscal policy statement along with the annual Budget; b. elimination of the revenue deficit by March 31, 2006 (i.e. in five years time); and c. bringing down the overall fiscal deficit to 2% of GDP by March 31, 2006. As a reference point, the current deficit projected in 200102 is Rs. 789 billion. The outturn for 200001 was Rs. 779 billion. The overall deficit for 200102 is projected at Rs. 267 billion.
892.
893.
894.
895.
896.
897.
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898.
However, when the bill was discussed with interested parties in India, considerable scepticism was evinced as to whether it will be passed or, if passed, whether it will be implemented. Commentators noted the absence of any medium-term plan for reducing the deficit, and argued that setting targets and achieving them were two entirely different things, especially in India. Recent press comment suggests that the Government is likely to dilute several provisions of the controversial bill, especially by including a best endeavour clause, i.e. that the Government will strive to achieve the targets. The bill is currently with the standing committee on finance, and it seems the proposed changes will be necessary to get it through this committee, which has already held several inconclusive sittings about this issue. The meaning of the best endeavour clause is that a failure on the part of the Government to stick to the timetable for fiscal and revenue deficit reduction would not automatically be construed as a breach of the provisions of the Act. Consequently, the Governments action is unlikely to be reviewed in court. This review might follow public interest litigations.
899.
900.
IMPLEMENTATION
901. The Government, acting through the RBI, has a wide range of targets. An article published in the Financial Times on November 24, 2000, based around an interview with the Governor of the RBI, noted: The RBI tries simultaneously to deliver low inflation, a stable rupee and high economic growth. This is contrary to the trend in other economies where increasingly macro-economic management has come to focus on a single policy variable. In the 1950s and 1960s, governments generally believed they could and should seek to steer the macro-economy. The Keynesian revolution (though Keynes would have rejected attempts at precise macro-economic management) had given economists an understanding of the linkages within the economy. Their perception was that the national economy was like some great ship with the finance minister and central bank at the helm making fine corrections to steer the economy away from recession and towards growth. The nautical analogy was commonly used in discussions, with references to hands on the tiller, etc. Typically, governments set themselves a range of objectives (e.g. low unemployment, growth, stable prices, steady exchange rate) and felt that the tools available to them fiscal policy, interest rate/monetary policy and exchange rate management supplemented by tariff policies and industrial intervention policies were sufficient to achieve their aims. Through the 1950/1960s the prescription appeared to work. Growth was high, or at least positive, prices were fairly stable (a little inflation was seen as desirable to oil the wheels of adjustment) and exchange rates were locked to the US dollar at the Bretton Woods parities. Occasional accidents such as devaluations happened, but were seen as the way the system adjusted within the controlled economic environment.
902.
903.
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904.
The 1970s saw a new situation that invalidated many beliefs in the feasibility of detailed macro-economic management. Governments found they were increasingly unable to control anything in the macro-economy. Unemployment and inflation rose to what had been seen as impossible levels. However, this was seen as a consequence of a unique event, the rise in oil prices driven by the OPEC8 cartel, rather than a weakness in the underlying concept of macro-economic management. The inflationary experiences of the 1970s left scars, so that most countries entered the 1980s with a perception that inflation was the main policy problem (though unemployment was also high). Governments also shifted away from the idea of omniscience and omnipotence in the macro-economy. The experiences of the 1970s had convinced them that: a. the information on which they made their macro-economic decisions was frequently wrong or out of date; and b. the tools they had to control the economy were uncertain in their effect and timing. In effect, they were trying to steer the ship by looking backwards into a fog and with the control levers operating through elastic bands. This led to a focus on monetary policy and money supply as the main policy variables both to measure and to control the economy. Governments also moved towards medium-term policies, away from the notion of economic management, as they recognised the uncertainty of the linkages between policy and effect. These policies also generally failed to deliver, because: a. the monetary variables chosen to measure and control almost immediately became useless (Goodharts Law9); the move towards monetary control coincided with financial deregulation, so that many old distinctions broke down and monetary concepts became more fluid and interchangeable; b. policy-makers neglected to consider that the agents supposedly controlled by their policies were themselves rational and would respond in ways that negated or anticipated the effects of their policies; c. despite the supposed medium-term nature of the policies, governments continued to try and tweak the variables to suit short-term policy needs still the hand on the tiller; and d. global capital markets restricted the power of governments to pursue policies that were distinctive, forcing them towards the general economic consensus (less important for India which had, by and large, cut its economy off from the rest of the world for much of this period). These dispiriting experiences have led governments to believe that the vision of macro-economic control was an illusion. The best the Government could do was to create a stable environment in which private economic agents could work.
905.
906. 907.
908.
8 9
Organisation of Petroleum Exporting Countries. Named after Professor Charles Goodhart, London School of Economics: As soon as the government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends, Financial Innovation and Monetary Control, Oxford Review of Economic Policy, 2(4), 1986. Page 214
Regrettably, there would be times when the macro-economy behaved badly, but any attempt at intervention would almost certainly make the situation worse rather than better, because the Government inevitably would do the wrong thing at the wrong time and to the wrong extent. 909. The 1990s have been marked by very low ambitions in terms of macro-economic policy. Increasingly, governments have: a. restricted themselves to one policy variable target inflation. Of course, growth was desirable, but the only contribution the Government could make was to provide a stable backdrop; b. set themselves only one variable to achieve that aim the interest rate: fiscal policy is now all about prudent management rather than pump priming; exchange rates are either floating or handed over to another authority through currency boards; c. forsworn frequent and dramatic interventions in favour of gradual small changes; the large interventions of the past are seen as more destabilising than the policy problem they were trying to correct; and d. removed macro-economic policy from the political arena, either by granting operational independence to the central bank or by making policy decisions subject to an independent entity. The policy shift was supported by the plain fact that countries that had adopted active and politicised macro-economic policies had generally seen lower long-term economic success than those that had followed stable, less interventionist and less politicised policies. India appears to have rejected the lessons of the last 50 years in macro-economic policy. Its policy approach is marked by: a. multiple targets; b. frequent interventions; and c. a continuously changing backdrop. The Governor of the RBI is right to say that the situation is more complex than one instrument, one variable (a reference to a past economic debate that argued that if a Government had n objectives, it needed n tools to achieve them). However, the lesson learned in other countries is that the situation is just too complex for a wide range of objectives to be simultaneously achievable. Governments cannot achieve fine-tuning; indeed, any attempt will be destabilising. The best they can do is ensure a stable monetary and fiscal environment. The two main objectives pursued by the RBI are the exchange rate and interest rates, though the Governor also mentioned inflation and economic growth.
910.
911.
912.
913.
CURRENCY EXCHANGE RATE

914. For as long as the Indian Rupee currency exchange rate is not freely convertible, international perspective will remain uncertain as to its true value. There is a strong perception in international circles that non-convertible currencies tend to be
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artificially supported by central control that would not necessarily be sustained in a free environment. However, until such time as the currency is freely convertible, no reliable conclusion can be made as to the realism of this view. 915. Nevertheless, India is a large and important economy and, to this extent, its economic, financial and fiscal policies are very significant to the world at large. The stability and potential progress of the currency exchange rate position is, for many international portfolio managers, the most important element of making any investment decision, particularly for those professional investors who follow the so-called top down approach to asset allocation, where all decisions are based first on currency selection. Where the currency rate is not seen as being sufficiently stable or sustainable, this can result not only in volatility in balances in payments for export/import relationships, but also in adverse fluctuations in foreign currency inflows and outflows which will tend to destabilise market prices. For most large foreign investors, the exchange rate is the primary decision factor in the top-down asset allocation process. What is most relevant is whether the currency is likely to appreciate in value over the next 12 months and how stable that currency rate is relative to the foreign investors domestic currency rate. Hence, if this rate is perceived as being sustainable, this will encourage foreign investors, although there are other macro factors to take into account to justify this decision. On the other hand, currency rates matter little to domestic investors, since asset/liability matches will have greater importance and require less risk management than investing in foreign currencies. Their main concerns, for bond investing, will centre on the domestic inflation rate and interest rate levels and movements. The RBI claims, supported by evidence, that it does not target the long-term US dollar exchange rate; indeed, its aim is a steady depreciation over time aimed at increasing export competitiveness. (Arguably, this will not be effective over time, as domestic expectations, and hence inflation, will rise to offset the depreciation.) This, indeed, has been the pattern in recent years. However, it does appear to seek to remove short-term volatility in the exchange rate, and it does so by acting in the market to change (usually raise) the call money rate. The perception is that the intervention is usually too late, in that the RBI allows the exchange rate to move too far from what it considers the correct rate to be and then jerks the market back sharply. It is not within our scope to question the exchange rate policy, although it is difficult to see why the RBI is so concerned about short-term volatility when it is quite happy to see a medium-term depreciation. The effect of the interventions is to add to the conviction (discussed below and in Chapter 4) that interest rates continue to be largely a result of RBI management rather than market forces.
916.
917.
918.
919.
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MONETARY POLICY
920. The government or central bank control of monetary policy in general, and money supply in particular, from the point of view of the debt markets, needs not only to be understood but also, to a large extent but within reasonable bounds, predictable. It is uncertainty which is the prime enemy of every financial market; and, for debt markets in particular, frequent changes, or even apparently frequent changes, can unsettle the fund managers investment policies, i.e. where to place priorities throughout the respective yield curves. It is an accepted norm in international markets that governments use short-term interest rates as an aid to controlling short-term money flows and inflation policies, but that long-term rates are usually left to market forces to dictate. The latter is not the reality of the case in India, as is indicated by the relative evenness of the Government bond yield curve. Further, it is also an accepted norm that, in order to provide benefit to the nations corporates, Government does not compete with its own corporate borrowers, particularly when they are seeking to borrow long-term. This is also a natural aim of the public debt office, i.e. to try and reduce borrowing costs by identifying and taking opportunities from gaps in the supply of bonds by other issuers. The RBI is familiar with this concept and does indeed attempt to limit its borrowings to the slow period of the year. However, its style of debt management, more generally, appears to be geared more to Government funding needs and policies to lengthen or shorten its overall maturity profile, rather than any specific recognition of gaps in the market or avoidance of competition with corporates. To be fair, the current size of the borrowing requirement would make it difficult to avoid competing with corporate borrowers. The RBIs action in the forex market and its bond issuance strategies leave a perception in the market that interest rates are not market-determined. This is always the case, since all central banks seek to achieve their target through the use of interest rate policy. The difference in India is that the RBIs influence is perceived as not confined to the short end of the spectrum, as is the case in most other economies, but as affecting the long-term rates as well. The perception, supported by empirical evidence presented in this report, is that the term structure of interest rates is heavily influenced, indeed to a dominant extent, by the actions of the RBI. This introduces considerable instability and uncertainty into markets, since the element of predictability is lost, the value of fundamental research is diminished and the only game in town becomes watching for possible RBI signals.
921.
922.
923.
RECOMMENDATIONS
924. Although recommendations on macro-economic policy are outside the scope of this project, the current policies create clear difficulties for the bond markets. We would therefore advocate greater simplicity in macro-economic objectives and , as it is not possible to reconcile multiple objectives and to try to do so merely confuses the
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markets. This, as we have suggested, becomes more important as India becomes more involved in, and subject to, global economic/financial forces. 925. In addition, we are mindful of market criticism, whether fully justified or otherwise, that monetary policy is often reactive to short-term events and thus is not sufficiently stable for investors to feel comfortable with adopting even mediumterm investment strategies. Hence, where it is at all practicable, we would suggest that a longer-term approach is adopted by the RBI towards monetary policy, such that the number of apparent policy changes is reduced. This can often be achieved by a broad publication of a stable outline policy that then only needs to be tweaked to affect short-term circumstances. We would also argue strongly for greater transparency of objectives. Even if the objectives are faulty, letting the market know what they are and acting in a consistent and visible way to achieve them enables market participants to factor them into their forecasts in a rational way. This leads to smoother adjustment, as participants are less likely to be surprised and so can anticipate developments. Smoother, more predictable adjustment makes participants more willing to commit to positions (long- or short-term) with greater security, leading over time to both lower borrowing and transaction costs. It is obvious that a large and growing Government deficit puts strains on the ability of corporates to issue debt. The Government of India has itself recognised that the burden of debt is not sustainable in the longer term and has introduced the Fiscal Responsibility Bill with the intention of sharply reducing Government borrowing by 2005. If the bill is enacted and the timetable is followed, then a significant barrier to development of the corporate debt market will have been removed. However, a structural change of that magnitude is very large and difficult to achieve, so there have to remain doubts as to whether the timetable will be met. The credibility of the policy could be enhanced if, after enactment, the Government of India were to publish a strategy for medium-term policies to achieve the goals of fiscal responsibility. Such gains in credibility would bring shorter-term rewards in that corporates would be more willing to enter the bond market in anticipation and expectation of greater, lower-cost liquidity in the primary market. Moves to dilute the bill by introducing a best endeavours escape clause are unwelcome, since presumably the Government has already been trying its best and felt it needed statutory support for its endeavours. This further strengthens the need for a credible action plan to implement the bill when enacted and achieve the targets.
926.
927.
928.
929.
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Volume 2 Analysis and Recommendations Chapter 10 Development Methodology
Chapter 10 Development Methodology

930. The Indian capital market is on the cusp of moving into the group of mature markets. There are a number of things that could improve the domestic debt market, but there is one feature of capital market evolution that needs to be developed. One of the features of mature markets is that they develop selfgenerating mechanisms for promoting and managing change. India has shown that it has such a mechanism for initiating development, but the process needs to be grown to meet the needs of the larger, more complex and more integrated market that India is becoming. Mature capital markets do not need external assistance to develop; the institutions in the market have techniques for capturing changing needs, building consensus (despite the greater diversity that mature markets usually display) and implementing the changes. This is usually accomplished without disruption to the flow of markets, with risk to participants minimised, with due regard to the business needs of participants and without risk to related activities. Where financial markets are small or relatively simple in terms of integration with other markets, it is sensible to adopt ad-hoc or visionary approaches to market development. The risk of collateral damage is slight and the gains are large. As markets become larger and more complex, then it becomes more important to take a measured approach to development. This is applicable to the whole range of developments, including infrastructure, regulation and the development of new products. Our view is that India has had considerable success with development on a relatively ad-hoc basis. Such development is characterised by: a. low levels of consultation, because the needs are obvious; b. target setting, because it is necessary to cut through any obstructions to achieve the obvious aim; c. addressing problems as they arise, because disruption is not too costly; d. lack of documentation, because speed is of the essence; and e. involving a small group of drivers with the vision to see beyond the obstacles. These characteristics are all present in the Indian capital market. They have achieved some notable successes, e.g. the NSE and NSDL. However, in the future we expect that this approach will be less successful. We already see signs of: a. important infrastructure projects where demanding targets have been set but where we have serious doubts as to whether they will be delivered to those timescales; b. developments where it is clear that many of the crucial participants have serious reservations about the design and where the non-involvement of those participants would be fatal;
931.
932.
933.
934.
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c. developments where the requirements on users who want to participate are undefined at an advanced state of the project and where this imposes major business risks on those users; d. regulatory responses that are ad-hoc responses to a current crisis but which are damaging to the market or its users and where a more measured development of regulations before the problem became a crisis would have defined a better solution; e. difficulties in prioritising possible developments; now that the obvious is in place, it becomes difficult to decide between attractive competing possibilities for development; f. missing possible responses to needs that have been successfully adopted in other markets; and g. developments that have low take-up because they offer only part of a solution or are close, but not exact, answers to market requirements. 935. Two illustrations are given below. They relate to different aspects of the market. The difficulty for the consultants was not to find examples but to select some representatives from the multitude of examples. One of the most striking features of the Indian market, in the opinion of the international consultants, was the low level of preparation, planning and consultation that went into very significant changes. This will become increasingly a barrier in the future as the number, size and diversity of market participants increases. The approach can be characterised as moving directly from concept or vision to hard delivery dates. It is something that the consultants came across on several different occasions and seems to be very much part of the fabric. On several occasions, the consultants have asked for specifications or other details, or indeed any documentation, of fundamental changes and developments that were due to be implemented imminently. They were told that the documentation did not exist or that operational decisions would be taken once the system was up and running. Hard experience in other markets has taught that this approach can sometimes work, and may sometimes be needed just to get things moving. (The NSE in India and CREST in the UK are examples of where it was necessary to force through a vision.) However, it is risky in that, without consultation, it is not truly possible to know what is feasible, what the users want, or what providers are willing to provide; and without documentation of proposals, specifications, decisions, etc., it is not possible for users to prepare.
936.
IMPENDING SYSTEM DEVELOPMENTS

937. The Finance Minister gave commitments on delivery of: a. the CCI by June 2001; b. the NDS by June 2001; and c. RTGS within 18 months. These deadlines appear very ambitious to the international consultants, and they also fear that the projects, when delivered, will not meet market needs so that takeup (if voluntary) will be low. This is for the following reasons:
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938.
a. There has been no extensive consultation exercise that we are aware of as to the requirements as expressed by market participants. These are complex structures where failure to examine details of requirements can lead to a serious shortfall in the systems ability to assist the market. b. We have asked participants if they were aware of these systems, and if they were, did they have information on how they would be expected to interact with them, what rules would apply, or whether their systems staff had received interface specifications. Most were aware in general terms, but no one with whom we spoke was able to give precise and certain information on operation, etc. No technical specifications had been received. c. Given the closeness of some of the delivery dates, we would expect there to be documentation of the systems to allow potential users to design interfaces to the new system, test their internal procedures, train staff, etc. We have not been able to discover any such documentation. 939. There is a widespread view that at least some of the deadlines in the budget were designed to shame the RBI into releasing functions. While we would agree that the RBI could usefully divest itself of some functions, including IT development, such public shaming may well have an effect opposite to that desired.
KNEE-JERK REGULATION
940. SEBI has shown itself quick to respond with fairly draconian changes to regulation. Examples are firing the board of the BSE and prohibiting short-selling of equities. While few would mourn the passing of the BSE board, it is not clear that SEBI has anything to put in its place, and the short-selling ban is apparently already causing disruption in the market. SEBI seems to be highly subject to the current preoccupations of the political establishment and therefore reacts by shooting from the hip, rather than going through the more rational usual process of consulting about regulatory changes before acting in a considered and measured way. The consensus seems to be that SEBI is long on regulation, reacts without considering the full implications, and is short on enforcement. Hence, its rules are ignored until there is a crisis, when it feels obliged to clamp down hard to demonstrate its regulatory commitment. Here we explain the nature of an alternative approach. The process in mature markets is based around wide consultation, high transparency, market-wide impact analysis, validation/testing and realistic planning. Their strength is that they: a. are self-sustaining; they do not require external input; b. are business-driven; c. are more likely to identify obstacles in advance; d. are more likely to meet the needs of users; e. minimise risk to participants; f. provide conduits for new ideas; g. build consensus to support, or at least accept, change;
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941.
942.
943.
h. build credibility through achievement; i. are less costly in the long term; j. draw on the best of international experience through continuous benchmarking against global norms; and k. build a culture of a common interest in the probity and success of the market. 944. Our conclusion is that a more developed market requires this more sophisticated business development methodology. If India wishes to join the group of developed, mature markets and attract global players to that market, then it will need to change to a more sophisticated methodology. Without it the path of market evolution will be seen as too arbitrary and risky to attract serious commitment from major international players. They will conclude that their business interests will not necessarily be considered when market developments are being decided and implemented, and so they will go to markets where their interests are considered.
RECOMMENDATIONS
945. We do not see this as something that can be imposed or imported as a package. In any significant market, the current situation is a result of a long development. Therefore, while markets have similarities (more so because of the influence of globalisation), and particularly in India, organic growth of a business development methodology for capital market development is most likely to be accepted and be successful. But we have concluded that there are important lessons in change management and market development from other countries. In Indias case, this means the most mature and developed markets, since these are commensurate with Indias state of development. Of course, market development can only succeed when participants, especially those in authority at regulators and other agencies, have a good knowledge of their own and comparable markets, as uninformed development is likely to fail to deliver what is required. This suggest two needs: a. A programme of education for regulators and other agencies on the facts of market design and structure, encompassing all aspects, covering their own and comparable, foreign markets; and b. A programme of experience exchange with equivalents in advanced markets, enabling them to understand the development process in those other markets and translate it into an Indian context. The exchange element will enable those from advanced markets to understand the Indian situation and assist in adapting approaches to suit.
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Volume 2 Analysis and Recommendations Chapter 11 Endnote
Chapter 11 Endnote
946. From an oversight perspective, it was clear during our research that the circumstances of 199210 have still not been forgotten, or in some cases forgiven. We are not close enough to the culture of the Indian market to appreciate the personal losses, not only financially but also of confidence, to judge how deep the concerns of repetition remain. For us the task is not to look back, but to be forward looking and make recommendations that could take the Indian debt market to heights its size and importance merits. However, we must also be realistic in the sense that, although the endemic population are traders, it should be accepted that the debt market volumes seen in 1992 may not reappear, since it may be assumed that many of those players and their successors are now active in equity stocks. The results of our recommendations will require many changes to legislation, particularly to commercial law but also elsewhere, and regulation. Some of these are even likely to need government policy change. Bearing in mind past proposals by agencies such as the World Bank, the speed with which some of those recommendations, especially those for economic reform, have been implemented is, at best, disappointing. For example, in the World Bank report of mid-late 1999 the following paragraph appeared, which unfortunately is still almost all true today. Nearly two years on and the same problems persist. The government securities market is increasingly providing a solid foundation for corporate bond market development. But despite this gradual strengthening, the government securities market will not be able to operate at full tilt unless something is done to improve primary dealer relationships with RBI; to introduce short selling; to facilitate trading, clearing and settlement; and to cultivate the investor base. With the exception of visible signs of activity in improving settlement, but not necessarily clearing, all of the other factors mentioned remain problems that are hindering the development of these markets. In summary, we appreciate that the task list indicated by our recommendations is not small, but we believe that all are important and potentially significant. Much of the workload will fall on the regulators and medium of the marketplaces, and we would wish to see each of these organisations strengthened and operating in a stricter fashion to ensure that the right levels of discipline and efficiencies can be achieved.
947.
948.
949.
950.
951.
10
1992 saw a major scam involving Government stock repos. Page 223
Volume 2 Analysis and Recommendations Appendix A Glossary of Terms
Appendix A Glossary of Terms

ACH AIFI AMFI ARP BIS BSE CBDT CCI CDSL CGT CHAPS CLF CM CPSS CRAR CRISIL CRR CSD CSGL DFHI DMO DRF DVP EC ELOB EMU EPF EPFO EPS FAFO FFI FI FICCI FIFO FIMMDA FIPB FRA G30 GDP GIC GOI GSM IASC IBA Automated Clearing House All-India financial institutions Association of Mutual Funds of India Automation Review Procedures Bank for International Settlements The Stock Exchange (Mumbai) Central Board of Direct Taxes Clearing Corporation of India Central Depository Services Ltd Capital Gains Tax Clearing House Automated Payments System Collateralised Lending Facility Continuous Market Committee on Payment and Settlement Systems Capital to Risk-weighted Asset Ratio Credit Rating Information Services of India Ltd Cash reserve ratio Central Securities Depositories Constituent Subsidiary General Ledger Discount and Finance House of India Debt Management Office Development Research Fund Delivery versus Payment Error correction Electronic limit order book European Monetary Union Employees Pension Fund Electronic limit order book Employees Pension Scheme First-Available-First-Out Foreign financial institution Financial institution Federation of Indian Chambers of Commerce and Industry First-In-First-Out Fixed Income and Money Market Dealers Association Foreign Investment Promotion Board Forward rate agreement Group of Thirty Gross Domestic Product General Insurance Corporation of India Government of India Government Securities Market Indian Accounting Standards Committee Indian Banks Association
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ICAI ICICI IDB IDBI IDFC IDS IFCI IIBI IOSCO IRDA LAF LIC LSF MIBOR NAV NBFC NDS NDTL NEAT NHB NSCCL NSDL NSE OPEC OTC P&L PDAI PDO PPF PSU PvP QIB RBI Rs. RTGS S&P SBI SEBI SECOM SFI SGL SIC SIDBI SLR SPV SRO STCI SWIFT
Institute of Chartered Accountants of India Industrial Credit and Investment Corporation of India Limited Inter-dealer broker Industrial Development Bank of India Infrastructure Development Finance Corporation Interim Dealing System Industrial Finance Corporation of India Industrial Investment Bank of India International Organisation of Securities Commissions Insurance Regulatory and Development Authority Liquidity Adjustment Facility Life Insurance Corporation of India Liquidity Support Facility Mumbai Inter-bank Offer Rate Net asset value Non-bank financial company Negotiated Dealing System Net demand and time liabilities National Exchange for Automated Trading National Housing Bank National Securities Clearing Corporation Ltd National Securities Depository Ltd National Stock Exchange Organisation of Petroleum Exporting Countries Over the counter Profit & Loss Primary Dealers Association of India Public Debt Office Public Provident Fund Public Sector Undertaking Payment versus Payment Qualified institutional buyer Reserve Bank of India Rupees Real Time Gross Settlement Standard and Poors State Bank of India Securities and Exchange Board of India SEGA Communications System State-level financial institution Subsidiary General Ledger Swiss Inter-bank Clearing Small Industries Development Bank of India Statutory Liquidity Ratio Special-purpose vehicle Self-regulatory organisation Securities and Trading Corporation of India Society for Worldwide Inter-bank Financial Telecommunications
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TARGET T-Bills UTI VaR WDM WPI YTM
Trans-European Automated Real-time Gross Settlement Express Transfer Treasury Bills Unit Trust of India Value at Risk Wholesale Debt Market Wholesale Price Index Yield to maturity
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Volume 2 Analysis and Recommendations Appendix B Real Time Gross Settlement
Appendix B Real Time Gross Settlement (RTGS)

INTRODUCTION
This appendix sets out some of the critical issues and design features of RTGS systems derived from experience of implementation of RTGS in developed markets and from work performed by the Bank for International Settlements and its Committee on Payment and Settlement Systems (CPSS). The specific issues discussed are: payment processing; limitation of payment risks; intra-day liquidity; message flows; relationships to other systems; and queuing.
An RTGS system is defined as an electronic gross settlement system using telecommunications networks in which both processing and final settlement of funds transfer instructions take place continuously on a real-time basis. The gross settlement attribute of an RTGS system can be defined as a settlement process in which transfers are settled individually, without netting debits against credits. The realtime attribute of an RTGS system can be defined as a processing environment where the system effects final settlement continuously, rather than periodically at pre-specified times, provided that a transmitting bank has sufficient covering balances or credit. The RTGS settlement process is based on the real-time transfer of central bank money and, as such, the system can be characterised as a funds transfer system that is able to provide continuous intra-day finality for individual transfers.
BACKGROUND
RTGS systems are used in all the Group of Ten (G10) countries, which are: Belgium France Germany Italy Japan Netherlands Sweden Switzerland United Kingdom United States
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In order to support stage three of economic and monetary union, the Central Banks of the European Union have collectively decided that every EU member state have an RTGS system for large-value transfers and that these domestic RTGS systems be linked together to form a pan-European RTGS system known as the Trans-European Automated RealTime Gross Settlement Express Transfer (TARGET) system. The use of RTGS systems has also grown outside the G10 and the European Union. RTGS systems are in operation in Australia, China, the Czech Republic, Hong Kong, Korea, New Zealand, Saudi Arabia and Thailand. Information pertaining to RTGS is included in this appendix to present generally accepted global standards for RTGS and to provide an assessment benchmark for RBIs planned implementation of an RTGS system.
PAYMENT PROCESSING
The operational design of RTGS systems can differ widely. An important difference among systems is the approaches to payment processing when the sending bank does not have sufficient covering funds in its Central Bank account. In some RTGS structures the system will reject such orders and return them to the sending bank, with rejected transfer orders being input into the system at a later time when the sending bank has covering funds. Until such time as the sending bank has funds to cover, sending banks may keep and control the pending transfers within their internal systems in internal queues. Other RTGS systems may temporarily retain such transfer orders in their central processor in centrally located queues instead of rejecting them. In this case, the pending transfers will be released for settlement when covering funds become available on the basis of predefined rules, agreed between the system and the participating banks. In many systems, transfer orders are processed and settled with the extension of Central Bank credit, normally provided for a period of less than one business day. In such systems the Central Bank provides participating banks with the necessary covering funds at the time of processing by extending such credit. Central Banks usually take a range of approaches to the provision of intra-day credit in terms of (i) the amount of credit, including a zero amount, (ii) the method by which credit is extended, such as overdraft or repo, (iii) the terms of the credit, and (iv) the collateral requirements. Payment processing methodologies such as rejection, centrally queued and Central Bank credit settlement are not mutually exclusive. In some systems when the provision of Central Bank credit is constrained in some way, transfer orders for which the sending bank could not or would not obtain Central Bank credit will be rejected or centrally queued. In recent years, newly implemented RTGS systems have tended to apply a combination of payment processing methodologies rather than being based on only one form of payment processing.
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LIMITATION OF PAYMENT RISKS

RTGS systems can contribute substantially to limiting payment system risks. With their continuous intra-day final transfer capability, RTGS systems are able to minimise or even eliminate the basic inter-bank risks in the settlement process. RTGS systems can also substantially reduce the duration of credit and liquidity exposures. To the extent that sufficient covering funds are available at the time of processing, lags will approach zero and so the primary source of risks in inter-bank funds transfers can be eliminated. Once settlement is effected, the receiving bank can credit the funds to its customers, use them for its own settlement purposes in other settlement systems, or use them in exchange for assets immediately without facing the risk of the funds being revoked. This capability also implies that, if an RTGS system were linked to systems, the real-time transfer of irrevocable and unconditional funds system to the other systems would be possible. The use of RTGS contribute to linking the settlement processes in different funds transfer the risk of payments being revoked. other settlement from the RTGS could therefore systems without
As a corollary of the benefits of RTGS in inter-bank funds transfers, applying RTGS to funds transfers in an exchange-for-value settlement system can contribute to the reduction of principal risk that may arise in such a system. Since RTGS permits the final transfer of funds at any time during the day, subject to the availability of covering funds, the final transfer of funds or payment leg can be coordinated with the final transfer of assets or the delivery leg so that one takes place if, and only if, the other also takes place. In this way, RTGS can provide an important basis for a DVP or Payment versus Payment (PVP) mechanism, thereby contributing to the reduction of settlement risk in securities and foreign exchange transactions. In the markets where RTGS systems operate, it is generally agreed that RTGS systems offer a powerful mechanism for reducing systemic risk. As Central Banks have a common interest in limiting systemic risk, this capability has been the primary motive for many Central Banks implementing RTGS systems for large-value transfer systems. The appeal of RTGS in terms of systemic risk containment can be broken down into the following elements: Losses and Liquidity Shortfalls The substantial reduction of intra-day inter-bank exposures can significantly lower the likelihood that banks may become unable to absorb losses or liquidity shortfalls caused by the failure of a participant in the system to settle its obligations. Unwinding RTGS precludes the possibility of unwinding payments, which can be a significant source of systemic risk in net settlement systems.
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Settlement Pressure In an RTGS environment, banks can, in principle, make final funds transfers at the time of their choice during the day. In such an environment, settlement pressures are not concentrated at particular points in time. The element of choice in final funds transfer makes it likely that banks will have more time to cope with problems such as participant liquidity or solvency. Control of final funds transfer can minimise problems by providing time for the raising of alternative funds or the receipt of incoming transfers from other participants.
INTRA-DAY LIQUIDITY
Provided that there are no legal problems with regard to settlement finality, the only structural impediment to continuous intra-day finality is any liquidity constraint a sending bank may face during the day. A liquidity constraint in an RTGS environment has two basic characteristics, namely that it is a continuous constraint for settling funds transfers and that intra-day liquidity requirements must be funded by Central Bank money. It is therefore required that banks must have sufficient balances in their Central Bank accounts throughout the processing day. The requirements for intra-day liquidity raise important issues for both Central Banks and the private sector. Central Banks face a choice as to whether or not to provide participant banks with intra-day liquidity and, if so, what form that provision will take. For individual banks, intra-day liquidity requirements can lead to concerns about the associated liquidity costs. Liquidity costs may include direct funding costs such as interest paid and charges/fees on Central Bank credit, opportunity costs of maintaining funds in Central Bank accounts, or opportunity costs of tying up collateral or securities in obtaining Central Bank credit. Additionally, individual banks must bear the costs of actively managing their payment flows in order to use intra-day liquidity. Critical dependencies for intra-day liquidity requirements under a particular RTGS system are the structure of financial markets and systems and the Central Banks policy regarding the provision of intra-day credit. The means by which intra-day liquidity is provided can significantly affect the extent to which immediate, or timely, final settlement occurs, which can ultimately influence the balance between the potential benefits and costs of an RTGS system.
Liquidity Components
Individual participants in an RTGS system in general have four possible sources of funds: Central Bank Balances Balances maintained at the Central Bank can be a basic source of liquidity for the purpose of making funds transfers during the day. During the day, the level of the balances for an individual participant is determined by the starting/overnight balance and payment activities such as RTGS payments and other
transactions across the account, credit extensions by the Central Bank, and Central Bank monetary operations that have taken place by that time. Starting balances may be generated by reserve requirements that are usually imposed for monetary policy reasons. Provided they are available for payment purposes during the day, required reserves can be a helpful source of intra-day liquidity, as has proved to be the case in several G10 countries. The importance of required balances may, however, vary between countries, depending on the nature of the reserve maintenance regime governing the level of the required reserve ratio and any averaging provisions. Incoming Transfers Incoming transfers are an important source of intra-day liquidity. The importance of incoming transfers depends on the patterns and predictability of payment inflows and outflows. Payment flows, such as net payment outflows, tend to result in a specific pattern for a particular bank, or if the intra-day timing of incoming and outgoing transfers tends to be asymmetrical, incoming transfers may be less reliable as a funding source for outgoing transfers. The usefulness of incoming transfers may be affected by the availability of transfer information. The more transfer information that is available in real time, the more effectively banks may be able to use incoming transfers in their liquidity management. Central Bank Credit Intra-day liquidity may be provided by a Central Bank through credit extensions. Many Central Banks provide intra-day credit, typically free of interest charges, through fully collateralised intra-day overdrafts or intra-day repos. The Fedwire in the United States charges a fee for the use of the uncollateralised intra-day overdraft facility that it provides up to a limit based on a banks creditworthiness and capital. Central Banks may also have overnight liquidity facilities that RTGS participants may access under certain conditions. However, overnight credit extensions from the Central Bank, such as overnight loans or overdrafts, may be considered a relatively costly funding source to support intra-day payment activities because the funds needed only for an intra-day period must be borrowed overnight and they can incur an implicit or explicit extra cost or penalty rate in addition to the discount or market rate. Inter-bank Money Market Borrowings Banks in an RTGS system may also be able to obtain funds by borrowing from other banks through the inter-bank money markets. Money market credit extensions such as overnight and term loans may allow banks to fund intra-day payment flows, depending on the time of day that market conventions provide for loans to be arranged, made available and repaid. In cases where banks can borrow from overnight inter-bank markets throughout the operating hours of the RTGS system, the loan proceeds could be available to fund transfers intra-day. While credit extensions from the Central Bank can be regarded as external liquidity support that injects additional liquidity into the system, money markets can only
serve to redistribute funds already within the system, although that may nevertheless make an important contribution to reducing the reliance on banks reserve balances and Central Bank credit extensions.
Liquidity Measures
On the basis of the four components discussed above, liquidity as applied to the operation of RTGS systems may be measured from both an individual banks perspective and a system perspective. To an individual bank, intra-day liquidity may be taken to be the banks ability to settle a given value and number of transfers within a given time constraint. One way to characterise this concept would be to define net intra-day liquidity on the basis of actual cash flows. As already noted, a banks actual balance at a Central Bank at a given point in time during the day is determined by the starting balance as well as any payment or monetary activities and credit extensions that have taken place by that time. An individual banks actual balance, however, may not necessarily represent the liquidity immediately available for the bank to initiate new outgoing transfers at that time, because some or all of the transfers that it has already initiated may be queued within its internal system or in the centrally located queue. An individual banks net intra-day liquidity, which may correspond more closely to its ability to settle its outgoing transfers at a given point in time, can be defined as the actual balance minus the value of all pending transfers. Alternatively, a banks net intra-day liquidity could be defined on the basis of the sum of actual and potential cash flows. This concept has been adopted by some RTGS systems as a measure of available liquidity, although in some other cases it has been felt that incorporating potential cash flows may be too difficult. Potential cash flows refer to potential funds which a bank could mobilise or use for cover. In some cases, an individual bank might include queued incoming transfers as a source of liquidity that it expects to be available shortly for its own outgoing transfers. In this case, a banks net intra-day liquidity is defined as the actual balance plus the value of queued incoming transfers minus queued outgoing transfers. As potential sources of liquidity, a bank might also include unused credit lines. If its net intra-day liquidity is negative, an individual bank can be viewed as being illiquid in the sense that it is unable to settle some or all of its queued outgoing transfers. However, care needs to be taken in interpreting the concept of a banks illiquidity. Although transfers processed through an RTGS system have some degree of time-criticality, not all transfer orders are time-critical in the sense that they must be settled either at or by a specific point in time during the day or within a specified and limited interval of time during the day. Many funds transfer orders may be time-critical only in a same-day sense even in an RTGS environment. Time-criticality and intra-day time constraints may be influenced by the nature of the transfers and transaction pricing policy. Even if an individual bank becomes illiquid, it may be able to delay certain less time-critical transfers in order to allow subsequent incoming transfers to provide the necessary liquidity. The scope for such liquidity management will vary, and typically will narrow towards the end of the day. In practice,
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therefore, for illiquidity to have a significant impact on a bank, it must occur over some significant time interval.
System Gridlock
The concept of intra-day liquidity could be related to the amount of funds that enables the system to process transfers between all or most banks in a timely manner. However, it is more difficult to analyse system liquidity because it is not simply the sum of each banks net intra-day liquidity. Whether the system is liquid or not also depends crucially on the distribution, or concentration, of liquidity among banks in relation to their payment needs. Gridlock can be characterised as a case of system illiquidity in which the failure of some transfers to be executed prevents a substantial number of transfers from other participating banks from being executed. Gridlock can occur when the aggregate liquidity is insufficient, but it can occur even if the liquidity in the system, taking into account all queued incoming and outgoing transfers, is adequate overall but poorly distributed. In the instance where two systems had the same aggregate sum of bank liquidity, one might be liquid while the other might be in gridlock if liquidity was concentrated among a few banks in that system. Due to the realistic possibility of gridlock, some RTGS systems provide banks with ways of breaking gridlock. In connection with system liquidity it is important to consider negative externalities relating to the use of a banks liquidity. The term externality refers to a case in which the behaviour of one participant has a direct effect, which is not controlled through the price mechanism, on the situation faced by another participant. An individual bank may, for instance, be deliberately slow in processing transfers in order to economise on its own liquidity by relying on the receipt of incoming transfers from others. If such behaviour is widespread in the system, there is the potential for a kind of imposed gridlock as each bank delays sending its payments until others do so, with the result that in extreme cases none are sent.
Liquidity Management
The management of intra-day liquidity from a system perspective concerns both management of the aggregate level of liquidity relative to payment requirements in the system and management of the distribution of liquidity among individual banks. In order to manage the aggregate level of liquidity, a Central Bank may typically provide individual banks with credit directly for settlement purposes or indirectly through monetary operations according to its policy. It is possible that the optimal liquidity management from an individual banks perspective may not necessarily be best for the system as a whole. As previously noted, a bank may make a deliberate attempt to delay the processing of transfers to economise on its own liquidity by relying on the expected receipt of liquidity from others. To minimise the possible negative effects of such behaviour on system liquidity, RTGS systems may incorporate mechanisms to discourage selfish behaviour and to encourage
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early processing and/or settlement of transfers. One mechanism utilised is to establish specific rules governing banks outgoing payment flows, such as guidelines requiring banks to send a certain proportion of their daily payment messages by specified times. Such rules can discourage banks from delaying transfers. Liquidity rules must be carefully created and enforced. In some cases, banks may have atypical intra-day patterns of transfers, making it unrealistic for them to observe such rules. Such rules may also be incompatible with the pattern of transfers deriving from DVP or future PVP arrangements, where the timing of transfers is critical. Therefore, some flexibility may be needed in establishing and enforcing such a rule. Liquidity may also be managed through the implementation of a transaction pricing policy that would encourage the early input, processing and settlement of transfer orders. The Swiss Inter-bank Clearing (SIC) system applies a pricing schedule for sending banks that sets a higher charge on late input and settlement of transfer orders, while the receiving bank is subject to a flat pricing schedule. This has led banks to send and settle their bulk low-value payments as early as possible, ahead of large-value funds transfers. Some systems are also considering the possibility of adopting a pricing policy that would set a higher charge on queued or late transfers, such as transfers that are entered only shortly before the system close. Charging a penalty fee on the transfers that remain unsettled at the end of the day could also be used to complement such a transaction pricing policy.
Liquidity Monitoring
Central Banks are in many cases concerned with monitoring and managing liquidity in RTGS systems so as to maintain a smooth flow of payments and to detect and prevent possible gridlocks. There are significant differences in the technical approaches Central Banks take to monitoring system liquidity. The Bank of Italy utilises an indicator approach to real-time monitoring, whereby the Central Bank pays particular attention to synthetic indicators calculated on the basis of several key parameters, such as the total amount of liquidity available in the system, the volume of transfers entered into the system and the volume of settled transactions. The indicators are used to observe the queues and intra-day liquidity in the system as a whole, and also to identify any potential gridlocks which may require further investigation of an individual banks net liquidity position. The Bank of France takes a more micro approach, whereby it monitors, in real time, each banks net intra-day liquidity. In contrast, the Swiss National Bank does not systematically monitor system liquidity in its SIC system. The Swiss National Bank maintains the view that monitoring liquidity is mainly the responsibility of participants and that there should be no intervention by the Central Bank or the system in the centrally located First-in-Firstout (FIFO) queue.
Liquidity Structural Factors

There are many structural factors that may affect liquidity requirements and liquidity management in an RTGS system which include, but are not limited to:
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Number of Participants The number of participants may be of significance in establishing liquidity requirements and monitoring liquidity. An RTGS system with relatively fewer participants than a larger system may internalise a greater proportion of third-party payments and therefore have a lower level of inter-bank transfers sent over the system. As a result, less intra-day liquidity might be required at the system level to process a given volume of payments. Such a system may also have more concentrated, offsetting payment flows between banks and thus incoming transfers would be a relatively more important source of liquidity. It also may be less complicated from a technical perspective for individual banks to monitor, control and sequence payment flows in a system with relatively fewer participants. Market Size The relative market size in terms of payment activity or average asset size of individual participants may affect liquidity. An RTGS system with a mixture of large, medium and small participants may have a different set of intra-day liquidity requirements from a system consisting of participants of broadly equal size. Larger individual banks may have a more balanced intra-day flow of incoming and outgoing transfers, so that incoming transfers can provide the liquidity needed to fund outgoing transfers, while smaller individual banks may process fewer transfers or tend to be net senders/receivers of funds in the RTGS system. Larger individual banks may also find it easier to obtain the necessary liquidity if they have better access to funding and credit markets or a larger deposit base than smaller banks. Participant Specialisation Participants areas of specialisation may affect liquidity. If an RTGS system is composed of banks that specialise in a variety of different market segments such as merchant banking, credit card transactions, deposit-taking, clearing activities, foreign exchange transactions and securities transactions, payment flows and patterns and the resulting liquidity requirements may differ from those in systems where participants tend to offer a more uniform range of products and services. External Factors The structure of the payment systems and flows outside the RTGS system may affect RTGS liquidity. Non-RTGS payments can be an important external factor affecting individual banks RTGS liquidity. The mechanism through which non-RTGS payments influence RTGS liquidity may take a variety of forms. In most cases, net settlement obligations resulting from other settlement systems such as cheque clearing, other largevalue transfer systems, Automated Clearing House (ACH) transactions and securities settlement systems, are settled periodically over the RTGS system or processed through the same Central Bank account as that on which the RTGS system relies for intra-day liquidity. In instances where RTGS payments and the settlement of non-RTGS payments are interrelated and competing uses of liquidity could therefore arise, individual banks may use internal systems capable of integrating their RTGS and non-RTGS payment activities on an intra-day basis to manage their overall liquidity.
Since the settlement of foreign exchange transactions accounts for a substantial part of the total value handled by many RTGS systems, most netting arrangements for such transactions may, by the net value of the transactions to be settled, have an effect on the value and timing of transactions and consequently on the liquidity of the RTGS systems. Central Bank Account Structure The structure of Central Bank accounts may be an important factor influencing RTGS liquidity. In the global marketplace there are many different ways in which Central Bank accounts are organised. Central Bank accounts for RTGS may be unified with or segregated from Central Bank accounts maintained for other purposes, such as reserve accounts. Central Bank accounts may be centralised with accounts for making transfers at only one office of the Central Bank, or decentralised with accounts for making transfers at more than one office of the Central Bank. In considering a decentralised account structure, it is important for a Central Bank to consider the capacity of individual banks to monitor balances and shift them efficiently between accounts on a real-time basis for liquidity purposes. In general, the structure of Central Bank accounts in a country is determined by a number of considerations and therefore an optimal account structure will not necessarily depend only on the settlement arrangements for RTGS systems. However, in countries that have a decentralised account structure and where RTGS systems are operating, there has been a tendency to centralise/consolidate Central Bank accounts, or at least to centralise the arrangements for processing account data. This may suggest that a centralised structure is, in many cases, a more efficient and straightforward structure for an RTGS environment, particularly in terms of liquidity management.
MESSAGE FLOWS
A lag between the time at which information is made available to receiving banks and the time at which settlement takes place has important risk implications in large-value funds transfer systems. Even in an RTGS environment, where both processing and final settlement are made in real time, several circumstances can be identified in which the treatment of payment messages or the associated information could be a source of risk. To initiate a funds transfer, the sending bank dispatches a payment message which is subsequently routed to the Central Bank and to the receiving bank as the system processes and settles the transfer. Arrangements for routing payment messages in the majority of RTGS systems are based on a V-shaped message flow structure. In a V-shaped structure the full message with all the information about the payment, including the details of the beneficiary, is initially sent to the Central Bank and is then sent to the receiving bank only after the transfer has been settled by the Central Bank. An illustration of a basic V-shaped message flow structure is provided below.
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V-SHAPED MESSAGE FLOW
Sending Bank
Receiving Bank
Full Payment Message
SETTLEMENT
Some RTGS systems, particularly those that use the SWIFT (Society for Worldwide Interbank Financial Telecommunication) network, apply an alternative structure, known as a Yshaped structure. In a Y-shaped structure the payment message is transmitted by the sending bank to a central processor. The central processor stores the original message and takes a subset of information that is necessary for settlement from the original message and routes the core subset to the Central Bank. Upon receipt of the core subset, the Central Bank checks that the sending bank has sufficient covering funds in its account and informs the central processor of the status of the transfer, i.e. whether it is queued or settled. Once settled, the full message containing the confirmation of settlement is rebuilt by the central processor and sent to the receiving bank. The business information exchanged between the sending bank and receiving bank, such as the identity of the beneficiary, is not communicated to the settlement agent. An illustration of a basic Y-shaped message flow structure is provided below.
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Y-SHAPED MESSAGE FLOW
Sending Bank
Receiving Bank
Confirmation
Settlement Request
SETTLEMENT Central Bank The British RTGS system, CHAPS (Clearing House Automated Payments System) has adopted an L-shaped structure, which is conceptually similar to a Y-shaped structure. The configuration was chosen because it could be implemented by modifying rather than rewriting the software supporting the previous Domestic Net Settlement arrangement. The payment message dispatched by the sending bank is held at a system gateway attached to the sending banks internal processing system, and a subset of information contained in the original message, the settlement request, is sent to the Central Bank. If the sending bank has sufficient covering funds in its account, settlement is completed and the Central Bank sends back a confirmation message to the sending banks gateway. On receipt of the confirmation, and only on receipt of the confirmation, the original payment message is
released automatically from the gateway of the sending bank and sent to the receiving bank. An illustration of a basic L-shaped message flow structure is provided below. L-SHAPED MESSAGE FLOW
SETTLEMENT Central Bank
Settlement Request Confirmation
GATEWAY
Sending Bank
Receiving Bank
The individual structures reflect differences in both the network configuration of the system and the operational role of the Central Bank. In both the V-shaped and the Yshaped structures, all messages from the sending bank are routed first to a central entity, SWIFT, a central processor or the Central Bank itself, and after settlement all messages to the receiving bank are sent by that central entity. In the L-shaped structure, where message routing is based on the bilateral exchange of information between banks, there is no central entity for delivering messages. In terms of its operational role in the system, the Central Bank is directly involved in both the settlement and processing of payment messages in the V-shaped structure, while in the Yand L-shaped structures the process of message routing can be handled by the network operator or the banks themselves, with the Central Bank only acting as the settlement agent.
The three messaging structures mentioned so far all have the common feature that the receiving bank will receive the full payment message only after the transaction has been settled by the Central Bank. In these structures the message flow structure per se cannot give rise to the possibility that the receiving bank will act upon unsettled payments. In the construction of an RTGS system, it is possible to implement a T-shaped message flow structure in which the sending bank routes payment messages directly to the receiving bank, through the message carrier, with copies made by the message carrier sent simultaneously to the Central Bank. In a T-shaped message flow structure, the receiving bank will first receive the full, unsettled payment message immediately after the sending bank has dispatched it, and will subsequently also receive a confirmation message from the Central Bank once settlement has taken place. The T-shaped structure has generally been viewed as being incompatible with the basic principle of RTGS, that a funds transfer should be passed to a receiving bank if, and only if, it has been settled irrevocably and unconditionally by the Central Bank. The receiving bank may not easily be able to distinguish between settled and unsettled payment messages at the time of receipt of unconfirmed messages. In cases where it can make the distinction, competitive pressures may cause it to credit the funds to the beneficiary customer on the basis of the unsettled message, or it may anticipate the arrival of the funds in other ways. To the extent that this happens, credit and liquidity risks would be generated. As this aspect has been recognised as a drawback in an RTGS environment, the T-shaped message flow structure has not been widely used. A basic illustration of a T-shaped message flow structure is included, below, for the sake of completeness.
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T-SHAPED MESSAGE FLOW
Sending Bank
Receiving Bank
Confirmation
COPY Full Payment Message
SETTLEMENT Central Bank
SYSTEM RELATIONSHIPS
An RTGS system usually operates with some form of direct or indirect relationship with other payment or settlement systems. The nature of the relationship may vary depending on such factors as the type of system with which the RTGS system is linked, and whether it is a domestic or international relationship.
Domestic System Relationships

In the domestic context, there are two major types of interrelationship. The first type of interrelationship concerns Domestic Net Settlement systems for inter-bank funds transfers in which participants net settlement positions are settled over an RTGS system at one or more designated times.
A key feature of this type of interrelationship is that the final settlement of transfers in DNS systems is effected when debits or credits based on participants net settlement positions are posted to their Central Bank accounts through the RTGS system. The net settlement positions may stem from various types of systems, such as large-value DNS systems or retail payment systems. The second type of interrelationship concerns securities DVP mechanisms. The nature of the DVP relationship between an RTGS system and a securities settlement system depends on how the DVP system is structured and operates. A real-time DVP system is a model 1 DVP system operating in real time. In such a system, transfers for both securities and funds settle on a trade-by-trade basis, with simultaneous final transfers of securities and funds. Depending primarily on whether or not the securities system maintains both securities and funds accounts for participants, real-time DVP can be achieved through an on-line communication link between the RTGS system and the securities settlement system, as in the SICSECOM link in Switzerland, or within the securities settlement system itself, as in the US Fedwire book-entry securities transfer system. In both cases, the cash legs of securities transactions are settled continuously by RTGS, which creates a close, real-time interrelationship between the RTGS system and the securities settlement system. An example of RTGS domestic relationships is provided by systems operating in Switzerland. Since 1995 an on-line link between the securities settlement system, SECOM, and the RTGS system, SIC, has provided real-time DVP. On settlement date, when both the buyer and seller of securities are SIC participants, the SECOM system earmarks the corresponding securities in the safe custody account of the seller. If sufficient securities are available, a payment message is automatically transmitted from the SECOM system to the SIC system. The SIC system checks the cash account of the buyer, and if sufficient covering funds are available, the SIC accounts of the buyer and the seller are debited and credited, respectively. The SIC system transmits a message confirming the payment to the SECOM system, which then makes the final transfer of the securities. If sufficient funds are not available, the payment message is kept in the central queue in the SIC system and tested for cover until settlement can take place.
International System Relationships

At the international level, PVP mechanisms for foreign exchange transactions involve important cross-border relationships between two or more national RTGS systems. Greater overlap of the opening hours of RTGS systems can facilitate this process. The TARGET system developed by the EU Central Banks represents a type of cross-border linkage between national RTGS systems. The system provides a sound and efficient mechanism to settle cross-border payments denominated in a single currency. National RTGS systems in the EMU (European Monetary Union) member states are linked to each other via a common infrastructure using common procedures known as the Interlinking System. In this type of system, a cross-border transfer is initiated when the sending credit institution transmits a payment message to the local national central bank through the local RTGS system. Assuming the sending credit institution has sufficient funds available, the amount of the payment will be irrevocably and immediately debited from the account the
sending credit institution holds at the NCB. The sending NCB will then transfer the payment message through the Interlinking network to the receiving NCB. The receiving NCB will credit the receiving credit institutions account. A basic illustration of the TARGET systems linkage is provided below. Interrelationships also occur when an RTGS system is involved in the designated time settlement of the cash leg of securities transactions, typically the net positions resulting from the cash leg of securities transactions. The economic feature of this relationship is essentially the same as the previously RTGSDNS relationship. The number and type of relationships with other payment or settlement system is one factor that makes the design, testing, implementation and operation of an RTGS system very complex. The flawed or incomplete design of an RTGS system, especially in its relationships with other payment or settlement systems, can have a catastrophic effect on a countrys financial stability.
Interrelationship Impact
The liquidity interdependence between an RTGS system and other payment and settlement systems is particularly important for the maintenance of an orderly market and financial stability. Linkages between an RTGS system and other systems can improve the intra-day distribution of liquidity across payment systems because RTGS allows banks to use final funds during the day for the purpose of settlement in other systems and, as a result, more intra-day payment flows between participants can occur. However, if an RTGS system is involved in the settlement processes of other payment and settlement systems, external settlement pressures can be generated by the linked system on the settlement process in the RTGS system, and vice versa.
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INTERNATIONAL LINKAGES TARGET SYSTEM
Communications Network
Interlinking System
TARGET
INTERLINKING INTERLINKING
RTGS
(1)
RTGS
National RTGS System

Queuing & Cash Management
Credit Institutions
(1)
Credit Institutions
Many RTGS systems provide queuing and cash management facilities on an optional basis
External pressures can affect intra-day liquidity requirements at the level of both individual banks and payments in the RTGS system. The impact on the RTGS systems liquidity depends on the size and timing of the external settlement pressures. In cases where the interrelationship occurs only at designated times, as in an RTGSDNS interrelationship, the impact may be local and concentrated in a particular short period of time. If settlement is to take place, it is important that the
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participants in the DNS system ensure that they have the necessary covering funds available at the designated times. In cases when an RTGS system is linked continuously with other systems, as in the case of real-time DVP systems, the impact on the RTGS systems liquidity can be more widespread and significant. In this type of linkage, participants may want or need to earmark the necessary intra-day funds in their Central Bank account for the settlement of the transactions in the linked systems on a continuous basis during the day. This situation may increase the demand for intra-day Central Bank credit, or might increase the number/value or duration of queued transfers if the necessary liquidity is not obtained promptly. Where the settlement of the transactions is effected through the linkage, as in the case of real-time DVP, the expected liquidity position in the RTGS system would, in turn, affect the completion of settlement of the transactions under the linkage. Whether intra-day liquidity requirements in the RTGS system are increased by the interrelationships is an empirical question. To the extent that the need to settle the transfers from the linked systems gives rise to competing uses of balances at the Central Bank, intra-day liquidity management issues are likely to arise. In particular, to the extent that the transfer orders stemming from the linked systems are time-critical, banks may need to address how they could be reconciled with other time-critical funds transfer orders, such as those relating to Central Bank operations, in terms of the use of RTGS liquidity. It is recommended that Central Banks carefully analyse the liquidity implications that may arise from interrelationships. To ensure that such implications do not impinge on the efficient operation of either the RTGS system or the linked systems, it is also recommended that consideration be given to the design features of the RTGS systems and the linked systems.
QUEUING
The manner in which a payment system manages the flow of transfer messages is critical to the maintenance of order and stability in financial markets. Queuing can be generally defined as an arrangement whereby funds transfer orders are held pending by the sending bank or by the system in a certain order so as to prevent any limits set against the sending bank from being breached or to manage liquidity. In RTGS systems, queues are most commonly generated when sending banks do not have sufficient covering funds in their Central Bank account. Individual banks messages may be held in a queue at the systems central processor, which is normally designated a system or centrally located queue. Individual bank messages may also be held within the banks internal systems, which are normally designated as internal queues. These two broad possibilities, according to the location of the queues, are not mutually exclusive. Individual banks may maintain internal queues in addition to the queues at the centre, as is done in some RTGS systems with centrally located queues. Queuing can also differ according to the management of the queues, or how an individual banks queue is controlled. Management of the queue may be carried
out by the centre as centralised management, or by banks individually as decentralised management. Irrespective of whether the queues are physically located at the centre or within banks internal systems, the management of queues can in principle be either centralised or decentralised, with combinations of the possibilities determining an RTGS systems queuing structure.
Queue Processing
Most centrally located queuing arrangements have adopted a form of a FIFO rule for queue processing. Where the FIFO rule is applied, funds transfer orders are held in the order in which they are dispatched by the sending bank. The payment at the top of the queue is released and settled when covering funds become available, and only then is the payment behind it in the queue considered for settlement. Some systems apply variations on the strict FIFO rule known as Bypass FIFO. In applying a Bypass FIFO rule the system tries to process the first transfer in the queue, but if that cannot be executed owing to lack of funds it then tries to settle the next transfer instead. The FIFO rule, or a variation on the FIFO rule, is the predominant method used in centrally located queuing because of its simplicity. Although non-FIFO rules such as sophisticated mathematical algorithms might be more efficient in settling a greater number of transfers, the same efficiency may be achievable in a more straightforward way by combining simple FIFO processing with queuing enhancements such as prioritisation, reordering or optimisation. In practically all centrally located queuing arrangements, the system provides facilities whereby priority codes are attached to funds transfers. Where this is the case, the transfers are placed in the queue on the basis of the assigned priorities and are released for settlement on a FIFO basis within each priority level. The use of priority codes means that no transfers of a particular priority will be settled until all those of a higher priority have been settled. In some systems, the priorities are chosen by the sending banks based on the sending banks assessment of the urgency of the transfer, whereas in other systems transfer orders are prioritised automatically by the system according to the type of transaction. In the latter case, a high priority tends to be attached to transfer orders relating to Central Bank operations or settlement obligations stemming from other systems such as securities DVP systems and netting systems. The use of priorities helps banks to achieve greater flexibility when using FIFO processing.
Queue Management and Intervention

Centralised queuing arrangements sometimes include queue management or intervention facilities that allow the system centre such as the Central Bank, system operator and/or individual banks to control the number and value of queued transfers. One commonly used approach to queue management is reordering. Reordering facilities are designed so that the system centre and/or individual banks can reorder the transfers in the queue by changing the original order of receipt or priorities with a view to minimising the number and value of queued transfers. Where prioritisation facilities allow banks to sequence their transfers before they put them into the system, reordering facilities allow banks to sequence their transfers after the transfers have been placed in the queue.
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In systems where reordering is allowed, it can only take the form of moving a payment to the end of the queue or changing its priority code, with the processing effect being similar to that of cancelling and re-entering the payment. Many RTGS systems utilise a queue management option known as optimisation. The term optimisation can be defined in a number of different ways. In the broadest sense, optimisation refers to any form of intervention by the system centre to minimise the number and value of queued transfers. More narrowly and practically defined, optimisation can be defined as any pre-specified procedures or algorithms that the system centre can activate to minimise the number and value of queued transfers given available funds at designated times or when system gridlock occurs. Optimisation routines typically attempt to settle queued transfers simultaneously rather than settling in sequence, as in the case of reordering. The accumulation of queues, or gridlock, can occur in a situation where funds transfers cannot be settled in sequence owing to the distribution of liquidity among banks, even though overall system liquidity, including all queued transfers, is sufficient. Optimisation routines can provide an effective solution in such situations. However, in many RTGS systems optimisation may also have some disadvantages. In some systems, optimisation will be based on a concept of Simulated Net Balances that incorporates the net balance of queued transfers such as queued incoming transfers minus queued outgoing transfers in addition to the actual cash balance. The concept of Simulated Net Balances corresponds to the potential cash flow model of Net Intra-day Liquidity in which queued incoming transfers are regarded as potential cover for outgoing transfers. In calculating Simulated Net Balances, some systems will also count net positions, which are not yet settled, in other systems such as securities settlement systems or retail payment systems. An optimisation routine will then attempt to settle as many of the queued transfers as possible subject to the condition that the Simulated Net Balance for every participant is within the systems established limits. Other systems will apply methods that will not calculate the Simulated Net Balance explicitly, but will search for transfers in the queue for which offsetting transfers can be found. Many systems using optimisation perform such a search based on a First-Available-First-out (FAFO) rule whereby a transfer that can find an offsetting transfer or transfers will be executed first.
Revocability
Another important aspect of queuing is whether or not the sending bank can cancel queued transfers. Although end-of-day revocability typically applies automatically in RTGS systems to those transfers that have failed to settle by the close of the system, intra-day revocability is, in most cases, not allowed. In situations where intra-day revocability is allowed, it is restricted to exceptional circumstances such as input error.
Queue Transparency
In the global marketplace, it is required that RTGS systems provide on-line, real-time information facilities whereby banks can obtain data on the status of transfers, accounting balances and other basic parameters.
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An important element in defining the operational requirements of queuing is the information available to banks or the system centre with regard to queues. In centralised queuing, the system centre normally provides banks with a range of information not only on outgoing transfers in their own queues but also on any incoming transfers being sent to them that are held in other banks outgoing queues. The RTGS systems with centralised queuing in the G10 countries allow real-time access to the information on queued incoming transfers in some form or other so that queued incoming transfers are to some degree transparent. The information about queued incoming transfers and the conditions under which it is provided to banks vary significantly across systems. The key issue concerning the transparency of queued incoming transfers is the effect of provisioning transparency on the risk and efficiency of the overall process. It is possible that transparency could induce the receiving bank to act upon queued incoming transfers which by definition remain unsettled, thereby potentially generating risks in RTGS systems. This is another case in which risks may arise from a lag between the time when information about the payment is received and the time when the payment is actually settled. The risk involved in this situation is connected to the assumption that incoming transfers held in other banks queues will normally settle in due course and, acting on this assumption, a receiving bank might use the information about these transfers for liquidity management purposes in order to reduce its precautionary balances of liquidity or to minimise the liquidity it needs to raise from other sources. However, if the queued transfers assumed to settle did not in fact settle, the receiving bank could face a liquidity shortfall. If the liquidity shortfall occurs close to the end of the day, it might then be difficult for the receiving bank to raise the liquidity it needed from alternative sources. The receiving bank would thus be exposing itself to possible liquidity risk. In such circumstances, the severity of the receiving banks risk can be compounded if the receiving bank credits its customers accounts in anticipation of queued incoming transfers. In this case, the receiving banks credit risk could also rise. These risks might also have systemic consequences, particularly if a large number of banks, or a major bank with a relatively large amount of queued transfers, adopted such behaviour. These possible liquidity, credit and systemic risks are similar in nature to those associated with conditional transfers in unsecured DNS systems and a T-shaped message flow structure. Some developers of RTGS systems have adopted an approach that stresses the possible advantages of transparency in reducing liquidity risk rather than increasing it. This view maintains that better information on expected payment flows implies, other things being equal, a smaller probability of a liquidity shortfall even after any resulting adjustment of precautionary balances. Therefore the net effect of better information might be an overall reduction of liquidity risk. It is also possible that transparency can result in a reduction in liquidity curves if, as a result of improved information, banks do choose to hold smaller precautionary balances. Greater transparency might also enable banks to sequence incoming and outgoing transfers in a more efficient way, thereby additionally improving their liquidity management. To the extent that banks view the information as important, individual banks may implement their own advice-of-payment arrangements outside the system if the information is not provided within the RTGS system itself.
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Depending on individual market environments, the advantages of transparency can outweigh the disadvantages, provided that restrictions are placed on the release of the information. In some markets it may be that the more detailed the information, the greater the likelihood that the receiving bank will credit funds in advance. Recognising this, some RTGS systems allow banks to look at aggregated information such as the total number and/or amount of transfers, but not at the detail of individual transfers. Another transparency issue relates to the way in which access to the information is granted more specifically, whether it is released automatically or only on request. Considering that the automatic release of the information might involve greater risks, some RTGS systems provide the information only on request. There is also the view that receiving banks will be discouraged from acting imprudently on incoming queued transfers if sending banks have the ability to cancel such transfers that is, the sending banks ability to cancel will serve as a warning signal to the receiving banks, making it less likely that they will place undue reliance on the information. The costs and benefits of the transparency of queued incoming transfers depend primarily on how important incoming transfers are as a source of intra-day liquidity and whether the RTGS system typically operates with long queues. If other sources of intra-day liquidity are relatively scarce and the queues tend to be long, then the real-time availability of such information may be much more critical to the systems efficiency. The longer the queues, the greater the associated risks if banks do not use the information prudently. The importance of transparency may also depend on the operating environment of the RTGS system, such as the number of participants and the Central Bank account structure. Under a decentralised Central Bank account structure, the transparency of the information could in some cases help banks to monitor balances and use them efficiently across accounts.
Queuing Approaches
A number of different approaches to queuing have been taken by RTGS systems operating in G10 countries. At one end of the spectrum, there are centrally located queue approaches in which the system centre actively intervenes in the queues by reordering and/or optimisation, while at the other end there are no-management structures in which there is no intervention by the system centre or banks. The types of centrally located queue approaches range from environments in which the system centre actively intervenes in the queues by reordering and/or optimisation, to nomanagement environments in which there is no intervention by the system centre or banks. In contrast to centralised queuing approaches, there are fully decentralised queuing approaches in which the responsibility for queuing is left entirely to individual banks, with the system center having no queues. An important factor in the consideration of a queuing structure is whether the system centre or the individual banks manage the queues. From the viewpoint of reducing the need for liquidity, the more the system centre can intervene in the queues by reordering and/or using optimisation routines, the more efficient the queuing should in principle be, because
the centre can observe the queued transfers of all banks and thus maximise all available information to rearrange the transfers in the queue into an order that minimises overall liquidity needs. To the extent that it succeeds in reducing the number and value of queued transfers, such centralised management can contribute to efficiency and to the realisation of early settlement in RTGS systems. In instances where centralised management is adopted, there are several important issues that need to be addressed. The first issue is a legal issue. If, for example, some transfer orders were placed lower down in the queue by the centre and then failed to be executed because the sending bank defaulted, the centre might be held liable for any consequential damages. Such legal issues may be more acute if the system centre has discretion in its management, rather than processing transfers according to an algorithm agreed between the system centres and participating banks. In such a structure, the primary question is: how practical and cost-effective is it to devise and agree on an appropriate algorithm? Because of this, centrally located queuing arrangements often only process transfers in FIFO order within a given priority. If centralised management is conducted regularly during the day or is expected to occur in certain contingency situations, banks may come to rely on it as an alternative to their own active management of payment flow or liquidity management. It is possible that such moral hazard problems could be a particular disadvantage of optimisation routines if the provisioning of optimisation induces banks to reduce liquidity holdings which, in turn, might lead to longer queues and increase the potential for gridlock. Another consideration factor in the adoption of a queuing approach is the balance that may be needed between the control of the queues by the centre and the scope for competition by banks. Individual banks may feel that it would be inappropriate for them not to have full control over their queued transfers, not least because, from the perspective of individual banks, the effectiveness of queue management should be evaluated in terms of how speedily they are able to make transfers relative to other banks. Centralised management could narrow the scope for such competition. Decentralised approaches to queuing management, whereby banks manage their internal queues or their queues at the centre, can provide banks with greater flexibility in managing their queues and greater scope for competition. However, the use of decentralised management also raises some issues. In comparison with centralised management, decentralised management may be less efficient if each bank has to manage its own queue with insufficient information about what is being held in other banks internal queues. Additionally, aggressive behaviour by banks could increase negative externalities, leading to settlement delays and gridlock. A decentralised approach may also cause complications if the RTGS system is linked to other settlement systems such as a securities settlement system. If fully decentralised queuing includes funds transfers related to a DVP securities settlement system, the requests for those transfers would first have to be routed through the internal systems of the individual banks so that they could manage them. This routing requirement could affect the efficiency of the DVP process. It may therefore be necessary in the context of decentralised management for system operators and participants to
consider these issues and, where appropriate, address them through relevant operating procedures and/or changes to participants behaviour. In practice, the choice regarding queue management techniques may be determined primarily by the systems technical requirements or by the cost of providing and operating centrally located queues. The choice may also be affected by differing views about the importance of centrally located queuing. The existence of centrally located queuing enables the system to incorporate a system-wide, built-in mechanism for sequencing transfers that could offer offsetting-like efficiency. Centrally located queuing could thus be viewed as a critical design feature affecting the efficiency of an RTGS system and could also serve as an important basis for introducing more sophisticated liquidity-saving mechanisms into the architecture of RTGS systems. However, the existence of centrally located queuing might imply that the system itself potentially encourages settlement lags by allowing processed but unsettled payment messages to stay in the system. Many RTGS system operators feel that this may not be fully compatible with what they consider to be the core feature of RTGS, namely the ability to provide continuous settlement.
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TA 3473-IND

Development of a Secondary Debt Market

The International Securities Consultancy Limited

The BISYS/Aries Alliance Professional Services Group

Annex 1 Terms of Reference

ANNEX 1 TERMS OF REFERENCE Terms of Reference for Consultants

Annex 1 Terms of Reference

Annex 1 Terms of Reference

Annex 1 Terms of Reference

Bank Format Deliverables

Annex 1 Terms of Reference

Annex 1 Terms of Reference

Modernisation of the market infrastructure.

A strategy to eliminate impediments to the secondary debt market in a sequential manner.

Annex 3 List of People Met

ANNEX 3 LIST OF PEOPLE MET

Hari Shankar Chaitanya Chetan Shah J. J. Mehta

HDFC Mutual Fund ICCI Limited ICICI Limited

Annex 3 List of People Met

Name B. Mythili M. Balasubramanian G. V. Nageswara Rao Pradeep Madhav Binay Chandgothia

Chief General Manager

Chief General Manager

Dr. M. T. Raju Pratip Kar Prof. J. R. Varma

Economic Adviser Executive Director Board Member

Annex 3 List of People Met

I. Panju Tarun Saigal

State Bank of India

M. M. Kapur S. K. Basu K. Nathani R. Rangarajan Dr. S. Nayak

Assistant General Manager

Dr. Uma Shashikant

Volume 1: The Current Situation

The International Securities Consultancy Limited

The BISYS/Aries Alliance Professional Services Group

Volume 1 The Current Situation

Volume 1 The Current Situation Chapter 1 The Government Bond Market

Chapter 1 The Government Bond Market

Volume 1 The Current Situation Chapter 1 The Government Bond Market

199293 199394 199495 199596 199697 199798 199899 199900 200001

2900.00 (7.1) 2600.00 (7.3)

Dated Government Securities

Volume 1 The Current Situation Chapter 1 The Government Bond Market

Total No. Amount

Volume 1 The Current Situation Chapter 1 The Government Bond Market

Volume 1 The Current Situation Chapter 1 The Government Bond Market

Table 1.3 shows the amounts raised since 199596.

199596 199697 199798 199899 199900 200001

6274 6536 7749 12114 13706 11420

5931 6536 7193 10700 12405 11000

Source: Handbook of Statistics on the Indian Economy, 2000.

Volume 1 The Current Situation Chapter 1 The Government Bond Market

1995 1996 1997 1998 1999

Volume 1 The Current Situation Chapter 1 The Government Bond Market

Fixed Income Derivatives

Volume 1 The Current Situation Chapter 1 The Government Bond Market

Volume 1 The Current Situation Chapter 1 The Government Bond Market

Volume 1 The Current Situation Chapter 1 The Government Bond Market

Volume 1 The Current Situation Chapter 1 The Government Bond Market

Dated Government Securities

Volume 1 The Current Situation Chapter 1 The Government Bond Market

Percentage of notified amount at auctions that devolved (average)

Percentage of total issuance during the year

199596 199697 199798 199899 199900 200001

69.90 33.80 71.10 51.50 39.89 64.16

69.90 30.82 62.04 37.29 0 41.10