●
Some Thoughts on Institutional Framework for an Active Secondary Market in Debt Instruments in India
------------------------------------------------------The paper presented in 1993 is still relevant 22 years on !!
Some Thoughts on Institutional Framework for an Active Secondary Market in Debt Instruments in India
------------------------------------------------------The paper presented in 1993 is still relevant 22 years on !!
●
● V.K. SHARMA *
As the markets recover from the trauma of the recent financial cataclysm, the policy makers, the economic agents and the comity of the financial market participants have started focusing attention on the imperatives of carrying on with the financial sector reforms. In that context, there has lately been some evidence of public debate on the desirability of developing an active secondary market in debt instruments in general, and Government securities, in particular. However, the challenge of developing an active secondary market in debt instruments in India enjoins an integrated institutional approach, entailing appropriately sequenced and internally synchronized steps. The present paper seeks to adumbrate such an institutional framework with a view to realizing the objective of an active secondary market. Incidentally, reference to debt instruments in the paper is to Government securities.
2.Before, however, presenting the contours of the institutional framework, it would be a good idea to review the recent trends in yields and inflation. Thanks largely to confluence of relative fiscal restraint and tight monetary policy, the rate of inflation, as measured by WPI, has dramatically fallen to around 8% from a high of 16%- -----------------------------------------------------------------------------------------
* The views and opinions expressed in the paper are those of the
author only and not of the Reserve Bank of India (RBI).
The paper was presented at NIBM Seminar on 18th October 1993.
17%, two years ago. Such an impressive inflation management in the western markets would have almost simultaneously led to commensurate drop in long term yields, with the short-term rates constrained by the official interest rates like discount and repo rates. Indeed, typically, in the US fixed income markets, the debt market prices (and hence yields) adjust continually on the basis of consensus of expectations about critical numbers like output, employment, jobless claims, capacity utilization, inflation, etc. That is to say, the market responses are efficient in the sense that the consensus of rational expectations of the market as a whole are reflected instantaneously in the financial asset prices and, therefore, do not have to wait for the actual announcement of the critical market moving economic data. It is only if the announced data come in at variance with the market consensus, does the market move again. In other words, the materialization of the expected data has no price impact. Put another way, the market discounts/prices in the expected data in advance.
3.Compare the above financial market behaviour to the recent behaviour of debt market in India. In spite of such an impressive inflation performance, generic bond yields continue to rule more or less where they have been before! What this means is that the debt markets in India, far from pricing in advance, have not priced in the spectacular performance even after the fact! In fact, syndrome such as these throw into sharp relief the sine qua non nature of an active secondary market in debt instruments in the Indian setting. Significantly, if there is no reliable benchmark yield curve in India, it is precisely because of the absence of an active and liquid secondary market. The existence of a reliable secondary market yield curve – especially of the “When Issued” (WIs) – will also serve as a benchmark for getting the auction price right and facilitate cost-effective borrowing by Government.
The Institutional Framework
4.It seems from the recent debate that the right institutional framework will be an organized exchange-traded secondary market. But, unfortunately, such institutional predilection ignores the ground realities in the major international capital markets. It may be intriguing and puzzling to note that in the USA, UK, Japan and lately, even in the Philippines, Thailand, Malaysia and Indonesia, astronomical volumes in debt instruments (including Governments) are traded in the over-the-counter (OTC) markets and those traded on the organized exchanges pale into relative insignificance. This is not the case with the equity though. The OTC markets in debt instruments in the western markets are extremely liquid and efficient. On the other hand, the exchange traded debt instruments suffer from relative illiquidity and thin volumes. In view of the above, there is a far stronger case for pushing an OTC, rather than, the exchange – driven institutional framework in the Indian context too.
The Six Basic Elements
5.An OTC-based institutional framework has six basic elements: (i) market clearing interest rates, (ii) institution of primary dealers and market makers, (iii) delivery against payment requirement (iv) funding/financing of long position resulting both from market making and trading, (v) shorting of debt instruments again due both to market making and trading, and (vi) commercial banks acting as custodians of bonds for large institutional and retail investors. In what follows, the nitty-gritty – including rationale-of the six basic elements of the suggested institutional framework have been discussed.
Market Clearing Interest Rates
By market clearing interest rates is meant the yields (or prices) of debt instruments at which the “voluntary” demand for, and supply of, such instruments will clear, or balance. In the Indian context, the market in fixed income securities (debt instruments), until relatively recently did not – and to a great extent even now, does not – answer the description of truly market clearing interest rates. The reason has been the pre-emption of the financial resources of a “captive” banking system through the strait-jacket of SLR requirements, which were progressively increased over the years, to accommodate the financial resources needs of the Government. But recently, the RBI has started gradually reducing the SLR requirements and announced a phase-out programme over the next few years. At the same time, it has also started yield-based auction of Government debt. It is only when the present system of pre-emption is phased out will interest rates be truly market clearing.
Institution of Primary Dealers and Market Makers
The institution of primary dealers and market makers is critical to the development of an active, deep and liquid secondary market in debt instruments – especially the Government securities. Whether India opts for a German style “universal banking”, or the US style, dichotomous “commercial – investment banking”, system will determine the types of financial institutions which will act as primary dealers and market makers. In the USA, primary dealers – which are approved by the Fed and the Treasury and regulated and supervised also by the SEC – essentially comprise investment banking/securities firms, although some commercial banks also are on the approved list. Ideally, the market makers ought to be securities/investment banking firms and rarely the commercial banks. The reason for this – unless one is talking about ‘universal banking’ system – is to be found in the very nature of the investment banking and commercial banking operations. While the former by their very nature entail underwriting, retailing to end-investors and trading (incurring market risk), the latter essentially entail making commercial and industrial loans which always command higher spreads/margins over the cost of funds of the commercial banks. Depending upon the shape (steepness or inversion) of the yield curve, unlike investment banking firms, the commercial banks may, or may not at all, be willing to invest in Government paper. For example, in the USA, during the last two years, the commercial banks accounted for a substantial holding (30% - 40%) of medium-term US Government securities (2-5 years) which is very unusual. But this had to do with the fact that in the USA, the yield curve steepened dramatically and, therefore, it made sense for banks to invest in medium-term Government paper at comfortable margin/spreads over their cost of funds and yet do with smaller capital due to zero-risk weight for Government paper. But imagine what would happen if the yield curve were to invert. Commercial banks would no longer be voluntarily investing in Government securities due to negative margins/spreads over their cost of funds. But unlike the commercial banks, the investment banking/securities firms still have to underwrite, retail to end-investors, and trade on their own account. Besides, market-making and trading in fixed income securities requires very different kind of professional skills, technical expertise, and face very different risk-return objectives than what commercial banking would typically entail.
In view of the foregoing, it is felt that a panel (say 20-25) of well capitalized and professionally well-equipped investment banking/securities firms could be approved and registered with the RBI and SEBI. Incidentally, the recent announcement regarding setting up a Securities Trading Corporation of India, with a capital base of Rs.500 crores, is a welcome but a small step in this direction. Considering the fact that the outstanding Government securities, PSU bonds and corporate debentures aggregate close to Rs.200, 000 crores, it would be beyond the capacity of one single institution to make active and liquid market in debt instruments. What is, therefore, needed is a (20-25 strong) panel/’syndicate’ of professional and well-capitalized securities firms to act as market makers. Of course, unlike in the case of the Basel Committee norm of zero-risk weight for Government securities, the primary dealers/market makers will not be allowed the same risk – weighting. The reason is that securities firms are exposed to considerable market risk on Government and other debt. The capital requirements of 8%, or whatever, will have to be maturity, or more accurately, duration-specific. That is to say, for a given capital, the market maker/primary dealers could have higher exposure to shorter duration paper and lower exposure to longer duration Government paper.
The privilege of being a primary dealer/market-maker will entail compulsory participation in the periodical Government debt auctions and commitment to make two-way prices. The primary dealers/market makers would also enjoy clearing account facility at the RBI. Once the institution of market-maker/primary dealers is in place, the present liquidity management repo auctions of the RBI should be conducted with such primary dealers/market makers as it is in the USA, and not with commercial banks, as at present. Besides, to facilitate inter dealer whole-sale training, a small group of inter-dealer brokers will also be necessary.
Delivery Against Payment Requirement
The trades must settle on delivery against payment only. There should be absolutely no exception to this critical requirement. This will mean the delivery of securities purchased will only be against simultaneous payment of consideration and vice-versa. In other words, no payment, no delivery and no delivery, no payment. Only in the case of futures trades, will this requirement not be necessary because in the case of futures, there is an alternative discipline of marking to market and posting of additional margins by the counterparties to the futures exchange on a daily basis.
Funding/Financing of Long Positions both from Market Making and Trading
A market maker typically performs two main functions: (a) making two-way prices in debt instruments and (b) trading on his own account. In performing the first function, he may ‘involuntarily’ go long a debt instrument and in performing the second, he may ‘voluntarily’ or rather, deliberately, go long, because he may be bullish on the debt market. In either case, since a securities firm (market maker) does not have the resource base of the kind a commercial bank, or for that matter, an institutional investor has, he would need to finance/fund his both ‘involuntary’ and ‘deliberate’ long positions. Easy and efficient availability of funding is critical to performance of both the functions. Indeed, as it is, access to efficient funding is crucial for imparting liquidity in the market place. Typically, source of such funding should be the repo market. What a market maker would do is lend the debt instrument he has purchased against cash which then is used to pay for the debt instrument purchased. Since such borrowing of cash by the market maker is collateralized by the bond he has gone long, the borrowing/funding costs will typically be lower than the corresponding unsecured borrowing, for example, from his commercial banks. Generally, a market maker would not use up his bank credit lines and, to the extent possible, fund/finance his long positions entirely in the repo market. The counterparties to a market maker would typically be risk-averse, but return conscious, institutional investors, or cash-rich corporates, looking for secured short-term investments. This is because a repo is effectively a ‘secured’ short term money market instrument.
Shorting of Debt Instruments
Just as a market maker-cum-trader does not have natural funding resources, he does not also ‘naturally’ own debt instruments the way institutional investors like pension and mutual funds and insurance firms do. In performing the function of market making, i.e. making, two-way prices, he is likely to end up being ‘involuntarily’ short i.e. he may end up selling the bond he does not possess, or own. He is just as likely to go short for two other important reasons. For one thing, he may be bearish on the bond market and, therefore, wishes to make profit by selling first and buying back later when his view has come right. For another, he may wish to hedge the market risk of a large corporate bond development arising from his role as an underwriter. With the mandatory nature of the delivery against payment system, the market maker-cum-trader will have to deliver if he has to receive sale proceeds. The repo, or rather the reverse repo, market is against accessed to ‘borrow’ the debt instrument in question, by collateralizing the same with cash proceeds of ‘short sale’. The ability of the market maker to ‘borrow’ the security for delivery into the short sale, enables the market maker to make two-way prices with tighter/narrower bid – offer spreads, which is another name for ‘liquidity’. In this context, it is noteworthy that the degree of short-squeeze in a particular bond/debt instrument will determine the cost of borrowing to ‘shorts’. The greater the short squeeze, the lower the interest rate at which the bond borrowers (shorts) will be prepared to lend their cash proceeds to the lenders of the bond in question. In other words, so much higher the cost of borrowing the bond for the ‘short’ market maker/trader. In the extreme case, it is quite possible to borrow cash against such a ‘short-squeezed’ bond at almost zero rate of interest.
Commercial Banks Acting as Trustees/Custodians of
Debt Instruments/Bonds for Large Institutional and
Retail Investors
The last element too has a pivotal role to play in the institutional framework for an active secondary market in debt instruments. This is because typically the RBI’s cash and custodial accounts facilities will be the privilege of only the scheduled banks and the market makers/primary dealers. This will leave out a large segment of retail and institutional investors like the pension funds, mutual funds and the corporates. It is here that commercial banks will have an important role to play as custodians of fixed income securities on behalf of retail and institutional investors. This will generate extra fee income for commercial banks. Typically, in the US markets, the custody fees are around five basis points of the amount under custody. Not only this, but there will also be another add-on in the form of bond lending arrangements on behalf of their investor clients. The income-sharing will lead to extra fee income over and above the custody fee income. In fact, such bond lending arrangements will compete with the more direct, one-to-one transactions between the ‘short’ market makers and the large institutional investors. The question of which one of the two will be preferred will largely be a function of the cost-effectiveness. For instance, smaller institutional investors may not be able to access the repo market directly because of smaller lots of bonds they could offer on loan. Besides, the small scale of their operations may not justify the back office and administrative costs. The custodians, on the other hand, will be able to add value in such cases due to the obvious advantages of economies of scale by aggregating such small lots. The larger institutional investors, on the contrary, are likely to be much better off going it alone even though they still have to have the custodial arrangements with banks.
The Summing up
6.The six basic elements of the institutional framework described in detail above constitute necessary and sufficient conditions. The important point to note is that all the six institutional steps are to be synchronized with each other. In other words, it will not do, for example, to go in for financing and funding of debt instruments in isolation and consider introduction of ‘shorting’, later. This is because the funding/financing will take care of only the bid-side and not the offer-side of the market-making/trading function, and as we have seen, for an active and ‘liquid’ market, both are equally essential. It is only then will be ‘liquidity’, represented by narrow/tight bid-offer spreads, be achieved. Put another way, there cannot be a half-way house; the market-making is either there or, it is not there. Besides, the repo market which currently stands banned by the RBI should continue to remain so as far as the commercial banks are concerned. Here it may be clarified that reference is not to the RBI’s repo auctions conducted with banks, but to inter-bank repos only. In other words, the repo market must only subserve the function and role for which it is meant i.e. imparting liquidity and activity in the secondary bond market and not for the ‘fine-tuning’ of SLR management. This is because, however structured, the repos are effectively short term secured/collateralized money market instruments and, therefore, investing in them is not the same thing as investing in, or owning, the underlying SLR securities. The ban should be lifted only after the institution of primary dealers and market makers is in place, with clear mandate to fund/finance the long positions, and ‘shorting’, and consequential borrowing, of debt instruments, in the repo market. The ‘delivery versus payment’ must be strictly enforced and there should be absolutely no exception to this mandatory requirement.
-x-x-x-x-x-x-x-x-
As the markets recover from the trauma of the recent financial cataclysm, the policy makers, the economic agents and the comity of the financial market participants have started focusing attention on the imperatives of carrying on with the financial sector reforms. In that context, there has lately been some evidence of public debate on the desirability of developing an active secondary market in debt instruments in general, and Government securities, in particular. However, the challenge of developing an active secondary market in debt instruments in India enjoins an integrated institutional approach, entailing appropriately sequenced and internally synchronized steps. The present paper seeks to adumbrate such an institutional framework with a view to realizing the objective of an active secondary market. Incidentally, reference to debt instruments in the paper is to Government securities.
2.Before, however, presenting the contours of the institutional framework, it would be a good idea to review the recent trends in yields and inflation. Thanks largely to confluence of relative fiscal restraint and tight monetary policy, the rate of inflation, as measured by WPI, has dramatically fallen to around 8% from a high of 16%- -----------------------------------------------------------------------------------------
* The views and opinions expressed in the paper are those of the
author only and not of the Reserve Bank of India (RBI).
The paper was presented at NIBM Seminar on 18th October 1993.
17%, two years ago. Such an impressive inflation management in the western markets would have almost simultaneously led to commensurate drop in long term yields, with the short-term rates constrained by the official interest rates like discount and repo rates. Indeed, typically, in the US fixed income markets, the debt market prices (and hence yields) adjust continually on the basis of consensus of expectations about critical numbers like output, employment, jobless claims, capacity utilization, inflation, etc. That is to say, the market responses are efficient in the sense that the consensus of rational expectations of the market as a whole are reflected instantaneously in the financial asset prices and, therefore, do not have to wait for the actual announcement of the critical market moving economic data. It is only if the announced data come in at variance with the market consensus, does the market move again. In other words, the materialization of the expected data has no price impact. Put another way, the market discounts/prices in the expected data in advance.
3.Compare the above financial market behaviour to the recent behaviour of debt market in India. In spite of such an impressive inflation performance, generic bond yields continue to rule more or less where they have been before! What this means is that the debt markets in India, far from pricing in advance, have not priced in the spectacular performance even after the fact! In fact, syndrome such as these throw into sharp relief the sine qua non nature of an active secondary market in debt instruments in the Indian setting. Significantly, if there is no reliable benchmark yield curve in India, it is precisely because of the absence of an active and liquid secondary market. The existence of a reliable secondary market yield curve – especially of the “When Issued” (WIs) – will also serve as a benchmark for getting the auction price right and facilitate cost-effective borrowing by Government.
The Institutional Framework
4.It seems from the recent debate that the right institutional framework will be an organized exchange-traded secondary market. But, unfortunately, such institutional predilection ignores the ground realities in the major international capital markets. It may be intriguing and puzzling to note that in the USA, UK, Japan and lately, even in the Philippines, Thailand, Malaysia and Indonesia, astronomical volumes in debt instruments (including Governments) are traded in the over-the-counter (OTC) markets and those traded on the organized exchanges pale into relative insignificance. This is not the case with the equity though. The OTC markets in debt instruments in the western markets are extremely liquid and efficient. On the other hand, the exchange traded debt instruments suffer from relative illiquidity and thin volumes. In view of the above, there is a far stronger case for pushing an OTC, rather than, the exchange – driven institutional framework in the Indian context too.
The Six Basic Elements
5.An OTC-based institutional framework has six basic elements: (i) market clearing interest rates, (ii) institution of primary dealers and market makers, (iii) delivery against payment requirement (iv) funding/financing of long position resulting both from market making and trading, (v) shorting of debt instruments again due both to market making and trading, and (vi) commercial banks acting as custodians of bonds for large institutional and retail investors. In what follows, the nitty-gritty – including rationale-of the six basic elements of the suggested institutional framework have been discussed.
Market Clearing Interest Rates
By market clearing interest rates is meant the yields (or prices) of debt instruments at which the “voluntary” demand for, and supply of, such instruments will clear, or balance. In the Indian context, the market in fixed income securities (debt instruments), until relatively recently did not – and to a great extent even now, does not – answer the description of truly market clearing interest rates. The reason has been the pre-emption of the financial resources of a “captive” banking system through the strait-jacket of SLR requirements, which were progressively increased over the years, to accommodate the financial resources needs of the Government. But recently, the RBI has started gradually reducing the SLR requirements and announced a phase-out programme over the next few years. At the same time, it has also started yield-based auction of Government debt. It is only when the present system of pre-emption is phased out will interest rates be truly market clearing.
Institution of Primary Dealers and Market Makers
The institution of primary dealers and market makers is critical to the development of an active, deep and liquid secondary market in debt instruments – especially the Government securities. Whether India opts for a German style “universal banking”, or the US style, dichotomous “commercial – investment banking”, system will determine the types of financial institutions which will act as primary dealers and market makers. In the USA, primary dealers – which are approved by the Fed and the Treasury and regulated and supervised also by the SEC – essentially comprise investment banking/securities firms, although some commercial banks also are on the approved list. Ideally, the market makers ought to be securities/investment banking firms and rarely the commercial banks. The reason for this – unless one is talking about ‘universal banking’ system – is to be found in the very nature of the investment banking and commercial banking operations. While the former by their very nature entail underwriting, retailing to end-investors and trading (incurring market risk), the latter essentially entail making commercial and industrial loans which always command higher spreads/margins over the cost of funds of the commercial banks. Depending upon the shape (steepness or inversion) of the yield curve, unlike investment banking firms, the commercial banks may, or may not at all, be willing to invest in Government paper. For example, in the USA, during the last two years, the commercial banks accounted for a substantial holding (30% - 40%) of medium-term US Government securities (2-5 years) which is very unusual. But this had to do with the fact that in the USA, the yield curve steepened dramatically and, therefore, it made sense for banks to invest in medium-term Government paper at comfortable margin/spreads over their cost of funds and yet do with smaller capital due to zero-risk weight for Government paper. But imagine what would happen if the yield curve were to invert. Commercial banks would no longer be voluntarily investing in Government securities due to negative margins/spreads over their cost of funds. But unlike the commercial banks, the investment banking/securities firms still have to underwrite, retail to end-investors, and trade on their own account. Besides, market-making and trading in fixed income securities requires very different kind of professional skills, technical expertise, and face very different risk-return objectives than what commercial banking would typically entail.
In view of the foregoing, it is felt that a panel (say 20-25) of well capitalized and professionally well-equipped investment banking/securities firms could be approved and registered with the RBI and SEBI. Incidentally, the recent announcement regarding setting up a Securities Trading Corporation of India, with a capital base of Rs.500 crores, is a welcome but a small step in this direction. Considering the fact that the outstanding Government securities, PSU bonds and corporate debentures aggregate close to Rs.200, 000 crores, it would be beyond the capacity of one single institution to make active and liquid market in debt instruments. What is, therefore, needed is a (20-25 strong) panel/’syndicate’ of professional and well-capitalized securities firms to act as market makers. Of course, unlike in the case of the Basel Committee norm of zero-risk weight for Government securities, the primary dealers/market makers will not be allowed the same risk – weighting. The reason is that securities firms are exposed to considerable market risk on Government and other debt. The capital requirements of 8%, or whatever, will have to be maturity, or more accurately, duration-specific. That is to say, for a given capital, the market maker/primary dealers could have higher exposure to shorter duration paper and lower exposure to longer duration Government paper.
The privilege of being a primary dealer/market-maker will entail compulsory participation in the periodical Government debt auctions and commitment to make two-way prices. The primary dealers/market makers would also enjoy clearing account facility at the RBI. Once the institution of market-maker/primary dealers is in place, the present liquidity management repo auctions of the RBI should be conducted with such primary dealers/market makers as it is in the USA, and not with commercial banks, as at present. Besides, to facilitate inter dealer whole-sale training, a small group of inter-dealer brokers will also be necessary.
Delivery Against Payment Requirement
The trades must settle on delivery against payment only. There should be absolutely no exception to this critical requirement. This will mean the delivery of securities purchased will only be against simultaneous payment of consideration and vice-versa. In other words, no payment, no delivery and no delivery, no payment. Only in the case of futures trades, will this requirement not be necessary because in the case of futures, there is an alternative discipline of marking to market and posting of additional margins by the counterparties to the futures exchange on a daily basis.
Funding/Financing of Long Positions both from Market Making and Trading
A market maker typically performs two main functions: (a) making two-way prices in debt instruments and (b) trading on his own account. In performing the first function, he may ‘involuntarily’ go long a debt instrument and in performing the second, he may ‘voluntarily’ or rather, deliberately, go long, because he may be bullish on the debt market. In either case, since a securities firm (market maker) does not have the resource base of the kind a commercial bank, or for that matter, an institutional investor has, he would need to finance/fund his both ‘involuntary’ and ‘deliberate’ long positions. Easy and efficient availability of funding is critical to performance of both the functions. Indeed, as it is, access to efficient funding is crucial for imparting liquidity in the market place. Typically, source of such funding should be the repo market. What a market maker would do is lend the debt instrument he has purchased against cash which then is used to pay for the debt instrument purchased. Since such borrowing of cash by the market maker is collateralized by the bond he has gone long, the borrowing/funding costs will typically be lower than the corresponding unsecured borrowing, for example, from his commercial banks. Generally, a market maker would not use up his bank credit lines and, to the extent possible, fund/finance his long positions entirely in the repo market. The counterparties to a market maker would typically be risk-averse, but return conscious, institutional investors, or cash-rich corporates, looking for secured short-term investments. This is because a repo is effectively a ‘secured’ short term money market instrument.
Shorting of Debt Instruments
Just as a market maker-cum-trader does not have natural funding resources, he does not also ‘naturally’ own debt instruments the way institutional investors like pension and mutual funds and insurance firms do. In performing the function of market making, i.e. making, two-way prices, he is likely to end up being ‘involuntarily’ short i.e. he may end up selling the bond he does not possess, or own. He is just as likely to go short for two other important reasons. For one thing, he may be bearish on the bond market and, therefore, wishes to make profit by selling first and buying back later when his view has come right. For another, he may wish to hedge the market risk of a large corporate bond development arising from his role as an underwriter. With the mandatory nature of the delivery against payment system, the market maker-cum-trader will have to deliver if he has to receive sale proceeds. The repo, or rather the reverse repo, market is against accessed to ‘borrow’ the debt instrument in question, by collateralizing the same with cash proceeds of ‘short sale’. The ability of the market maker to ‘borrow’ the security for delivery into the short sale, enables the market maker to make two-way prices with tighter/narrower bid – offer spreads, which is another name for ‘liquidity’. In this context, it is noteworthy that the degree of short-squeeze in a particular bond/debt instrument will determine the cost of borrowing to ‘shorts’. The greater the short squeeze, the lower the interest rate at which the bond borrowers (shorts) will be prepared to lend their cash proceeds to the lenders of the bond in question. In other words, so much higher the cost of borrowing the bond for the ‘short’ market maker/trader. In the extreme case, it is quite possible to borrow cash against such a ‘short-squeezed’ bond at almost zero rate of interest.
Commercial Banks Acting as Trustees/Custodians of
Debt Instruments/Bonds for Large Institutional and
Retail Investors
The last element too has a pivotal role to play in the institutional framework for an active secondary market in debt instruments. This is because typically the RBI’s cash and custodial accounts facilities will be the privilege of only the scheduled banks and the market makers/primary dealers. This will leave out a large segment of retail and institutional investors like the pension funds, mutual funds and the corporates. It is here that commercial banks will have an important role to play as custodians of fixed income securities on behalf of retail and institutional investors. This will generate extra fee income for commercial banks. Typically, in the US markets, the custody fees are around five basis points of the amount under custody. Not only this, but there will also be another add-on in the form of bond lending arrangements on behalf of their investor clients. The income-sharing will lead to extra fee income over and above the custody fee income. In fact, such bond lending arrangements will compete with the more direct, one-to-one transactions between the ‘short’ market makers and the large institutional investors. The question of which one of the two will be preferred will largely be a function of the cost-effectiveness. For instance, smaller institutional investors may not be able to access the repo market directly because of smaller lots of bonds they could offer on loan. Besides, the small scale of their operations may not justify the back office and administrative costs. The custodians, on the other hand, will be able to add value in such cases due to the obvious advantages of economies of scale by aggregating such small lots. The larger institutional investors, on the contrary, are likely to be much better off going it alone even though they still have to have the custodial arrangements with banks.
The Summing up
6.The six basic elements of the institutional framework described in detail above constitute necessary and sufficient conditions. The important point to note is that all the six institutional steps are to be synchronized with each other. In other words, it will not do, for example, to go in for financing and funding of debt instruments in isolation and consider introduction of ‘shorting’, later. This is because the funding/financing will take care of only the bid-side and not the offer-side of the market-making/trading function, and as we have seen, for an active and ‘liquid’ market, both are equally essential. It is only then will be ‘liquidity’, represented by narrow/tight bid-offer spreads, be achieved. Put another way, there cannot be a half-way house; the market-making is either there or, it is not there. Besides, the repo market which currently stands banned by the RBI should continue to remain so as far as the commercial banks are concerned. Here it may be clarified that reference is not to the RBI’s repo auctions conducted with banks, but to inter-bank repos only. In other words, the repo market must only subserve the function and role for which it is meant i.e. imparting liquidity and activity in the secondary bond market and not for the ‘fine-tuning’ of SLR management. This is because, however structured, the repos are effectively short term secured/collateralized money market instruments and, therefore, investing in them is not the same thing as investing in, or owning, the underlying SLR securities. The ban should be lifted only after the institution of primary dealers and market makers is in place, with clear mandate to fund/finance the long positions, and ‘shorting’, and consequential borrowing, of debt instruments, in the repo market. The ‘delivery versus payment’ must be strictly enforced and there should be absolutely no exception to this mandatory requirement.
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