ta3473 ind final report

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TA 3473-INDDevelopment of a Secondary Debt Market

Final ReportFebruary 2002

The International Securities Consultancy Limited

9/F Carfield Commercial Building75-77 Wyndham Street, Central, Hong Kong

Also in London and the Middle East

In association with:

The BISYS/Aries Alliance Professional Services Group


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Introduction

T.A. 3473-IND: Development of a Secondary Debt Market Page 1

Final Report February 2002The International Securities Consultancy Limited

ADB TA 3473-INDDevelopment 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 theproject.


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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 willhave the following responsibilities:

(i) Jointly with the international capital market operations specialist and the domesticfixed 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.

(ii) Identify legal and regulatory constraints pertaining to all market transactions on thesecondary 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 lawsand 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.

(iii) Study accounting and tax-related issues for the development of the secondary debtmarket. 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 optionswill 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.

(iv) On the basis of these studies and best international practices, recommend clear andcomprehensive 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


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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 internationalcapital 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 timelyand 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);

(ii) resolving other pending barriers hindering efficient and transparent tradingactivities in the domestic debt market, including institutional capacities of financial,

market intermediaries, issuers, and investors;

(iii) improving the attractiveness of financial instruments on the secondary debt 8market for trading;

(iv) developing effective secondary market mechanisms to enhance liquidity andhedging instruments for managing risks in the domestic debt market; and

(v) creating a benchmark index for efficient pricing and performance measurement ofthe domestic debt market.


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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 marketregulations and tax expert, the consultant will

(i) review the legal and regulatory frameworks of trading and investing in fixed-income 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

(ii) 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.

2. Securities Operations Back Office Specialist (4 person-months)The consultant will have solid experience in all aspects of back-office operations of fixed-

income 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, andspecify factors hindering efficient functioning of the secondary domestic debt

market and propose changes; and

(ii) review institutional capacities of the investors and financial intermediaries toactively participate in the secondary domestic debt market.

3. Fixed-Income Trading Specialist (4 person-months)

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 marketpractices and the price discovery system in particular, constraining investors active

participation in the secondary domestic debt market; and propose measures for

improvement; and

(ii) identify potential investors to increase heterogeneity of market participants.4. Fixed-Income Securities Analyst (4 person-months)

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 economicvariables determining its dynamics, including the fiscal and monetary policies of

the Government;

(ii) quantitatively assess the current level of market liquidity, volatility and marketconcentration 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;

(iii) evaluate the existing hedging mechanism for fixed-income securities, and proposemeasures for improvement; and

(iv) support creation of a benchmark index to facilitate pricing and performancemeasurement.

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 identifydistortions 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 inthe domestic debt market will be analyzed. Disclosure requirements and the

transparency of private placements will be studied. Specific impediments to newdebt-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.

(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 priceand 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.

(iv) The adequacy of financial instruments available for investment and trading toenhance market activities on the secondary debt market, and specific capacityconstraints 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.

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 debt-

related 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.


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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 thesecondary 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 AT DRAFT FINAL REPORT STAGE

(i) The current interest rate

regime in India and theeconomic 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 identifydistortions and the scope of its

impact on secondary debt

market development.

Deliverable:

An analysis of the current

interest rate regime on the

capital market.

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 isdiscussed 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 abarrier 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 timelytrade 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




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 andoptions 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 supportfully-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.

The study will examine

appropriateness of laws,

regulations, accountingpractices, and taxes applicable

to all market participants,

financial intermediaries,issuers, and investors of fixedincome securities to ensure a

fair, efficient, and transparent

bond market.

The incentive structure for

market participants will alsobe analysed. Furthermore, the

capacity of regulatory and

supervisory bodies to monitor

and enforce regulations will befully assessed.

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. Wemake extensive reference to the lack of transparency in the

secondary market. The regulation of issuers is addressed inVolume 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 thebond 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 withrestrictive 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 questionwhether there was any real gain to becoming a Primary Dealer.


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Annex 2 Comparison




Deliverable:

Clear and comprehensive

legal/regulatory/accounting/tax

frameworks that will support

market efficiency, growth,liquidity, and transparency.

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 priceand 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 on-

exchange markets will be a critical issue in market development.

It is essential to ensure the over the counter market is notdestroyed 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).

Adequacy of the current

market infrastructure to

support transactions of new

debt-related instruments suchas securitized papers and

interest rate futures andoptions as well as its

compatibility with global bond

trading systems will be

assessed.

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.

Also, the impact of effective

hedging and secondary market

mechanisms, such as repos and

futures on market liquidity willbe 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 notsee 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 interdealer brokers trading to allow laying off of positions by primary

dealers.

Creation of an index for the

debt market will be supported

to facilitate pricing and

performance measurement of

fixed income securities.

ICICI, a major investment bank and bond market participant

operates an index that shows all the desirable features of a well-

constructed index .


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Annex 2 Comparison




Contain proposals for

solutions and implementation

of these solutions including

assessment of barriers and

risks.

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

(iv) Adequacy of financial

instruments available for

investment and trading for

enhancing market activities onthe secondary debt market and

specific capacity constraints of

market participants issuers,

financial intermediaries, andinvestors.

Also, potential investors and

traders of fixed incomesecurities will be identified to

increase heterogeneity of

market participants.

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 particularlyparticipants 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.

(v) Modernisation of the market

infrastructure.

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.

(vi) A strategy to eliminateimpediments to the secondary

debt market in a sequential

manner.

The impediments have been documented throughout Volume 2Chapters 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.


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Annex 3 List of People Met



ANNEX 3 LIST OF PEOPLE MET

Name Position Organisation

S. Mehta Country Head - India AIG

D. N. Upadhye Deputy General Manager Bank of India

A Balasubramanian Chief Dealer Birla Sun Life Mutual Fund

J. Beswick Chief Executive Officer Birla Sun Life Mutual Fund

K. Ramanathan Head of Fixed Income Birla Sun Life Mutual Fund

R. Vaidyanath General Manager Bombay Stock Exchange

S. Purdy Chief Representative Manager CGU

M. Agrawal Head - Corporate Ratings CRISIL

P. Agrawal Manager - Corporate Ratings CRISIL

R. Ravimohan Managing Director CRISIL

Dr. Chiragra

Chakraborty

(in capacity as Vice-President,

DFHI)

currently at UTI Institute of Capital

Markets

Manoj Yadav Head-Operations Global Securities

Services

Deutsche Bank

Hari Shankar Chaitanya Director Deutsche Bank - Custody Services

Chetan Shah Co-Head Global Markets India Deutsche Bank - Global Markets

J. J. Mehta Senior Vice President - Head of

Debt

DSP Merrill Lynch

M. Barve Managing Director HDFC Mutual Fund

Dr. Nachiket Mor Executive Director ICCI Limited

Ashish Ghiya ICICI Limited

K. V. Subramanian Assistant Manager ICICI Limited

N. Balasubramanian Deputy General Manager ICICI Limited

Sudershan Sharma Vice President ICICI Limited

Sudipto Lahiry Deputy Manager ICICI Limited

A. Gokhale Assistant Vice President ICICI Securities and Finance Company

K. Kulkarni Vice President ICICI Securities and Finance Company

A. S. Unnikrishnan Manager IDBI


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B. Mythili Deputy General Manager IDBI

M. Balasubramanian Deputy General Manager IDBI

G. V. Nageswara Rao Managing Director IDBI Capital Market Services Limited

Pradeep Madhav Senior Vice President IDBI Capital Market Services Limited

Binay Chandgothia Head - Fixed Income IDBI-Principal Asset ManagementCompany Ltd.

A Singh Vice Chairman Infrastructure Professionals Enterprise

G. N. Bajpal Chairman Life Insurance Corporation of India

S. C. Bhargava Secretary Life Insurance Corporation of India

Rajendra P. Chitale Managing Partner M. P. Chitale & Co.

Amit Sinha Assistant Vice President National Securities Depository Ltd.

C. B. Bhave Managing Director National Securities Depository Ltd.

Gagan Rai Executive Director National Securities Depository Ltd.

V. R. Narasimhan Senior Vice President National Securities Depository Ltd.

Dr. Gangadhar Darbha Consultant National Stock Exchange of India Limited

Ravi Narain Managing Director & CEO National Stock Exchange of India Limited

Golak C. Nath Manager, Wholesale Debt Market National Stock Exchange of India Ltd

Dr R. K. Pattnaik Director Reserve Bank of India

K. R. Ganapathy Chief general Manager-In-Charge Reserve Bank of India - Information

Technology

A. P. Gaur Director Reserve Bank of India - Internal Debt

Management

Chandan Sinha General Manager Reserve Bank of India - Internal Debt

Management

Dr. T. C. Nair Chief General Manager Reserve Bank of India - Internal Debt

Management

Usha Thorat Chief General Manager Reserve Bank of India - Internal Debt

Management

Dr. M. T. Raju Economic Adviser Securities and Exchange Board of India

Pratip Kar Executive Director Securities and Exchange Board of India

Prof. J. R. Varma Board Member Securities and Exchange Board of India


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D. Basu Chairman Securities Trading Corporation of India

Limited

P.K. Naik Senior Dealer Securities Trading Corporation of IndiaLimited

R. V. Joshi Managing Director Securities Trading Corporation of India

Limited

S. R. Kamath General Manager Securities Trading Corporation of India

Limited

I. Panju Director Smif Securities

Tarun Saigal Head Fixed Income Global

Markets India

Standard Chartered Bank

A. B. Lal Deputy General Manager

(Insurance)

State Bank of India

B. Virupaksha Goud Managing Director & CEO Stock Holding Corporation of India

J. Vishwanath Murthy Vice President & Advisor Stock Holding Corporation of India

L. Viswanathan Senior Vice President Stock Holding Corporation of India

R. H. Mewawala Senior Vice President Stock Holding Corporation of India

R. Vij Chief Executive Officer Templeton Asset Management

Dr. R. H. Patil Chairman The Clearing Corporation of India Ltd.

R. Ravimohan Managing Director The Credit Rating Information Services of

India Limirted

M. M. Kapur Executive Director Unit Trust of India

S. K. Basu Executive Director Unit Trust of India - Corporate Office

K. Nathani Manager Unit Trust of India - Funds Management

R. Rangarajan General Manager Unit Trust of India - Funds Management

Dr. S. Nayak Chief General Manager Unit Trust of India - Research, Policy and

Planning

V. C. Shukla Assistant General Manager Unit Trust of India - Research, Policy and

Planning

Dr. Uma Shashikant Professor UTI Institute of Capital Markets


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TA 3473-INDDevelopment of a Secondary Debt Market

Volume 1: The Current SituationFebruary 2002

The International Securities Consultancy Limited

9/F Carfield Commercial Building75-77 Wyndham Street, Central, Hong Kong

Also in London and the Middle East

In association with:

The BISYS/Aries Alliance Professional Services Group


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Volume 1 The Current Situation

T.A. 3473-IND: Development of a Secondary Debt Market


Table of Contents

Chapter 1 The Government Bond Market..................................................................... 1

Instruments ...................................................................................................................... 1Issuance 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............................................................................................................... 35Credit 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


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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 workinggroup (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 TreasuryBills (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 areissued 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 T-

Bills 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.

4. Auctions of 364-day T-Bills were introduced on April 28, 1992 and replaced thethen-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.

5. 364-day T-Bills form part of the Governments budgeted market borrowings duringthe year and have constituted, on average, about 11.5% of the Governmentsmarket 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.

6. T-Bills provide risk-free investment opportunities for investors with short-termsurpluses. They are also eligible for repo and liquidity adjustment facilities.


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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-dayT-Bills (Table 1.1).

Table 1.1 Gross borrowings via T-Bills

(Rs. crore)

Year 364-day 182-day 91-day 14-day Total

199293 8796.74

(86.7)

- 1350.00

(13.3)

- 10146.74

(100)199394 21019.76

(56.2)

- 16350.00

(43.8)

- 37369.76

(100)199495 16139.88

(56.5)

- 12450.00

(43.5)

- 28589.88

(100)199596 1874.74

(13.6)

- 11950.00

(86.4)

- 13824.74

(100)199697 8240.63

(24.6)

- 25200.08

(75.4)

- 33440.71

(100)

199798 16246.56

(17.3)

- 12840.18

(13.7)

64940.60

(69.1)

94027.34

(100)199899 10300.00

(23.0)

- 16348.00

(36.6)

18150.00

(40.6)

44698.00

(100)199900 13000.00

(31.9)

2900.00

(7.1)

8257.50

(20.2)

16653.41

(40.8)

40810.91

(100)

200001 15000.00(42.1) 2600.00(7.3) 7605.00(21.3) 10450.50(29.3) 35655.50(100)Notes: (i) 364-day T-Bills were introduced in April 1992, 91-day in January1993, 14-day inJune 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 Economy2000, RBI.

Dated Government Securities

8. Both the Central and State Governments regularly access the market for theirfunding needs by issuing dated Government securities. Being eligible as Statutory

Liquidity Ratio (SLR) investments, these securities provide an attractive investmentoption 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 showsthe amounts raised

since 199596.


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Table 1.2 Borrowings of Central Government by issuance type

(Rs. crore)

Year Auctions Private placement Tap/floatation Total

Price-based Yield-based

No. Amount No. Amount No. Amount No. Amount No. Amount

199596 9 15441.95 3 5500 8 17522.57 20 38464.52

(40.1) (14.3) (45.6) (100)199697 9 18911.06 3 9000 12 27911.06

(67.8) (0) (32.2) (100)199798 8 27000 3 11000 2 5390.38 13 43390.38

(62.2) (25.4) (12.4) (100)199899 16 43500 11 30000 5 10252.82 32 83752.82

(51.9) (35.8) (12.2) (100)199900 18 51645 3 9500 8 27000 1 2129.85 30 90094.85

(57.3) (10.5) (30.0) (2.4) (100)200001 17 56000 8 23500 5 18000 1 2683.45 31 100183.5 (55.9) (23.5) (18.0) (2.7) (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-annualcoupons. 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 (thefirst 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 onSeptember 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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The base rate will be the average of the implicit yields in primaryauctions 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 -0.05per 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.c. 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).

d. Partly paid stock (13.85% 2006) aggregating Rs. 5000 crore was sold ontap 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)

Year Gross Net

199596 6274 5931

199697 6536 6536

199798 7749 7193

199899 12114 10700

199900 13706 12405

200001 11420 11000

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

13. Until very recently, the RBI conducted State Government borrowings in commontranches. 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 thespread of yields.

Table 1.4 Market Borrowings of States: Summary of Auction Results

State Date of auction Amount of issue Cut-off yield

(Rs. crore) (Per cent)

1. West Bengal 08.08.2000 250 11.80

2. Maharashtra 08.08.2000 280 11.70

3. Andhra Pradesh 08.08.2000 400 11.80

4. Tamil Nadu 08.08.2000 290 11.70

5. Kerala 29.08.2000 200 11.75

6. Karnataka 05.12.2000 250 11.57

7. Kerala 17.04.2001 200 10.53

8. Gujarat 20.07.2001 190 9.50

9. Gujarat 06.08.2001 250 9.40

10. Andhra Pradesh 13.08.2001 475 9.53

11. Madhya Pradesh 13.08.2001 105 9.55

12. West Bengal 13.08.2001 250 9.72

Source: RBI Annual Report 2000-01


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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 January13, 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 oftheir market borrowings, there are contingent liabilities on account of the

guarantees that are provided by them to certain entities to support the latters fund-

raising 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 62468 48479 110947

(6.0) (4.7) (10.7)1996 65573 52631 118204

(5.4) (4.3) (9.7)1997 69748 63409 133157

(4.9) (4.5) (9.4)1998 73877 73751 147628

(4.7) (4.7) (9.4)1999 74606 83075 157681

(4.2) (4.7) (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 ofcomfort 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 playersto 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.

18. 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 theforex market as an underlying benchmark rate.

Repos

19. Repos (often known as ready forward contracts or buy-back deals) act as moneymarket 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.

20. In India, repos can be executed either as (i) inter-bank deals or (ii) by any permittedentity 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.

21. In view of the continuing demand from market participants to widen the scope ofrepo 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. Therecommendations, 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.

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.

24. 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 hasalso 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.

25. Short-selling is prohibited; entities entering into repo transactions are not permittedto effect any sale transaction without actually holding the securities in their

portfolio.

Repos with the RBI Liquidity Adjustment Facility

26. The RBI has been using repos actively for liquidity management, both forabsorbing 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.

27. The Liquidity Adjustment Facility (LAF) was introduced in June 2000, replacingthe Additional Collateralised Lending Facility earlier extended to banks and the

Level II liquidity support earlier extended to primary dealers. The funds are


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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 RBIconducts 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.

31. The RBI notifies the amounts to be offered at the auction. These are currently set atRs. 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.)

32. Important changes have taken place in the T-Bill issuance procedure in recentyears. 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


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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 June1997 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.

34. In the initial years, the RBI used to pay primary dealers an underwritingcommission 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 allprimary dealers together absorb 100% of the issue.

35. Effective 199899, non-competitive bids are kept outside the notified amount toprovide 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 uniform-

pricing 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

Year 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.

36. The move to an auction system from an ad-hoc issuance procedure was expected tofacilitate 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,


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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 movetowards 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 price-

based 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).

38. In order to maintain a stable interest rate environment, the RBI, on occasions, alsoaccepts 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.

39. Tap issues are issues sold to market participants on a first-come first-served basis;these are issued at par (Rs. 100).

40. Unlike T-Bills, the RBI does not have a fixed calendar for auctions of datedGovernment securities. The RBI announces an auction four to five days prior to the

auction date through a public notification. The notification includes details of thesecurity 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 hisunderwriting fee for the amount he has committed to underwrite at the rate he has

quoted.

41. Once the underwritten amounts are decided, primary dealers bid for the security foran 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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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 securitiesYear Percentage of notified amount

at auctions that devolved

(average)

Percentage of total issuance

during the year

No. Total RBI Primary

dealers

Total RBI Primary

dealers

199596 11 69.90 69.90 0 37.16 37.16 0

199697 6 33.80 30.82 2.98 20.28 18.49 1.79

199798 5 71.10 62.04 9.06 39.29 34.28 5.01

199899 8 51.50 37.29 14.21 15.41 11.16 4.25

199900 3 39.89 0 39.89 3.30 0 3.30

200001 9 64.16 41.10 23.06 27.19 17.42 9.78

Notes: (i) Devolvements include private placements.(ii) Notified amounts are amounts issued through auctions and private placementsexclusive ofissues sold on tap.

42. The system of underwriting imposes an implicit cost on primary dealers, which isdifficult 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 asunderwriter, 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.

43. 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).

PARTICIPANTS

Intermediaries

44. Primary dealers and satellite dealers act as intermediaries and market makers forGovernment securities.


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Primary Dealers

45. Guidelines for setting up the institution of primary dealers were announced by theRBI in March 1995. It was envisaged that primary dealers would:

a. strengthen the infrastructure in the Government securities market and helpmake it vibrant, liquid and broad-based;

b. ensure development of underwriting and market-making capabilities forGovernment securities outside the RBI; and

c. improve the secondary market trading system which could contribute toprice discovery, enhance liquidity and turnover, and encourage voluntary

holding of Government securities among a wider investment base.

46. Primary dealership can be set up as subsidiaries of scheduled commercial banks orfinancial 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.

47. Discount and Finance House of India (DFHI) was the first entity to be grantedprimary 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.

48. The ownership structure of primary dealers is shown in Table 1.8.

Table 1.8 Ownership structure of primary dealers

Ownership No.

Public sector bank subsidiary 8

Private sector 3

Foreign 5

49. Primary dealers do not have unique access to primary auctions, but the RBI extendsother 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 dealershave access to Level I liquidity support up to three times their Net Owned Funds at

the Bank Rate and access to the LAF.

50. Performance of primary dealers is assessed by the RBI and judged on the basis oftheir 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

1 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.


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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 Governmentsecurities. 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 reverserepos. 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, bringingtogether counterparties and negotiating terms. They provide research and market

intelligence, as well as anonymity during negotiation. Once a deal is finalised, thebroker 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.

53. Brokers are regulated by the exchange of which they are a member (NSE, in thiscase) and by SEBI.

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


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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

(percentages)

End-March RBI Commercial

banks

LIC Others

1996 7.3 64.9 16.8 11.0

1997 2.8 63.0 18.7 15.5

1998 10.7 58.9 18.0 12.4

1999 9.1 59.5 17.9 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.

56. Scheduled commercial banks are the largest investors in Government of Indiasecurities. 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 CreditPolicy of April 2001, the banking system holds 35% of NDTL in Government

securities.

57. The RBI guidelines stipulate classification of banks investment portfolios (whichinclude 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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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 pu

ta3473 ind final report

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