In January 2003, the government, Reserve Bank of India (RBI) and Securities and Exchange Board of India (Sebi) had first proposed exchange-based trading of government debt securities. Exactly 10 years later, the idea appears to be finally seeing the light of day. Last week, Sebi issued a circular to stock exchanges saying they can choose to provide a separate debt segment which will trade all debt instruments including corporate bonds and government securities (subject to RBI approval). The central bank had, on its part, issued a circular to banks in early November saying they can become members of stock exchanges and undertake proprietary transactions in the corporate bond market. The stage now seems set for the introduction of trading on corporate bonds and government securities on stock exchanges.
Prima facie, the development looks good and in line with the worldwide movement of financial trading from over-the-counter markets to exchange-traded markets. Even so, Indian exchanges have had no success with the interest rate futures product, and establishing a robust screen-based trading system for debt securities can be another big challenge.
The world over, debt securities are traded over-the-counter, typically through bilateral negotiations. In India, thanks to the pioneering work of Clearing Corp. of India Ltd (CCIL), trading of government debt securities has moved to an electronic system called Negotiated Dealing System (NDS). While NDS operates almost like an exchange system, one big difference is that participation is limited only to institutional investors. CCIL also clears and settles these trades, acting as a central counterparty long before the term became fashionable post the financial crisis. Corporate bonds are negotiated bilaterally and then reported to the Fixed Income Money Market and Derivatives Association of India. Since December 2009, these transactions are being settled through the clearing corporations of stock exchanges. This has removed settlement risk for the buyer of bonds, which had to earlier transfer funds to the seller before receiving the bonds.
With both of the above-mentioned systems working smoothly, the pertinent question is if exchange-based trading is required at all. The main argument in favour of exchange-based trading is that it will open up the market to an array of market participants who currently can’t get in because they aren’t permitted by the central bank. Proponents of this argument point to the liquid equity derivatives market, where non-institutional participants account for the bulk of trading.
Debt market participants argue, on the other hand, that unlike equities, the number of debt securities is very large and that most bonds trade infrequently, thanks to which non-institutional participation will be limited. They also point to the much larger size of bond market trades, making it conducive for institutional trading.
Sebi’s solution for this is to have a separate market for institutional trades and another where all market participants including retail investors will participate. As far as government securities go, the institutional segment will be an extension of what is already happening at CCIL, and one wonders whether there is a need for another trading system which will fragment liquidity. The institutional corporate bonds market may benefit from increased transparency and hence participation. The retail segment, which will be restricted to bonds that were issued publicly, can gain from the creation of a focused debt trading segment, which will facilitate the entry of new participants such as banks. In sum, the results from the shift to exchange-based trading may not be spectacular.
Having said all this, one must not lose sight of the fact that interest rate derivatives are by far the most liquid exchange-traded products in developed markets. Also, India’s financial market participants have gained rich experience in trading equity derivatives, and there is a growing number of firms trading sophisticated interest rate derivatives on overseas exchanges. According to an official from an overseas exchange, some firms operating from India are among the largest volume providers for products such as Euribor futures.
All of this experience and skill can be harnessed in creating a robust interest rate derivatives market in India. Of course, it’s well known that policymakers have worked hard at establishing such a market twice over, but have failed on both occasions. While there are a number of reasons for the failure of the interest rate futures products currently on offer, the main problem is that policymakers have been far too involved in designing these products. It’s far better to provide broad guidelines and leave it to exchanges to design products based on market feedback.
One can argue that the central bank and Sebi have also taken on board market feedback before designing interest rate futures contracts. However, one of the keys to market design is the ability to make quick fixes as well as the ability to launch new products which incorporate lessons from the failures of previous products. When exchanges are given this freedom, they can be nimble-footed and adapt to market needs. When market design is done by policymakers, such changes may either take months or may not happen at all. The interest rate futures market, unfortunately, has almost come to a stage where policymakers believe that nothing can be done to revive the market. But things can change if they let go of product design.
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