Last week, the Indian central bank issued the final guidelines for ready forward contracts, or repo in corporate debt. This will enable mutual funds, insurance firms and non-banking finance firms to borrow money by offering corporate bonds as collateral, starting March. A few months ago, the Reserve Bank of India (RBI) introduced plain vanilla credit default swaps (CDS) for corporate bonds.
Repos, or repurchase agreements, are contract for the sale and repurchase of securities and treasury bills at a future date. In this transaction, the seller repurchases the financial asset at the same price at which it was sold, and pays interest on it. Essentially, repo is a short-term, interest-bearing loan against the collateral of securities. The repo rate is negotiated by counterparties independently of the interest rates or the coupons of the underlying securities and is influenced by overall money market conditions.
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After serious irregularities in securities transactions that led to India’s biggest stock market scam in 1992, RBI came down heavily on such deals, but the restriction on repo existed even before the scam. A June 1969 government notification, under section 16 of the Securities Contract (Regulation) Act, 1956, prohibits any person from entering a repo deal without its permission. Globally, central banks use this short-term instrument to iron out excessive volatility in the money market. In India, too, RBI has been doing this and it is the sole authority to regulate this market.
In 1987, it even said that the units of the erstwhile Unit Trust of India, the country’s oldest mutual fund and a proxy for any sovereign paper, could not be used as collateral for repo deals. As the repo market grew phenomenally and there was rampant misuse of the facility, in 1988 RBI prohibited banks from entering into repo deals with non-bank clients.
In fact, the genesis of the 1992 stock market scam was a thriving repo market. Some banks used repos to understate their actual liabilities, by advising non-bank customers to lend them money by way of repos instead of placing the same in the form of deposits. There were others who first committed to borrow through repo deals and later invested the funds in securities. In many cases, commitments to repurchase or resell the securities were not even documented. RBI banned repo deals and barred banks from undertaking repos in government bonds and other approved securities with effect from 22 June 1992. Repos in treasury bills, however, were exempted from the prohibition. The restrictions were lifted in phases. In 1995-96, RBI partially reopened the market only for specified government securities, but only banks and primary dealers that buy and sell government securities were allowed to strike repo deals. At the second stage, in 1997-98, all government securities and treasury bills were made repoable and in 2003, mutual funds were allowed into this segment.
Now double-A and better rated corporate bonds are being made repoable but certificates of deposit, commercial paper, and non-convertible debentures of less than one-year tenure will not be eligible for undertaking repos. The maturity of repo deals could range from one day to one year and they will be settled through clearing platform of stock exchanges either on T+1 basis or T+2. This means the settlement could be done in two or three trading days after striking the repo deal. Finally, one will have to keep a margin of at least 25% for such deals. This means a borrower would get only Rs75 crore after offering Rs100 crore worth of corporate bonds. Most market participants are finding the margin too high. Besides, under RBI guidelines, rollover of repos isn’t possible. In a T+1 system, for a one-day repo, the borrower deposits the security in a lender’s security account and gets cash on the second day and gets back the security on the third day. In the absence of the rollover facility, the borrower can’t organize funds on the third day even if the money is needed and must wait till the security comes back to the account. Does this mean that the repo in corporate bonds will be a flop? No. It will make the financial system more democratic as the relatively weaker players who cannot access bank funds will be able to raise money through this route. Also the mutual funds, who are often forced to sell bonds to meet the redemption pressure, will now be able to generate cash by repoing out securities.
Besides overnight call money and repo market, there is another market called collateralized borrowing and lending obligation (CBLO). While the repo is a bilateral deal in which both parties—the borrower and the lender—are obliged to follow the terms of the contract, CBLO is a tradable repo in which either side can change the contract by using the trading screen of Clearing Corp. of India Ltd. In other words, if a borrower has raised seven-day money through this route by using bonds as collateral, and doesn’t need the funds after three days, it can snap the contract. This is possible because of the tradable nature of the instrument. It is similar to any anonymous order matching scheme with real time information. The CBLO volume has been on the rise. It now accounts for almost 80% of money market volume in India. Repo in corporate bonds will not change the scene overnight, but at least a beginning is being made.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Comment at firstname.lastname@example.org