On 1 December 2009, the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi) made the settlement of corporate bond trades through clearing corporations mandatory. Exactly a year later, India’s first corporate bond repurchase deal was struck between ICICI Securities Primary Dealership and Infrastructure Development Finance Co. Ltd.
Secure settlement through clearing corporations and a repo market are among the top policy initiatives to revive the secondary market for corporate bonds. But, apart from the fact that they were both implemented on 1 December, unfortunately there’s little in common in the way these initiatives have been implemented.
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While all financial sector regulators have bought into the idea of centralized settlement, only RBI has approved corporate bond repos. As a result, the market hasn’t taken off, with only a handful of deals being struck since the first one over two months ago.
Compulsory settlement of trades through clearing corporations of stock exchanges, on the other hand, was a well-coordinated move, with all entities regulated by RBI and Sebi required to comply. Other regulators, including those overseeing insurance companies and pension funds, followed suit and now almost all corporate bond trades are settled through clearing corporations.
While no study has yet been done to assess the impact of this move, it’s fair to assume that market participants would now be much more comfortable transacting in corporate bonds, simply because centralized settlement considerably reduces counterparty risk. Needless to say, the market wouldn’t have fully benefited if all regulators hadn’t pushed for this.
Similarly, unless entities regulated by Sebi and the Insurance Regulatory and Development Authority are allowed to participate in corporate bond repos, this segment of the market will not take off. Mutual funds, after all, are the biggest lenders in the collateralized borrowing and lending obligation (CBLO) market. Their participation on the lending side would lead to a pick-up in volumes in the corporate bond repo market as well.
Sebi, interestingly, is still in the process of framing guidelines to allow mutual funds participate in this segment. (The regulator hasn’t responded to a mail sent last Thursday asking for reasons for the delay.) According to Sebi’s website, in late 2007 it had requested RBI to initiate action on corporate bond repos since it fell under the latter’s regulatory purview.
RBI finally came out with guidelines in early 2010 and made modifications later in the year based on market feedback. It is ironic that Sebi itself hasn’t allowed its regulated entities access to the market, even three years after it approached RBI to get the market started.
Sebi may have a legitimate concern about the liquidity risk associated with corporate bonds. If a large proportion of funds are lent against corporate bonds, a mutual fund could get into trouble if it’s faced with redemption pressure. But this problem can surely be tackled by prescribing a limit up to which mutual funds can participate in the repo market. This will contain the risk in the system and at the same time provide room for mutual funds to provide liquidity in the new market segment.
The importance of a well-functioning corporate bond repo market cannot be overstated. Globally, repo markets substantially increase the liquidity of the underlying product as well help in increase the investor base for the underlying product. Without doubt, a well-functioning repo market will increase the perception of liquidity of corporate bonds and as a result draw more investors both in the secondary and primary markets.
One can argue that all’s not lost and that as and when Sebi gives approval, mutual funds will enter the segment and volumes would grow over time. But this argument misses the importance of launching a new product well. Currently only a handful of RBI regulated entities are exploring opportunities with corporate bond repos. It won’t be surprising if some of them lose interest because of the lack of liquidity. There’s a high likelihood of interest waning in the segment.
On the contrary, if all prospective users were allowed to participate from day one, interest in the segment would have only grown with every passing day. Liquidity, after all, attracts liquidity.
Apart from the failure of the interest rate futures market, this is another glaring example of the pitfalls of having two regulators work together on a product. It’s important for policymakers to realize this and work on remedial measures quickly.
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