1 December is likely to be remembered as the day the revival of the corporate bonds market in India was set in motion. All entities regulated by the Reserve Bank of India (RBI) and the Securities Exchange Board of India (Sebi) will compulsorily start settling their trades in corporate bond from Tuesday through clearing corporations of stock exchanges. This includes a large number of active participants such as banks, primary dealers and mutual funds.
Currently, corporate bonds are traded and settled bilaterally. Once a deal is struck, the buyer transfers the funds to the seller, who then hands over the bonds to the buyer. Since the bonds have to be handed over only after the funds have been received, it creates huge settlement risk from a buyer’s perspective.
Also Read Mobis Philipose’s earlier columns
Settlement through a clearing corporation will be vastly different. Trading will continue to happen on a bilateral basis, but after a deal is struck, the buyer and seller will transfer funds and securities, respectively, to the clearing corporation. It’s only after both parties have honoured their obligations that the clearing corporation will release funds to the seller and securities to the buyer. Counterparty risk will reduce considerably, leading to lower transaction costs, increased liquidity and better price discovery.
Of course, there’s still the chance that one of the parties would default, in which case the clearing corporation would return the funds or securities.
This is unlike the equities market, where the clearing corporation guarantees all trades. If, say, the seller defaults, the clearing corporation procures the securities from the market and transfers them to the buyer. Whatever loss the clearing house would have incurred in procuring the securities from the market at prevailing prices (vis-à-vis the traded price) is recovered from the margins collected from the seller. This process is difficult in the corporate bond market because they are far less liquid compared with equities, and hence isn’t being attempted.
But defaults are normally few and far between, and would hardly take away from the larger good a central clearing system will bring. Thanks to the reduction in settlement risk, players will be more comfortable trading.
According to a fund manager at an insurance company, foreign institutional investors haven’t been active in the corporate debt market primarily because of the counterparty risk involved in the settlement process.
What’s more, details of most trades will be captured by clearing corporations because of the compulsory settlement diktat, resulting in a higher degree of post-trade transparency. The transparent dissemination of corporate bond prices and quantities traded will also facilitate better participation by market participants. Once the settlement system is in place, it’ll pave the way for a corporate bond repo market. Ultimately, all this will help in reviving the primary market for corporate bonds.
There are likely to be some teething problems, however, with the new settlement system. The circulars by RBI and Sebi apply only to entities regulated by them. Pension funds, for instance, which are relatively large players in the corporate bond market, haven’t been issued any circular by India’s Pension Fund Regulatory and Development Authority (PFRDA).
Some market participants say that pension funds are likely to be slow adopters of the new system, and one large section of the market may be relatively inactive in the near term. It’s not that pension funds can’t register with clearing houses of stock exchanges, but regulated entities in India generally act cautiously and are unlikely to be proactive in registering unless a circular is issued.
Of course, this could be detrimental for them since a large section of the market, namely banks and mutual funds, will have to compulsorily settle through a clearing corporation. Unless they, too, register, they would have to trade with each other or with brokers, which will entail bigger spreads, and hence higher transaction costs. While this learning happens in the first few months of the new settlement system, trading with at least some of the small pension funds spread across the country could be affected.
This is a classic example of inefficiencies in some sections of the Indian markets because of multiple regulators. The corporate bond market will be governed be Sebi, but participants are regulated by multiple regulators such as RBI, Sebi, PFRDA and the Insurance Regulatory and Development Authority. One may argue that all new ventures have teething problems and that they would eventually get sorted out. But as one market intermediary points out, regulators should be involved in ironing out operational difficulties rather than making things more difficult.
Another example of the confusion caused by having multiple regulators is RBI’s decision to continue with the diktat that all its regulated entities have to necessarily use the reporting platform of the Fixed Income Money Market and Derivatives Association of India (Fimmda) to report their corporate bond transactions. Now that all RBI-regulated entities will be compulsorily settling their trades through clearing corporations, all their trades will be captured, and there’s no need for an additional level of reporting. Quite evidently, this makes the circular on reporting trades redundant.
Perhaps there is need for better coordination among regulators to see the obvious.
In The Money runs every other Tuesday. We welcome your comments at firstname.lastname@example.org