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Home / Opinion / Views /  Indian bond trading is in need of better market making

Whether apocryphal or real, it used to be said in the 90s and even the first decade of the 21st century that whenever India’s stock market had to be stabilized, North Block would speak to insurance companies or Unit Trust of India and ask them to intervene. With these big institutions buying shares, a market drop would be brought to a halt. They were not exactly market makers, but stabilizers. When the Reserve Bank of India (RBI) stopped the automatic monetization of the fiscal deficit in 1997 and made the government borrow money from the market, it was necessary to have some entities that would pick up the Centre’s bond issuances, or else funds would not be available to it. These were primary dealers, or PDs, who were paid a commission for playing that role. They came to be known as market makers who would provide buy and sell quotes in the secondary market for government bonds and thus help ensure sufficient liquidity.

When it comes to the country’s corporate bond market, the challenge is different. Here, it’s typically remunerative for a buyer to buy a security and hold on to it till its maturity. Therefore, insurance companies, provident funds and pension funds just love such long-term paper, as they can match the tenure of their assets with liabilities. But this does not add liquidity to the market, and anyone buying a corporate bond today may not find someone to sell it to tomorrow as this market has little trading depth. This had kept several players away. It is in this context that the Securities and Exchange Board of India’s (Sebi) idea of creating market makers holds immense significance.

The fundamental problem here is that a bond is different from a share. A company’s share can easily be bought and sold. It can be exchanged seamlessly because every share in the market is the same slice of ownership. In the case of bonds, however, there are several issuances of a company. Company XYZ may have issued in October 2015 a bond with a face value of 100 that pays 6% interest and is due for redemption in 2030, which will be quoted on exchanges for trading (if it’s being traded). But, in 2021, it is no longer a 15-year bond, but a 9-year paper. Its tenure has changed and hence one needs to understand that its implicit yield, which is based on its prevailing price, will no longer be 100 but higher or lower, depending on the interest rate regime and variations in it. Therefore, the security loses importance, as the market normally uses benchmarks like 5 or 10 or 15 years; and every bond drops in the pecking order once it crosses these thresholds. We seldom hear of an 8- or 9-year paper being bought or sold.

This is a problem with government securities, or G-Secs, too. The 6.10% 2031 paper, which is widely traded, will stop being traded next year once it becomes a 9-year security. Therefore, we need to have market makers who will offer quotes for all major securities and thereby ensure that critical bonds are still available for trading. The market makers that can make a difference are primary dealers or brokers, who can be assigned this role, but they need incentives to perform it.

Playing market maker will involve a cost and hence there should be certain waivers provided to them on trading fees. Second, they can be given preferential access to new issuances, so as to build up an inventory. Third, the mark-to-market (MTM) rules could be waived for a specified period, as valuation differences can affect their profit and loss accounts. At times, it is possible that sparse trading leaves them with excess inventory. Fourth, capital can be made available at a lower cost to market makers, as they require funding for the same. Fifth, trade among market makers can be awarded benefits in terms of fees or easier taxes on gains made.

The development of bond indices is important here. We need to have tradable-bond indices that reflect the price movements of a basket of bonds that they track. These indices can be constructed by a market maker to take into account bond tenures and ratings. Made public, such indices will provide appropriate arbitrage opportunities for investors to come in, and this should generate liquidity in the market for these bonds. To enable indices, the market maker should be allowed access to data on a real-time basis.

Debt markets intrinsically have challenges because of the nature of bonds and their issuers. A single financial institution or non-bank financial company could have as many as 10 issuances a year of varied maturities and interest rates, making each of them a unique instrument. Even in the G-Sec market, where we assume plenty of liquidity, the statistics are interesting. There are presently 94 securities in circulation. Around 2,000 trades take place on a daily basis, of which 75% are in the 5-, 10- and 15-year benchmarks. The rest are scattered and no more than 10-15 securities see over 10 trades a day. Therefore, it is a thinly-traded market, even though the perception is that it is very liquid. The truth is that it isn’t easy to trade even a government security once it loses its benchmark status.

The Indian market for corporate debt needs buoyancy and this has been high on the agenda of our regulators. Market makers are a way out. While success cannot be guaranteed, the idea should be adopted nonetheless, as with credit default swaps. It’s a work-in-progress. Let’s speed it up.

Madan Sabnavis is chief economist, Care Ratings and author of ‘Hits & Misses: The Indian Banking story’.  These are the author’s personal views

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