Indian Bond Markets Assessment and Prospects

1. Indian Bond Markets Assessment and Prospects H R Khan Reserve Bank of India FIMMDA Network Event, September 17, 2010

2. Opening Thoughts • Importance of bond markets • Government Bond Market • Provides a risk-free yield curve • Liquid, deep, and broad-based market necessary to facilitate optimal government borrowing • Corporate Bond market • Providing corporate sector a financing avenue complementary to bank finance • Promote financial stability • Two decades of market reform • Covered a lot of ground but a lot still to be done • Times have never been more interesting • Global Crisis is an opportunity to look back and reflect on the road travelled • Look at the issues in a SWOT framework

3. Government securities market (GSM)

4. GSM- Strengths (1) • Large supply of securities • Enabling creation of benchmark securities with sufficient outstanding stock • Issuances across the yield curve • ‘State of the Art’ primary issuance process • Electronic bidding • Faster processing • Flexibility to dispose of securities on the same day

5. GSM-Strengths (2) • Well capitalised and efficient Primary Dealer System • CRAR @ 15%, much above the Basel norms • 100% of the notified amount underwritten • Sound Depository system • Proprietary and custodial accounts • Complete dematerialization • ‘State of the Art’ market infrastructure • Mandatory reporting –NDS • Trading systems – NDS-OM (above 80 percent of trades) • Real time price dissemination • Clearing and settlement system on DvP III • Guaranteed settlement through CCP (CCIL)

6. GSM-Strengths (3) • Availability of instruments and processes • Short sale • ‘When Issued’ • STRIPS • FRBs • Security Financing • Repo • CBLO • Derivatives • IRS/FRA • IRF

7. GSM-Strengths (4) • Predominant holding by residents • No default risk perception – a sovereign will not default on debt in its own currency • marginal susceptibility to exchange rate volatilities • Sophisticated participants • Enabling adoption of advanced techniques and processes • Non participation of RBI in primary market • Facilitating market based price discovery • Close coordination between • debt and monetary managements • monetary and fiscal policies

8. Source: CCIL’s Rakshitra

9. Maturity and yield-Balancing Act Source: RBI’s Annual Report

10. GSM-Weaknesses (1) • Fiscal dominance • Supply outstripping demand • Illiquidity • HTM regime for SLR securities. Any alternative? • Skewed investor base • banks, Insurance Companies and RBI account for sizeable portion of outstanding stock • Active participants with similar IR exposures • Herding

11. GSM-Weaknesses (2) • Absence of Term Money market • Lack of retail interest • Absence of market making • Skewed participation in IRS • Not much activity in • Short selling • When issued • IRFs • Participants’ inertia – Lazy treasuries? • Participants do not come in till liquidity improves • Liquidity will not improve till participants come • Chicken and Egg problem

12. Source: RBI monthly bulletin

13. Opportunities (1) • Latecomer’s advantage - development can be based on wider experience • Tap latent investor base • Nascent pension sector- a potential large investor • Market G-secs as another investment product, not as a mandated product • Enhance liquidity • Increase policy leeway

14. Opportunities (2) • Innovate and introduce new products • To suit diverse investor interests • Inflation Indexed Bonds • Interest Rate Options • Scope for calibrated increase in FII participation • Reduce the load on domestic investors and free domestic resources • To be considered in light of other implications- interest rate and exchange rate volatility

15. Threats (1) • Low volume markets susceptible to manipulation • Underdeveloped domestic markets for hedging products may encourage migration off-shore • Opacity of off-shore markets and difficulty of monitoring and regulation • Lack of sophistication by certain participants • Shallowness of the market • Rapid opening may cause excessive volatility • Slower opening results in losses due to missed opportunities

16. Threats (2) • Pressure for rapid opening of rupee debt market to foreign participation • Sovereign insulated from exchange risk • But the market exposed to Interest Rate and Exchange Rate volatility • Migration to IFRS – implications for valuation and recognition of P & L

17. Corporate bond market (CBM)

18. CBM- Strengths • Jurisdictional clarity • Increased regulatory focus • Dematerialized holding • DvP settlement of OTC trades • Reporting and dissemination of OTC data • Availability of repo facility • Secondary market activity on the rise

19. Source: SEBI

20. CBM-weaknesses • Historically a bank based financial system • Too few public issuances • Preference for bank loans, ECBs or Private Placements • Illiquidity • Predominantly buy and hold investors - cause • Lack of exit options dissuades potential investors- effect

21. CBM-Opportunities and Threats • Opportunities • Enormous scope for expansion of this market • Investment demands of a growing economy particularly huge infrastructure investments • Growing pension sector • Tapping latent investors with innovative products • IFRS norms- symmetrical treatment to loans and bonds • Threats • Shallow markets- risk of volatility, manipulation and unreliable price discovery

22. Bond markets- Way forward

23. Way forward: G-sec market • Widen the investor base • By fine-tuning the delivery channels • Direct access to retail segment in primary issuance • By fine-tuning the trading infrastructure • Direct access to retail segment in secondary market • By active and concerted market making • Banks and PDs to actively undertake market making

24. Way forward: G-sec market • Market G-secs as an investment class • As part of overall portfolio management by participants • Reduce the reliance on regulatory mandates and concessions • Benefits • Increase in market activity • Increased policy leeway

25. Way forward: G-sec market • Enhance activity and broadbase participation in • IRF • Floaters • STRIPS • ‘When issued’ and short sale • Introduce new instruments and products • Inflation Indexed Bonds • Interest Rate Options • To complete markets

26. Way forward: G-sec market • Prepare for migration to new accounting framework • Calibrated opening for foreign participation • Reducing the burden on domestic investors

27. Way forward: Corporate Bonds • Higher activity in corp bonds • To meet the funding gap for corporates and infra sector • Repo in corporate bonds • Review of haircuts and settlement cycle • Introduction of CDS • Expected to encourage participation • Widening of the menu of IRFs • To enable hedging IR risk

28. Parting thoughts

29. Role of FIMMDA in the changing times • More proactive and coordinating role • Higher responsibilities • Reporting platforms for corporate bonds (outright and repo) and CPs, CDs • Introduction of CDS • Feedback on policies • Facilitation of active participation by members • FIMMDA as an SRO?

30. Role of market participants • Market liquidity is a result of active participation from members • Look within • Regulator only facilitates • Market development is a cycle of conception introduction, feedback and review • Participants’ active role is indispensible • New products need more nurturing in the early stages before they become self sufficient

31. Thought for Food “One of the very nicest things about life is the way we must regularly stop whatever we are doing and devote our attention to eating” - - Luciano Pavarotti & William Wright Because “There is no love sincerer than the love of food” - George Bernard Shaw

32. Thank you