Indian Securities Market : Interesting Times

1. Indian Securities Market : Interesting Times Presentation at the Continuum 2003 August 23, 2003

2. Our Capital Markets have a long history • The Bombay Stock Exchange was set up in 1875! • The markets acquired breadth and size in the late 80s and early 90s • Initial momentum provided by MNC dilution • Followed by a spate of public issues • And now, PSU divestments • Till recently, the Indian markets lacked the depth in terms of players and asset classes • As a result, the retail stakeholder was the venture capitalist, speculator and investor – all in one

3. There are no innovations yet……..Just alignment with Global Markets • The Indian Capital Markets today present a vastly different picture from what it was a decade ago : • Lots of checks and balances with efficient and electronic trading, and settlement systems • A range of players that include mutual funds, FIIs, hedge funds, corporates and other institutions • Expansion of asset classes • From offer price to price discovery, GDR to reverse ADRs • There is however, very little innovation as such – we are just getting aligned with global practices

4. The drivers for transition SEBI, RBI Policy and Regulation Electronic Trading, Settlement systems The National Stock Exchange MFs, FIIs, Hedge Funds, Pvt Equity investors, Prof Fund Mgr, Pvt Bkg arms of Banks Players Private equity, debt, Equities, derivatives Asset Classes ICRA, FITCH, CARE, CRISIL Rating Agencies Accounting Standards

5. The impact of transition is all pervasive • Profile of CFO changed from an Accountant to a Corporate Finance Specialist • Emergence of a new breed of Institutional Intermediaries • Extensive use of securities markets by corporates and Government to achieve fiscal objectives and to manage risks

6. Brady Bonds : A Digression • Brady Bonds are a classic example of use of capital markets by Governments • The Brady Plan was originally implemented to bail out Mexico and other Latin American countries from an acute debt crisis • Subsequently, the Brady Plan has become accepted internationally as a methodology to restructure and rehabilitate a sovereign debt profile

7. Brady Bonds : The Concept • In essence, the Brady Plan improved near term debt service capacity by : • Undertaking a structural reform program • Exchanged loans for bonds with strong and recognized collateral • Reduced near term debt service requirements by extending the maturities of the bonds • Opened up access to the capital market • The depth of the Indian financial system and its capital market provides an opportunity to formulate a similar operation

8. The Brady Bond Framework • The Brady framework allowed for multiple options to restructure commercial debt : • Loans for a series of new 30 year sovereign bonds at fixed but below market rates • Discounted value of the loans (usually 35%) for floating rate bonds • New loans, over four year period to cover 25% of old loans and restructuring payments • Investors chose their options based on their view on interest rate movements, and the prospects of economic recovery • The Brady bonds were collateralized by US Treasury zero coupon securities of similar maturities along with a partial guarantee for interest payment

9. Indianising the Brady Bonds • The Brady bonds essentially provided Governments with the elbow room to restructure the local economy back into health • State Government’s high cost non-SLR capital market borrowing could be securitized in the fashion of the Brady bonds • Such an approach would complement the restructuring efforts of State Government with respect to their finances • Obviously, a key objective is to ensure that such a programme is not merely a quick fix band-aid solution catering to short term requirements • A necessary condition would be defined measures to be implemented by the State that is assisted, and to sustainsuch measures over time

10. Coming Back to Indian Markets….. • Some of the major developments in the markets have been in the area of : • Primary markets • Extent of Participation of Institutional Players • Introduction and progress of Derivatives • Settlement and monitoring systems • We will focus on Derivatives

11. What are Derivatives? • Hedging instruments • A contract between two parties to buy / sell a commodity at a future date at a pre-defined price • Derivatives could be structured on several underlying products ranging from commodities, to securities to the weather

12. Derivatives – A journey well begun Exchange traded OTC • June 2000 – Equity Index futures • June 2001 – Equity Index options • July 2001 – Stock Options • November 2001 – Stock futures • June 2003 – Interest rate futures • 1980s – Currency Forwards • 1997 – Long term FC –Rupee swaps • July 1999 – Interest rate swaps and FRAs • July 2003 – FC-Rupee options November 2002 - RBI Working group on Rupee derivatives March 2003 - RBI Working group on credit derivatives

13. Derivatives – Acquiring size Introduction of new products have resulted in increased volumes • Notes: • Gross turnover in interbank Spot and forward markets for FY’02 • Estimated annual turnover for FY’03 for GOISec, Corporate bonds and Swaps • Gross turnover on BSE and NSE during FY’03

14. Growth in derivatives

15. Interest rate derivatives • Launched on June 24, 2003 • Short end : • 91D T-Bill • Long end : • 10 year zero coupon • 10Year notional coupon bearing • Basis: NSE ZCYC • Participants: • Banks, FIs, FIIs, MFs, Corporates, HNIs

16. Market structure and regulation • Interest rate Futures • Current contract design leads to large basis risk between futures and cash market • Need for wider set of benchmarks • Regulatory restriction on Banks • IRF can be used only for hedging and not trading • Strict hedge definition applicable only to IRFs • Restriction on short selling in cash market

17. Market Structure and regulation • Derivatives usage by corporates • Can use OTC derivatives for hedging purpose only • No such restriction in case of exchange traded derivatives • Accounting and tax treatment • Lack of comprehensive guidelines for accounting and tax treatment • Balance sheet disclosures • Fair value and purpose

18. IRD - the future…. • Statutory approvals – RBI, IRDA • Increase in volumes • Increase in liquidity • Enhanced participation • More products • Options • MIBOR and MIFOR based • Baskets

19. The Road Ahead He who predicts the Future is a Liar Even if he is telling the truth Koran Having said that, it is quite clear that in future all changes will be profound and rapid and all market participants have to understand and keep pace with these changes

20. " Although the benefits and costs of derivatives remain the subject of spirited debate, the performance of the economy and the financial system in recent years suggests that those benefits have materially exceeded the costs." Alan Greenspan “We view them as time bombs both for the parties that deal in them and the economic system. In our view derivatives are financial weapons of mass destruction (WMD), carrying dangers that, while now latent, are potentially lethal.” Warren Buffet