Project on Indian Financial Market Structure
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Structure of Debt Market

The domestic debt market comprises two main segments, viz., the Government securities and other (mainly corporate) securities comprising private corporate debt, PSU bonds and DFIs bonds. The government securities market is pre-dominant, while the other segment is not very deep and liquid.

The size of the Government securities market is large and is growing. This is evident from the fact that secondary market transactions in Government securities increased to Rs. 5,39,255 crore in 1999-2000 as against Rs. 1,27,179 crore in 1995-96.

The Government securities market witnessed significant transformation in the 'nineties. Its development was constrained mainly by lack of definite limits on the automatic monetisation of the Central Government budget deficits and by relatively low coupon rates offered on the Government securities. The artificially low yield on Government securities had an impact on the entire yield structure of financial assets in the system. Both these factors were corrected during the 'nineties. As regards the secondary market, there was not much activity which was hindered by low bond yields and predominence of captive investors. The secondary market activity increased following the introduction of auction based yields. The activity in the secondary market could further pick up once bond yields are better aligned and investors, other than institutions (banks and insurance companies) start actively transacting in the market.

As a part of developing money market instruments, a variety of Treasury bills, viz., 14-day, 91-day, 182-day, 364-day maturities have been introduced. Innovations have also been introduced with respect to long-term bonds, which include zero coupon bonds, floating rate bonds and capital indexed bonds.

An event of significance to the gilt market was the introduction of auction system for dated securities in June 1992, marking a move to market related rates on the Government securities. The important objective to be achieved through the auction system was the process of price discovery. At present, the sale of Government securities in India is done both through auction method as well as pre-determined coupon/tap issues. Auctions are of the discriminatory/multiple price, sealed bid type. The multiple price auction is the mostly used selling technique. The sale of Treasury bills is conducted through the auction method. Apart from the allotment through auction, the practice of entertaining non-competitive bids in Treasury bills to State Governments, non-government provident funds and other central banks at the weighted average price determined in auctions also exists. Non-competitive bids are, however, accepted outside the notified amount. This is done to encourage participants who do not have sufficient expertise in such bidding. The Reserve Bank also participates on a non-competitive basis in Treasury bills and dated securities to primarily take up some part of the issues in case of under-subscription. In the recent years, with a view to moderating the market impact of the large borrowing programme on interest rates, the Reserve Bank has accepted private placement of government stocks and released them to the market when the interest rate expectations turned out to be favourable.

With a view to eliminating the problem of "winner's curse", associated with the multiple price auction, and broadening the market participation, the uniform price auction method was introduced in respect of 91-day Treasury bill. Since 1999-2000 most of the current primary issues of dated securities are through re-issues and price-based auctions, instead of yield-based auctions, to enable consolidation of securities. Such consolidation is necessary for ensuring sufficient volumes and liquidity in any one issue and to facilitate the emergence of bench-marks and development of Separately Traded Registered Interest and Principal of Securities (STRIPS).

While there exists a fixed calendar for auctions of all types of treasury bills, auctions/ issues of dated securities are not based on any fixed calendar (Table 4.3). However, the auction/ issue of Treasury bill and dated security is announced in advance through a public notification. While the 14-day and 91-day Treasury bills are auctioned on a weekly basis, the auctions of 182-day and 364-day Treasury bills are held on a fortnightly basis. The treasury bills/bonds are issued to successful bidders in the form of stock certificates or by credit to their Subsidiary General Ledger Account.

The main investors in the Government securities market in India are commercial banks, co-operative banks, insurance companies, provident funds, financial institutions (including term-lending institutions), mutual funds especially the gilt funds, primary dealers, satellite dealers, non-bank finance companies and corporate entities. The Reserve Bank also absorbs primary issuance of Government securities, either through private placement or devolvement. Though banks have traditionally been the dominant investors in the Government securities due mainly to SLR requirements, they have, in recent years, found it advantageous to invest in the Government securities beyond the statutory requirements partly because of the better risk-return characteristic of such securities in the context of adherence to capital adequacy requirements and partly because of relatively sluggish demand for commercial credit. The share of commercial bank holdings continued to rise during the 'eighties and the early 'nineties. It reached a peak of 72.5 per cent as at end-March 1994 before declining to 59.5 per cent as at end-March 1999 (Table 4.4).

A large participant base reduces the borrowing cost for the Government, reduces market volatility and imparts competition in the market. A market with adequate depth and liquidity for participants with different perceptions and liquidity requirements should emerge; this is also essential to avoid unidirectional movements in the market. The present structure of the Government securities market is pre-dominantly institutional, while the household participation is negligible or nearly absent. Foreign Institutional Investors (FIIs) are also permitted to invest in the dated Government securities and Treasury bills, both in the primary and secondary markets, within the overall debt ceilings. While FIIs are allowed to invest in the debt up to a maximum of 30 per cent of their total investments, there is no such limit for dedicated debt funds.

In order to promote the retail market segment and provide greater liquidity to retail investors, the Reserve Bank allowed banks to freely buy and sell Government securities on an outright basis at prevailing market prices, removing restriction on the period between sale and purchase. Furthermore, the interest income on government securities was exempted from the provision of Tax Deduction at Source (TDS) with effect from June 1997, facilitating quotations at 'clean prices' and genuine trading in the secondary market.

A crucial issue in the development of the Government securities market is the need for a well functioning secondary market, which requires (i) a transparent system of trading; (ii) a secure system of settlement of transactions; (iii) an institutional structure whereby the market players have divergent perceptions about liquidity and interest rates; and (iv) a liquid market with a matured system of price determination.

To develop the secondary market for the Government securities, the following measures were initiated.

The central banks often play the role of market makers providing two-way quotes through their sales window to infuse liquidity in the secondary market for the Government securities. Generally, two approaches are adopted for operating the secondary market window by the central banks: (i) fixing buying and selling prices and announcing them to the market, and (ii) using a dynamic approach whereby the secondary market window pricing is continuously adjusted in response to the market dynamics. During the initial stages of market development, the Reserve Bank used to announce the sale and purchase prices of securities. In the recent period, however, the Reserve Bank has offered a select list of securities for sale, depending upon supply and demand conditions. A few securities are also included in the purchase list, with a view to improving liquidity through select securities. The sale/purchase prices and the securities offered on sale are frequently revised.

The DFHI was originally set up in April 1988 for developing the money market. It was also allowed to participate in Treasury bills and dated securities. Further, for developing an efficient institutional infrastructure for an active secondary market in Government securities and public sector bonds, the Securities Trading Corporation of India (STCI) was set up in May 1994. Both DFHI and STCI later transformed themselves into PDs.

The primary dealer system was evolved and made functional in 1996 with the objective of strengthening the securities market infrastructure and bringing about improvement in the secondary market trading, liquidity and turnover in Government securities as also encouraging their voluntary holding amongst a wider investor base. PDs have ensured maximum participation in the auctions of Government securities. In the secondary market, they act as market makers by providing continuous two-way quotes thereby ensuring liquidity and support to the success of primary market operations. The system also creates appropriate conditions for open market operations of the Reserve Bank and facilitates the transfer of market making activities from the Reserve Bank to the market agents. 4.76 As on March 31, 2000, there were 15 approved PDs in the gilts market. The Reserve Bank guidelines specify that the institutions willing to register as PDs should have sufficient and continuous presence in the Government securities market and a certain minimum financial capacity (minimum net owned funds of Rs.50 crore). A PD commits bids in the auction for a minimum amount in the Central Government dated securities and Treasury bills, maintains a minimum level of success ratio, underwrites predetermined parts by which subscriptions/accepted bids fall short of the notified amounts, offers two-way quotes for Government securities and achieves an annual turnover of not less than five times in Government dated securities and ten times in Treasury bills, within which outright transactions should be three and six times, respectively. In return to such obligations, the Reserve Bank extends to them facilities like current account/SGL account, liquidity support linked to bidding commitments, freedom to deal in money market instruments and favoured access to open market operations. The primary market purchases of PDs in Government securities and Treasury bills rose from Rs.20,835 crore in 1996-97 to Rs.53,797 crore in 1999-2000. The secondary market turnover (outright plus repos) of PDs also recorded significant growth from Rs.90,453 crore to Rs.3,34,471 crore during the same period.

With a view to broadening the market with a second tier of dealer system in trading and distribution and imparting greater momentum in terms of increased liquidity and turnover, a system of SDs was put in place in December 1996. The Reserve Bank had granted registration to 9 entities as SDs in the Government securities market. The network of satellite dealers provides retail outlets thereby encouraging voluntary holding of Government securities among a wide investor base. The SDs are also given limited liquidity support from the Reserve Bank. It may be noted that some of the SDs have become PDs. At present 4 SDs are in operation. The scheme for approval of both PDs and SDs has been made an ongoing process. However, the response to the scheme of SDs has been limited so far.

The Reserve Bank also encouraged setting up of mutual funds dealing exclusively in gilts, called gilt funds with a view to encouraging schemes of mutual funds dedicated to Government securities and creating a wider investor base for them. Mutual funds dedicated exclusively to investment in Government securities are also provided liquidity support by the Reserve Bank by way of reverse repos in Central Government securities outstanding at the end of the previous calendar month. The liquidity support provided by the Reserve Bank would be to the extent of 20 per cent of the investment in Government dated securities.