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

Structure of Debt Marke (Contd)

Trading and Settlements/Clearing Systems

Under market microstructure theory, the market efficiency is significantly influenced by the transaction costs or costs of trading (Box IV.1). The transaction costs are, in turn, determined by the type of trading, clearing and settlement system existing in a market. A well developed market in Government securities requires a system of transparent pricing and allotment, which, in a special sense, refers to information needs. In turn, such a system would imply active market making activity and broad-based participation. The National Stock Exchange (NSE) introduced a transparent screen-based trading system in the wholesale debt market, including Government securities in June 1994. The trading system known as National Exchange for Automated Trading (NEAT) is a fully automated screen-based trading system. The Over the Counter Exchange of India (OTCEI) also started trading in Government securities in July 1997. However, a major part of government securities transaction in the secondary market is operated through over-the-counter negotiated deals. The brokers, who are members of the NSE and OTCEI can transact business on behalf of commercial banks. The OTCEI and NSE markets complement each other. As announced in the Mid-term Review of Monetary and Credit Policy for 2000-01, the Reserve Bank has taken an in-principle decision to move over in due course to order-driven screen-based trading in Government securities on the stock exchanges. The screen based trading system would be applicable to all stock exchanges on which banks and FIs can operate.

The presence of a fast, transparent and efficient clearing system constitutes the basic foundation of a well-developed secondary market in Government securities. In India, a major step in this direction was the establishment of the DvP system. The Reserve Bank presently operates a Government securities settlement system for those having Subsidiary General Ledger (SGL) Accounts in its Public Debt Offices through DvP System. The DvP system ensures settlement by synchronising the transfer of securities with the cash payment. This reduces settlement risk in securities transactions and also prevents diversion of funds through SGL transactions.

Under the current system, banks, financial institutions, insurance companies and now PDs are allowed to hold SGL Accounts for securities and Current Accounts for cash. For these participants, the settlement takes through the DvP system. Other participants like corporates, mutual funds, provident funds, cooperative banks and societies and individuals are not allowed to hold direct SGL Accounts with the Reserve Bank. However, the SGL account holders are provided the facility to maintain a second SGL Account called Constituents' SGL Account with the Reserve Bank to enable them to hold Government securities on behalf of their constituents.

The secondary market transactions in Government securities (through SGL Accounts), as published from September 1994, have witnessed significant growth with an average annual growth rate working out to 91 per cent during the period 1994-95 to 1999-2000. This reflects the increased depth of the Government securities market (Table 4.5). The average annual transactions increased by 10-fold between 1994-95 and 1999-2000. The composition of transactions reveals that the share of outright transactions consistently rose from 42.1 per cent in 1994-95 to 84.7 per cent in 1999-2000. The steady growth in outright transactions is an evidence of the emergence of a more liquid and matured Government securities market.

Auctions have contributed to the development of bidding skills among banks and institutions. Banks, in particular, have been paying special attention to treasury operations as they could become centres of profit. An elastic band of interest responsiveness from the investors as part of active investment management to a range of maturities is an important step in the process of competitive pricing of securities in the primary and secondary markets. The interest rates on Government securities are now within the range of substitutability where rate movements evoke a response from investors leading to a possible confluence of interest rates in the system.

Since the switchover to the market mechanism for issuing securities, the primary issues of the Central Government have reflected a more than ten-fold increase. However, with the emergence of an active Government securities market, the Reserve Bank's absorption of primary issues came down drastically from 45.9 per cent in 1992-93 to 1.45 per cent in 1993-94 and to barely 0.74 per cent in 1994-95, partly reflecting the rise in market absorption. However, in recent years, the primary subscription by the Reserve Bank has remained high (29.4 per cent in 1999-2000), reflecting the unfavourable market conditions at the time of issuances. The monetary impact of the Government borrowings was contained by offloading these securities in the market at a favourable time through an open market operation of the Reserve Bank. Thus, an active use of open market operations to ensure the success of the borrowing programme and the lesser reliance on the Reserve Bank is a reflection of the depth acquired by the Government securities market. Market orientation to issues of Government securities paved the way for the Reserve Bank to activate open market operations as a tool of market intervention.

The corporate debt market still constitutes a small segment of the debt market despite policy initiatives taken during the 'nineties. The interest rate ceiling on corporate debentures was abolished in 1991 paving the way for market based pricing of corporate debt issues. In order to improve the quality of debt issues, all publicly issued debt instruments, irrespective of their maturity, are presently required to be rated. The role of trustees in case of bond and debenture issues has also been strengthened over the years.

A large proportion of corporate debentures in India is of hybrid variety combining features of both debt and equity. The corporate sector has been issuing debt instruments of longer maturity, incorporating features of liquidity and often at floating rates of interest. Besides the public issue of debt instruments, the private placement route has also emerged as an important mode of floatation of new corporate debt issues during the 'nineties. During 1999-2000, the private sector debt issues in the private placement market amounted to Rs.18,122 crore, as against Rs.2,401 crore by way of public and rights issues. Some privately placed debt-instruments are subsequently listed on stock exchanges for trading.

DFI bonds have emerged as an important segment of the debt market. During the last 8 years or so, DFIs made large issues of bonds in varying maturity ranging from 1 year to as long as 20 years. Some of the bond issues of DFIs offered innovative features including call and put options at various points of time during the currency of the bonds. DFIs have issued bonds by way of public issues as well as on a private placement basis. 4.88 Since the middle of the 'eighties, long-term bond issues (maturity 5-10 years) by public sector undertakings (PSUs) imparted a new dimension to the debt market. Resource mobilisation through PSU bonds, which included both tax free and taxable bonds, increased sharply to touch Rs.5,663 crore in 1990-91, of which 44.9 per cent was accounted for by tax-free bonds. The 'nineties, however, witnessed a steady decline in the issue of tax-free PSU bonds, accounting for only 4.6 per cent of PSU bonds (Rs.8,622 crore) during 1999-2000. While traditionally most of the PSU bonds were floated in the public issues market, in the recent years, most of such bond issues were privately placed. This is one reason why secondary market activity in PSU bonds has been limited.

The secondary market activity in the debt-segment, in general, however, remains low and subdued both at BSE and the Wholesale Debt Market Segment of the NSE, partly due to of lack of sufficient number of securities and partly due to lack of interest by retail investors. In order to improve the secondary market activity in this segment, the Union Budget for 1999-2000 abolished stamp duty on transfer of dematerialised debt instruments.