Ownership Pattern of Central and State Government Securities – The Indian Financial System: Markets, Institutions and Services, 3rd Edition

Ownership Pattern of Central and State Government Securities

The subscribers to government securities are the RBI, commercial banks, insurance companies, mutual funds, provident funds, and others.

As is seen from Table 10.9, notwithstanding various reform measures to develop and widen the primary market for government securities, the market continues to be dominated by captive investors such as commercial banks and insurance companies. Banks have traditionally been the dominant investors of the government securities due to SLR requirements. The investment of commercial banks constitutes, on an average, 57 per cent of the stock of government securities even though the SLR of the banks was significantly lowered to 25 per cent in 1997. Banks have found it advantageous to invest in government securities beyond the statutory requirements due to attractive market related interest rates offered since 1992–93, zero-risk nature of these securities, and depressed commercial credit market.

 

  • Market borrowings of the central government increased substantially and had an adverse effect on interest rates. To curb an increase in interest rates, the central government needs to curtail its borrowing programme.

This narrow ownership base has a two-fold implications for the government. First, the large magnitude of borrowing puts pressure on the absorptive capacity of the market, particularly when the commercial banks hold excess government securities. Therefore, their choice regarding further subscription to government paper depends upon the attractiveness of return on other competing assets, particularly on loans and advances. When the industrial outlook improves and the demand for credit takes off, banks may not show their willingness to subscribe to government securities. Secondly, the concentration of the debt market in a few large investors introduces an element of rigidity in the downward adjustment of interest rate on government securities, particularly in the event of fulfilling the targeted market borrowing programme of the government.

 

TABLE 10.6(c) Market Borrowings of the Central and State Governments and Their Sponsored Institutions

 

Source: RBI, Annual Report, various issues.

 

TABLE 10.7 Gross and Net Borrowings of Central and State Governments

 

Note: Gross and Net Market Borrowing of the centre include normal market borrowings, other medium-and long-term borrowings and 364-day treasury bills.

GFD: Gross Fiscal Deficit.

Source: RBI, Annual Report, various issues.

 

TABLE 10.8 Measures of Deficit of the Central Government

 

Note: The gross fiscal deficit is the excess of total expenditure including loans, net of recoveries over revenue receipts (including external grants) and non-debt capital receipts. The net fiscal deficit is the difference between gross fiscal deficit and net lending. The revenue deficit is the difference between revenue receipts and revenue expenditure.

Source: RBI, Handbook of Statistics on Indian Economy, various issues. RBI, Annual Report, various issues.

 

TABLE 10.9 Ownership Pattern of Central and State Government Securities (Percentage to Outstanding Government Securities)

 

Source: RBI, Hand Book of Statistics on Indian Economy, various issues.

 

The RBI's holding of government securities declined steeply in 1994–95 to 2.0 per cent from 20.3 per cent in 1990–91. This reflects that the government securities market has developed after reforms. However, this trend reversed in 1997–98 with the surge in the RBI's holdings to 10.7 per cent as special securities in the bank's portfolio were converted to marketable lots with a view to facilitating open market operations.

The Reserve Bank's absorption of primary issues: Table 10.10 shows that the RBI's absorption of primary issues came down drastically from 49.3 per cent in 1990–91 to 1.8 per cent in 1994–95. This was due to the higher absorptive capacity of the market. The RBI's subscription increased in the year 1998–99 due to the central government's recourse to gross market borrowings; and to contain the impact of high government borrowings, it privately placed the issues with itself. The monetary impact of the government borrowings was contained by offloading these securities in the market at a favourable time through open market operations (Table 10.11).

 

  • The largest investors in government securities are banks and insurance companies

  • The RBI's subscription to primary issues has substantially declined

The Fiscal Responsibility and Budget Management (FRBM) Act, 2003 stipulates that the Reserve Bank cannot participate in the primary auctions of government securities from April 1, 2006. As seen in Table 10.10, the Reserve Bank's subscription to primary issues substantially declined during 2004–05 and during the year 2005–06, gross issues of Rs. 10,000 were privately placed with the Reserve Bank at the end of the year. The RBI did not subscribe to primary issues of the central government during 2007–08 and 2008–09.

Maturity structure of central government dated securities outstanding : With a move towards market related interest rates for meeting the borrowing requirements of the central government, there has been a significant shift in the maturity pattern of central government dated securities. A significant transformation in the maturity structure is clearly seen in Table 10.12. The maturity structure of dated securities was highly skewed at the short end. The government's heavy dependence on short-to medium-term securities for the mobilisation of market borrowing was due to uncertainty in market conditions and investor's preference for short-term maturities. Moreover, it was a conscious policy on the part of the government to minimise the cost of borrowing by placing a large part of the borrowings at the shorter end of the market. This maturity structure tilted towards short-term securities which led to significant higher gross borrowings to adhere to the repayment schedule. To avoid such high cost borrowings and redemption pressure entailing refinance risk, the government has avoided excessive maturities at the short end and the trend is towards issue of long-term securities since 1999–2000.

 

TABLE 10.10 The RBI's Subscription to Primary Issues of Central Government Securities

 

Source: RBI, Annual Report, various issues.

 

TABLE 10.11 Change in Reserve Bank's Holding of Government Securities (G-Sec) Through Private Placement, Devolvement and Open Market Operation (OMO)

 

Source: RBI, Annual Report, 2008–09.

 

TABLE 10.12 Maturity Profile of Central Government Dated Securities

 

Source: RBI, Annual Report, various issues.

 

About 65 per cent of the total primary issues was raised through securities of above 10 years maturity in 1999–2000 as against 14 per cent in 1998–99. Securities over 10-year maturity constituted the largest share in the outstanding stock of securities as well as in new issuances. The market participants also found the long-term paper to be attractive due to low inflationary expectations and improvement in liquidity. As a result, the weighted average maturity of dated securities during 1999–2000 increased to 12.64 years from 7.7 years in 1998–99 and 6.6 years in 1997–98. The weighted average maturity of debt dropped from 12.64 years to 10.6 years during 2000–01. This was due to the issue of short-term securities to accommodate the market's preference for short-term paper during the phases of market uncertainty. The weighted average maturity again rose to 14.3 years in 2001–02, 13.8 years in 2002–03 and 14.9 years in 2003–04. The low inflation rate and development of the government securities market helped in the successful elongation of maturity.

The weighted average maturity of the primary issues of dated securities rose to 16.9 in 2005–06 a recent high till now (Table 10.13) as 74 per cent of the securities issued during the year were of a maturity above 10 years (Table 10.12). This was on account of higher demand for government securities from non-bank participants such as insurance companies and provident funds. However, the weighted average maturity declined in the subsequent years.

 

  • Securities over 10-year maturity constituted the largest share in the outstanding stock of securities as well as in new issuances

Interest rates in the primary market: The yield rates in the primary market refer to the interest cost at which the government borrows from the market. The interest rates in the primary market are influenced by the prevailing liquidity conditions, RBI's intervention by way of devolvement and private placement, and amount and frequency of issues during the year.

The weighted average interest rate of dated securities of the centre progressively rose from 11.41 per cent in 1990–91 to 13.75 per cent in 1995–96 (Table 10.13). The increased recourse to borrowing from the market and spells of tight liquidity put pressure on interest rates. Since 1996–97, the interest rates have declined; in the year 1999–2000, the interest rates were very close to the interest rates in 1991–92. Inspite of an increase in the market borrowing of the central government, the RBI was in a position to contain the interest rates. The RBI accepts the private placement of government stocks and releases them to the market when interest rate expectations become favourable. This policy of the RBI moderates the adverse impact of large borrowings by the central government. Moreover, liquidity conditions also softened in the money market which helped in containing the interest rates. The yields on primary issues of dated government securities eased during the year 2003–04. However, in the subsequent years there was a sharp increase in the weighted average interest rates of dated securities on account of hardening of interest rates and tight liquidity conditions (Figure 10.1).

 

  • Yield curve depicts relationship among yields of securities that differ only with respect to their term of maturity

Yield curve: The shape of the yield curve reflects the relationship among yields of securities that differ only with respect to their term of maturity. The curve depicts the various rates at which the same borrower is able to borrow for different periods of time. The most closely watched yield curve in any country is that of the government securities’ which is the closest approximation of a risk-free yield. Other yield curves, such as the one for corporate borrowers, are best understood in comparison with the risk-free yield.

The yield curve is drawn against two axes: the vertical showing yield and the horizontal giving the term in years. The precise shape of the yield curve varies slightly from day-to-day and can change significantly from month to month. Normally, a yield curve is upward sloping which indicates a higher yield for longer maturity security. If long-term interest rates rise relative to short-term interest rates, the curve steepens. If short-term interest rates rise relative to long-term rates, the curve flattens.

A number of studies confirm that the slope of the yield curve contains significant information about the future path of macro-economic variables in a number of countries. The yield curve is used to forecast short-term interest rates. When investors repeatedly purchase money market instruments rather than long-term instruments, and if a steeper yield curve emerges, it implies that they expect the money market yield to be higher in future than it is now. An inverted yield curve emerges when short-term interest rates are higher than long-term interest rates. Such a yield curve indicates that there is credit squeeze by the central bank. This credit squeeze is based on lower inflation expectation. Hence, investors in longer term instruments willingly accept lower nominal interest rates than one available on short-term instruments. This behaviour leads to an inverted yield curve.

Box 10.3 Yield and Bond Prices

The price of a bond in the market is dependent on forces of demand and supply, economic conditions, general money market conditions, interest rates prevalent in the market, future interest rate expectations, and credit quality of the issuer.

Yields and bond prices are inversely related. When the interest rates in the market rise, the price of outstanding bonds will fall until the yield of these bonds is high enough to match the high interest rates on the new bond issues and the effect is vice versa when interest rates fall.

After a three-year period of positive returns on the notional one-year zero-coupon bond, negative returns were experienced in 2004 as the interest rates had gone up. An increase in interest rates leads to a fall in the bond prices which results in negative returns.

 

TABLE 10.13 Yield and Maturity of Centre's Primary Issuances

 

Source: RBI, Annual Report, various issues.

–: No issues.

YTM: yield to maturity.

 

TABLE 10.14 Yield Spread (In Per Cent) Based on Primary Yield Rates

 

Source: RBI, Annual Report, various issues.

RBI, Report on Currency and Finance, various issues.

 

Varying liquidity conditions and lack of adequate trading depth in the secondary market for government securities caused frequent shifts in the term structure of interest rates in the primary market.

The yield curve became inverted in 1993–94 due to spells of tight liquidity conditions. A downward shift was witnessed in 1994–95 but it shifted upward again in 1995–96 and 1996–97. Differences in the short and long-term inflationary expectations and temporary imbalances in the short-term money market and foreign exchange markets led to an inverted yield curve. The yield curve declined in 1997–98 and 1998–99 due to the RBI's policy of private placement to itself and a comfortable liquidity position in the money market. The yield curve of 2001–02 reflects a decline in both short and long-term yield rates. The yield curve flattened during 2003–04 as the long-term yields fell due to surplus liquidity. The yield curve shifted upwards during the year 2006–07 and 2007–08 with the increase in the interest rates across the maturity spectrum (Figure 10.1).

 

  • The shape of the yield curve provides information about market expectations of future interest rates and inflation rates

Yield spread : Yield spread is the yield differential of an instrument over the previous year or yield differential in case of two instruments of differing maturities. The components of yield spread are term risk premia and inflation expectations. The yield spread carries important information on the stance of the monetary policy and future economic activity.

Table 10.14 presents information about yield differential over the previous year in case of the same instrument and yield differential in case of two instruments of differing maturities.

 

  • Yield spread is the yield differential of an instrument over the previous year or yield differential in case of two instruments of differing maturities

During 1994–95 and 1995–96, the yield differential was positive in case of the 91-day and 364-day treasury bills due to spells of tight liquidity conditions. Easy liquidity conditions were reflected in the softening of interest rates in securities across the maturity spectrum during 1996–97 and 1997–98. The yield spread between 91-day and 364-day treasury bills, 91-day T-bill and 5-year paper, and 91-day T-bill and 10-year paper, declined substantially by 149 basis points, 177 basis points, and 87 basis points respectively in 1997–98. This depicted declining inflationary expectations in view of reduction in inflation since 1995–96. The lower spread shows that either the short-term rates were too high or the long-term rates low which did not reflect the higher risk premium required for long-term paper.

 

 

Figure 10.1 Weighted Average Coupon Rates on Government of India Dated Securities

 

However, the spread between 91-day and 364-day treasury bills increased in 1998–99 as the implicit yield at cut-off prices ranged on the higher side on account of a rise in the repo rate so as to contain pressure in the forex market. The yield differential and the yield spread declined in 1999–2000 and 2000–01 due to low inflationary expectations, stable call money market conditions, and improvement in liquidity. The yield spread between 91-day and 364-day T-Bills was positive at 15 basis points in March 2006.

 

 

Source: RBI, Macro-economic and Monetary Developments, pg 8, July 26, 2010.

 

Figure 10.2 Yields on Central Government Securities

 

The yield spread between one year and 10-year yields narrowed to 65 basis points by end-March 2008 from 146 basis points as at end-March 2006. The yield spread between 10-year to 20-year segment narrowed from 45 basis points during 2005–06 to 38 basis points during 2007–08. The yield spread between 5-year government securities and AAA-rated corporate bonds widened during 2007–08 because of increase in inflationary pressures. The yield spread widened to 106 bps and 151 bps at end-March 2007 and 2008, respectively (Table 10.15), on account of higher inflationary expectations.

Government Dated Securities—Secondary Market

Secondary market in government securities can be categorised into two segments: the wholesale institutional segment and the retail segment.

  • The wholesale institutional segment consists of active traders, mainly large banks, primary dealers, mutual funds, insurance companies, and others. The securities are traded in the SGL form and the market lot is Rs. 5 crore. The secondary market for government securities is wholesale in nature, with most deals negotiated over the telephone. The trade is generally closed on the telephone which are then reported on the wholesale debt market segment of the NSE. Trade is then settled through the RBI which acts as a depositing-cum-clearing house.

  • The retail segment includes cooperative banks, provident funds, non-banking finance companies, and others. The securities are traded in the SGL or physical form and the lots are odd, that is, less than Rs. 1 crore. Trades are settled directly by the counter-parties and these trades may or may not be reported on the exchange. The high costs involved may not make it viable for the broker to report the transaction on the exchange.

 

TABLE 10.15 Yield Spread (Long-term Papers) (In Basis Points)

 

Source: RBI, Annual Report, 2007–08.

 

With a view to promoting the retail market segment and providing greater liquidity to retail investors, banks were allowed to freely buy and sell government securities on an outright basis at prevailing market prices, without any restriction on the period between sale and purchase. Banks were permitted to undertake transactions in securities among themselves or with non-bank clients through the members of the OTCEI in addition to the NSE.

The interest income on government securities was exempted from the provisions of tax deduction at source with effect from June 1997 to facilitate quotations and trading in the secondary market. At present, the government securities market is predominantly institutional.

Trading system: Government securities do not have to be listed on an exchange. All government securities are ‘deemed’ listed as and when they are issued.

The NSE was the first stock exchange to introduce a transparent, screen-based trading system in the wholesale debt market including government securities, in June 1994. Prior to the commencement of trading in the WDM segment of NSE, the only trading mechanism available in the debt market was the telephone. The NSE provided, for the first time in the country, an online, automated, screen-based system known as the National Exchange for Automated Trading across a wide range of debt instruments. This system is an order-driven system which matches the best buy and sell orders on a price time priority and simultaneously protects the identity of the buyer and seller. Trading under this system leads to a risk-free, efficient price mechanism and transparency. The trades on the WDM segment could be outright trades or repo transactions with a flexibility for varying days of settlement (T + 0 to T + 1) for non-government securities and T + 1 for government securities. In case of repo transactions in government securities, first leg can be settled either on T + 0 or T + 1 basis. Order matching is carried out only between orders which carry the same conditions with respect to settlement days, trade type, and repo period, if any.

The OTCEI also started trading in government securities in July 1997. The NSE and OTCEI members are authorised to transact business on behalf of commercial banks. Non-banking clients may also trade via brokers. In order to provide another platform for trading in government securities, the RBI permitted trading in government securities at the BSE in October 2000. The trading, however, commenced in June 2001. Since 2000–01, trading in government securities is order-driven screenbased on all stock exchanges.

Settlements: Government securities can be held and transacted in two forms—dematerialised SGL form and physical form. Registration of the participant with the public debt office of the RBI is mandatory in case of holding and trading securities in the physical form. All trades in government securities are reported to RBI-SGL through the negotiated dealing system (NDS) of RBI. The Clearing Corporation of India Limited (CCIL) provides settlement guarantee for transactions in government securities.

Subsidiary general ledger account: The RBI acts as a depository-cum-clearing house and settlement is through accounts maintained with the RBI called the subsidiary general ledger (SGL) accounts. The physical securities are dematerialised and the relevant holdings are in the form of book entries. Every participant in the government securities market maintains SGL and current accounts with the RBI. Those not eligible to maintain direct accounts with the RBI have the facility to open constituent SGL accounts or SGL II accounts with banks who have direct SGL accounts. The RBI has permitted the National Securities Clearing Corporation Limited, banks, insurance companies, financial institutions, and primary dealers to offer constituent SGL account facility to an investor who is interested in participating in the government securities market. Any trade among participants are settled via this facility. The parties exchange the relevant SGL instruction receipts and the mode of transaction is delivery versus payment (DVP). The DVP system ensures settlement by synchronising the transfer of securities with cash payment. In the first phase, the RBI settled the payment of securities only on DVP-I basis where both funds and securities were settled on a gross basis. For all transactions undertaken directly between SGL participants, the settlement period was of T + 0 or T + 1 days while for transactions routed through brokers of the NSE, the BSE, or the OTCEI, the settlement period was upto T + 5 days. Participants had the flexibility to decide the terms of settlement. Trades were settled by T + 3, if desired by participants. This reduced settlement risks in securities transactions also prevented diversion of funds through SGL transactions.

 

  • An SGL account is a securities account maintained by banks, primary dealers and financial institutions with the RBI

  • CSGL is a secondary gilt account opened with a bank or any other entity which maintains an SGL account with the RBI

The RBI launched the third phase of delivery versus payments (DVP III) on April 2, 2004. DVP-III is an enhancement to the DVP-II form of settlement, as it allows netting of transactions in government securities. DVP-III has boosted trading and improved liquidity in bonds market. This new system has come as a major relief to the market for repos. Earlier, participants could not sell bonds on the same day of the maturity of the repo contract as the RBI credited the securities account, called the SGL account, a day after the trade book place. Under DVP-III, participants are able to sell bonds the same day and protect themselves against price risk. DVP-III allows short sales of bonds to the extent that the securities should be contracted for purchase (but are not credited to the SGL account), provided such a purchase is guaranteed by the Clearing Corporation of India Ltd (CCIL) or the RBI is a counterparty, to the deal. The settlement cycle of such a sale should be either the same as that of the purchase or a subsequent day, so that the delivery obligation under the sale contract is met by the bonds acquired under the purchase contract. The purchase leg of the transaction needs to precede the sell leg. If the securities are purchased on ‘T + 0’ basis (settlement on the same day), then it can be sold either on ‘T + 0 or ‘T + 1’ (settlement a day later) basis. If it is bought on “T + 1, it can be sold on “T + 1” on the day of purchase or ‘T + 0’/‘T + 1’ on the next day. DVP-III has also enabled participants to roll over repo contracts, which are guaranteed by the CCIL. The security prices and interest rates on repos need to be renegotiated on the roll over.

SGL accounts are maintained by the public debt office. The PDO oversees the settlement of transactions through SGL and enables the transfer of securities from one participant to another. The seller fills up the SGL form, the buyer countersigns it, and the seller sends this form to the RBI. The buyer transfers funds towards payment. Inter-bank government securities trades are settled on the same business day while trades with non-bank counterparties settle either on the same day or upto five business days after the trade date. Secondary market trades in government securities between banks are carried on upto 1.00 p.m. on business days and settled on the same day. Trades after that are settled the next day.

The transfer of government securities does not attract stamp duty or transfer fee. Moreover, there is no tax deduction at source on these securities.

Trade in the physical form is settled by the parties directly. Securities are delivered in the form of a physical certificate along with the transfer deed duly executed by the authorised signatures of the transferor. The transferee has to lodge the certificates with the RBI for transfer. The settlement cycle for secondary market government securities transactions has been standardised to T + 1 with effect from May 11, 2005.

Steps to develop the secondary market: With financial sector reforms, efforts have been made to develop and widen the government securities market. Of late, the government has realised that a vibrant liquid secondary market fosters the growth of the primary market and hence the emphasis has shifted to the development of a liquid and broad based secondary market.

Subsidiary general ledger transactions were introduced to foster the growth of the secondary market by imparting a greater element of transparency. The Discount and Finance House of India (DFHI) was allowed to participate in treasury bills and dated securities. The market infrastructure was strengthened by setting up of the Securities Trading Corporation of India in May 1994 to impart liquidity to government securities. The primary dealer system and the satellite dealer system were set up to strengthen the securities market infrastructure and to bring about an improvement in the secondary market trading, liquidity, and turnover.

The move to market related rates of interest has strengthened the development of the secondary market.

The RBI issued guidelines to banks for the retailing of government securities with non-bank clients on June 8, 1996. This move was a part of the measures to develop the secondary market in government securities and to make the market deep and broad based.

Box 10.4 Trading in Government Securities

Government securities are traded on the clean price (trade price) but settled on the dirty price. (trade price + accrued interest).

Trade Value = Trade price × No. of government securities. Suppose 3,000 government securities are traded at Rs. 101 each, then trade value = 101 × 3000 = Rs. 3,03,000.

Settlement value = trade value + accrued interest.

Accrued interest = coupon of bond × face value × (no. of days from interest payment date to settlement date/360).

Retail trading in government securities is settled on a T + 1 rolling settlement basis with effect from May 11, 2005.

Source: BSE.

 

The RBI introduced the delivery versus payment mode of settlement for subsidiary general ledger transactions in government securities, electronic payment system to initiate balance inquiry and extended the MICR cheque clearing to non-metropolitan centres. It has been decided by the RBI to set up a very small aperture terminals (VSATs) which will not only provide reliable communication to the financial sector but would also improve the payments and clearing systems, facilitate funds transfer, and help in the building up of securities settlements on a centralised basis.

The RBI encouraged the setting up of mutual funds dealing exclusively in gilts for encouraging retail participation. These funds, known as gilt funds, exclusively invest in government securities and the RBI provides liquidity support to the extent of 20 per cent of their investment by way of reverse repos in central government securities outstanding at the end of the previous calendar month.

The RBI provides two-way quotes—buy and sell quotes—through its sale window to infuse liquidity in the secondary market for government securities. It offers two-way quotes on a select list of securities to improve liquidity. It continuously revises the sale/purchase prices and the list of securities.

The RBI has planned to adopt the true real time gross settlement (RTGS) model system for government securities clearance and settlement. In RTGS, all transactions (claims or counter-claims) are settled immediately, that is, on a gross basis and this obviates the need for any clearing arrangement. However, participants under the RTGS system have to maintain sufficient liquidity throughout the trading cycle to instantly honour every claim that is placed against them. The RBI has proposed to provide intra-day liquidity support to the participants to maintain minimum cash balances.

 

  • An outright transaction is one in which there is no intended reversal of the trade at the point of execution of the trade

Secondary market transactions in government securities: The transactions in government securities have been made through the SGL since September 1994. The turnover consists of outright transactions as well as repos in eligible securities and treasury bills.

A study of Tables 10.16 and 10.17 reveal the following:

  • There were no repo transactions in state government securities till September 2001 and the extent of outright transactions in them was meagre. The volume of transactions in state government securities have registered an increasing trend except in the year 2000–01 when the volume was lower by 18.4 per cent.

  • In case of central government securities, repo transactions far exceeded the outright transactions till 1995–96. However, from 1996–97 to 2003–04, the outright transactions were predominant and constituted an average of 80 per cent of the total. Once again, the repo transactions have far exceeded the outright transactions since 2004–05. The overnight repo transactions accounted for 74 per cent while 2–3 days repo accounted for 24 per cent during 2007–08.

  • Both outright and repo transactions in central government dated securities exceeded those in treasury bills of all maturities.

    • Public sector banks, primary dealers, private sector banks, and foreign banks dominate the outright market. Mutual funds are the lenders and foreign banks, private sector banks and primary dealers are the major borrowers in the repo market
  • The aggregate volume of secondary market transactions more than doubled to Rs. 15,73,893 crore during 2001–02 from Rs. 6,98,121 crore during 2000–01, reflecting an increase in demand for government securities.

  • The turnover in central government securities (calculated by counting twice the volume of transactions in the case of outright transactions and counting four times the volume of transactions in the case of repos) during 1998–99, 1999–2000, 2000–01, 2001–02, 2007–08, and 2008–09 was Rs. 5,30,742 crore, Rs. 12,36,678 crore, Rs. 16,48,195 crore, Rs. 38,71,640 crore, Rs. 1,88,44,066 crore, and Rs. 2,04,90.084, respectively.

  • The turnover ratio in dated securities, defined as the ratio of total turnover to total outstanding securities, increased to more than 15 in 2007–08 as compared to 4.13 in 2000–01, 3.82 as on March 31, 2000, 1.7 as on March 31, 1999 and 5 in 2001–02.

  • The turnover of government securities to GDP was –34.21 per cent in 1996 which remarkably increased to 78.4 per cent in 2000–01, 272.2 per cent in 2004–05 but declined to 239 per cent in 2005–06 and then substantially increased to 406.4 per cent in 2007–08.

  • This record volume was attributable to several cuts in bank rates which made commercial banks flush with funds and to the sluggish equity market which led to an increased interest in the debt market.

  • There was a phenomenal increase in the turnover of central government securities during the years 2003–04, 2004–05, and 2005–06. The launch of the negotiated dealing system and the setting up of the Clearing Corporation of India Limited enabled a higher growth in volumes.

 

Box 10.5 Listing Criteria for Securities on WDM Segment

 

Source: NSE.

 

TABLE 10.16 Secondary Market Transactions in Government Securities on SGL

 

Note: Figures in parentheses indicate percentage change over the previous year.

Source: RBI, Annual Report, various issues.

RBI, Report on Currency and Finance, various issues.

 

TABLE 10.17 Central Government Securities Market in India

 

Note: NA: Not Available.

Source: RBI, Annual Report, 2008–09.

 

The steady growth in turnover and outright transactions reflects the increasing depth attained by the government securities market and the emergence of an active secondary market in government securities.

Secondary Market Turnover in the Wholesale Debt Market Segment of NSE The National Securities Clearing Corporation Limited, a wholly owned subsidiary of the NSE obtained permission from the RBI to open subsidiary general ledger accounts to offer constituent SGL facility to a wide range of investors. It has set up a common clearing and settlement framework for its SGL constituents to remove the counter-party risks. The majority of trades in government securities takes place through telephone but a large number of trades get routed through NSE brokers.

The trades in government securities on the WDM segment of NSE increased substantially during the years 2003–04 and 2004–05 (Table 10.18). Moreover, the share of the WDM segment in the total turnover of non-repo (outright) SGL transactions was 75.7 per cent in 2003–04 and 73.2 per cent in 2004–05 (Table 10.20). The transactions in dated securities account for a substantial share of transactions on the WDM segment. Banks were the dominant participants on the WDM segment, but their share in WDM trades was reduced to 18.11 per cent in 2008–09 from 42.72 per cent in 1999–2000. During 2008–09, trading members were the dominant participants in WDM trades (Table 10.19).

Total market capitalisation of the securities available for trading on WDM segment stood at Rs. 28,48,315 crore as on March 31, 2009 (Table 10.18). Central Government securities accounted for the largest share of the market capitalisation with 69.74 per cent.

There was a marked decline in the net traded value and number of trades during 2006–07 and 2007–08. The share of WDM in SGL also declined substantially during these years. However, there was an improvement in net traded volume and average trade size during 2008–09.

Tools for Managing Liquidity in the Government Securities Market

The RBI uses basically two tools to manage liquidity in the government securities market. These are: repos and open market operations. Repos have already been discussed in Chapter 4. The RBI manages short-term liquidity through repos and reverse repos and long-term liquidity through open market sales to absorb liquidity in conjunction with private placement/devolvement and open market purchases in tight liquidity conditions.

 

  • OMOs are a tool to manage liquidity in the system through sale or purchase of goverment securities by the RBI

Open Market Operations

Open market operation is an important tool of liquidity management. OMOs are actively used to neutralise excess liquidity in the system and to contain wide fluctuations in the domestic money and foreign exchange markets. It is an actively used technique of monetary control in developed countries such as the UK and USA. OMOs directly affect the availability and cost of credit. Its two objectives are: to influence the reserves of commercial banks, in order to control their power of credit creation and to affect the market rates of interest.

 

TABLE 10.18 Business Growth in the WDM Segment

 

 

TABLE 10.19 Security Wise and Participant Wise Distribution of WDM Trades (Per Cent)

 

TABLE 10.20 Secondary Market Transactions in Government Securities (Outright Transactions)

 

Source: RBI, Annual Report, various issues NSE, Fact book 2008.

 

OMOs involve the sale or purchase of government securities by the central bank. When the RBI sells government securities in the market, it withdraws a part of the deposit resources of the banks, thereby reducing the resources available with the banks for lending. The bank's capacity to create credit, that is, give fresh loans, depends upon its surplus cash, i.e., the amount of cash resources in excess of the statutory CRR stipulated by the RBI. The open market sale of securities reduces the surplus cash resources of banks as these resources are used to purchase government securities. Banks have to contract their credit supply to generate some cash resources to meet the CRR. The supply of bank credit which involves the creation of demand deposit falls and money supply contracts. The reverse happens when the RBI undertakes open market purchase of government securities. The open market purchase of securities leads to a reduction in the stock of securities of the seller bank and an expansion in the free surplus cash which augments the credit creation capacity of banks. The result is an expansion in the supply of bank credit and an increase in money supply.

OMOs do not alter the total stock of government securities but change the proportion of government securities held by the RBI and commercial and cooperative banks. Open market sales result in a fall in net RBI credit to government (NRCG) and an increase in the other banks’ (cooperative and commercial) credit to government (OBCG) without affecting the budget (fiscal) deficit in anyway.

 

  • Open market sale of securities reduces surplus cash resources of banks

The RBI resorts to private placement when market conditions for government securities are not favourable and conducts open market sales later when liquidity conditions turn favourable. Thus, the RBI influences the resource position of banks, yields on government securities, and cost of bank credit through the open market sale and purchase of government securities.

The RBI can buy or sell or hold government securities of all maturities without any restrictions. The bank purchased and sold government securities upto 1991–92 out of the surplus funds of IDBI, Exim Bank, NABARD, and other institutions under a special buy back arrangement. Till 1991–92, the market of OMOs was quite narrow as interest rates were administered and the government securities market was not broad based either. However, with the initiation of several measures to promote both primary and secondary markets in government securities, the OMO market has become active and OMOs have emerged as an important tool of debt management. Accordingly, various steps have been taken to alter the composition, maturity structure, and yield of government securities. The RBI also introduced the sale of securities from its own account on the basis of repo. Besides this, the bank offers for sale only a select number of securities which it wishes to undertake in response to market conditions, instead of maintaining a list including all dated securities in its portfolio. The RBI has also put on its purchase list a couple of securities for cash with a view to providing liquidity to at least a few securities.

 

  • Open market purchase of securities increases surplus cash resources of banks

In a move to augment the stock of marketable securities for active OMOs, special securities of value aggregating Rs. 15,000 crore at 4.6 per cent were converted into marketable securities of 10-year, 7-year, and 8-year maturities at 13.05 per cent, 12.59 per cent, and 11.19 per cent on June 3, June 18, and August 12, 1997, respectively. The cost of additional interest on account of this conversion is fully borne by the RBI and is paid to the government as part of transfer of profits from year to year.

The RBI included treasury bills of varying maturities in the OMOs in 1998–99. The resort to OMOs epitomises the move from direct to indirect instruments of monetary control.

OMOs have been successfully used by the RBI to groom or switch operations, i.e., the sale of long-term scrips in exchange for short-term loans. This helps in lengthening the maturity structure of government securities which, in turn, becomes favourable for the working of the monetary policy.

Table 10.21 reveals that the volume of RBI net sales (sales – purchase) increased over the years except in the year 1994–95 when tight money market conditions prevailed. Since 1996–97, OMOs have come into a sharper focus. The stock of marketable securities was augmented by conversion of special securities into marketable securities for conducting active OMOs. During 1996–97, outright sale of securities came into prominence to absorb excess liquidity which was due to large capital inflows and to maintain domestic interest rate and exchange rate at reasonable levels. The RBI did not purchase any security during 1998–99 through its OMO window. The open market sale rose significantly by 290 per cent in 1998–99. An important aspect in the OMO during 1998–99 was the inclusion of treasury bills of varying maturities. In 2000–01, due to uncertain foreign exchange market conditions and unfavourable market conditions for government securities, the RBI privately placed securities with itself. The securities were subsequently sold on-tap basis and through OMO auctions.

 

TABLE 10.21 Reserve Bank's Open Market Operations in Central Government Securities

 

Note: Figures shown in parantheses upto 1991–92 are inclusive of purchases/sales effected from time to time from surplus funds of IDBI, Exim Bank, NABARD, and other institutions under a special buy back arrangement. The RBI phased out the buy back arrangements in 1992–93.

Source: RBI, Annual Report, various issues.

 

The RBI conducted a series of open market purchases aggregating Rs. 5,084 crore during September 18–October 10, 2001, to support the government securities market in the face of the steep fall in the government securities prices due to adverse external developments after September 11, 2001. Subsequently, with stability in market conditions and easing of liquidity, it resorted to open market sales. These sales helped the RBI to absorb surplus liquidity on an enduring basis, stabilising the prices of government securities, and offloading the securities privately placed with it. The RBI once again purchased government securities in 2008 and 2009 to ease liquidity conditions in the market.

Infrastructure Development of the Government Securities Market

The government securities market constitutes the principal segment of the debt market. The development of any market requires the strengthening of the market infrastructure with large number of market players who have divergent perceptions about the market and who would continuously provide liquidity. One of the initiatives taken to develop the government securities market during the first stage of the reform process was the setting up of Securities Trading Corporation of India. The STCI, together with Discount and Finance House of India, had the task of developing an active secondary market in government securities.

The RBI introduced the primary dealer system and satellite dealer system to further strengthen the market infrastructure.

 

  • Primary dealers act as market makers in the secondary market of government securities and participate in primary market auctions of government securities

Primary Dealer System

The primary dealer (PD) system was first introduced in the US in 1960. In the US, there are 25 primary dealers, most of which are banking or investment banking institutions. Other countries with a successful PD system include Argentina, Brazil, Canada, France, Hungary, Italy, Korea, Mexico, Singapore, Thailand, and the UK. The obligations of PDs in these countries include participating in the primary market, serving as a market maker in the secondary market and providing market-related information to the central bank. Some advances countries such as Australia, Germany, and New Zealand have not yet established the PD system.

A system of primary dealers was introduced in India in 1996, to further strengthen the market infrastructure and to make it more liquid and broad based. The objectives of the introduction of this system were as follows.

  • To strengthen the government securities infrastructure and facilitate government's market borrowing programme.

  • To bring about improvements in the secondary market trading, liquidity and turnover in government securities.

  • To encourage a voluntary holding of government securities amongst a wider investor base.

  • To make PDs an effective conduit of OMOs.

The major focus of PDs would be on increasing the turnover of government securities rather than becoming a mere repository of this system. Hence, their role would be to act as market makers by providing two-way quotes in the secondary market, thereby ensuring liquidity and support to the primary market operation. In the long run, this system would facilitate the transfer of market-making activities from the RBI to PDs.

PDs can be subsidiaries of scheduled commercial banks, subsidiaries of all-India financial institutions, companies under Companies Act, 1956 engaged predominantly in government securities market, and subsidiaries of foreign banks/securities firms. Every PD has to maintain minimum net owned funds of Rs. 50 crore deployed daily in the government securities market. To ensure stability of PDs in times of volatile interest rates, the minimum capital requirement has been increased from Rs.50 crore to Rs.150 crore. PDs which intend to diversify into other permissible activities need to have net owned funds of Rs. 250 crore as against Rs.100 crore earlier.

Banks which do not have a partly or wholly owned subsidiary can undertake PD business if they fulfill the following eligibility criteria:

  1. Minimum net owned funds (NOF) of Rs.1,000 crore,
  2. Minimum capital adequacy ratio (CRAR) of 9 per cent and net NPAs of less than 3 per cent and a profit making record for the last three years.

They are also required to ensure that, at any point of time, there is a minimum balance of Rs.100 crore of government securities earmarked for PD business. Bank-PDs will not have separate access to call money market and liquidity adjustment facility (LAF).

Facilities Extended to PDs

  • Pression of current account and SGL facilities with RBI

  • Access to LAF

  • Liquidity support facility

  • A scheme of underwriting and bidding commitments

  • access to repo market

PDs as institutional entities fall in the category of non-banking finance companies. PDs are registered with and regulated by the Reserve Bank of India, irrespective of whether they accept public deposits or not.

Number of PDs DFHI and STCI were accredited as primary dealers on March 1, 1996. On June 1, 1996, four more PDs—SBI gilts, PNB gilts, Gilts Securities Trading Corporation Limited, and ICICI Securities—became operational. As on March 31, 2009, there were 19 approved PDs in the gilts market. Of these, eight were non-bank entities (stand alone PDs) and the remaining 11 were banks undertaking PD business departmentally(Bank PDs) registered as NBFCs under section 45 IA of the RBI act, 1934. The stand alone PDs are Securities Trading Corporation of India Ltd, SBI DFHI Ltd., ICICI Securities Ltd., PNB Gilts Ltd., ABN AMRO Securities (India) Pvt. Ltd., DSP Merrill Lynch Ltd., Deutsche Securities (India) Pvt Ltd., and IDBI Capital Market Services Ltd.

 

  • From April 1, 2006 the responsibility of supporting government securities auctions has shifted to the primary dealers

Obligations Upon PDs The Fiscal Responsibility and Budget Management (FRBM) Act, 2003 stipulates that the Reserve Bank cannot participate in the primary auctions of government securities from April 1, 2006. Due to this, the responsibility of supporting government securities auctions has shifted to the primary dealers (PDs). PDs are expected to play an active role in the government securities market, both in its primary and secondary market segments. In order to enable PDs to perform their role effectively, the RBI has cast certain obligations upon PDs. The major roles and obligations of PDs are:

  1. PDs are required to support primary market auctions for issue of Government dated securities and Treasury Bills as per the minimum norms for underwriting commitment, bidding commitment and success ratio as prescribed by RBI from time to time.
  2. PDs should offer two-way prices (market making)in Government securities, through the Negotiated Dealing System-Order Matching (NDS-OM), over-the-counter market and recognised Stock Exchanges in India and take principal positions in the secondary market for Government securities.
  3. PDs should maintain adequate physical infrastructure and skilled manpower for efficient participation in primary issues, trading in the secondary market, and to advise and educate investors.
  4. A Primary Dealer shall have an efficient internal control system for fair conduct of business, settlement of trades and maintenance of accounts.
  5. A Primary Dealer will provide access to RBI to all records, books, information and documents as and when required.
  6. PDs’ investment in Government Securities and Treasury Bills on a daily basis should be at least equal to its net call/notice/repo (including CBLO) borrowing plus net RBI borrowing (through LAF/Intra-Day Liquidity/Liquidity Support) plus the minimum prescribed NOF.
  7. PDs should annually achieve a minimum turnover ratio of 5 times for Government dated securities and 10 times for Treasury Bills of the average month-end stocks. The turnover ratio in respect of outright transactions should not be less than 3 times in government dated securities and 6 times in Treasury Bills (Turnover ratio is computed as the ratio of total purchase and sales during the year in the secondary market to average month-end stocks).
  8. A PD should submit periodic returns as prescribed by RBI from time to time.
  9. PDs’ operations are subject to prudential and regulatory guidelines issued by RBI from time to time.

Reforms in Primary Dealer System

  • Maintain capital adequacy

  • Follow prudent distribution policy

  • Brought under the purview of BFS

  • On-site and off-site supervision by RBI

  • Allowed to short-sell securities

  • Allowed to borrow foreign currency funds

  • Allowed to invest in non-SLR debt

  • to merge with the bank which promoted them

  • A new incentive structure in the underwriting auctions put in place

  • support facility revised

  • Stand-alone PDs permitted to diversify their activities

Facilities Extended by the RBI to PDs To strengthen this system and to make PDs fulfill their obligations, the RBI extends to them various facilities which include:

  1. Access to Current Account facility and Subsidiary General Ledger (SGL) Account facility (for Government securities) with RBI.
  2. Permission to borrow and lend in the money market including call money market and to trade in all money market instruments.
  3. Memberships of electronic dealing, trading and settlement systems (NDS platforms/INFINET/RTGS/CCIL).
  4. Access to the Liquidity Adjustment Facility (LAF) of RBI.
  5. Access to liquidity support from RBI under a scheme separately notified for standalone PDs.
  6. Favoured access to open market operations by Reserve Bank of India.

Sources and Application of Funds Call/Notice Money Market

  1. PDs are permitted to borrow funds from call/notice/term money market and repo (including CBLO) market.
  2. PDs are allowed to borrow from call/notice market, on an average in a reporting fortnight, up to 225 per cent of their net owned funds (NOF) as at the end March of the preceding financial year.
  3. PDs may lend up to 25 per cent of their NOF in call/notice market. The limit will be determined by PDs on an average basis during a ‘reporting fortnight.’
  4. These limits on borrowing and lending are subject to periodic review by Reserve Bank of India.

Liquidity Support from the RBI In addition to access to the RBI's Liquidity Adjustment Facility, stand alone PDs are also provided with liquidity support by the Reserve Bank of India against eligible Government securities including State Development Loans (SDLs). The parameters based on which liquidity support will be allocated are given below:

  1. Of the total liquidity support, half of the amount will be divided equally among all the stand-alone PDs. The remaining half (i.e., 50 per cent) will be divided in the ratio of 1:1 based on market performance in primary market and secondary market. Performance in primary market will be computed on the basis of bids accepted in the T-Bill auction and G-sec auction in the proportionate weights of 1 and 3. Similarly, the secondary market performance will be judged on the basis of outright turnover in T-Bills and dated Government securities in the proportionate weights of 1 and 3.
  2. The PD-wise limit of liquidity support will be revised every half-year (April-September and October-March) based on the market performance of the PDs in the preceding six months.
  3. The liquidity support to PDs will be made available at the ‘Repo rate’ announced by the Reserve Bank.
  4. The liquidity support availed by a PD will be repayable within a period of 90 days. The penal rate of interest payable by PDs if liquidity support is repaid after 90 days is Bank rate plus 5 percentage points for the period beyond 90 days.

Inter-Corporate Deposits Inter-Corporate Deposits (ICD) may be raised by Primary Dealers sparingly and should not be used as a continuous source of funds. After proper and due consideration of the risks involved, the Board of Directors of the PD should lay down the policy in this regard, which among others, should include the following general principles:

  1. While the ceiling fixed on ICD borrowings should in no case exceed 50 per cent of the NOF as at the end of March of the preceding financial year, it is expected that actual dependence on ICDs would be much below this ceiling.
  2. ICDs accepted by PDs should be for a minimum period of one week.
  3. ICDs accepted from parent/promoter/group companies or any other related party should be on ‘arms length basis’ and disclosed in financial statements as ‘related party transactions.’
  4. Funds raised through ICDs are subject to ALM discipline.

PDs are prohibited from placing funds in ICD market.

FCNR(B) Loans/External Commercial Borrowings

  1. PDs may avail of FCNR(B) loans up to a maximum of 25 per cent of the NOF as at the end of March of the preceding financial year and subject to the foreign exchange risk of such loans being hedged at all times at least to the extent of 50 per cent of the exposure.
  2. PDs are not permitted to raise funds through External Commercial Borrowings.

Primary Dealers are now allowed to issue subordinated Tier II and Tier III bonds at coupon rates as decided by their Boards of Directors.

Role of Primary Dealers in the Primary Market

Concomitant with the objectives of PD system, the PDs are expected to support the primary issues of dated securities of Central Government and State Government and Treasury Bills of Central Government, through underwriting/bidding commitments and success ratios. The related guidelines are as under:

Underwriting of Dated Government Securities

Dated securities of central government

  1. The underwriting commitment on dated securities of Central Government will be divided into two parts (i) Minimum Underwriting Commitment (MUC) and (ii) Additional Competitive Underwriting (ACU).
  2. The MUC of each PD will be computed to ensure that at least 50 per cent of the notified amount of each issue is mandatorily underwritten equally by all PDs. The share under MUC will be uniform for all PDs, irrespective of their capital or balance sheet size. The remaining portion of the notified amount will be underwritten through an Additional Competitive Underwriting (ACU) auction.
  3. RBI will announce the MUC of each PD and the balance amount which will be underwritten under the ACU auction. In the ACU auction, each PD would be required to bid for an amount at least equal to its share of MUC. A PD cannot bid for more than 30 per cent of the notified amount in the ACU auction.
  4. The auction could be either uniform price-based or multiple price-based depending upon the market conditions and other relevant factors, which will be announced before the underwriting auction for each issue.
  5. Bids will be tendered by PDs within the stipulated time, indicating both the amount of the underwriting commitment and underwriting commission rates. A PD can submit multiple bids for underwriting. Depending upon the bids submitted for underwriting, RBI will decide the cut-off rate of commission and inform the PDs.
  6. Underwriting commission: All successful bidders in the ACU auction will be paid underwriting commission on the ACU segment as per the auction rules. Those PDs who succeed in the ACU for 4 per cent and above of the notified amount of the issue, will be paid commission on the MUC at the weighted average of all the accepted bids in the ACU. Others will get commission on the MUC at the weighted average rate of the three lowest bids in the ACU.
  7. In the GOI securities auction, a PD should bid for an amount not less than their total underwriting obligation. If two or more issues are floated on the same day, the minimum bid amount will be applied to each issue separately.
  8. Underwriting commission will be paid on the amount accepted for underwriting by the RBI, irrespective of the actual amount of devolvement, by credit to the current account of the respective PDs at the RBI, Fort, Mumbai, on the date of issue of security.
  9. In case of devolvement, PDs would be allowed to set-off the accepted bids in the auction against their underwriting commitment accepted by the Reserve Bank. Devolvement of securities, if any, on PDs will take place on pro-rata basis, depending upon the amount of underwriting obligation of each PD after setting off the successful bids in the auction.
  10. RBI reserves the right to accept any amount of underwriting up to 100 per cent of the notified amount or even reject all the bids tendered by PDs for underwriting, without assigning any reason.
  11. An illustration pertaining to the underwriting procedure is given in Annexure III.

Dated securities of state governments

  1. On announcement of an auction of dated securities of the State Governments for which auction is held, RBI may invite PDs to collectively bid to underwrite up to 100 per cent of the notified amount of State Development Loans (SDL).
  2. A PD can bid to underwrite up to 30 per cent of the notified amount of the issue. If two or more issues are floated on the same day, the limit of 30 per cent is applied by taking the notified amounts separately.
  3. Bids will be tendered by PDs within the stipulated time, indicating both the amount of the underwriting commitments and underwriting commission rates. A PD can submit multiple bids for underwriting.
  4. Depending upon the bids submitted for underwriting, the RBI will decide the cut-off rate of commission and the underwriting amount up to which bids would be accepted and inform the PDs.
  5. RBI reserves the right to accept any amount of underwriting up to 100 per cent of the notified amount or even reject all the bids tendered by PDs for underwriting, without assigning any reason.
  6. In case of devolvement, PDs would be allowed to set-off the accepted bids in the auction against their underwriting commitment accepted by the Reserve Bank. Devolvement of securities, if any, on PDs will take place on pro-rata basis, depending upon the amount of underwriting obligation of each PD after setting off the successful bids in the auction.
  7. Underwriting commission will be paid on the amount accepted for underwriting by the RBI, irrespective of the actual amount of devolvement, by credit to the current account of the respective PDs at the RBI, Fort, Mumbai, on the date of issue of security.

Bidding in Primary Auctions of Treasury Bills

  1. Each PD will individually commit, at the beginning of the year, to submit bids for a fixed percentage of the notified amount of Treasury Bills in each auction.
  2. The minimum bidding commitment amount/percentage for each PD will be determined by the Reserve Bank, in consultation with the PD. While finalising the bidding commitments, the RBI will take into account the net owned funds (NOF), the offer made by the PD, its track record, and its past adherence to the prescribed success ratio. The amount/percentage of minimum bidding commitment so determined by the Reserve Bank will remain unchanged for the entire financial year or till the conclusion of agreement on bidding commitments for the next financial year, whichever is later.
  3. In any auction of Treasury Bills, if a PD fails to submit the required minimum bid or submits a bid lower than its commitment, the Reserve Bank may take appropriate action against the PD.
  4. A PD would be required to achieve a minimum success ratio of 40 per cent of bidding commitment for Treasury Bills auctions which will be monitored on a half yearly basis. A PD is required to achieve the minimum level of success ratio in each half year (April to September and October to March) separately.

Primary dealers can undertake ‘When Issued’ transactions in government securities, sale of securities allotted in primary issues on the same day and short sale in Central Government dated securities.

PDs are expected to play an active role in providing liquidity to the Government securities market and promote retailing. They are allowed to make full use of the facility to distribute Government securities to all categories of investors through the process of placing and picking-up orders on the exchanges. PDs may open demat accounts with a Depository Participant (DP) of NSDL/CDSL in addition to their accounts with RBI. Value free transfer of securities between SGL/CSGL and demat accounts is enabled by PDO-Mumbai subject to guidelines issued by RBI's Department of Government and Bank Accounts (DGBA).

Diversification of Activities by Stand-alone Primary Dealers

Primary Dealers reported a loss of Rs. 700 crore during 2004–05 on account of an upturn in interest rates and yields. The Reserve Bank permitted PDs to diversify their activities in addition to their existing business of government securities from July 4, 2006 subject to certain conditions such as:

  1. PDs, desirous of diversifying their activities should have a minimum net owned funds (NOF) of Rs. 250 crore as against Rs. 50 crore for a PD, which does not propose to diversify its activities.
  2. The eligible PDs may bifurcate their operations into core activities and non-core activities. The core activities should involve dealing in government securities, interest rate derivatives, security receipts issued by securitisation companies/reconstruction Companies, asset backed securities (ABS), mortgage backed securities (MBS) and other fixed income securities such as commercial papers and certificates of deposit, dealing and underwriting in corporate/PSU/FI bonds/debentures, lending in call/notice/term/repo/CBLO market and providing broking services in government securities. The non-core activities of PDs may include investment/trading in equity/units of equityoriented mutual funds/advisory services/merchant banking and other specified activities such as professional clearing services, distribution of mutual fund units, and distribution of insurance products. PDs are not allowed to undertake broking in equity, trading/broking in commodities, gold and foreign exchange. However, all PDs are required to ensure predominance of investment in government securities business by maintaining atleast 50 per cent of their total financial investments (both long-term and short-term) in government securities at any point of time.
  3. The exposure to non-core activities shall be subject to risk allocation. PDs may calculate the capital charge for market risk on the stock positions/underlying stock positions/units of equity oriented mutual funds using Internal Models (VaR based) based on the prescribed Reserve Bank guidelines. The capital charge for market risk so calculated should not be more than 20 per cent of the NOF as per the last audited balancesheet.
  4. PDs are not permitted to set-up step-down subsidiaries. PDs that already have step-down subsidiaries (in India and abroad) may restructure the ownership pattern of such subsidiaries. If the PD is a subsidiary of a holding company, the step-down subsidiary of the PD may become another direct subsidiary of the holding company. In case the PD itself is a holding company, then the step-down subsidiary may take up the PD activity and the holding entity may take up activities other than those permitted for PDs. The restructuring should be completed within a period of six months.

The Reserve Bank also gave primary dealers the option to merge with the bank which promoted them.

These Bank PDs have to fulfill the eligibility criteria and are subject to all obligation applicable to stand-alone PDs. They have also to adhere to the following prudential norms:

  1. The capital adequacy requirement for a bank will also apply to its PD business.
  2. The government securities under PD business are reckoned for the SLR requirement.
  3. The investment valuation guidelines as applicable to banks with regard to ‘held for trading’ portfolio are also applicable to the portfolio of government securities earmarked for PD business.

Investment Guidelines

Investment in SLR Securities (Government Securities)

  1. PDs should frame and implement investment and operational policy guidelines on securities transactions which should be approved by their Boards. While laying down these guidelines, the PDs should strictly adhere to Reserve Bank's instructions, issued from time to time. The effectiveness of the policy and operational guidelines should be periodically evaluated.
  2. PDs should necessarily hold their investments in Government securities portfolio in SGL with RBI. They may also have a dematerialised account with depositories (NSDL/CDSL). All purchase/sale transactions in Government securities by PDs should be compulsorily through SGL/CSGL/Demat accounts.
  3. PDs should hold all other investments such as commercial papers, bonds and debentures, privately placed or otherwise, and equity instruments, only in dematerialised form.
  4. All problem exposures, which are not backed by any security or backed by security of doubtful value, should be fully provided for. Where a PD has filed suit against another party for recovery, such exposures should be evaluated and provisions made to the satisfaction of auditors. Any claim against the PD should also be taken note of and provisions made to the satisfaction of auditors.
  5. The profit and loss account should reflect the problem exposures if any, and also the effect of valuation of portfolio, as per the instructions issued by the Reserve Bank, from time to time. The report of the statutory auditors should contain a certification to this effect.

Investment in Non-government Securities The RBI issued norms for investment by PDs in non-SLR debt in March 2004. These guidelines cover PDs’ investments in non-government securities (including capital gains bonds, bonds eligible for priority sector status, bonds issued by Central or State public sector undertakings with or without Government guarantees and bonds issued by banks and financial companies) generally issued by corporates, banks, FIs and State and Central Government sponsored institutions, SPVs, etc. These guidelines will, however, not be applicable to (i) units of equity oriented mutual fund schemes where any part of the corpus can be invested in equity, (ii) venture capital funds, (iii) commercial paper, (iv) certificate of deposit, and (v) investments in equity shares. The guidelines will apply to investments both in the primary market and the secondary market. According to the norms,

  1. The investment of PDs in unlisted non-SLR securities should not exceed 10 per cent of their portfolio. PDs’ investment in paper issued by securitisation and reconstruction companies and securitised debt in the nature of asset backed securities (ABS) and mortgage-backed securities (MBS) will be included in the 10 per cent ceiling for unlisted debt.
  2. PDs should not invest in non-SLR papers with an original maturity of less than one year, other than commercial paper and certificates of deposits. PDs are barred from investing in un-rated non-SLR bonds. The RBI has excluded investment in mutual fund schemes, which invest their entire corpus in debt securities from these norms for PDs. In addition, PDs are required to report their secondary market transactions in corporate bonds done in the OTC market on FIMMDA's reporting platform.

Supervision of PDs

PDs have been brought under the purview of the BFS in 2002–03 in view of their growing systemic importance in terms of the following attributes : (a) their large number, (b) highly leveraged portfolios with short-term funds, (c) substantial share in the government securities market, and (d) a significant position in the money market, comparable with banks. The RBI also undertakes on-site inspection of each PD besides the off-site supervision through prescribed periodic returns.

The off-site surveillance of PDs is done on the basis of three basic returns—PDR I, II, and III. PDR I is daily statement of sources and uses of funds and is used to monitor the deployment of call borrowing and the RBI liquidity support, leverage, and duration of PDs portfolio. PDR I return has been revised to capture more details on sources such as ICDs and CPs. PDR II is a monthly statement on the basis of which bidding commitments, success ratio, underwriting performance, and secondary market turnover of PDs are monitored. PDR III is a quarterly return on the basis of which the capital adequacy of PDs is monitored. Apart from these regular returns, additional details are called for as and when necessary. The ALM guidelines for NBFCs with some modifications were also made applicable to PDs. A new quarterly return—PDR IV was introduced from the quarter ended March 31, 2004. PDR IV is a quarterly return on certain balance sheet and profit and loss indicators.

Primary Dealers Association of India

PDs formed an autonomous, self-regulatory organisation (SRO),

Primary Dealers Association of India (PDAI) in 1996. The role of PDAI is as follows:

  • To promote a liquid debt market and set common standards for market participants.

  • To achieve a harmonious integration of different segments of markets.

  • To build a healthy relationship between different segments of market participants.

  • To remove some legal, procedural, and administrative bottlenecks in the efficient functioning of the market.

Banks and PDs together formed another autonomous self-regulatory body, Fixed Income Money Market and Derivatives Association of India (FIMMDAI), in 1997.

These two SROs have been proactive and are closely involved in contemporary issues relating to the development of the money market and government securities market. The credit for upgrading the technological infrastructure in these two markets goes to these two SROs. The representatives of the PDAI and FIMMDAI are members of the Technical Advisory Group on Money and Government Securities Markets of the Reserve Bank. The FIMMDAI has now taken over the responsibility of publishing the yield curve in the debt markets. The FIMMDAI prepared the guidelines for standard procedures and documentation to be followed by the participants in the commercial paper market and certificate of deposit market. Currently, the FIMMDAI is working towards the development of uniform documentation and accounting principles of the repo market.

Operations of PDs An analysis of Table 10.22 reveals that PDs bid substantially higher as against their bidding commitments in the primary market. The average success ratio was 52 per cent in case of treasury bills and 60 per cent in case of government dated securities. The amount of underwriting offered was also higher compared to the amount of underwriting accepted. Total primary purchases as a per cent to total primary issues reveals an increasing trend in case of both T-bills and dated securities. This ratio was highest in the year 2001–02 and depicts a close involvement of PDs in central government borrowings.

In the secondary market also, PDs achieved a higher turnover. This reflects that PDs have made an effort to provide liquidity to the secondary market in government securities in their existence of seven years. In a short span of time, PDs have sharpened their trading skills which has helped them in earning a greater return on assets. Besides this, factors such as a sharp decline in long-term interest rates, high liquidity, increase in investor preference for government securities, and thrust on the retailing of government securities have helped PDs in increasing the turnover in government securities.

The RBI, by way of a circular on July 26, 2002 made it mandatory for PDs to make public their performance accounts and results by way of newspaper advertisements.

The RBI divested its entire holdings in two PDs—Securities Trading Corporation of India and Discount and Finance House of India to avoid any potential conflict of interest generated by the ownership of regulated financial institutions.

Yields on government securities moved up by around 150 basis points during the year 2004–05. All PDs made losses as the soft interest rate regime ended. This resulted in low volumes, volatility in prices and low profitability. Moreover, PDs have to fulfill their bidding obligations and turnover requirements which has had an impact on their profitability. This led to a decline in the number of active PDs in the market, thus, limiting competition. In July 2006, PDs were allowed to cover their short positions in central government securities to enable them to cover their risks and give two-way quotes-leading to active trade calls.

The RBI has proposed to provide exclusivity to PDs in primary issuances through the introduction of book building for government security issues. Introduction of book building will necessitate that every player subscribing to an issue goes through the PD, who will run the book for an issue of government securities. This will enable the PD to make an effective bid as he will be aware of the quantity and price at which the demand for the issue is coming in and also provide an alternative revenue streams for PDs. Moreover, business opportunities for primary dealers are expected to decline with the reduction in the fiscal deficit, hardening of government security yields and with electronic trading of securities and auctions. Hence, the RBI is considering proposal to permit primary dealers to invest in overseas sovereign bonds, and allow setting of joint ventures/wholly owned subsidiaries abroad to enable them to diversify their balance sheets.

 

TABLE 10.22 Role of Primary Dealers in the Government Securities Market

 

Source: RBI, Report on Trend and Progress of Banking in India, various issues.

 

PDs entirely rely on trading in government and corporate bonds to earn revenues. Recently, they have urged the RBI to allow them into other areas such as equities, interest rate futures, foreign exchange, and commodities to reduce their dependence on bonds to earn revenues.

Conclusion

PDs have done a remarkable job in strengthening the government securities market infrastructure and improving the liquidity and turnover in the secondary market. PDs have emerged as dominant investors in the primary market issuances of government securities. The strengthening of the PD system enabled the RBI to successfully exit from the primary market with effect from April 1, 2006. However, there is still a long way to go for PDs. PDs together or their association, PDAI, should put in more efforts in the following areas for the healthy development of the government securities market.

  • PDs or PDAI should take initiative in building awareness of government securities amongst individual investors so that a retail market for government securities is developed. Retailing of government securities is necessary to impart liquidity to the government securities market.

  • One of the basic obligations of PDs is to offer two-way quotes in government securities, thereby providing continuous liquidity in the market. There is a need for greater transparency in the market-making function of PDs which, in turn, would impart credibility to PDs’ operations. This will also help in retailing of government securities.

  • PDs should continuously disseminate information to the RBI regarding market development. This would help the bank to know when to intervene in the market.

  • PDs should strengthen their capital base to reduce their dependence on call money borrowings. This will automatically reduce any risk arising on account of market volatility.

  • In Stage II of LAP, one-third of the liquidity support normally available to them at fixed rate of interest would then be available at market rates. This calls for a careful future business planning on part of PDs.

  • PDs should adopt proper risk management practices to improve their returns.

  • PDs should expand their branch network and spread their operations to other places to cater to the investment requirements of corporates and other large investors in government securities.

They need to be more proactive and business minded.

Satellite Dealers In order to widen the scope for organised dealing and distribution arrangement in the government securities market and to support the system of primary dealers, the RBI introduced a supporting infrastructure in the form of satellite dealers (SDs). SDs form the second tier of trading and distribution of government securities.

The guidelines for registration of satellite dealers in government securities market were announced on December 31, 1996. According to the guidelines, subsidiaries of scheduled commercial banks and all-India financial institutions (AIFIs), and companies incorporated under the Companies Act, 1956 with minimum net owned funds of Rs. 5 crore were eligible to be SDs. In pursuance of these guidelines, the RBI granted approval to 16 entities for registration as SDs in the government securities market.

Box 10.6 Comparative Position of Banks and Primary Dealers with Respect to Select Regulatory Parameters

Norm
1
Bank
2
Primary Dealer
3
CRAR Nine Per Cent of Total Risk-weighted Assets (RWA) Fifteen Per Cent. Tier-l and Tier-ll Capital Defined as in Case of Banks for Credit Risk. Tier-Ill Capital for Market Risk Subject to the Constraints as Per BIS Standards.
    Capital Adequacy for Subsidiaries not Applicable.
Investments SLR Securities and Non-SLR Securities (i.e., Total Investment Portfolio) Classified Into Three Categories, Namely Held to Maturity (HTM) (up to 25.0 Per Cent of Total Investments), Available for Sale (AFS), and Held for Trading (HFT) Categories, with Progressively Regular Mark to Market Norms. However, as per the Balance Sheet Format, Investments Continue to be Disclosed as Per Six Existing Classifications. The Government and Non-government Securities Portfolio, to the Extent of the Holding Period and Defea Sance Period Stipulations can be Satisfied, Treated as Trading and Marked to Market.
Disclosure Requirements Number of Items Net Borrowings in call (Average and Peak During the Period).
    Basis of Valuation at Lower of Cost and Market (LOCOM)/Mark to Market (MTM).
    Leverage Ratio (Average and Peak).
    CRAR (Quarterly Figures). Besides, PDs may Also Furnish More Information by Way of Additional Disclosures.
ALM Guidelines Introduced in February 1999. Banks to Ensure Coverage of 60 Per Cent of their Liabilities and Assets Initially, and Subsequently Cover of 100 Per Cent of their Business by April 1, 2000. Prudential Norms Prescribed Only for Negative Liquidity Mismatches in the First Two Time Buckets Namely, 1–14 days and 15–29 Days at 20 Per Cent Each of the Cash Outflows in these Time Buckets. ALM Guidelines to NBFCs Applicable to PDs with Necessary Modifications in Tune with their Nature of Operations from January 2002.
  • The Entire Government Securities Portfolio Treated as Liquid and Put in the First Time Bucket for Liquidity Risk Management. Non-Government Securities Treated as Trading Portfolio to the Extent that Holding Period and Defeasance Period Stipulations are Satisfied.

  • PDs have been Advised to Continue with Duration Gap, Present Value of a Basis Point (PVBP), Daily Earnings at Risk (DeaR), and Value at Risk (VaR), in Relation to Interest Rate Risk Management Measures Rather than Simple Maturity/Repricing Gap Method.

Resource Raising Not Applicable for Banks. PDs May Raise Resources by Means of the Following:
  • Call/Term Borrowing.

  • Borrowing from the RBI Under Normal/Backstop/LAF Facility.

  • Repo Borrowings from the Market.

  • Borrowings Under Credit Line from Banks/Financial Institutions.

  • Borrowings through ICDs/CP/Bonds.

  • Borrowing Under FCNR(B) Loans Scheme of Banks.

Source: RBI, Annual Report, 2002–03.

 

SDs were permitted to issue commercial papers for raising resources and could avail of liquidity support from the RBI and the facility of ready forward transactions. Some of the satellite dealers were promoted as primary dealers.

The network of satellite dealers was created to promote the retailing of government securities but the performance of the satellite dealers was not found to be satisfactory. The RBI decided to discontinue the system after obtaining the view of the Primary Dealers Association of India. Accordingly, no new SDs will be licensed and existing SDs were required to make action plans satisfactory to the RBI for termination of their operations as SDs by May 31, 2002.

Measures to Strengthen the Government Securities Market Infrastructure

For bringing about an improvement in trading and settlement in the money market and government securities market, the negotiated dealing system (NDS) and Clearing Corporation of India Limited have been set up.

 

  • NDS provides an online electronic bidding facility in the primary auctions of government securities and an electronic dealing platform for trading in government securities

The Negotiated Dealing System

The Reserve Bank introduced the NDS with a view to reforming the secondary market in government securities and money market operations, introducing transparency, and facilitating electronic bidding in auctions. Test runs on the NDS started in November 2001 and Phase I was operationalised from February 15, 2002, with 41 participants.

The NDS provides an online electronic bidding facility in the primary auctions of central/state government securities, OMOs/LAF auctions. It enables screen-based electronic dealing and reporting of transactions in money market instruments including repo, secondary market transactions in government securities, and dissemination of information on trades with the least time lags.

The NDS is integrated with the securities settlement system (SSS) of the Public Debt Office as also with the CCIL to facilitate paperless settlement of transactions in government securities and treasury bills and bring about improvement in services to investors in government securities. Once a trade is done/reported over NDS, it can be settled either through CCIL or directly through RBI-SGL. Settlement through CCIL is on delivery versus payment (DVP-II) mechanism. DVP-II refers to settlement of securities on a gross basis (trade-by-trade basis) while funds will settle on a net basis.

Banks, PDs, and financial institutions having SGL accounts and current accounts with the RBI are eligible to participate in the NDS. It provides an electronic dealing platform for these participants in government securities. It enables the execution of deals in both the computer matching mode or a chat mode for negotiating deals on the system itself. Members are expected to report all the trades negotiated outside the system for settlement. It facilitates member participation in the primary auctions of government securities and treasury bills by submitting their bids/applications for auctions/floatation through their own terminals or pooled terminals. The pooled terminal facility is provided at all regional offices for use by SGL account holders not having member terminals. The NDS is used by the RBI for extending the liquidity adjustment facility to eligible members. All entities having SGL accounts with the RBI were advised to become members of the NDS by May 31, 2002. Till August 5, 2002, 138 SGL account holders were members of the NDS. On an average, 526 deals were reported daily on the NDS, of which 473 deals for Rs. 11,688 crore were ready for settlement during the quarter ended June 2002. These deals comprised money market deals (109 deals for Rs. 8,762 crore), outright government securities trades (344 deals for Rs. 2,080 crore) and repo transactions among member participants. The settlement of the government securities transactions through the CCIL constituted 91.3 per cent of the total government securities trades dealt/reported on the NDS.

The RBI plans to set up an electronic trading platform for repos in government securities which will function in addition to the existing voice-based system.

As the trading facilities—both negotiated and quote driven—were hardly used, a new platform was started on the NDS of the Reserve Bank—the NDS-OM (the NDS—Order Matching System) for trading in government securities on August 1, 2005. NDS-OM is an anonymous platform which allows sellers and buyers to interface by placing quotes. Transactions are executed by matching quotes. Initially banks and primary dealers were the only two participants allowed to trade using the new system. Mutual Funds which are NDS members and large pension/provident funds like the Central Board of Trustees/Seamens/Coal Miners’ funds and insurance companies were later on permitted to access the NDS-OM market by opening temporary current/SGL accounts with the Reserve Bank. Primary dealers are executing trades on behalf of non-bank participants which will drive brokers out of business. The NDS-OM enables odd lot trading, trading of new securities in the when-issued market and trading of CSGL entities. It has become the preferred mode of trading in the government securities market accounting for 60 per cent of trading in this market.

 

  • The goverment securities market now has deals being reported on a real-time basis

The NDS has brought about significant improvements in secondary markets also. It has helped in increasing the level of transparency of the dealings in government securities, T-bills, and other instruments. The system has facilitated screen-based trading, provision of on-line trade information, and reporting through trade execution system for settlement, thereby improving market efficiency. It has also facilitated dissemination of price information on a real time basis to market participants, thus enabling them to execute trades effectively.

Clearing Corporation of India Limited

  • Acts as the central counter-party in settlement of all trades in securities and forex segment

  • Manages risks to avoid system failures

  • Provides guarantee to non-SLR trades

  • Operates a settlement guarantee fund

  • Manages the NDS-OM and NDS-CALL electronic trading platforms for trading in government securities and call money

  • Introduces innovative products/tools such as ZCYC, Bond and T-bill indices, and benchmarks reference rates

  • Introduced CBLO and FX-CIEAR

Clearing Corporation of India Limited

The Clearing Corporation of India Limited (CCIL) was registered on April 30, 2001 under the Companies Act, 1956. The State Bank of India is the chief promoter of the CCIL. Its other promoters are banks, financial institutions, and PDs. It has been set up as an ordinary, limited liability, non-government company under the Companies Act, 1956 with an equity capital of Rs. 50 crore. It functions like a business entity that is subject to corporate tax on its business profits.

It acts as the central counter-party in the settlement of all trades in government securities, treasury bills, money market instruments, repos, inter-bank foreign exchange deals, and derivatives of any kind where the underlying instrument is a security or money market instrument. The CCIL is the clearing and settling agency in respect of all trades by institutional players such as banks, DFIs, primary dealers, mutual funds, corporates, and NBFCs who account for more than 98 per cent of the total trades. It also supports through its fully owned subsidiary, ClearCorp Dealing Systems (India) Ltd., three trading platforms in the forex and money market segments. It launched its forex dealing platform, FX-CLEAR on August 7, 2003 to meet the requirements of the inter-bank foreign exchange market in India. It developed an anonymous trading platform, NDS-OM in August 2005 to facilitate transparent and efficient trading in the government securities market. It launched an electronic screen-based quote driven dealing system-NDS-CALL on September 18, 2006 for call, notice, and term money operations.

After trade has been concluded on the negotiated dealing system (NDS), CCIL takes up the responsibility of settlement of trade via INFINET. During the settlement process, CCIL assumes certain risks, which may arise due to a default by a member to honour its obligations. For this, CCIL has designed the margining system and collects initial margin and mark to market (MTM) margin from members in respect of their outstanding trade. Initial margin covers the likely risk from future adverse movement of prices of the securities while mark to market margin covers the notional loss (i.e., the difference between the current market price and the contract price of the security covered by the trade) already incurred by any member. In addition, CCIL also collects volatility margin and operates a settlement guarantee fund (SGF) wherein each member contributes to it.

CCIL has put in place settlement arrangements on the Securities and Forex segments. In the securities segment, the settlement operation has been switched over to DVP III mode with netting of both funds and securities which has facilitated the rollover of repos. This has enabled participants to buy and sell securities on the same day subject to the stipulations of the Reserve Bank. It has also enabled members to reduce the risks from failed trades arising out of the defaults by their counter-parties. By becoming central counter party to the trades done by its members, the CCIL absorbs risks.

CCIL acts as a central counter-party for forex trading also. Every eligible foreign exchange contract entered into between members, gets novated and is replaced by two new contracts—between CCIL and each of the two parties, respectively. The rupee leg is settled through the member's current account with the Reserve Bank and the US Dollar leg through CCIL's account with the designated settlement banks at New York. The settlement through CCIL has reduced the gross dollar requirement by more than 90 per cent.

The CCIL manages various risks such as credit and market risk, liquidity risk and operational risk to avoid serious system failures.

In securities transactions, the CCIL covers the credit and market risk by making members maintain initial margins as well as mark-to-market margins to cover future adverse movements of securities and notional loss respectively. Members are required to maintain adequate balances in the settlement guarantee fund (SGF) in the form of eligible government securities/treasury bills and cash (minimum 10 per cent) to cover the margin requirements in respect of their trades.

In foreign exchange transactions, the CCIL resorts to loss allocation mechanism to manage credit and market risk and restricts the membership to authorised dealers only.

To ensure liquidity for uninterrupted settlements, CCIL has arranged rupee securities through member contributions to the SGF, rupee funds through line of credit with various banks, and US dollar funds by way of a fully collateralised line of credit with the settlement bank. It has commenced settlement of forex forward trades with guarantee from the trade date from October 20, 2008.

To deal with operational risk, CCIL is developing a fully automated system for processing trades. A disaster recovery site is being set up at the Institute for Development and Research in Banking Technology (IDRBT), Hyderabad, to ensure business continuity in case of a disaster.

The CCIL clears all transactions in government securities and repos reported on the NDS of the RBI and also rupee/USD free spot and forward deals. All repo transactions have to be necessarily put through the CCIL and all outright transactions upto Rs. 20 crore have to be settled through the CCIL. Government securities trades up to Rs. 20 crore have to be settled compulsorily through the CCIL. Since most transactions are of a value below Rs. 20 crore, more than 80 per cent of the government securities transactions are compulsorily routed through the CCIL. This move is aimed at protecting retail investors in the government securities market against counter-party risks and defaults and enable higher retail participation in the government securities market. For larger transactions, the market players have the option of settling transactions either through the CCIL or directly through the SGL account system of the RBI.

The RBI has asked banks to report all spot transactions in listed and unlisted non-SLR securities on the NDS and settle through the CCIL. This measure is expected to increase transparency in the non-SLR segment. The CCIL provides guarantee to non-SLR trades which will reduce default risks.

There were 153 active members in CCIL's securities clearing settlement as on March 31, 2009. The size of the guarantee fund was Rs. 4,380.64 crore. The CCIL's turnover in the government securities segment increased to Rs. 62,54,579 crore in 2008–09 from Rs.26,92,129 crore in 2004–05. The CCIL cleared and settled an aggregate volume of Rs. 3,20,16,852 crore in 2008–09 across its securities, forex, and CBLO segments. The caps placed by the RBI on call money borrowings by banks and PDs, the increased activity in the repo market and the general upswing in the securities market boosted the CCIL's turnover.

The CCIL proposes to launch a screen-based Repo Dealing System which would facilitate dealing in basket repos and special repos. Basket repo enables grouping of the underlying security into different baskets based on instrument category, liquidity and outstanding maturity profile. Special repo enables the borrowers/lenders to specify the security against which they want to borrow/lend. It is also developing a trading system and a system to undertake guaranteed settlement of trades in the IRS/FRA market.

The CCIL, which offers clearing and settlement facilities for inter-institutional government securities transactions and inter-bank foreign exchange transactions, has been recognised as a systemically important payment system (SIPS).

Impact of Reforms in the Government Securities Market

  • The operational autonomy of the RBI has increased through measures such as the abolition of automatic monetisation through ad hoc T-bills and introduction of the system of WMAs for the central government.

  • The introduction of a variety of new instruments such as floating rate bonds, capital indexed bonds, treasury bills of varying maturities, and others, and improvements in market micro-structures such as yield-based and price-based auctions, tap loans, preannounced notified amounts, noncompetitive bids outside notified amounts, re-issue of dated securities, announcing calendar of treasury bills, and the DVP system have added to the breadth and width of the government securities market.

  • The institutional infrastructure of the government securities market has improved through the system of PDs.

  • The government is borrowing from the market at market rates; this has led to greater market absorption and low devolvement on the RBI and PDs.

  • Transparency has increased since the onset of reforms. The RBI has started publishing SGL data regularly. There has been an increase in reporting of deals in government securities on the NSE's WDM screen.

  • The reforms have compelled the RBI to increase focus on treasury management and interest rate risk management.

  • The auction system for raising funds has contributed to the development of bidding skills among the investors.

  • The trading volumes have increased in the secondary market in government securities, reflecting the increasing depth attained by the government securities market. Moreover, the repo transactions have dominated the aggregate turnover which is again a reflection of the emergence of an active secondary market in government securities.

  • The RBI has made efforts in the midst of the large borrowing programme of the central government to soften the medium and long-term interest rates on government securities either through direct devolvement or private placement combined with open market operations.

  • Open market operations has emerged as an important tool for liquidity management together with repos to neutralise excess liquidity in the system and to contain wide fluctuations in the domestic money and foreign exchange markets.

  • The settlement system has improved significantly. Safety of the settlement has been ensured through strict monitoring of the deals by banks and primary dealers and through the delivery versus payment mechanism.

  • The consolidation of the government stocks by re-issuances of existing loans has imparted liquidity to the existing stocks and limited the number of floating stocks.

  • Retail participation has been encouraged through the scheme of non-competitive bidding facility.

  • The RBI introduced the NDS to enhance transparency in trading practices. The CCIL has been set up to significantly improve settlement systems and market efficiency and integrity. The NDS and the CCIL, have brought about a radical transformation in the government securities market which is similar to that which the NSE brought about in the equity markets.

  • The government securities market has benefitted from the emergence of self-regulatory bodies, such as, the Primary Dealers Association of India and Fixed Income Money Markets and Derivatives Association (FIMMDA).

Relative Size of Financial Markets in India

Tables 10.23 and 10.24 provide an overview of the relative size of financial markets in India. The money market constitutes the bulk of the market with an average share of 80 per cent in the total average daily turnover, followed by the equity market and then the government securities market. The average daily turnover of government securities and equities to GDP is a meager 0.2 and 0.4 per cent of GDP respectively. The share of money market almost doubled from 1.6 per cent in 1999–2000 to 2.8 per cent in 2007–08. The size of all the three segments has increased in the post reform period. One of the objectives of the reforms was to foster integration of various segments of the financial markets. The reforms have helped in linking the various segments but these linkages need to get widened and deepened to facilitate linkages with the global financial markets.

 

TABLE 10.23 Relative Size of Financial Markets in India

 

* Covers call money, term money, CBLO, and repo markets.

Source: RBI, Report on Currency and Finance, various issues.

 

TABLE 10.24 Financial Markets at a Glance

 

*Covers call money, term money, CBLO, and Repo market.

Source: RBI, Report on Currency and Finance.

Conclusion

The volume of activity in the debt market has increased significantly. The growth of the government securities market in the post-reforms period is noteworthy. The RBI has done a commendable job for the development of the government securities market. The sluggish equity market conditions have shifted the investors’ preference towards debt. This has led to a growth in volume of trading not only in the government securities market but in the corporate debt market also. The entire debt market is witnessing an upsurge in trading volumes.

KEY TERMS

Debt Market, Auction, STRIPS, Non-competitive Bidding, Yield Curve, Yield Spread, SGL account, Open Market Operations, Primary Dealers, Negotiated Dealing System.

SUMMARY
  1. The debt market is one of the most critical components in the financial system of any economy and acts as the fulcrum of a modern financial system.
  2. In the post-reforms era, a fairly well-segmented debt market has emerged comprising the private corporate debt market; the public sector undertakings bond market; and the government securities market.
  3. The government securities market accounts for more than 90 per cent of the turnover in the debt market. It constitutes the principal segment of the debt market.
  4. The RBI regulates the government securities market and money market while the corporate debt market comes under the purview of the Securities Exchange and Board of India (SEBI).
  5. The major participants in the debt market are central and state governments, primary dealers, public sector undertakings, corporates, banks, mutual funds, foreign institutional, investors, provident funds, charitable institutions, and trusts.
  6. With effect from October 31, 2001, banks, financial institutions, and primary dealers can make fresh investments in and hold bonds and debentures, privately placed or otherwise, only in demat form.
  7. In the primary market, new debt issues are floated either through prospectus, rights, or private placement. The debt instruments are traded on the OTCEI, the BSE, and the WDM segment of the NSE.
  8. Corporates adopt either the public offering route or the private placement route for issuing debentures/bonds. The corporate debt market constitutes a small segment of the debt market despite measures taken to promote this market during the 1990s.
  9. Public sector undertaking bonds are medium-and long-term obligations issued by public sector undertakings. The majority of PSU bonds are privately placed with banks or large investors. PSUs are permitted to issue two types of bonds: tax-free and taxable bonds. PSUs are allowed to issue floating rate bonds, deep discount bonds, and a variety of other bonds. All new issues have to be listed on a stock exchange. The level of activity is quite low as most of the PSU bonds are privately placed leading to a reduction in the floating stock.
  10. Government securities market not only provides resources to the government for meeting its short-and long-term needs but also acts as a benchmark for pricing corporate papers of varying maturities.
  11. Government securities are issued by the central government, state governments and semi-government authorities which also include local government authorities such as city corporations and municipalities.
  12. Considering the significance of a vibrant government securities market and for activating an internal debt management policy, a number of measures were announced in the middle of 1991 to reform the government securities market.
  13. STRIPS is a process of stripping a conventional coupon bearing security into a number of zero coupon securities which can be traded separately.
  14. The existence of a strong retail segment is a prerequisite for the development of the government securities market. The RBI has made efforts to promote retailing of government securities.
  15. The system of ways and means advances (WMAs) has been evolved to accommodate temporary mismatches in government receipts and payments. WMA is not a source of financing budget deficit and is not included in the budget estimates. It is only a mechanism to cover day-to-day mismatches in receipts and payments of the government.
  16. The Government of India securities are medium-to long-term obligations issued by the RBI on behalf of the government to finance the latter's deficit and public sector development programme. Government securities are issued either through auction, sale, or private placement with the RBI.
  17. The RBI introduced non-competitive bidding with a provision for allocation of upto 5 per cent of the notified amount in specified auctions of dated securities for allotment to retail investors on a non-competitive basis at the weighted average rate.
  18. Since 1990–91, the borrowing programme of both the centre and the states handled by the RBI increased more than 40-fold from Rs. 11,000 crore in 1990–91 to Rs. 4.36 lakh crore in 2008–09.
  19. Notwithstanding various reform measures to develop and widen the primary market for government securities, the market continues to be dominated by captive investors such as commercial banks and insurance companies.
  20. Secondary market in government securities can be categorised into two segments: the wholesale institutional segment and the retail segment.
  21. The government securities can be held and transacted in two forms—dematerialised SGL form and physical form. Registration of the participant with the public debt office of the RBI is mandatory in case of holding and trading securities in the physical form. The RBI acts as a depository-cum-clearing house and settlement is through accounts maintained with the RBI called the Subsidiary General Ledger (SGL) accounts. The physical securities are dematerialised and the relevant holdings are in the form of book entries. Every participant in the government securities market maintains SGL and current accounts with the RBI. SGL accounts are maintained by the public debt office. The transfer of government securities does not attract stamp duty or transfer fee. Moreover, there is no tax deduction at source on these securities.
  22. The steady growth in turnover and outright transactions reflects the increasing depth attained by the government securities market and the emergence of an active secondary market in government securities.
  23. The National Securities Clearing Corporation Limited, a wholly owned subsidiary of NSE obtained permission from the RBI to open SGL accounts to offer constituent SGL facility to a wide range of investors. It has set up a common clearing and settlement framework for its SGL constituents to remove the counter-party risks.
  24. Open market operation (OMO) is an important tool of liquidity management. OMOs are actively used to neutralise excess liquidity in the system and to contain wide fluctuations in the domestic money and foreign exchange markets. OMOs involve the sale or purchase of government securities by the central bank.
  25. A system of primary dealers (PDs) was introduced in India in 1996 to further strengthen the market infrastructure and to make it more liquid and broad based. As on March 31, 2009, there were 19 approved PDs in the gilts market.
  26. The NDS provides an online electronic bidding facility in the primary auctions of central/state government securities, OMOs/LAF auctions. It enables screen-based electronic dealing and reporting of transactions in money market instruments including repo, secondary market transactions in government securities, and dissemination of information on trades with the least time lags.
  27. The Clearing Corporation of India Limited (CCIL) was registered on April 30, 2001 under the Companies Act, 1956. It acts as the central counter-party in the settlement of all trades in government securities, treasury bills, money market instruments, repos, inter-bank foreign exchange deals, and derivatives of any kind where the underlying instrument is a security or money market instrument.
REVIEW QUESTIONS
  1. Why is the debt market an important segment of the capital market? Who are the participants in the debt market?
  2. What should be done to revive the corporate debt market and public sector undertakings bond market?
  3. Discuss the role played by the RBI in the government securities market.
  4. Which are the tools for managing liquidity in the government securities market?
  5. State the objectives for the introduction of the primary dealer system? Discuss the role played by them in the government securities market.
  6. Explain in brief the NDS and the role of the CCIL in the government securities market.
  7. Explain uniform price auctions and multiple price auctions.
  8. State the measures taken to promote the corporate debt market.
  9. ‘The corporate debt market constitute a small segment of the debt market despite measures taken to promote this market.’ Discuss.
  10. Write short notes on
    1. STRIPS in the government securities market
    2. Retailing of government securities
    3. When-issued market in government securities
    4. Open market transaction
  11. What is ways and means advances? What are its advantages?
  12. Describe briefly the auction process for central government securities.
  13. State the steps taken to develop the secondary market for government securities.
  14. What kind of reforms have been undertaken in the government securities market? Discuss the impact of reforms on the government securities market.
  15. Describe the trading and settlement system of government securities.

Answer in Brief

  1. What is a yield curve? State the different types of shapes of a yield curve.
  2. What is a yield spread? What are the components of a yield spread?
  3. State the relationship between yield and bond prices.
  4. Who are the investors and issuers in the government securities market?
  5. What are the objectives of reforms in the government securities market?
  6. State some important reform measures undertaken in the government securities market.
  7. What is competitive and non-competitive bidding?
  8. What is SGL and CSGL?

Choose the Right Answer

  1. The 91-day t-bills are auctioned_______________
    1. daily
    2. weekly
    3. fortnightly
    4. monthly
  2. _____________ bids are conducted to encourage participants who do not have sufficient experience in bidding.
    1. competitive
    2. non-competitive
  3. If short term interest rate rise relative to long term rates, the yield curve________________
    1. steepens
    2. flattens
    3. inverts
  4. The______________provides an on-line electronic bidding facility in the primary auctions of government securities.
    1. WDM
    2. NDS
    3. CCIL
  5. The________________provides an anonymous trading platform of government securities.
    1. WDM
    2. NDS
    3. NDS-OM
  6. The_______________is the central counterparty in the settlement of all trades in government securities.
    1. NSCCL
    2. NDS
    3. CCIL
  7. The________________is an electronic screen based quote driven dealing system for call, money and term money operations.
    1. NDS
    2. NDS-OM
    3. NDS-CALL
  8. The________________is the yield differential of an instrument over the previous year.
    1. yield curve
    2. yield spread
  9. To encourage retail participation in the primary market for government securities, an allocation of upto_________________per cent has been provided to retail investors on a non-competitive basis.
    1. 5
    2. 10
    3. 15
    4. 20
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3. Patil, R. H. (2002), ‘Reforming Indian Debt Markets,’ Economic and Political Weekly, February 2–8, pp. 409–20.

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5. Rane, Manoj (1998), ‘Problems with Secondary Debt Market,’ in Gautam Bharadwaj (ed.), The Future of India's Debt Market, Tata McGraw-Hill, pp. 87–94.

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10. Reserve Bank of India, Report on Trend and Progress of Banking in India.

11. Reserve Bank of India, Annual Report.

12. Reserve Bank of India, Handbook of Statistics on Indian Economy, 2001.

13. Reserve Bank of India, Report on Currency and Finance.

14. Vaidhyanathan, R. (2002), ‘Indian Debt Markets: Bonding with the Times,’ Chartered Financial Analyst, March, pp. 15–18.

15. World Bank (1995), ‘The Emerging Asian Bond Market: India,’ Report prepared by ICICI Securities and Finance Company Limited.

16. World Bank (2001), ‘Developing Government Bond Markets—A Handbook.’

17. Gersappa, Ravindra (2004), ‘That Sinking Feeling—Primary Dealers.’ The Economic Times, December 1, p. 8.

18. Clearing Corporation of India Ltd., Factbook, 2008 www.rbi.org.in www.nse-india.com www.ccilindia.com.