A missed opportunity to fast-forward reform

The Reserve Bank has done precious little to improve the market structure

MUMBAI: The mid-term review of the monetary and credit policy is noteworthy not only for what it did (namely hike the CRR) but also for missing an opportunity for fast forwarding improvements in the market structure.

While the intent (of improving market structure to enable innovation) is stated, precious little is visible in terms of concrete actions.

It is widely acknowledged that our government bond markets are shallow and the market for corporate bonds hardly exists. Introduction of interest rate derivative instruments is considered a necessary condition for the market to move towards greater maturity. However, the regulatory regime has continued to drag its feet on this front.

Take the case of interest rate futures. They were first introduced in 2003 without much discussion with market participants. This resulted in faulty design. In addition, the Reserve Bank of India (RBI), for some inexplicable reasons, prohibits banks from taking open positions in interest rate futures. Effectively this means that banks can only go short (since SLR requirements and other related considerations ensure that banks are always long underlying bonds) in the futures segment. Naturally, considering that banks are the largest players in the Indian bond market, no trading took place.

The solution to the problem was simple. Revamp product design in discussion with market participants and allow banks to develop expertise in market making. However, even after four years since rate futures were supposed to have been introduced, we now have one more committee to examine the lessons that have been learnt all these years and revisit the issue from scratch. It appears that we have one more interminable wait.

Similar is the story with credit derivatives. The initial draft discussion paper on credit default swaps (CDS) were issued on March 26, 2003, and feedback / comments were solicited. No further action was taken for more than four years until a couple of months ago when another a set of draft guidelines were issued for feedback. A revised set of guidelines has now been put in the public domain last week. Hopefully, concrete action on these guidelines would be forthcoming before the calendar year end.

Even the revised guidelines place significant restrictions like insistence of a credit rating and inclusion in the rating transition matrix etc which could hamper the development and growth of the market even before it has come into being. Another matter of note is that entities like insurance companies and mutual funds which are important in the context of the development of the market would have to wait till their respective regulators understand the instrument and allow them access to it. If one goes by historical precedence, this is not a prospect that would excite many.

Globally, CDS has become a tool of choice to take a view on credits. The CDS market has become the prime indicator of an entity’s creditworthiness. This was facilitated by derivatives trading not being limited by supply (all you need is a willing counterparty) and market standardisation - instead of having to pick from several different bonds of an entity, you have one CDS curve traded across the market. As a result the volume of CDS trades has exceeded the volume of bonds outstanding, unleashing further innovation in the form of credit event auctions for settlement instead of the standard physical settlement.

And does anybody even remember STRIPS (Separately Traded Registered Interest and Principal Securities). STRIPS are important constituents in developing a long term zero coupon yield curve, which works towards providing the market and policymakers with clear price signals. Several committees worked on this and some initial movement was also made in the roadmap to the introduction of these instruments. It now, seems to have been confined to the dustbin.

The lessons that we draw from all this is clear. Financial market regulators need to move with alacrity. Lethargy and delay is something we can ill afford, if we intend to foster a culture of innovation. Finally, regulators seem to be intent on using a heavy hand in discharging their obligations. On the contrary, furious pace of innovation in some of the global financial markets teach us that it is best to regulate with a light hand. Set up a fair set of rules and then watch Adam Smith’s invisible hand take over and do the rest.

The author is founder and business head of Finanzlab Advisors an independent consultancy.

dheeraj.singh@finanzlab.com