Context

The Indian market for corporate debt needs buoyancy and this has been high on the agenda of our regulator

Background

• The Reserve Bank of India (RBI) stopped the automatic monetization of the fiscal deficit in 1997 and made the government borrow money from the market.
• There are primary dealers or PDs, who pick up the Centre’s bond and provide buy and sell quotes in the secondary market for government bonds and thus help ensure sufficient liquidity.
• The PDs came to be known as market makers and are paid a commission for playing that role.

Liquidity challenge in the corporate bond market

• Unlike the market for government bonds,  in the case of the country’s corporate bond market, the challenge is different.
• It’s typically remunerative for a buyer to buy a security and hold on to it till its maturity.
• Therefore, insurance companies, provident funds, and pension funds hold such long-term paper, as they can match the tenure of their assets with liabilities.
• But this does not add liquidity to the market, and anyone buying a corporate bond today may not find someone to sell it to tomorrow as this market has little trading depth.
•  Even in the G-Sec market, where we assume plenty of liquidity, it is a thinly-traded market, even though the perception is that it is very liquid.

Why do we need market makers for the corporate bond market

• To deal with the lack of depth and liquidity in the corporate debt market, the Securities and Exchange Board of India’s (Sebi) idea of creating market makers holds immense significance.
• The fundamental problem here is that a bond is different from a share.
• A company’s share can be exchanged seamlessly because every share in the market is the same slice of ownership.
• Lack of quotes for different bonds of different tenure: In the case of bonds, however, there are several issuances of a company.
• A single financial institution or non-bank financial company could have as many as 10 issuances a year of varying maturities and interest rates, making each of them a unique instrument.
• Company XYZ may have issued in October 2015 a bond with a face value of ₹100 that pays 6% interest and is due for redemption in 2030, which will be quoted on exchanges for trading (if it’s being traded).
• But, in 2021, it is no longer a 15-year bond, but a 9-year paper.
• Therefore, the security loses importance, as the market normally uses benchmarks like 5 or 10 or 15 years; and every bond drops in the pecking order once it crosses these thresholds.
• Therefore, we need to have market makers who will offer quotes for all major securities and thereby ensure that critical bonds are still available for trading.

Suggestions

• Provide waivers: Playing market maker will involve a cost and hence there should be certain waivers provided to them on trading fees.
• Preferential access: They can be given preferential access to new issuances, so as to build up an inventory.
• Waiver of mark-to-market: The mark-to-market (MTM) rules could be waived for a specified period, as valuation differences can affect their profit and loss accounts.
• Capital at lower cost: Capital can be made available at a lower cost to market makers, as they require funding for the same.
• Fifth, trade among market makers can be awarded benefits in terms of fees or easier taxes on gains made.
• Create bond index: We need to have tradable-bond indices that reflect the price movements of a basket of bonds that they track.
• Made public, such indices will provide appropriate arbitrage opportunities for investors to come in, and this should generate liquidity in the market for these bonds.

Consider the question “Why bond market in India lacks the depth as compared to equity markets. What are the factors responsible for this? Suggest the way forward.”

Conclusion

Market makers are a way out. While success cannot be guaranteed, the idea should be adopted nonetheless, as with credit default swaps. It’s a work-in-progress. Let’s speed it up.

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Back2Basics: Automatic monetization of deficit

• The monetization of deficit was in practice in India till 1997, whereby the central bank automatically monetized government deficit through the issuance of ad-hoc treasury bills.
• Two agreements were signed between the government and RBI in 1994 and 1997 to completely phase out funding through ad-hoc treasury bills.
• And later on, with the enactment of the FRBM Act, 2003, RBI was completely barred from subscribing to the primary issuances of the government from April 1, 2006.

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