Will RBI’s new regulations be effective for bond market?

Abhirup Ghosh

9 February 2015

Moneylife

RBI’s new regulations on bond market prescribe settlement through clearing houses, allows inclusion of instruments issued by several agencies to bring more liquidity and the ‘haircut’ to help corporates to leverage more The Reserve Bank of India (RBI) on 3 February 2015 came out with a new set of regulations on the ready forward contracts on Corporate Debt Securitiesreplacing the old one of 2010. The new regulations are certainly looking better than the old one, but not sure of how effective will it be. There are three things that work for the new regulation. Firstly, unlike the earlier regulations, this one prescribes for settlement through the clearing houses of the three stock exchanges, BSE, NSE and MCX-Stock Exchange (MCX-SE).

This would reduce risk of malpractices adopted by the intermediaries, which is what happened in the Harshad Mehta scam. Secondly, the inclusion of the money market instruments and instruments issued by the multilateral agencies in the list of the eligible collaterals will bring in more liquidity in the corporate bond market. Lastly, the minimum haircut has been kept quite low by the RBI, which would help the corporates to leverage to a greater extent as compared to the earlier regulations. Let us discuss this by way of numerical. Say a bank holds investments in AAA securities worth Rs100. In order to enter into a ready forward contract, the minimum haircut that it will have to bear is 7.5%. Therefore, in order to utilise Rs100, it will have to spend Rs7.5 and thus will be able to leverage up to 12 times [i.e. Rs (100 – 7.5)/ 7.5]. Thus, this would help to the corporates to leverage more than it could normally do. What is a ready forward transaction or a repo transaction? To describe in commoners’ language, a ready forward transaction, which is commonly known as a repo transaction, is where a repo seller sells a security to and investor with an agreement to repurchase the transaction at a pre-determined date at a pre-determined rate. In India, these have tenure of less than one year and are therefore money market instruments and the participants to these transactions are financial institutions as listed down by RBI from time to time. The concept of repo is very common in the US as well is managed by the Federal Reserve. What is new in the new regulations? 1. The 2010 regulations allowed repo transactions against only listed corporate debt securities with an ‘AA’ or above rating held in demat form, however, the Commercial Papers (CPs), Certificates of Deposit (CDs) and other instruments including Non-Convertible Debentures (NCDs) of less than one year of original maturity, were not considered as eligible collateral. The new regulations have something more in store – in addition to what we had earlier, the list of eligible collateral now includes all the money market instruments which were earlier prohibited and bonds with ‘AA’ or above ratings issued by multilateral agencies like World Bank Group (e.g., IBRD, IFC), the Asian Development Bank (ADB) or the African Development Bank and other such entities as may be notified by the Reserve Bank of India from time to time. This is surely a welcome move of RBI. However, the security receipts and the securitised debt instruments still stays excluded from the definition of corporate debts securities. 2. The old regulations prescribed for OTC settlement whereas the new regulations provide that these instruments are to be settled only through the clearing house of NSE, BSE and MCX-Stock Exchange (MCX-SE). 3. The minimum rates for the haircut have also undergone change and in the new regulations, different rates have been provided for securities with different ratings. Higher the rating, lower the haircut. (Haircut means the percentage, which is subtracted from the market value of an asset that is being used as collateral.) For AAA/A1 securities – 7.5% For AA+/A2+ securities – 8.5% For AA/A2 securities – 10% Earlier the minimum rate for the haircut was prescribed at 25%. 4. The CRR and SLR requirements for these securities will be in line with those applicable to the government securities. The concept was in limelight in the early nineties, thanks to the Harshad Mehta scam. Mehta was engaged in stock manipulation scheme financed by undervalued bank receipts, which his firm brokered in ready forward transactions between the banks. The amount involved in this scandal was about Rs5,000 crore rupees! There were several loopholes in the then regulatory framework, which was later on corrected but the concept was discouraged by several bodies in the country. (Abhirup Ghosh works as researcher at Vinod Kothari & Company)