Development & Regulation Of Financial Markets

IX

DEVELOPMENT AND REGULATION OF FINANCIAL MARKETS

reverse repos, a series of open market purchases of government securities to support the gilt market and foreign exchange sales. The development of financial markets in terms of building up the institutional and technological infrastructure and fine-tuning of market microstructure was continued apace with the changing context of the regulatory function.

9.1 Orderly conditions prevailed in financial mar kets dur ing 2001-02 with br ief per iods of uncertainty associated with extraordinary events in September and December 2001. Barring these episodes, the call money market remained stable and generally range-bound within the informal reporeverse repo corridor. The foreign exchange market experienced comfortable supply conditions. Yields fell across all maturities in the government securities market, accompanied by a significant rise in turnover. Orderly market conditions were engendered by the active management of liquidity in the money, foreign exchange and gilt markets. The Reser ve Bank absorbed sizeable liquidity on a continuous basis through repos. Foreign exchange purchases were effected to offset strong capital inflows and open market sales of government securities were employed on some occasions to absorb excess liquidity (Chart IX.1). Market reactions to the September 11, 2001 event were calmed by injections of liquidity through

9.2 The Negotiated Dealing System (NDS) (Phase I) was operationalised with effect from February 15, 2002 with 41 participants. The NDS provides on-line electronic bidding facility in the primary auctions of Central/State Government securities and OMO/LAF auctions. It enables screen-based electronic dealing and reporting of transactions in money market instruments, secondary market transactions in government securities and facilitates dissemination of information on trades with the minimal time lag. It also permits “paperless” settlement of transactions in government securities with electronic connectivity to the Clearing Corporation of

Chart IX.1 : Reserve Bank’s Operations in the Financial Markets

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DEVELOPMENT AND REGULATIONS OF FINANCIAL MARKETS

India Limited (CCIL) and the delivery versus payment (DVP) settlement system at the Public Debt Office. As on August 5, 2002, 138 SGL account holders had joined the NDS. On an average, 526 deals were reported daily on NDS, of which 473 deals for Rs.11,668 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 market participants. The settlement of government securities transactions through the CCIL constituted 91.3 per cent of total government securities trades dealt/reported on the NDS.

9.3 The CCIL also commenced its operations from February 15, 2002 in clearing and settlement of transactions in government securities. Acting as a central counterparty through novation, the CCIL provides guaranteed settlement and has in place risk management systems to limit settlement risk. It operates a settlement guarantee fund (SGF) made up of contributions from its members and backed by lines of credit from commercial banks (Box IX.1). All repo transactions have to be necessarily put through the CCIL while all outright transactions up to Rs.20 crore have to be settled through the CCIL. The option to settle outright transactions in government securities above the face

Box IX.1 Risk Management by the Clearing Corporation of India Limited (CCIL) securities deposited into the SGF, a ‘haircut’ is applied which is currently at 5 per cent.

The CCIL has been set up to function as an industry service organisation for clearing and settlement of trades in foreign exchange, gover nment secur ities and other debt instruments. It is owned by major banks (58.5 per cent of the equity), financial institutions (24 per cent of equity) and primary dealers (17.5 per cent of equity). As the Central Counter Party (CCP) to all trades executed by its members, the CCIL is required to have a sound system for risk management since the failure of a CCP would have serious systemic consequences, especially where multiple markets are served by one CCP. The CCIL manages various risks and reallocates risk among its participants as set out below.

(ii) Foreign Exchange Transactions - Unlike in securities transactions which settle on a DVP basis, default in foreign exchange transactions because of time zone differences results in the loss of the asset purchased. The CCIL does not, however, bear this principal risk which is borne by the members; in its role as the CCP, CCIL ensures the liquidity of the system by delivering the counter-value funds to the buyer on the value date. Credit risk arising on account of a member’s default in settlement of its obligation in a currency is managed by the CCIL by resorting to its loss allocation mechanism (i.e., by apportioning the loss arising out of such default, net of the margin collected from the defaulting member, to its counterparties in proportion of their net buy position vis-a-vis the defaulting member in the currency of default). To ensure that the members are in a position to absorb any loss due to default in a foreign exchange trade, membership is restricted to authorised dealers with a threshold level of financial strength assessed by using a model based on criteria like capital, profitability, asset quality, liquidity size, etc. The maximum exposure to be taken by the CCIL on a member or Net Debit Cap (NDC), is arrived at on this basis. The margin factor of a member is decided on the basis of the financial standing. The margin factor also includes a factor for Rupee/US dollar exchange rate volatility (VaR at 99 per cent confidence level for three-day holding period). The actual exposure taken by the CCIL to a member is decided by the margin factor and the value of SGF contribution, with NDC acting as the outer limit. Utilisation of the Exposure Limit by member banks is monitored to ensure that there is no breach of limit. Any exposure in excess of NDC is entirely covered by deposits by the member in US dollars. It is ensured (through appropriate computation of the margin (Contd....)

1. Credit and Market risk (i) Securities Transactions - The operation of the CCIL through a deliver y versus payment (DVP) mechanism in the books of the Reserve Bank eliminates any principal risk (loss of assets purchased) of default. In case of any default, the CCIL’s risk is essentially limited to market risk arising from any adverse change in the price of the security. The CCIL covers this risk by making members maintain initial margins to cover future adverse movements of prices of the securities as well as mark-to-market margin to cover the notional loss, i.e., the difference between the current market price and the contract price in respect of the outstanding trades. The margins are computed trade-wise. The initial margin requirement for each trade is calculated by multiplying the value of the security by a margin factor (calculated on the basis of security-specific VaR) for the security. The markto-market margin is required to be maintained by members holding adverse positions; no credit is allowed for positions with notional gains. 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. For

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ANNUAL REPORT

(Concld....)

default by the member having the largest NDC. An additional clean committed line of credit of substantial amount has also been arranged from the settlement bank. In case these lines are not enough for completion of settlement at the time designated, a Shortfall Allocation Procedure, along the lines of the Loss Allocation Mechanism is initiated.

factors) that the collateral collected from the members is sufficient to secure a line of credit (fully collateralised) large enough to absorb at least the default by the member having the largest NDC. The settlement bank would provide the credit line. 2. Liquidity Risk - The CCIL’s primary commitment is to ensure uninterrupted settlement and therefore it is required to provide adequate liquidity in terms of government securities, rupee funds and US dollar funds for completion of settlements. To cover its liquidity risk, CCIL has arranged

3. Operational Risk - To deal with operational risk, the CCIL is developing a fully automated system for processing trades. CCIL’s computer systems are robust with sufficient redundancies built in to suppor t uninterrupted operations. The trade data are received from the Negotiated Dealing System in an automated process avoiding possible human errors. 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. High level of data security has been implemented using latest technologies like Firewall and PKI based encryption. Suitable personnel have been recruited and appropriate authority structure, workflow design and control systems are in place.

(i) rupee securities through members’ contribution to the SGF; (ii) rupee funds through lines of credit with various banks; the securities in the SGF could also be used for repo operations in the market with PDs/banks which, in turn, could use the securities for repos with the Reser ve Bank under the Liquidity Adjustment Facility (LAF); (iii) US dollar funds by way of a fully collateralised line of credit with the settlement bank, (collateralised by members’ contribution to the SGF in US dollars) which would be enough to absorb at least the

Source : Clearing Corporation of India Ltd.

value of Rs.20 crore either directly with the Reserve Bank or through the CCIL is available to NDS members.

would meet short-term liquidity mismatches and not undertake regular financing operations. With the rationalisation of the standing liquidity facilities, the Liquidity Adjustment Facility (LAF) has emerged as the prime instrument for managing market liquidity and for setting a corridor for the movement of the short-term rates consistent with policy objectives (Table 9.1). From May 2001, the Reserve Bank shifted to the system of multiple price auctions for repos and reverse repos conducted under LAF. Simultaneously, attempts are being made to develop the term money market, repo and other money market instruments for more balanced growth of various segments of money market.

9.4 There are 141 active members in the CCIL’s securities clearing segment of which 139 members have contributed to the SGF. The size of the guarantee fund is at Rs.1,031 crore. The cash component of SGF is Rs.199 crore, while the securities component is Rs.832 crore. The propor tion of settlement of outright transactions through the CCIL to total outright transactions settled in the Public Debt Office (PDO) of the Reserve Bank, Mumbai improved significantly from 44.7 per cent (Rs.45,469 crore) in April 2002 to 79.1 per cent (Rs.49,484 crore) in June 2002. The rise in settlement of the first leg of repo transactions through CCIL had also been significant, i.e., from 24.4 per cent (Rs.11,455 crore) to 67.2 per cent (Rs.25,436 crore) of the total repo settlement in PDO, Mumbai.

9.6 The daily minimum reserve maintenance requirement of banks was relaxed from 65 per cent of required reserves for the reporting fortnight (excluding reporting Friday) to 50 per cent for the first week while keeping it at 65 per cent for the second week of the reporting fortnight (including reporting Friday), effective from the for tnight beginning August 11, 2001. Simultaneously, the inter-bank term liabilities of original maturity of 15 days to one-year were exempted from the CRR prescription. Fortnightly repo auctions were introduced from November 5, 2001.

Money Markets 9.5 The thrust of monetary policy in recent years has been to develop an array of instruments to transmit liquidity and interest rate signals to the short-term money market in a flexible manner. The objective is to develop a liquid short-term rupee yield curve to enable efficient price discovery and to improve the operational effectiveness of monetary policy. Over the medium term, it is expected that the call/notice money market would evolve into a pure inter-bank market where participants

Call/Notice Money Market 9.7 In order to achieve a smooth phasing out of non-bank institutions from call/notice money market, 144

DEVELOPMENT AND REGULATIONS OF FINANCIAL MARKETS

Table 9.1: Repo and Reverse Repo Operations under Liquidity Adjustment Facility Month

Average Daily Repos (LAF) outstanding (Rupees crore)

1

Average Daily Reverse Repo (LAF) Outstanding (Rupees crore)

Repo Rate Movements

Reverse Repo Rate Movements

Date/Month

Cut-off rate (Per cent)

Date/Month

Cut-off rate (Per cent)

2

3

4

5

6

7

2001 March April May June July August September October November December

3,952 10,968 2,132 2,458 2,350 3,243 1,139 1,325 4,553 2,469

650 169 1,737 45 200 – 233 866 845 166

March 2 April 27 May 28 June July August September October November December

7.0 6.75 6.5 6.5 6.5 6.5 6.5 6.5 6.5 6.5

March 9 April 30 June 7 June July August September October November December

9.0 8.75 8.5 8.5 8.5 – 8.5 8.5 8.5 8.5

2002 January February March April May June July

4,821 3,590 2,986 8,119 1,924 9,640 14,636

– 2 370 132 17 – –

January February March 5 April May June 27 July

6.5 6.5 6.0 6.0 6.0 5.75 5.75

January February March 28 April May June July

– 8.5 8.0 8.0 8.0 – –

– Indicates no holding of reverse repo auctions.

non-bank financial institutions were permitted to lend, on an average, up to 85 per cent of their average daily lending during 2000-01 in a repor ting for tnight, effective May 5, 2001; corporates were phased out from lending in this market, effective July 1, 2001 (Table 9.2). With the full-scale operationalisation and wide accessibility of the NDS and the CCIL, non-bank

participants would be allowed to lend, on an average, in a reporting fortnight up to 75 per cent of their average call lending during 2000-01. 9.8 Efforts are underway to define the prudent limits on exposure of banks to the call money market so as to reduce the chronic reliance of banks on call

Table 9.2 : Time Table for Pure Inter-bank Call Money Market Stages

Time Table announced in April 2001

Progress Achieved so far

1

2

3

Stage I

Effective May 5, 2001, non-bank institutions (i.e., financial institutions, mutual funds and insurance companies) were allowed to lend, on average, up to 85 per cent of their average daily lendings in the call money market during 2000-01 in a reporting fortnight. Permission to corporates to route their call transactions through primary dealers was available up to June 30, 2001. Effective from the date of operationalisation of CCIL, nonbanks were to be allowed to lend up to 70 per cent of their average daily lendings in the call/notice money market during 2000-01.

Implemented

Stage II

Stage III Effective 3 months after Stage II, access to non-banks to the call money market would be 40 per cent of their average daily lendings in the call/notice money market during 2000-01. Stage IV Effective three months after Stage III, access to non-banks to the call money market would be 10 per cent of their average daily lendings in the call/notice money market during 2000-01.

145

Implemented NDS and CCIL were operationalised on February 15, 2002. It was announced in April 2002 that the limit on non-bank lendings in the call/notice money market would be scaled down to 75 per cent of their average daily lendings in the call money market during 2000-01. The effective date of which would be announced when NDS/CCIL becomes fully operational and widely accessed. Not yet implemented.

Not yet implemented.

ANNUAL REPORT

market other than for meeting unforeseen mismatches. Accordingly, as announced in the Monetary and Credit Policy for 2002-03, prudential limits on the exposure of commercial banks to call/notice money market were stipulated in two stages (Table 9.3).

Banks, financial institutions (FIs) and primary dealers (PDs) were permitted to make investments and hold CPs only in the dematerialised form since June 30, 2001 without prejudice to the provision of Depositories Act, 1996 and to convert existing outstandings also into demat form by October 31, 2001. The standard procedures and documentations to be followed by participants in the CP market were prepared by the Fixed Income Money Mar ket and Der ivatives Association (FIMMDA), in consultation with the market participants and issued on June 29, 2001.

9.9 The daily borrowings of State Co-operative Banks (SCBs) and District Central Co-operative Banks (DCCBs) in call/notice money market should not exceed 2.0 per cent of their aggregate deposits as at the end of March of the previous financial year. Temporary increase in access to call/notice market to any bank facing mismatches could, however, be allowed by Reserve Bank on request and for a longer period for banks with fully functional ALM systems.

Certificates of Deposit (CDs) 9.12 On the same lines, the FIMMDA has prepared and made public the guidelines and documentation procedures for issuing CDs. The minimum denomination of a CD was reduced to Rs. 1 lakh in June 2002 in order to increase the investor base. As a further step towards transparency, banks and FIs were required to issue CDs only in the dematerialised form with effect from June 30, 2002, without prejudice to the provisions of Depositories’ Act 1996. Existing outstandings of CDs need to be converted into the demat form by October 2002.

9.10 In pursuance of the recommendations of the Working Group set up to recommend the criteria for fixing the limits for Primary Dealers (PDs) in the call/notice money market, PDs are permitted to lend in call/notice money market up to 25 per cent of their net owned funds (NOF) with effect from October 5, 2002. The call borrowings of PDs would be reduced in two stages with the borrowing limits being stipulated up to 200 per cent of their NOF as at end-March of the preceding financial year in Stage I and up to 100 per cent of their NOF in Stage II. The first stage would become operational after requisite developments in the repo market. The PDs would, however, be exempt from this limit for the days on which government dated securities are issued to the market. On implementation of the real-time gross settlement system (RTGS), the exemptions would be reviewed. All these measures are expected to facilitate the activation of term money and repo markets.

Government Securities Market 9.13 The guiding objectives in the development of the government securities market have been to develop a smooth yield curve, to create a suitable benchmark for pricing of various debt instruments and to enable use of indirect instruments for the operation of monetary policy. The significant steps taken towards deepening and widening of the government securities market during 2001-02 include elongation of maturity profile of outstanding securities, development of benchmarks by consolidating new issuances in key maturities, enhancing fungibility and liquidity through

Commercial Paper (CP) 9.11 The Reserve Bank had issued guidelines for issuance of CP on October 10, 2000, relaxing the terms and conditions and streamlining the procedures.

Table 9.3: Prudential Limits on Exposures of Commercial Banks in Call/Notice Money Market Stage 1

Policy Measure 2

Stage 1

With effect from the fortnight beginning October 5, 2002, lending of scheduled commercial banks in the call/notice money market, on a fortnightly average basis, should not exceed 50 per cent of their owned funds (paid-up capital plus reserves) as at the end of March of the previous financial year; however, banks are allowed to lend a maximum of 100 per cent of their owned funds on any day during a fortnight. Borrowings by scheduled commercial banks in the call/notice money market, on a fortnightly average basis, should not exceed 150 per cent of their owned funds or 2 per cent of aggregate deposits as at the end of March of the previous financial year, whichever is higher; however, banks are allowed to borrow a maximum of 250 per cent of their owned funds on any day during a fortnight.

Stage II

With effect from the fortnight beginning December 14, 2002, lending of scheduled commercial banks, on a fortnightly average basis, should not exceed 25 per cent of their owned funds; however, banks are allowed to lend a maximum of 50 per cent on any day during a fortnight. Similarly, borrowings by scheduled commercial banks should not exceed 100 per cent of their owned funds or 2 per cent of aggregate deposits, whichever is higher; however, banks are allowed to borrow a maximum of 125 per cent of their owned funds on any day during a fortnight.

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DEVELOPMENT AND REGULATIONS OF FINANCIAL MARKETS

Table 9.4: Benchmarks and their Selections in G-10 Government Bond Markets Country

Number of benchmarks

Type

Criteria of selection

1

2

3

4

Canada

Seven

On-the-run issues for each maturity

Italy

Five

3-and 6-month; 1-,2-,5-,10- and 30-year 2-,3-,5-,7-, and 10-year

Japan

One

10-year

10-year bond with large issue amount, and being traded near par value

United Kingdom

Four

5-,10-,20-, and 30 year

On-the-run issues for each maturity

United States

Seven for fixed-coupon

3-,6-month, 1-,2-,5-,10-, and 30-year

On-the-run issues for each maturity

securities Two for index-linked bonds

10-and 30- year

Belgium

Two

5- and 10-year

On-the-run issues for each maturity

France

Seven for fixed-coupon securities Two for index-linked bonds

3- and 6-month, 1-,2-, 5-,10-, and 30-year 10- and 30-year

On-the-run issues for each maturity

Germany

Four

2-,5-,10- and 30-year

On-the-run issues for each maturity

Netherlands

Two

10-and 30-year

On-the-run issues with a size of at least Dfl 10 billion for each maturity

Sweden

Twelve

2-,3-,4-,5-,6-,7-,8-,9-,10-, 11-,12-, and 16-year

All bonds that can be reopened

Switzerland

Six

7-,9-,10-,11-,12-, and 13-year

Liquid benchmarks with maturities of around 10 years

On-the-run issues (with the highest trading volume) for each maturity

Source : Developing Government Bond Markets - A Handbook,The World Bank, IMF, 2001.

consolidation by reissue of existing loans, promoting retailing of government securities and re-introduction of Floating Rate Bonds. The development of key benchmark securities in the Indian gilt market is in line with international best practices with the 10-year government security evolving as a benchmark, as in several developed countries (Table 9.4).

Primary Market 9.14 The issuances of government dated securities are normally concentrated in the first half of the year. In 200102, more than two thirds of the issuance was raised during the first half of the year with Rs. 28,000 crore or 24.5 per cent of total issuance raised in April 2001 (Chart IX.2). 9.15 To encourage retail participation, in particular amongst the mid-segment investors in the primary market for government securities, the Reserve Bank implemented a scheme of Non-Competitive Bidding with provision for allocation of up to 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. The scheme was

operationalised from January 14, 2002 with the auction of 15-year Government stock (Box IX.2). 147

ANNUAL REPORT

Box IX.2 Non Competitive Bidding Scheme: Features •

Retail investors like individuals, firms, companies, cor porate bodies, urban co-operative banks, institutions, provident funds, trusts and any other entity as may be prescribed by Reserve Bank are allowed to participate in auctions as non-competitive bidders.

•

Non-competitive bidders are required to submit their bids through banks and PDs.

•

Allocation for non-competitive bidding is within the

notified amount and if the amount tendered by the non-competitive bidders is less than the reserved amount, all participants receive full allotment and the shortfall is transferred to competitive portion. If the amount received is more than the reserved amount, all applicants receive pro rata allotment. •

9.16 The Floating Rate Bond (FRB) was reintroduced on November 21, 2001 with a 5-year maturity issue for a notified amount of Rs.2000 crore. On December 5, 2001, another FRB with maturity of 8 years for notified amount of Rs.3,000 crore was auctioned. Later in July 2002, a 15 year-FRB for a notified amount of Rs.3,000 crore was floated. The interest rate on these bonds is calculated by adding a fixed spread (determined in the auction) over a variable base rate. The base rate is the average of the implicit yields arising at the immediately preceding six auctions of 364-day Treasury Bills, prior to the relative half-year coupon period. The interest rate is reset every six months.

9.18 The Reserve Bank announced a core calendar for issuance of dated securities for the period April to September 2002 (see Section XI). A 10-year bond with call and put options on or after five years was floated on July 17, 2002 for an amount of Rs. 3,000 crore.

Secondary Market 9.19 In the secondary market for government securities, open market sales served the purpose of absorbing surplus liquidity on an enduring basis, stabilising the prices of government securities and off-loading the securities privately placed with the Reserve Bank earlier in the year (Table 9.6).

9.17 The issue of 14-day and 182-day Treasury Bills was discontinued with effect from May 14, 2001. The notified amount of 91-day Treasury Bill auctions was increased from Rs.100 crore to Rs.250 crore from May 18, 2001 and dates of payment were synchronised with the dates of payment of 364-day Treasury Bills to provide a fungible stock of Treasury Bills of varying maturities and to activate the secondary market. A calendar for the auctions of Treasury Bills was announced on May 12, 2001 which was valid till March 31, 2002 (Table 9.5). The notified amount of the 364day Treasury Bill was increased from Rs.750 crore to Rs.1,000 crore from April 3, 2002.

9.20 The Reserve Bank conducted a series of open market purchases aggregating Rs.5,084 crore during September 18-October 10, 2001 to support the gilt market in the face of the steep fall in the government security prices due to adverse external developments after September 11, 2001(Table 9.7). 9.21 The Reserve Bank has been encouraging holding of government securities in dematerialised form. Trading in government securities through the subsidiary general ledger accounts (SGL) with the Reserve Bank, wherein the DVP system ensures simultaneous transfer of securities against funds, accounts for 99 per cent of total transactions in securities. In view of recent irregularities in the government securities market, the Reserve Bank banned, with effect from May 20, 2002, any transactions by any of its regulated entities in physical form with any broker and made it mandatory to hold gilt investments in either SGL (with Reserve Bank) or constituent subsidiary general ledger (CSGL) [with a scheduled commercial bank/State Cooperative Bank/PD/FI/sponsor bank (in case of RRBs)], Stock Holding Corporation of India Ltd. (SHCIL) and National Securities Clearing Corporation Limited (NSCCL) or in a dematerialised account with depositories (NSDL/ CDSL).

Table 9.5 : Calendar for Auction of Treasury Bills Type of Treasury Bill 1 91-day

364-day

Periodicity

Notified Amount (Rupees crore)

Day of Auction

Date of Payment

2

3

4

5

Weekly

250

Fortnightly

A non-competitive bidder is permitted to submit only one bid in the auction with a minimum amount of Rs.10,000 and a maximum of Rs.1 crore.

Every Following Wednesday Friday

750* Wednesday Following preceding Friday the reporting Friday

* Increased to Rs.1,000 crore effective April 3, 2002.

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DEVELOPMENT AND REGULATIONS OF FINANCIAL MARKETS

Table 9.6 : Open Market Operations during 2001-02 – Sales* Date of Issue

Government Security

1 April 21-23, 2001 June 6-8, 2001 June 21, 2001 July 12, 2001 August 29, 2001 August 31, 2001 September 1-4, 2001 December 3, 2001

December 10, 2001

Amount Accepted (Rupees crore)

Price (Rupees)

Yield (Per cent)

Method of Sale

2

3

4

5

6

11.60 % GS 2020 11.50 % GS 2011 10.25 % GS 2021 11.03 %GS 2012 12.59 % GS 2004 10.25 % GS 2021 10.71 % GS 2016 13.05 % GS 2007 11.75 % GS 2006 9.81 % GS 2013 11.43 %GS 2015 11.50 % GS 2011 10.18 % GS 2026 10.95 % GS 2011 10.18 % GS 2026

4,999 1,315 507 4,000 5,000 4,493 3,731 2,000 322 679 2,000 2,500 2,000 830 520

104.75 110.45 100.80 108.85 112.25 102.50 107.00 120.69 116.13 102.90 125.25 124.65 117.55 117.00 112.50

11.00 9.87 10.16 9.71 7.83 9.95 9.80 8.37 7.55 9.39 8.30 7.88 8.47 8.32 8.92

Tap Tap Tap Tap Auction Tap Auction Auction Tap Tap Auction Auction Auction Auction Auction

Total

34,899

* To market participants.

Primary Dealers market has been the establishment of the primary dealer system, which is in operation for the last seven 9.22 One of the impor tant steps taken by the years (Box IX.3). Reserve Bank to develop the government securities Table 9.7 : Open Market Operations during 2001-02-Purchases* Date 1 September 18, 2001

September 19, 2001

September 20, 2001

September 21, 2001

September 24, 2001

September 26, 2001

October 3, 2001

October 10, 2001

Government Security (GS) 2 11.40 % GS2008 11.50 % GS2011 10.71 % GS2016 10.25 % GS2021 11.68 % GS2006 11.99 % GS2009 11.03 % GS2012 11.60 % GS2020 11.00 %. GS2006 11.90 % GS2007 11.30 % GS2010 11.60 % GS2020 11.75 % GS2006 9.39 % GS2011 10.47 % GS2015 10.70 % GS2020 11.98 % GS2004 11.40 % GS2008 11.50 % GS2011 10.45 % GS2018 12.50 % GS2004 11.68 % GS2006 11.03 % GS2012 11.43 % GS2015 11.00 % GS2006 9.40 % GS2012 10.71 % GS2016 10.25 % GS2021 11.00 %GS 2005 11.99 % GS2009 9.81 % GS2013 10.75 % GS2020

Total

Amount of Bids (Rupees crore) Received Accepted 3 500 555 976 515 105 480 605 159 635 305 1,025 190 450 1,184 911 116 259 723 585 376 374 103 510 440 105 35 91 270 60 235 415 14

4 110 360 356 140 20 195 25 – 450 210 455 100 305 809 216 106 25 438 365 165 105 3 – 10 – – 31 85 – – – –

13,306

5,084

* From market participants

149

Cut-off price (Rupees)

Cut-off Yield (per cent)

5 113.50 113.50 105.85 101.20 114.25 115.50 110.20 – 111.00 116.00 112.00 112.00 114.25 99.85 104.00 105.00 110.60 113.50 113.50 103.75 110.90 114.25 – 111.40 – – 106.25 102.45 – – – –

6 8.76 9.41 9.94 10.10 7.89 9.10 9.50 – 8.20 8.31 9.28 10.16 7.96 9.41 9.92 10.10 7.89 8.76 9.40 9.98 7.61 7.88 – 9.90 – – 9.89 9.96 – – – –

ANNUAL REPORT

Box IX.3 System of Primary Dealers in the Government Securities Market: International Experience The Reserve Bank introduced the system of PDs in March 1995 to strengthen the infrastructure in the government securities market and ensure development of underwriting and market-making capabilities and to develop an effective conduit for open market operations. 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. Furthermore, the PDs have been made subject to minimum obligations with respect to bidding, success ratio and turnover commitments. PDs are also obliged to act as market makers by providing firm two-way quotes in select securities.

The Primary Dealer (PD) system is an integral part of the government securities market internationally. The system has existed in a variety of forms. Typically the PDs comprise banks, financial institutions and securities broker-dealers. In India, specialist entities have been chosen as PDs since banks have traditionally been investors rather than traders. The USA has one of the older PD systems. The system is also prevalent in UK, Canada, France, Italy, Belgium, South Africa among others. In contrast, the PD system does not exist in Australia, Germany, Netherlands and New Zealand. The PD system worldwide is closely monitored by the central bank or the Treasury. PDs are selected on the basis of financial soundness, adequate managerial capacity and active presence in the market and the continuation of the license of a PD is dependent on their performance in treasury auctions, open market operations and in the secondary market.

In recent times, there is growing interest in the system worldwide. In March 2002, Mauritius introduced a PD system similar to the Indian PD system. In April 2002, Japan has also taken steps to introduce a PD system by abandoning the traditional syndication system.

The Reserve Bank provides liquidity support to PDs through repos/refinance against Central Government securities under three levels. At the first level, normal refinance at Bank Rate is provided up to a specified amount. A backstop refinance at a variable rate up to a fixed quantum is provided at the second level. Finally, discretionary suppor t is extended through Liquidity Adjustment Facility (LAF). The total assured liquidity support for all PDs together is about Rs.4,500 crore for 2002-03 as against Rs.6,000 crore during 2001-02, of which, two-third is under the normal facility and one-third under the back-stop facility. PDs can open current account and SGL accounts with the Reserve Bank (which also makes them eligible to undertake ready forward transactions in eligible government securities) and transfer funds under the Remittance Facility Scheme. As PDs have the status of “Financial Institutions” for the purpose of Section 18 of Banking Regulation Act, 1949 and Section 42 of RBI Act, 1934, the borrowings by commercial/cooperative banks from them would be netted for reckoning their demand and time liabilities for the purpose of computation of cash reserves. PDs can underwrite primary issues of government securities and earn underwriting commission. In view of their systemic importance PDs have since been brought under the supervisory jurisdiction of the Board for Financial Supervision (BFS). In accordance with international practices, capital adequacy guidelines have been laid down for the PDs. The PDs in India are also in the process of instituting risk management practices based on Value-at-Risk (VaR) models.

9.23 During 2001-02, the PDs absorbed 65 per cent of auctioned primary issues of government securities and 83 per cent in the Treasury Bill auctions. The PDs achieved a turnover (outright) of Rs. 6,52,127 crore (representing 26.9 per cent of outright market transactions) during 2001-02 (Table 9.8). While the call money borrowings remained a steady source of finance for their gilt investments (at an average daily

net call money borrowing of Rs.6,711 crore in 200102 as against Rs.6,216 crore in the previous year), the average daily utilisation of liquidity support by the PDs, at Rs.1,529 crore in 2001-02, was well below the utilisation of Rs.4,145 crore during 2000-01. This lower utilisation reflects the ample liquidity available in the system during the year. With the development of the repo market and measures taken to facilitate

The system works on a quid pro quo basis with the PDs having a set of obligations in return for which they have certain privileges. While PDs are obliged to absorb a minimum auction share in the USA, Italy, UK and France, they are committed towards a minimum bidding amount in India, Poland and Hungary. Secondary market commitments are also practiced in many countries, such as, Belgium and South Africa. In many countries, PDs underwrite the auction of government securities. In the secondary market, the PDs ensure liquidity by continuous presence in the market and by quoting two-way prices on specific types of securities. PDs may enjoy a wide range of privileges which ranges from funding by the central bank to exclusivity in auction process. One major privilege given to PDs is exclusive participation in the auction process (USA and Canada), exclusivity to open market operations (USA and UK) and exclusive participation in non-competitive bidding. In addition to these explicit privileges, PDs enjoy indirect advantages such as the prestige of their special status in the government securities market or direct access to infor mation about the extent and context of the government’s borrowing needs.

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to discontinue the system and existing SDs were required to make satisfactor y action plans for terminating their operations by May 31, 2002.

Table 9.8 : Select Indicators of the Primary Dealers (Amount in Rupees crore) Item

end March end March end March 2002 @ 2001 2000

1

2

Number of PDs Total Capital (NOF) Total assets

Of which: Government Securities Government Securities as percentage of total assets PD system turnover (Outright) Market turnover (Outright) PD turnover to Market Turnover (per cent, Outright) Liquidity Support limits

3

9.26 The Reserve Bank reconstituted the Technical Advisor y Committee (TAC) on Money and Government Securities Markets in September 2001 to advise it, on an on-going basis, on the development of a healthy and vibrant money and government securities markets. The TAC held five meetings during 2001-02 to discuss general market developments, retailing of government securities, establishment of the NDS and CCIL, prudential aspects of banks’ investment in government securities, development and regulation of the institution of PDs, SDs and introduction of STRIPS.

4

18

15

15

4,437

3,184

2,688

15,658

14,772

15,399

12,236

10,401

10,502

78

70

68

6,52,127

3,16,915

2,34,337

24,23,933

11,44,291

9,12,986

26.9

27.7

25.7

4,000 (Normal) 2,000 (Backstop)

6,000

5,900

@ Unaudited. Note : Turnover data pertains to the financial year.

Foreign Exchange Market 9.27 The foreign exchange market was generally stable during 2001-02 except for brief periods of uncertainty during May 2001 (on account of pressure on oil prices), September 2001 (aftermath of terrorist attacks in the US) and December 2001 (terrorist attack on the Indian Parliament). In order to stabilise the domestic financial markets during these episodes, the Reserve Bank undertook a series of measures (See Section I).

transaction in the repo market, it is expected that over the years the repo market will provide the major source of funds for PDs’ operations. 9.24 Under the new guidelines to improve the risk management system of PDs issued in December 2000, they are required to maintain minimum capital of 15 per cent of aggregate risk weighted assets, including market risk capital. Market risk capital is arrived at by a standardised model and also by using the Value-at-Risk(VaR) method and the higher of the two is maintained. PDs in the process of developing a VaR system have to maintain 7 per cent market risk capital during the interim period. In January 2002, PDs were advised to provide back-testing results for the year ended December 31, 2001 and to follow a prudent distribution policy so as to build up sufficient reserves even in excess of regulatory requirements which can act as a cushion against any adverse interest rate movements in the future. The daily reporting format of PDs was modified to reflect the diversified nature of sources and application of funds. Further, in view of the risks involved in accepting InterCorporate Deposits (ICD) and deploying those funds in non-SLR bonds, PDs were advised to restrict acceptance of ICDs to 50 per cent of their Net Owned Funds and evolve a policy for acceptance of ICDs after due consideration of the risks involved. The ALM discipline was also extended to PDs during 2001-02. Unlike other NBFCs, the entire portfolio of government securities of PDs has been allowed to be treated as liquid.

9.28 A number of steps were taken in continuation of the phased approach to capital account liberalisation during the year. Non-resident nonrepatriable (NRNR) account and non-resident special rupee (NRSR) account schemes were discontinued with effect from April 1, 2002 in order to provide full convertibility on non-resident deposit schemes. While no new deposits would be accepted under these schemes, existing term deposit accounts under both the schemes have been allowed to continue up to the date of maturity. Existing NRSR accounts, other than term deposits, have been allowed to continue up to September 30, 2002. On maturity, the proceeds of NRNR scheme shall be credited to the account holders’ non-resident (external) (NRE )account, while those in the case of NRSR scheme shall be credited to the account holder’s non-resident (ordinary) (NRO ) account. 9.29 Amongst the facilities available to corporates, existing limits for Indian direct investment overseas under the automatic route were raised from US $ 50 million in a financial year to US $ 100 million. Indian investors can now purchase foreign exchange up to 50 per cent of their net worth as on the date of last audited balance sheet as against the existing limit of

9.25 A review of the operation of the Satellite Dealer (SD) system in consultation with the market participants was made during 2001-02. It was decided

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ANNUAL REPORT

25 per cent. At present, corporates are allowed to prepay external commercial borrowings (ECBs) to the extent of the balances in their EEFC accounts. Exportoriented units and others can credit up to 70 per cent and 50 per cent, respectively, of their foreign exchange earnings to their EEFC accounts. In order to enable the Indian companies more flexibility and to take advantage of lower interest rates and prepay their ECBs, the corporates were allowed to credit higher than the stipulated proportions of export proceeds to their EEFC accounts on a case-by-case basis.

investment was only permitted in ADRs/GDRs issued by Indian companies in overseas markets. 9.35 As regards current account transactions, NRIs were allowed to repatriate their current income in India such as rent, dividend, pension, interest, etc. by submitting an appropriate cer tificate from their chartered accountant subject to certain limits and payment of applicable taxes. In order to provide greater flexibility to travellers, the ceiling of US $ 500 or equivalent to travellers proceeding to countries other than Iraq, Libya, Islamic Republic of Iran, Russian Federation and other Republics of Commonwealth of Independent States without prior permission from the Reserve Bank, was enhanced to US $ 2000 or its equivalent, out of overall foreign exchange released to them.

9.30 Issues of Foreign Currency Convertible Bond (FCCB) were allowed under the automatic route up to US $ 50 million. The Indian companies were permitted to raise the 24 per cent limit on Foreign Institutional Investors (FIIs) investment to the sectoral cap/statutory ceiling as applicable. As announced by the Finance Minister in his Budget speech for 200203, FIIs’ portfolio investments will henceforth not be subject to sectoral limits for foreign direct investment except in specified sectors.

9.36 Authorised Dealers (ADs) were permitted to allow impor ters and expor ters to book forward contracts in the aggregate, not exceeding 25 per cent of the average of the previous three financial years’ actual import/export turnover, subject to a cap of US $ 50 million or equivalent, on the basis of a declaration of an exposure. The cap would be reckoned separately for impor t and expor t transactions. Furthermore, with a view to enabling corporates to manage their exposure efficiently, the facility to cancel and rebook forward contracts which was available in respect of export transactions only was extended to all forward contracts effective April 1, 2002. The EEFC scheme was further liberalised for exporters with proven track record who have been certified as ‘Status Holder’ in terms of EXIM policy; such exporters were permitted to credit up to 100 per cent of their eligible receipts of foreign exchange to their EEFC accounts in respect of foreign exchange received on or after April 1, 2002.

9.31 Indian corporates with proven track record were allowed to contribute funds from their foreign exchange earnings for setting up Chairs in educational institutions abroad, and for similar such purposes on a case-by-case basis. 9.32 In order to provide banks greater operational flexibility and to integrate the domestic interest rates with international rates, the existing limit of borrowing as well as investment on banks of 15 per cent of their unimpaired Tier I capital was increased to 25 per cent. The borrowings should be within the bank’s open position and gap limits. The increase in borrowing/ investment limits would enable banks to get cheaper funds and thus reduce the cost of funds for the banks.

9.37 With the introduction of Euro notes and coins, the Reserve Bank started announcing reference rate for Euro in addition to the US dollar. The Central Government has given the option to the Reserve Bank to use Euro as intervention currency in addition to US dollar.

9.33 Banks were permitted to invest their FCNR(B) deposits in longer term fixed income instruments, provided these instruments have an appropriate rating prescribed for the money market instruments and the banks have obtained prior approval from their Boards with regard to type/tenor of instruments along with relevant rating and likely cap on such investments within the asset-liability management (ALM) guidelines in force.

9.38 The Reserve Bank intervenes in the foreign exchange market in order to even out lumpy demand or supply and maintain orderly conditions in the foreign exchange market. The Reserve Bank conducts operations in the spot, forward and swap segments of the market combined with monetary and other administrative measures as part of its intervention strategy.

9.34 In order to increase the avenues for investment abroad, Indian mutual funds were allowed to invest in rated securities in countries with fully convertible currencies, within the existing limits. Earlier such

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DEVELOPMENT AND REGULATIONS OF FINANCIAL MARKETS

Outlook

flexibility in managing interest rate risk, would help in addressing the asset-liability mismatch problem of banks/institutions. Banks with typically short maturity funding can hold short duration STRIPS (i.e., coupon STRIPS) while the longer duration STRIPS can be held by insurance companies and pension funds, etc. To facilitate the market for STRIPS (which are essentially zero coupon bonds (ZCBs), the tax anomaly that existed in respect of ZCBs has been removed by Central Board of Direct Taxes (CBDT) in a notification issued in February 2002. Accordingly, ZCBs are now to be taxed on a total return basis by treating the marked-to-market gains to the holder during the assessment year as taxable.

9.39 Development of financial markets is viewed as a continuum and an essential concomitant in the process of financial sector reform. The medium-term objective is to develop the call/notice money market into a pure inter-bank market while simultaneously broadening and activating other segments of the money market. Deliberations are also underway for extension of repos (outside Reserve Bank) to CSGL account holders. It is also expected that the CCIL would offer variants of repo products for facilitating liquidity and cash management and enlargement of repos to other participants. The phased evolution of the LAF towards becoming the primary instrument for liquidity management is consistent with this objective.

9.42 A proposal for replacement of the existing Public Debt Act, 1944 by Government Securities Act has been approved by the Central Government. The concurrence of almost all the State legislatures has also been obtained. The enactment of the Government Securities Bill would simplify the procedures for transactions in government securities and allow for lien-marking/pledging of securities and recognise the legal rights of benefical owners.

9.40 It is expected that the operationalisation of NDS and CCIL would give a fillip to secondary market activity. The next phase of operationalisation of PDONDS project will provide for centralised securities settlement system with distributed servicing to investors through regional PDOs. It will help in increased geographical par ticipation in primary issuance of government securities from terminals located at regional PDOs and member terminals connected to the system.

9.43 India’s exchange rate policy of focusing on managing volatility with no fixed rate target, while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way, has stood the test of time. The Reserve Bank will continue to follow the same approach of watchfulness, caution and flexibility while dealing with the foreign exchange market.

9.41 A road map for developing Separate Trading for Registered Interest and Principal of Securities (STRIPS) has been prepared. The Reserve Bank is actively pursuing the creation and development of the STRIPS market which, in addition to providing more

153