V. DEVELOPMENT AND REGULATION
OF FINANCIAL MARKETS
The financial markets functioned smoothly during 2010-11. With a view to further strengthening the regulatory
architecture while promoting greater efficiency in the financial markets, the Reserve Bank initiated policy measures
to address certain regulatory gaps, promote transparency and improve liquidity in the money markets. The policy
initiatives in the area of foreign exchange management were directed towards procedural simplifications and
maintaining sustainability of the liberalisation process. In the derivatives market, the Reserve Bank persisted with
a calibrated and sequential approach towards launching of new market instruments keeping a balance between
financial stability issues and market efficiency.
V.1 Financial stability has been recognised as a
key objective of the Reserve Bank’s monetary policy.
Financial stability entails stability of the financial
markets and financial institutions. Financial market
stability minimises uncertainties and facilitates
investment decision making with due assignment of
measurable risks. Market development augments
market efficiency that reduces transaction costs,
promotes transparency, establishes benchmarks for
the purpose of pricing, and fosters long-term savings
and investment for growth. Market instability affects
risk taking behaviour and impedes sustained growth
and hence financial market regulation is necessary
for growth. Development and regulation of financial
markets can, however, entail trade-offs at least in the
short run, when the regulatory measures that are
designed to promote financial stability impede market
efficiency. Accordingly, the recognition of the tradeoffs
to achieve the best possible outcome is a requisite
for a central bank that is vested with the responsibility
of the development and the regulation of the various
segments of the financial markets.
MONEY MARKET
V.2 The money market is an important segment
of the financial market because it not only reflects
the impact of liquidity mismatch in the system but also
operates as the first leg in transmitting monetary policy
changes to the other parts of the financial system.
With liquidity transiting to a deficit mode in May 2010,
policy measures during 2010-11 were aimed at
ensuring smooth functioning of the markets so as not to destabilise economic activity. Against this
macroeconomic backdrop, policy measures were
taken with a view to addressing certain regulatory
gaps, promote transparency and improve liquidity in
the money market.
Regulation of NCDs of maturity up to one year
V.3 In order to address the regulatory gap that
existed in the case of issuance of NCDs of maturity
up to one year through private placement, the Reserve
Bank issued Directions in terms of section 45W of
the RBI (Amendment) Act, 2006 on June 23, 2010.
The Directions provide for regulation of the issuance
of NCDs of maturity up to one year, which are money
market instruments. The Directions are applicable to
both secured as well as unsecured NCDs. As per the
Directions, NCDs cannot be issued for maturity less
than 90 days and cannot have call/put options that
are exercisable within 90 days from the date of issue.
The eligibility criteria, rating requirements, etc., for
these NCDs have been prescribed broadly in line with
the extant guidelines on issuance of CPs. Taking into
account the feedback received from the market
participants, the Reserve Bank has issued an
amendment Direction on December 6, 2010, inter alia,
permitting financial institutions (FIs) to invest in NCDs
of maturity up to one year; non-banking financial
companies including Primary Dealers that do not
maintain a working capital limit to issue NCDs of
maturity up to one year; and FIIs to invest in NCDs of
maturity up to one year subject to extant provisions
of FEMA and SEBI guidelines issued in this regard.
Reporting platform for CDs and CPs
V.4 Towards transparency in the secondary
market for CDs and CPs, the Reserve Bank
introduced a reporting platform for all secondary
market transactions in CDs and CPs. The reporting
platform was operationalised by FIMMDA with effect
from July 1, 2010. The Reserve Bank, SEBI and IRDA
have mandated all their regulated entities to report
their OTC trades in CDs and CPs on the FIMMDA
reporting platform.
Repo in corporate bonds
V.5 As a measure aimed at provision of liquidity
to the corporate bond market, the Reserve Bank had
issued guidelines in January 2010, permitting repo in
corporate bonds. To further facilitate repo transactions
in corporate bonds, a review of the guidelines
governing repo in corporate bonds was undertaken
by the Reserve Bank in consultation with the market
participants. Consequently, the minimum haircut
applicable on the underlying collateral has been
revised from 25 per cent to 10 per cent (in case of
AAA-rated bonds), 12 per cent (AA+) and 15 per cent
(AA). Further, settlement of repo trades in corporate
bonds on a T+0 basis (in addition to T+1 and T+2)
has also been permitted.
GOVERNMENT SECURITIES MARKET
V.6 The government securities market is a key
segment of the financial market as it finances the fisc
in a cost effective manner, provides reference points
for the pricing of corporate debt, serves as a conduit
for monetary policy transmission across the maturity
spectrum and also provides the wherewithal for the
central bank’s liquidity management by way of open
market operations. During 2010-11, the purchase of
government securities from the market participants
under the open market operations served to infuse
liquidity and reduce the structural liquidity
mismatches. During the recent years, the Reserve
Bank has been taking a series of measures that has
contributed to price discovery, widening of investor
base, increasing transparency of the market and
safeguarding the financial system. The initiatives regarding the development of the government
securities market during 2010-11 were aimed at
ensuring a balance between greater market liquidity
and effective regulation.
Government Securities Act, 2006, Sections 27 &
30 - Imposition of penalty for bouncing of SGL
forms
V.7 The guidelines for SGL transfer were reviewed
in the light of the provisions of sections 27 and 30(3)
of the Government Securities Act, 2006 and the
existing regulatory penalty for SGL bouncing was
replaced with a transparent and rule-based pecuniary
penalty in July 2010. Under the revised guidelines,
graded monetary penalties (subject to a maximum
penalty of `5 lakh per instance) are charged for the
first nine instances in a financial year while the tenth
default would lead to debarment from undertaking
short sales for the remaining part of the financial year.
The permission to undertake short sales shall be
restored in the next financial year subject to certain
requirements in terms of improved internal controls,
etc.
Extension of DvP III facility in the Government
Securities market to Gilt Account Holders
V.8 The settlement of trades in Government
securities through CCIL was shifted from DvP II to
DvP III with effect from April 2, 2004. The DvP III facility
was not, however, available to transactions by the
gilt account holders. With the stabilisation of the
transaction and settlement infrastructure, DvP III
facility has been extended in July 2011 to transactions
by the gilt account holders (excluding transactions
between the gilt account holders of the same
custodian) so that the gilt account holders get the
benefit of efficient use of funds and securities.
FOREIGN EXCHANGE MARKET
V.9 During 2010-11, capital flows were largely
absorbed by the current account deficit (CAD). FII
investment, ECBs, external assistance and NRI
deposits dominated capital flows during the year.
However, the slowdown in inward FDI was a causefor concern, although inward FDI during 2011-12
(April-June) has been encouraging. The policy
initiatives in the area of foreign exchange
management during the year under review were
directed towards procedural simplifications, stability
of forex market and maintaining sustainability of the
liberalisation process.
Current Account
V.10 The specific counter cyclical measures
initiated during the crisis period were either scaled
down or rolled back as part of the exit policy. The
special rupee refinance facility to the EXIM Bank was
discontinued with effect from April 1, 2010, and the
swap facility to it was scaled down from US $ 1 billion
to US $ 525 million (the outstanding level as on
January 25, 2010) and the same was made available
up to September 30, 2010.
V.11 With the continued recession in the advanced
economies impacting India’s exports in the immediate
post crisis period, the relaxation allowed to exporters
in realisation and repatriation of export proceeds
within 12 months from the date of export of goods
and services was extended up to September 30, 2011.
In case of write-off of unrealised export bills, AD
Category – I banks were advised not to insist on
surrender of the proportionate incentives, subject to
certain terms and conditions, other than those under
the Duty Drawback Scheme, if availed of by the
exporters under any of the Export Promotion
Schemes under the Foreign Trade Policy 2009-14.
V.12 Acknowledging the importance of the services
provided by the Online Payment Gateway Service
Providers (OPGSPs) to the exporters in facilitating
export transactions, particularly for small value goods
and services, suitable guidelines to ensure orderly
conduct of such transactions in line with the FEMA
Regulations, have been issued to AD banks.
V.13 To facilitate greater use of Indian Rupee in
trade transactions, non-resident importers and
exporters have now been permitted to hedge their
currency risk in respect of exports from and imports
to India invoiced in Indian Rupees with AD category I
banks in India.
V.14 The currency component of foreign exchange
for visits abroad was reviewed and increased during
the year to US $ 3,000 or its equivalent, as against
US $ 2,000 earlier to a traveller proceeding to
countries other than Iraq, Libya, Islamic Republic of
Iran, Russian Federation and other Republics of
Commonwealth of Independent States, without the
prior permission from the Reserve Bank.
V.15 AD Category – I banks were required to obtain
an unconditional, irrevocable standby Letter of Credit
(LC) or a guarantee from an international bank of
repute situated outside India or a guarantee of an AD
Category – I bank in India, if such a guarantee is
issued against the counter guarantee of an
international bank of repute situated outside India,
for an advance remittance for imports of goods
exceeding US $ 100,000 or its equivalent. The limit
has been enhanced to US $ 200,000 or its equivalent,
for importers other than a Public Sector Company or
a Department/Undertaking of Central/State
Governments where the requirement of bank
guarantee is to be specifically waived by the
Ministry of Finance, Government of India for
advance remittances exceeding US $ 100,000 or its
equivalent.
Capital Account
V.16 ECB policies have been progressively
liberalised to channelise more external funds to the
infrastructure sector. The recent liberalisation
measures include expansion of the definition of
infrastructure to include “cold storage or cold room
facility, including for farm level pre-cooling, for
preservation or storage of agricultural and allied
produce, marine products and meat”, allowing
Infrastructure Finance Companies (IFCs) for availing
ECBs for on-lending to the infrastructure sector, facility
of credit enhancement for raising debt through capital
market instruments by entities in the infrastructure
sector and the scheme of take-out finance through
ECB under the approval route for refinancing of rupee
loans availed from domestic banks for development
of new projects in the sea port and air port, roads
including bridges and power sector. Corporates
engaged in the development of integrated township were permitted to avail of ECB, under the approval
route, up to end-December 2010. Corporates in select
services sectors, such as software, hospital and hotel
have been allowed to avail ECB above US $ 100
million under the approval route.
V.17 The facility of premature buyback of FCCBs
which was available up to end-June, 2011 has been
extended up to end-March, 2012 with reduced
minimum discount rates. In order to meet the
redemption obligations, Indian companies have been
allowed to raise fresh ECBs/FCCBs as per the extant
ECB guidelines under the automatic route to refinance
their outstanding obligations, subject to certain
conditions.
V.18 Keeping in view the requirement of huge funds
for the infrastructure sector and to enable the
development of government securities and corporate
bond markets in the country in a calibrated manner,
the FII investment limits were enhanced from US $ 5
billion to US $ 10 billion in respect of government
securities and from US $ 15 billion to US $ 40 billion
in respect of corporate bonds issued by companies
in the infrastructure sector, subject to the condition
that the incremental limit should be earmarked for
investment in corporate bonds with a residual maturity
of over five years. The incremental limit in corporate
bonds will have to be earmarked for investment in
the corporate bonds issued by the companies in the
infrastructure sector, as defined under the ECB policy.
This measure, besides augmenting the flow of finance
to the infrastructure sector, would also enhance the
liquidity of long-term papers.
V.19 Keeping in view the utility and usage of the
instrument of performance guarantees in project
executions abroad and also considering the risks
associated with such guarantees vis-a-vis financial
guarantees, henceforth only 50 per cent of the amount
of the performance guarantees would be reckoned
for the purpose of computing financial commitment
to its JV/WOS overseas, within the 400 per cent of
the net worth of the Indian Party. Irrespective of
whether the direct subsidiary is an operating company
or a SPV, the Indian promoter entity may
extend corporate guarantee on behalf of the first generation step down operating company under the
Automatic Route, within the prevailing limit for
overseas direct investment. Further, the areas relating
to restructuring of the balance sheet of the overseas
entity involving write-off of capital and receivables and
disinvestment by the Indian Parties of their stake in
an overseas JV/WOS involving write-off were
liberalised.
V.20 Non-resident investors (other than SEBI
registered FIIs and SEBI registered FVCIs) who meet
the KYC requirements of SEBI, have been permitted
to purchase on repatriation basis rupee denominated
units of equity schemes of domestic MFs, within an
overall ceiling of US$ 10 billion. These investors have
also been allowed to invest up to an additional amount
of US$ 3 billion in units of debt schemes of domestic
MFs which invest in infrastructure (as defined under
the ECB norms) with a minimum residual maturity of
5 years, within the existing ceiling of US$ 25 billion
for FII investment in corporate bonds issued by
infrastructure companies.
V.21 Recognising the important contribution of nonresident
Indians (NRIs) and persons of Indian origin
(PIOs) in India’s growth process and the need for
facilitating genuine foreign exchange transactions by
non-resident Indians (NRIs) as well as resident
individuals under the current regulatory framework
of FEMA, a committee (Chairperson: Smt. K.J.
Udeshi) has been constituted in April 2011 to identify
areas for streamlining and simplifying the procedure
so as to remove the operational impediments, and
assess the level of efficiency in the functioning of
authorised persons, including the infrastructure
created by them. The Committee submitted its report
in August 2011. The recommendations of the
Committee are under examination.
DERIVATIVES MARKET
V.22 Derivatives can serve as important
instruments in the development of the financial
markets when these instruments permit portfolio
diversification and risk hedging, thereby ensuring
financial stability. Derivatives can, however, turn out
to be a double-edged sword as the global financial crisis would testify. During the post-crisis period,
instead of addressing the risks, derivatives emerged
as the source of off balance sheet and hidden
exposures of banks and financial institutions. In India,
the Reserve Bank has persisted with a calibrated and
sequential approach towards launching of new market
instruments in recognition of the trade-offs between
financial stability issues and market efficiency.
Introduction Interest Rate Futures (IRF) on
91-Day T-Bills
V.23 The Interest Rate Futures contract on 10-year
notional coupon bearing Government of India
security was re-introduced on August 31, 2009.
Based on the market feedback and the
recommendations of the Technical Advisory
Committee (TAC) on the Money, Foreign Exchange
and Government Securities Markets, it was decided
to introduce short-tenor IRF contracts. Accordingly,
in order to provide participants with additional
instruments to manage volatility in the short-term
interest rates, IRFs on 91-day Treasury Bills were
permitted since March 2011.
Introduction of Credit Default Swaps (CDS)
V.24 Lack of instruments to manage credit risk was
a long-felt need and to address the same the
introduction of credit default swaps was taken up in
2003 and further followed up in 2007. However, the
initiatives had to be put on hold in view of the unfolding
of the global financial crisis. Taking into account the
lessons learnt from global financial crisis, it was
decided to permit CDS on corporate bonds and the
final guidelines in this regard were issued in May 2011
(Box V.1).
Exchange Traded Currency Derivatives
V.25 The currency futures market remained active
during 2010-11. The average daily turnover in
currency futures on the three active exchanges (NSE,
MCX-SX and USE) stood at US $ 8.0 billion in March
2011 as against US $ 7.1 billion in March 2010.
Increased globalisation of the economy increases the
foreign exchange exposure of Indian firms and
individuals with exchange rate risk arising from domestic and global financial market developments.
This has necessitated introduction of various
instruments by the Reserve Bank to hedge the
exchange exposure by the residents. Currently,
residents in India are permitted to trade in futures
contracts in four currency pairs on recognised stock
exchanges.
V.26 In order to expand the menu of tools for
hedging currency risk, recognised stock exchanges
were permitted to introduce plain vanilla currency
options on spot US Dollar/Rupee exchange rate
for residents. The exchange traded currency
options market is functioning subject to the
guidelines issued by the Reserve Bank and the
Securities and Exchange Board of India (SEBI) from
time to time.
V.27 In view of the large positions held by the FIIs
and considering the increased depth of the Indian
forex market to absorb the impact on the exchange
rate, FIIs have now been permitted to cancel
and rebook up to 10 per cent of the market
value of the portfolio as at the beginning of the
financial year as against 2 per cent that was permitted
earlier.
Non-deliverable Forwards Market
V.28 NDF market exists mostly in non-convertible
or in currencies with limited on-shore hedging
options. With increasing capital flows to the EMEs,
the NDF market offers a convenient hedging
mechanism for foreign investors who may not have
full access to the onshore market of the concerned
currency due to restrictions or may prefer to transact
in an international financial centre they are familiar
with for the sake of convenience. Though
comprehensive information is not available on the
global NDF market, Brazilian Real, Chinese
Renminbi, Taiwanese dollar, South Korean Won and
the Indian Rupee reportedly account for the major
share. The major centres for the Indian Rupee NDF
market are reportedly Singapore, London, New York
and Hong Kong. In India, the linkage between the
NDF market and the domestic financial markets
remains weak (Box V.2).
Box V.1
Guidelines on Credit Default Swaps (CDS) for Corporate Bonds
Introduction of credit derivatives in India was actively
examined in the past to provide the market participants tools
to manage credit risk. Accordingly, draft guidelines on
introduction of CDS were issued in 2003 and 2007. However,
taking into account the status of the risk management
practices then prevailing in the banking system and also the
experiences relating to the financial crisis, the issuance of
final guidelines was deferred.
The matter was reviewed and the Second Quarter Review
of Monetary Policy of 2009-10 had proposed introduction of
plain vanilla OTC single-name CDS for corporate bonds
subject to appropriate safeguards. Accordingly, an internal
Working Group was constituted to finalise the operational
framework for the introduction of single-name CDS for
corporate bonds in India. The Group submitted its final report
in February, 2011. Based on the recommendations of the
report, the draft guidelines on CDS were prepared and placed
on the Bank’s website on February 23, 2011 for public
comments. Taking into account the feedback received from
the market participants and other stake holders, the final
guidelines on CDS were issued on May 23, 2011 and would
become effective from October 24, 2011.
The salient features of the guidelines are as under:
• The CDS shall be permitted on listed corporate bonds,
unlisted but rated bonds of infrastructure companies and
unlisted/unrated bonds issued by the Special Purpose
Vehicles (SPVs) set up by infrastructure companies as
reference obligations.
• The reference entities shall be single legal resident
entities.
• The permitted participants have been categorised into:
a) Market Makers: Participants such as Commercial
Banks, NBFCs and stand-alone Primary Dealers are
permitted to undertake both protection buying and
protection selling subject to satisfying the prescribed
eligibility norms. Insurance Companies and Mutual
Funds would be allowed to act as market-makers
subject to the approval of their respective regulators.
b) Users: Participants permitted only to hedge their
underlying exposures, such as, Commercial Banks, Primary Dealers, NBFCs, Mutual Funds, Insurance
Companies, Housing Finance Companies, Provident
Funds, Foreign Institutional Investors (FIIs) and listed
corporates.
• Users cannot purchase CDS without having the
underlying exposure and the protection can be
bought only to the extent (both in terms of quantum
and tenor) of such underlying risk.
• For users, physical settlement is mandatory. Marketmakers
can opt for any of the three settlement methods
(physical, cash or auction settlement), provided the CDS
documentation envisages such settlement.
• The CDS contracts shall be standardised in terms of
coupon, coupon payment dates, etc.
• Bankruptcy, Failure to pay, Repudiation/moratorium,
Obligation acceleration, Obligation default, Restructuring
approved under Board for Industrial and Financial
Reconstruction (BIFR) and Corporate Debt Restructuring
(CDR) mechanism and corporate bond restructuring are
the eligible credit events for CDS.
• As CDS markets are exposed to various risks, such as,
sudden increases in credit spreads resulting in markto-
market losses, jump-to-default risk, basis risk,
counterparty risks, etc., market participants are required
to take these risks into account and build robust and
appropriate risk management system to manage such
risks. The guidelines specifically prescribe for having
counterparty credit exposure limits, PV011 limit and an
independent risk management framework for reporting,
monitoring and controlling all aspects of risks, assessing
performance, valuing exposures, monitoring and
enforcing position and other limits for CDS.
• Market-makers shall report their CDS trades with both
users and other market-makers on the reporting platform
of CDS trade repository within 30 minutes from the deal
time. The trade repository would disseminate key
information on market participants’ positions and help
regulators and market participants gain a clear and
complete snapshot of the market’s overall risk exposure
to CDS.
OTC Foreign Exchange Derivatives
V.29 The comprehensive guidelines on OTC
foreign exchange derivatives and overseas hedging
of commodity price and freight risks were issued in
December 2010. The important elements of the revised guidelines, which became effective in
February 2011 are: (i) AD Category I banks can only
offer plain vanilla European cross currency options;
(ii) allowing embedded cross currency option in the
case of foreign currency-rupee swaps; (iii) permitting
use of cost reduction structures, both under the contracted exposures and past performance routes,
subject to certain safeguards; and (iv) allowing swaps
to move from rupee liability to forex liability, subject
to certain safeguards.
Box V.2
NDF Market and its Implications for the Domestic Financial Markets
A non deliverable forward (NDF) refers to an OTC forward
transaction that is settled not by delivery but by exchange
of the difference between the contracted rate and some
reference rate. Such transactions usually involve a nonconvertible
(with some degree of capital control) or in
currencies with limited on-shore hedging options and take
place in an offshore location either in order to overcome
on-shore regulations or because it is convenient for the
transacting parties. The contract is for a fixed amount (of
the non-convertible currency), on a specific due date, and
at an agreed forward rate. At maturity, the prevailing spot
rate (reference rate) is compared with the contracted NDF
rate. The difference is usually paid in the convertible
currency on the maturity date. There is no delivery of the
reference or domestic currency on the maturity date. No
payment or account movement takes place in the nonconvertible
currency. When a NDF transaction is agreed,
the parties must also agree on a way to determine the
reference rate (at maturity). This might be the daily rate
fixed by the central bank in question, or an average rate
published by several banks. NDFs require a special
contract that meets the provisions of the internationally
recognised International Swaps and Derivatives
Association (ISDA).
NDF market in Indian Rupee
The demand for Rupee NDF may arise from many sources,
e.g.
1. Hedge funds/FIIs for hedging potential future exposure
to Indian equity/bond market (since the present
dispensation allows hedging only of actual, but not
potential, exposures);
2. MNCs having manufacturing or business interests in
India, who do their invoicing in Indian Rupee but are not
allowed to hedge their rupee exposure; and
3. Directional bet by the speculators on the Indian Rupee
without any underlying exposure.
The linkage between the NDF market and the domestic
market may come from banks and corporates who have
global books and can, therefore, take offsetting positions in
their foreign and Indian books. This linkage would transmit
the price movement in the NDF market to the domestic
market or vice versa. However, the linkage is weak because
corporates’ domestic forex forward transaction is based on
underlying exposure and there is a limit on the aggregate
(cash and derivative) positions that banks can take. The
empirical analysis also brings out a weak causality between
the NDF and domestic market rates.
Reference :
Padmanabhan, G. (2011), ‘Forex Market Development -
Issues and Challenges: Thoughts of a Returning Forex
Market Regulator,’ Keynote address at the seminar of Forex
Association of India, Singapore, August 13.
V.30 With the return to normalcy in the financial
markets, the Reserve Bank persisted with its objective
of maintaining an appropriate balance between its
market development objectives and effective
regulation in order to promote financial stability which is a precondition for long term sustainable growth.
Policy measures were taken with a view to addressing
certain regulatory gaps, promoting transparency and
improving liquidity in the financial markets. The
Reserve Bank’s calibrated and sequential approach
towards the introduction of new market instruments
in recognition of the trade-offs between financial
stability issues and market efficiency has contributed
to the stability of financial markets.
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