9.1 The maintenance of stable and orderly conditions in financial markets assumed priority for the Reserve Bank in 2003-04. Taking advantage of the headroom provided by the comfortable liquidity conditions, the marked improvement in Central Government`s finances and somewhat muted demand for bank`s non-food credit in the first half of the year, the Reserve Bank carried forward the development of the money, debt and foreign exchange markets over which it has direct regulatory jurisdiction. Satisfactory operation of paperless and straight through settlement of transactions through the Negotiated Dealing System (NDS)/Clearing Corporation of India Limited (CCIL) brought with it significant gains for the functioning of markets. It facilitated speeding up the process of phasing out non-banks from the call/notice money market and simultaneous growth of a buoyant repo market outside the LAF. New modules in the NDS-CCIL system were introduced leading to a switch to the Delivery versus Payment (DvP) III mode in the Government securities market from April 2, 2004. Measured liberalisation of external transactions was undertaken with a view to adding depth to the foreign exchange market and freeing outflows by resident corporates and individuals. Sensitising market participants to the risks embedded in sudden shifts in market conditions in accordance with global developments remained a concurrent priority.

9.2 Against this backdrop, this Section presents regulatory and developmental aspects of the functioning of the money, debt and foreign exchange markets in 2003-04. In the money market, the focus of the review is on upgradation of the technological infrastructure and various initiatives taken to improve activity including in the emerging segments. The major initiatives in the Government securities market relate to introduction of new instruments and the functional autonomy accorded to market participants. The review of the foreign exchange market underscores the significant liberalisation granted to all classes of participants with a view to deepening the market, while simultaneously improving transparency in an overall move away from micro management of transactions to macro management of flows. Building and upgrading the technological wherewithal for markets is a recurring theme through this Section.

9.3 The Reserve Bank continued to foster balanced development of different segments of the money market. The strategy for market development was characterised by initiatives to introduce new instruments, reduce dependence of participants on uncollateralised exposures, facilitate price discovery in the short-end and upgrade the payment system infrastructure.

9.4 The smooth operation of NDS/CCIL enabled progression in the endeavour to develop the call segment as a pure inter-bank market. Exposures of non-banks in the call/notice money market were brought down from 85 per cent of their average daily lendings during 2000-01 to 75 per cent in June 2003, to 60 per cent in December 2003 and further to 45 per cent in June 2004 (Table 9.1). This process was smoothened by the assurance of temporary reprieve from the phase-out in case any non-bank institution faces any genuine difficulty in deploying excess liquidity.

9.5 With effect from February 7, 2004, primary dealers (PDs) were permitted to borrow up to 200 per cent of their net owned funds (NOFs), as at end-March of the preceding financial year, on average, in a reporting fortnight. Any PD facing genuine difficulty in adhering to the limit was permitted to approach the Reserve Bank for extension of period of compliance.

9.6 An endeavour of the Reserve Bank has been to improve transparency in the call/notice money market. Effective the fortnight beginning May 3, 2003, reporting of call/notice money market transactions on the NDS was made mandatory, irrespective of whether executed on the NDS or outside and whether the counterpar ty is a member of the NDS or not. Necessary changes in the software and dissemination of data to NDS members was executed in July 2003.

9.7 The Reserve Bank had instituted prudential limits of exposure to the call/notice money market for banks from October 2002 keeping in view the potential risk of systemic instability arising out of defaults due to large recourse to the uncollateralised money market segment. Rupee funds raised under the Reciprocal

Line Facility were exempted from these limits. This exemption was phased out from the fortnight beginning February 7, 2004.

9.8 Activity in the Certificates of Deposit (CDs) segment picked up considerably after the issuance of guidelines by the Reserve Bank and the SEBI on investments by banks and mutual funds in non-SLR debt securities, the reduction in stamp duty on CDs effective March 1, 2004 and disallowance of premature closure of CDs vis-à-vis alternative competing instruments such as fixed deposits. These developments stimulated demand for investment in CDs by mutual funds, particularly on account of improved funds positions. An encouraging development in this area was rating of CDs by some banks even when such rating is not mandatory under the existing guidelines.

9.9 Non-bank entities, including corporates, were allowed during 2003-04 to offer unconditional and irrevocable guarantees for credit enhancement to CP issuances so as to provide flexibility to both issuers and investors. The issuer is required to fulfil the eligibility criteria prescribed for issuance of CP with the guarantor requiring a credit rating of at least one notch higher than that of the issuer from an approved credit rating agency. The offer document for CP needs to disclose the net worth of the guarantor names of the companies to which the guarantor has issued similar guarantees, the extent of the guarantees offered and the conditions under which the guarantee will be invoked. Banks were allowed to invest in CP guaranteed by non-bank entities, provided their exposure remains within the regulatory ceiling for unsecured exposures. Along with the reduction in stamp duty on CP, the recent guidelines by the Reserve Bank on investments in non-SLR securities evinced keen interest from mutual funds for investment in CPs vis-à-vis bonds and fixed deposits.

9.10 The Reserve Bank allowed banks and primary dealers to transact in exchange traded interest rate futures in June 2003 in order to make available a wide array of products for banks to hedge their interest rate risk effectively. While PDs were allowed to hold trading as well as hedging positions in Interest Rate Futures (IRFs), banks were allowed only to hedge their underlying Government securities in 'available for sale' (AFS) /'held for trading' (HFT) category portfolio through IRFs. The National Stock Exchange (NSE) introduced futures on a notional 10-year Government security, a 3-month Treasury Bill rate and a 10-year Government zero coupon in June 2003. Activity in the IRF market has not, however, picked up as yet because of valuation problems. Furthermore, the activity in the IRF market was subdued as banks have been allowed only to hedge but not to trade. The Reserve Bank set up an Internal Working Group on Derivatives in September 2003 which recommended, inter alia, (i) a harmonisation of regulations between over-the-counter (OTC) interest rate derivatives and exchange traded interest rate derivatives; and (ii) permission to those banks to hold trading positions in IRF market which have adequate internal risk management and control systems and a robust operational framework. The SEBI revisited issues pertaining to introduction of new futures contracts in consultation with the Fixed Income Money Market and Derivatives Association of India (FIMMDA). On January 5, 2004 it permitted trading of interest rate futures contract on an underlying 10-year coupon-bearing notional bond which would be priced on the basis of the yield-to-maturity (YTM) of a basket comprising bonds with maturity ranging from 9 to 11 years.

9.11 Collateralised Borrowing and Lending Obligation (CBLO) was operationalised as a money market instrument through the CCIL on January 20, 2003. With a view to developing the market for the CBLO, it was exempted from CRR. Furthermore, securities lodged in the gilt accounts of the bank maintained with the CCIL under the Constituent`s Subsidiary General Ledger (CSGL) facility and remaining unencumbered at the end of any day can be reckoned for SLR purposes. The wider usage of the instrument is expected to receive impetus from the establishment of real time connectivity between the Public Debt Office (PDO) of the Reserve Bank and the CCIL and value-free transfer of securities between market participants and the CCIL.

9.12 The Reserve Bank has been making efforts to develop the repo market, so as to provide a stable collateralised funding alternative with a view to promoting smooth transformation of the call/notice money market into a pure inter-bank market and for deepening the underlying Government securities market. To broaden the repo market, the Reserve Bank enabled non-banking financial companies, mutual funds, housing finance companies and insurance companies not holding SGL accounts to undertake repo transactions with effect from March 3, 2003. These entities were permitted to access the repo market through their ‘gilt accounts’ maintained with the custodians. Necessary precautions were built into the system to ensure ‘delivery versus payment’ (DvP) and transparency, while restricting the repos to Government securities only. Rollover of repo transactions in Gover nment secur ities was facilitated with the enabling of DvP III mode of settlement in Government securities which involves settlement of securities and funds on a net basis, effective April 2, 2004. This provided significant flexibility to market participants in managing their collateral.

9.13 The Reserve Bank stepped up efforts to broaden and deepen the Government securities market during 2003-04. Initiatives to promote liquidity in the Government securities market took the form of relaxation of restrictions relating to transactions in the Government securities, introduction of new instruments such as interest rate derivatives to enable participants to hedge market risk and initiation of stricter prudential regulation and surveillance.

9.14 During 2003-04, the Reserve Bank continued to issue Floating Rate Bonds (FRBs) as an instrument for hedging interest rate risk by investors in the context of elongation of the maturity profile of Government debt in the recent period. During 2003-04, FRBs were issued in three tranches (May 20, August 8 and November 10, 2003) accounting for 16 per cent of the total issuances of dated securities, excluding those issued by way of private placements with the Reserve Bank. The interest rate on these bonds was calculated by adding a fixed spread (determined in the auction) over a variable base rate. With a view to simplifying the price discovery process in the secondary segment of the Government securities market, the design of determining the variable base rate of FRBs was modified with effect from the auction held on May 19, 2003. In terms of the modified design, the base rate was set equal to the average cut-off yield in the preceding three auctions (instead of six) of 364-day Treasury Bills with annual resetting instead of semi-annual. During 2004-05 (up to August 10, 2004), FRBs were issued in three tranches (May 7, July 2, and August 10, 2004) of Rs. 6,000 crore each accounting for 14.4 per cent of budgeted issuances of dated securities.

9.15 Development of the Separate Trading for Registered Interest and Principal of Securities (STRIPS) market received impetus from the steps taken to realign the coupon payment dates with four identified dates so as to create a critical mass for issue of coupon STRIPS. Accordingly, a new security, viz., 6.01 per cent Government Stock 2028 was issued on August 8, 2003 with coupon dates of the new security aligned with the set of coupon payment dates, viz., March 25 and September 25 as identified by the Working Group on STRIPS. The enabling legal provisions for STRIPS will come into effect with the passage of the Government Securities Bill.

9.16 Banks and PDs were permitted to undertake transactions in exchange traded IRFs in June 2003. Operational guidelines were formulated to enable participation of the entities regulated by the Reserve Bank (see Para 9.10 for details).

9.17 The country wide anonymous, screen-based and order-driven trading in Government securities, which was introduced in stock exchanges (NSE, BSE and OTCEI) in January 2003, continued to register low trading volumes during 2003-04. A Working Group on Screen Based Trading in Government Securities (Chairman: Shri R. H. Patil) was constituted to examine the successful operationalisation of screen-based trading in the NDS as well as the issue of improving liquidity in Government securities trading in the exchanges. Following its recommendations, an anonymous, screen-based, order matching trading system is being incorporated in the NDS. The introductory demonstration was held on August 11, 2004.

9.18 The LAF module was operationalised on January 13, 2004 in the Reserve Bank`s PDO-NDS. LAF auctions were announced by providing all parameters such as issue, duration, type of auctions, opening and closing time. Market participants submit bids within the cut-off time on the system. Members facing genuine systems problems are permitted to submit physical bids. The Treasury Bill auction module was operationalised on October 22, 2003 on the PDO-NDS. The auction is announced and processed online in a straight through process (STP) on the system. These two modules are being further fine tuned, encompassing new features and feedback received from market participants.

9.19 The Reserve Bank permitted market participants to sell Government securities from April 2, 2004 against confirmed purchase contracts, provided the previous purchase contracts were either guaranteed by the CCIL or have the Reserve Bank as the counterparty. A sale transaction would be settled either in the same settlement cycle as the preceding purchase contract or in a subsequent settlement cycle so that the delivery obligation under the sale contract is met from the securities acquired under the purchase contract. This dispensation would not only reduce the market risk of participants but also facilitate rollover of repos. It was operationalised by switching over to the DvP III mode of settlement of Government securities transactions under which securities are settled on a net basis (as against gross basis under the DvP II mode).

9.20 The primar y dealer system has been introduced in a number of countries with the objective of strengthening the securities market infrastructure and bringing about improvement in the secondary market trading, liquidity and turnover in Government securities as also for encouraging voluntary holding amongst a wider investor base. The primary dealer system has been in operation in India for the last eight years (Box IX.1).

9.21 There were 18 primary dealers (PDs) in operation in India at the end of March 2004 (Table 9.2). Bidding commitments in Treasury Bill auctions for all PDs taken together were fixed at 121.8 per cent of the issue amount indicated to be raised in 2003-04. Total bids received at Rs. 99,279 crore amounted to 157.78 per cent of the total Treasury Bill issues of Rs. 62,921 crore. For dated securities auctions, the bidding commitments for all PDs taken together were originally fixed at Rs.1,31,000 crore. Subsequently, the bidding commitments were reduced to Rs. 98,200 crore due to the reduction in the market borrowing programme of the Government. Actual bids tendered by PDs at Rs.1,10,953 crore were 110.95 per cent of the amounts notified. The success ratio was 66.6 per cent for Treasury Bills and 45.1 per cent for dated securities in 2003-04 as against 62.6 per cent and 45.3 per cent, respectively, in the previous year. PDs offered Rs.1,00,000 crore for underwriting primary issues during the year, out of which bids for Rs.49,150 crore were accepted by the Reserve Bank. The share of total primary purchases by the PDs was higher in 2003-04 at 67 per cent (for Treasury Bills) as against 65 per cent during 2002-03. For dated securities, PDs share was lower at 50.1 per cent as against 63.0 per cent in 2002-03, reflecting a more aggressive interest in the primary market by other investors. The share of turnover of PDs in outright market for Government securities has declined in recent years, reflecting increased participation by banks. The total bidding commitment (for auctions other than those under the MSS) for the year 2004-05 for dated securities for all PDs has been fixed at Rs. 1,20,300 crore (96.5 per cent of the borrowing programme), while the same for Treasury Bills amounted to 122.6 per cent of the issue amount to be raised. The liquidity support limit under the Standing Liquidity Facilities to all PDs was fixed at Rs. 3,000 crore, i.e., at a lower level than for 2003-04.

Primary dealers are financial intermediaries that agree to perform specific obligations or functions in the market for Government securities in exchange for specific privileges. The objectives of the PD system are to ensure that the Government`s financing needs and its obligations are met at the lowest possible cost consistent with a prudent degree of rollover risk. The obligations of PDs include (i) participating in the primary market in a substantial and consistent manner; (ii) serving as a market maker in the secondary market by providing two-way quotes; and (iii) providing market related information to the public debt manager.

The system of PD was first established in the US in 1960. In India, it was introduced in 1996. Some advanced countries such as Australia, Germany and New Zealand have not yet established the PD system. According to the IMF`s cross country survey in 2003, important prerequisites for establishing a PD system include (i) a debt issuance strategy which provides a medium term horizon of the investment; (ii) interest rate liberalisation in the Government securities market to ensure efficient price discovery; (iii) an adequate number of end investors; (iv) a diversified maturity spectrum in Government securities; (v) policy impetus for developing the secondary market for the Government securities without direct intervention; and (vi) a competitive market environment (Table).

The IMF survey also brings out the crucial role played by the supporting market segments (such as inter-bank and local capital markets) and the infrastructure (such as book-entry system, DvP and bidding technology). This supporting system is, however, still under-developed in many countries. With electronic trading of securities and auctions, which effectively expand investor base, the role of PDs in developed economies is losing importance. PDs, however, continue to play a critical role where the fiscal deficits and financing needs of the Government are large.

In India, the PD system has contributed to the development of a deep and vibrant market for the Government securities. Several issues such as granting the PDs limited exclusivity in the Treasury Bills auctions and permitting them to invest in overseas sovereign bonds and setting of joint ventures (JVs)/wholly owned subsidiaries (WOSs) abroad to enable them to diversify their balance sheets are under examination.

1. Armone, M. and G. R. Iden (2003), 'Primary Dealers in Government Securities: Policy Issues and Selected Countrie`s Experience', IMF Working Paper No. 45.