Sucheta Dalal :A Debt Market Sans Brokers Sans SEBI
Sucheta Dalal

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A Debt Market Sans Brokers, Sans SEBI  

Aug 23, 2004

However, the new system could permanently damage it by making it highly fragmented  

Frightened debt market brokers are once again fighting for survival and scurrying around for support and sympathy. A few weeks ago, the Securities Transaction Tax had threatened to shut down their business. This time, a structurally altered debt market will eliminate them from the core of the debt market and could force them to shut shop.

All this is set to happen from September 1. On that day, the Reserve Bank of India (RBI) quietly plans to launch an anonymous, order matched, screen-based trading in government securities on the Negotiated Dealing System (NDS). The NDS will be open only to banks and institutional investors to trade among themselves without the intermediation of brokers.

The NDS is the RBI’s own little exchange operating outside the purview of the Securities Contracts Regulation Act (SCRA) and the Securities and Exchange Board of India (SEBI). Until now, the NDS accounted for less than 30 per cent of debt deals, of which a few were direct trades between institutions. The debt market is largely a non-transparent telephone market where trades are only reported to the National Stock Exchange’s (NSE) wholesale debt market segment. The order-matched NDS, based on a report of the Dr RH Patil Committee, will have the Clearing Corporation of India Ltd as central counter-party and clearing house.

The problem is that in an era of reforms, transparency and competition, the report that argues for an order-matched NDS remains a secret. Contrary to accepted market practice among regulators, it has not been thrown open for public discussion and comment. Instead, banks have been ordered to send treasury officials for training in anticipation of the September 1 launch. And SEBI-registered brokers are forced to figure out their future on the basis of leaks from institutional clients.

As the managing director of the NSE, Dr Patil led the transformation of the India’s equity markets through exactly such an anonymous, order matched system that offered a single trading screen across the country. It increased market liquidity and caused trading volumes to soar. Will Dr Patil repeat the NSE’s success through the NDS? Or will he go a step further and create the world’s first debt market that dispenses with broker intermediation?

• The negotiated dealing system is being introduced on September 1

• So far there has been no public disclosure and debate

• Brokers fear that the new system will force them to shut shop

Dr Patil undoubtedly has a brilliant track record, but the NDS is a rather different kettle of fish. While it may intend to develop the debt market through a transparent system, it could permanently damage the debt market by fragmenting it, only to ensure that RBI, probably the least transparent among the regulators, has sole control over the debt trades of banks.

This creates a dangerously untenable situation. RBI is India’s monetary authority and signals interest rate movements, it is the regulator of banks and will supervise a segment of the debt market and it will also be the infrastructure provider who sets up an exchange. That is like SEBI setting up an exchange, running it and also acting as its regulator. But RBI does not see the need to debate this peculiar situation.

The absence of public debate is all the more outrageous given the RBI’s pathetic record as a banking supervisor; especially since the move comes at a time when the government is contemplating ways to make its supervisory function more accountable.

Another worrying aspect is the consequence of splitting the debt market into institutional and non-institutional segments as proposed by the new system. Institutional trades will be regulated by the RBI and non-institutional ones by SEBI. The NDS will also not be subject to the provisions of the SCRA. This means the two exchanges would operate under different sets of rules instead of competing on a level playing field.

Does it make sense? A large number of bankers are not very keen on a fragmented market, nor are they confident of dealing without brokers in the near term, until their traders are fully trained. Some fear that in the near term, lack of skills and flexibility would expose their officials to inducements and exploitation by smarter and savvier foreign and private banks.

This harks back to 1992, when RBI’s foolish decision to bar brokers from call money deals caused enormous mischief. Banks continued to use brokers’ services unofficially and weakened the system in finding dubious ways to compensate them. It could happen all over again.

The reality today is that debt market brokers, with sophisticated dealing rooms and information systems are the repository of enormous information on institutional portfolios and their needs. Cutting them out will create an information vacuum. Also, India badly needs a vibrant corporate debt market, but if the NDS drives brokers out of business, it will only stagnate further.

The finance ministry needs to pay close attention to the NDS experiment. It is no secret that the RBI had all but killed the interest rate derivatives market because it would entail regulatory overlap. With inflation nearing eight per and interest rates heading north, banks’ treasury profits have dried up. State Bank of India has already issued a profit warning and smaller banks may report losses. A developed market in interest rate derivatives would have helped banks hedge their risks. But this was not allowed to happen. Banks were told to keep off.

Instead of developing this market urgently, the RBI seems set to damage the debt market through fragmentation. All this is apparently happening without so much as a discussion with the finance ministry, which is usually called in when it is time to bailout banks.

The RBI could well have answers to all the questions raised by us and they may be contained in Dr RH Patil’s report. But then it must be thrown open to the public at least six weeks before it launches the new NDS. Also, it must register the NDS as an exchange under the SCRA rules and learn to cooperate with the capital market regulator. A new system cannot be started without full public disclosure and debate. 

-- Sucheta Dalal