Tamal Bandyopadhyay: A rescue plan for primary dealers

PNB Gilts, a primary dealer (PD), posted a net profit of Rs 106.95 crore last year. In the April-June quarter of this year, it recorded a net loss of Rs 83.63 crore. PNB Gilts is not the only PD that is in the red.

If industry sources are to be believed, 16 of the country's 17 primary dealers have made trading losses in the first quarter of financial year 2004-05. A few of them, however, have managed to post net profits courtesy incomes from advisory businesses.

The villain of the piece is rising interest rates. The yield on the benchmark 10-year government security has declined by over 800 basis points (one basis point is one hundredth of a percentage point) from 13 per cent in April 1997 to 4.95 per cent in October 2003 giving the PDs an opportunity to make money with both hands.

In the gilts market, yield and prices of securities move in opposite directions. This means, when the yield goes down, the prices of securities go up and gilts players make money. But when the yield starts going up, prices drop, leading to losses.

From the beginning of the financial year, the trend was reversed with the yield on 10-year paper going up by about 150 basis points in mid-August, splashing red ink all over the books of the PDs on whom the success of the government's Rs 1.5 lakh crore annual borrowing programme depends.

Before examining the problems that may force the industry to write the epitaphs of some of the PDs, let's look at their profile first. The PDs are market intermediaries appointed by the Reserve Bank of India (RBI) in 1996 to strengthen the infrastructure for the government securities market and deepen it by providing liquidity and increasing turnover.

The PDs, compulsorily registered as non-banking finance companies, act as underwriters in primary issuances and market makers in the secondary gilts market.

Initially, the Reserve Bank permitted six entities to become primary dealers "" DFHI, STCI, ICICI Securities, PNB Gilts, SBI Gilts and Gilts Securities Trading Corporation. Except for ICICI Securities, all other entities were subsidiaries of public sector banks or the Reserve Bank. Subsequently, the number of PDs swelled to 17 allowing foreign and private entities to set up shops.

The Reserve Bank also tried to create a second, parallel tier of dealers known as the satellite dealers to work in tandem with the PDs to cater to the market's retail requirements. However, this scheme proved a non-starter.

The PDs' primary role is to create the market for government securities by bidding in auctions of gilts, underwriting the issues and offering two-way quotes on a daily basis.

The PD framework has been employed by a number of countries in Europe and the Americas, although Japan, Germany, Australia and Switzerland do not follow the PD system for their government bond markets.

The PDs operating in the UK are called Gilt-edged Market Makers or GEMMs. At of March 2003, there were 16 GEMMs recognised by the Bank of England. They participate in the DMOs (Debt Management Office, Bank of England) gilt issuance programme by bidding competitively in all auctions.

The government bonds markets in Korea as well as France also operate within a primary dealer framework where the PDs act as market makers. Primary Dealers in France, also known as SVTs (Specialistes en Valeurs du Tresor), are the market counterparts of choice for the Agency France Tresor (AFT, Government of France Treasury). Their role is to advise and assist the AFT on issuance policy and debt management.

Overall, the system has been a remarkable success in India. Secondary market volumes of the government bond market have jumped, leading to a substantial deepening of the market. Last year, the PDs accounted for over half of the secondary market volumes and about two-thirds of subscriptions in primary issuance of government bonds and treasury bills.

Collectively, they made a profit before tax of about Rs 1,470 crore in 2003-2004. But with the rising interest rates, the honeymoon is over now.

Since inception, the PD business has been dependent on favourable domestic interest rates. They have been allowed to trade only corporate bonds and interest rate swaps (IRS) in addition to government bonds. The other income avenue for the PDs is underwriting commission for bidding in government bond auctions which has gradually been reducing over the years.

Under these circumstances, the best way to keep the PDs alive is to create an appropriate instrument for hedging the risk of adverse price movements in their government bond holdings. In the absence of such an instrument, PDs' appetite for holding government bonds will diminish and threaten market liquidity.

Theoretically, interest rate futures would enable the PDs to insulate their rate-sensitive asset portfolios. Besides, availability of an efficient hedge instrument is likely to increase activity in cash market too.

To the Reserve Bank's credit, it did introduce the instrument in June 2003. The PDs and banks rushed to strike deals to hit the newspaper headlines but nothing came of them. Why? Market participants point to the faulty product design.

The contracts were traded and settled on the zero coupon yield curve (ZCYC) methodology. They say that the ZCYC-based valuations of liquid bonds move quite differently from the actual market-traded prices and in fact, on some occasions, valuations moved in the opposite direction.

Therefore, participants hedging their debt portfolios using futures contracts could have been on the losing side on both the debt portfolio as well as the hedge portfolio.

The regulators, after consultation with all market participants, have proposed a new futures contract that will be traded and settled based on the average of market-traded yield of a basket of three liquid gilts with a residual maturity of 9 to 11 years. The market has been waiting for the new futures contract for over a year now.

However, interest futures alone may not be able to help the PDs protect their balance sheets. Perhaps it's time to take a relook at PDs' business model.

For instance, they are shut out from the foreign exchange market while other financial intermediaries "" banks, mutual funds, individuals "" have been allowed to take foreign currency exposure.

The PDs could be allowed to take similar exposure through assets as well as financial transactions like forwards, currency swaps and currency options. This would enable them to reduce their current risk concentration.

The currency market today is the exclusive preserve of commercial banks. The PDs can play a useful role in expanding the forex market, as in countries like South Korea.

Similarly, they could also be allowed entry into credit derivatives. In principle, commercial banks have been allowed to use credit derivatives to hedge their credit risk but no role has been envisaged for PDs in this market. PDs could operate effectively as entities facilitating such transfer of risks through market-making.

Finally, the PDs should also be permitted to take part in the commodity futures market. Internationally, commodity prices sometimes act as natural hedge for interest rate exposures and there is no reasonsto believe this will not be the case in the Indian context.

Allowing PDs to trade in this market can act as a major catalyst to boost liquidity, ultimately benefiting the hedgers through better price discovery and volumes.

The PDs could play a role in these markets as they have the flexibility and capital required to undertake any new activity. The average capital adequacy of primary dealers is around 30 per cent now against a regulatory minimum requirement of 15 per cent.

If the Reserve Bank does not allow them to diversify and spread the business risk, some of the PDs may be forced to surrender their licences and close shop.

If that happens, the government will be the biggest loser because it needs to see through its annual market borrowing. There will also be pressure on banks to rescue the borrowing programme. This will happen at a time when the banks are cutting their bond exposure fearing losses arising out of the rise in interest rates.