Tamal Bandyopadhyay: Death of a debt market

Rising interest rates and no derivatives have choked off the debt market.

In April 2004, the turnover of National Stock Exchange's wholesale debt market (WDM) was Rs 1,33,477.90 crore. The comparative figure for the equity market was Rs 1,45,744.85 crore and that of the commodity market (turnover of three exchanges "" MCX, NCDEX and NMC) was Rs 4,902.67 crore.

This month, the trading volume in the equity market has been Rs 1,60,705.07 crore while the volume in the commodity market zoomed to Rs 88,931.87 crore. However, the debt market turnover slumped to Rs 34,226.47 crore.

While the commodity market is the newest kid on the block, even agro-processing firms have become big players since this provides a method to both discover price as well as hedge risk. And the equity market got a lease of life with a host of reforms, including allowing of derivatives as well as dematerialisation.

The debt market, too, saw reform beginning in April 1997 when the practice of automatic monetisation of the government's Budget deficit through ad hoc treasury bills was abolished with the introduction of a new scheme of called ways and means advances (WMA). But matters came to a halt after that.

In August 2002, the Reserve Bank of India (RBI) spoke about the introduction of STRIPS (Separate Trading of Registered Interest and Principal of Securities), which allows debt market players to trade separately interest and principal of a bond.

An RBI-appointed working group on operational and prudential guidelines for STRIPS has submitted its report but nothing has happened on this front as yet.

Ditto about credit derivatives, interest rate derivatives and interest rate futures. While credit derivatives do not exist in the Indian debt market, interest rate derivatives and futures made a brief appearance and vanished thereafter.

Till a year ago, this didn't really matter too much as falling interest rates meant that bond traders made hefty profits trading government securities as interest rates fell from over 12 per cent to less than 5 per cent. The honeymoon ended last year with the first sign of rates moving up.

Commercial banks, which are the main players in the debt market, have virtually stopped trading in debt as with the rise in interest rates they need to mark-to-market their bond portfolio and provide for notional losses.

Going by the RBI norms, banks are required to allocate at least 25 per cent of their liabilities to buy government securities. Against this, the share of government securities in banks' books rose to over 40 per cent as they preferred gilts to loan assets in a falling interest rate scenario. Now, they are busy paring down their bond book and building their loan book.

Another fallout of the rising rates is the banks' reluctance to trade in government securities. They are shifting the bonds from their trading book to the "held-to-maturity" segment to ward off the impact of rate rise on their profitability as they do not need to mark-to-market securities held to maturity.

The other players in the debt market are mutual funds, primary dealers, insurance companies, provident funds and pension funds. Unlike in the equity market, the retail investors are absent in the debt market.

Even the mutual funds are shying away from the market as with the fall in bond prices the underlying portfolios of debt funds get eroded.

Between July this year and July 2004, assets managed under 45 income schemes of mutual funds has dropped from Rs 15,000 crore to Rs 4,174 crore, witnessing an outflow of 72 per cent. These funds invest in corporate debt and government securities.

The shrinkage in corporate bond market volume is even more glaring. If the CEO of a rating agency is to be believed, there has not been a single primary bond issue in the corporate debt market for many months now.

The main reason is the absence of any derivative to hedge the interest risk as well as credit risk in a rising interest rate scenario.

This brings us to the crux of the problem. Over the last one decade or so, the RBI has been trying hard to add width and depth to the debt market.

While the focus has been on creating the right infrastructure for the market, product diversification "" a key to any sophisticated debt market "" has taken a backseat.

The RBI's reluctance to push for derivative products could be the lack of clear regulatory structure in a multi-venue trading market. The Indian central bank regulates banks, while the Securities and Exchange Board of India (Sebi) regulates brokers, mutual funds and exchanges.

A 2002 report of the Asian Development Bank had said: "Sebi and the RBI must ensure the responsibilities for regulation and enforcement in the secondary markets result in consistent treatment of all trades irrespective of their origin. Ideally, all trading should be under a single, clear regulatory remit."

The RBI must shed its aversion to derivatives products. After all, a vibrant derivatives market can boost the liquidity in the cash market "" as is being seen in equities market "" and support the volumes.

If it does not do so, the debt market will continue to be a laggard trailing behind the equities, commodities and even the foreign exchange markets in volume, depth and sophistication.