Recipe for a vibrant govt securities mart

ANALYST'S VIEW

A when-issued (WI) market provides a platform whereby market participants can trade in government securities that have been announced for issuance through primary market at a future date.

The 'when issued' market in India started operations in August 2006. The market was introduced with the purpose of aiding price discovery and gauging the demand for relevant securities at the auction. Trading activity in the when-issued market has remained lacklustre since its inception. The volumes have barely been around Rs 100-300 crore.

The volumes in the when issued market, as a percentage of the issuance size, have rarely crossed 2 per cent. One would expect the trading volumes in a vibrant when-issued market to at least equal the primary auction size, if not exceed.

Reasons for the absence of vibrant WI market
PDs hesitant to take positions: One of the primary reasons for the sluggish development observed in the when-issued market is hesitancy on the part of primary dealers to take up positions in securities auction. This is especially observed in times of rising interest rates.

Unfortunately, the operationalisation of when issued market has coincided with a period of tight monetary policy. Short tenor securities see a demand from banks: Banks usually prefer to buy the short tenor securities to meet their SLR requirements.

As a result, banks aggressively buy at Treasury Bill auctions and G-Sec auctions of maturities below 10 years. Banks usually purchase the securities and transfer them to the 'held to maturity' category.

Aggressive buying by insurance companies in longer-tenors: The auctions for longer tenors hold a tendency of being cornered by large insurance firms. Moreover, the securities bought by such companies, are largely in the form of investments held till maturity and are rarely traded post the primary issuance.

PD no longer an essential counterparty: As per the initial RBI guidelines on the when-issued market, it was essential to have a primary dealer (PD) as counterparty in a transaction.

A compulsion on keeping PD, as counterparty would only prove to be a hindrance, especially when PDs lack any exclusivity in the primary market. As a result, this guideline was revised later and one leg of the transaction was not reserved for primary dealers. However, the revision of the guideline has not been beneficial in improving the volumes in when issued market.

Possible issues with exclusivity
1) Cornering of stock: The most important concern over exclusivity could arise from the fear of some PDs cornering certain stock. This could create a temporary shortfall and result in an excessive rise in secondary market prices. However, this issue can be handled by putting restrictions on biddinguccess quantum of individual PDs. The US Treasury market had experienced this situation in 1991, whereby Saloman Brothers allegedly cornered two-year notes. This led to some changes in auction regulations. We could look at the possibility of introducing exclusivity in all issuances, but limit it to a certain percentage of each issue.

2) Cartelisation by PDs: Apart from cornering of an entire issue, there could also be some anxiety regarding cartelization by PDs to get the auction stock at a particular price. This could also mean that PDs come together and bid at a very high yield, which is not acceptable to the issuer. In order to tackle this issue, a single window of underwriting could be considered whereby all the PDs compulsorily underwrite the entire issue. In a scenario of giving exclusivity to PDs, such an arrangement would deal with the anxiety of cartelization.

3) Sudden liquidity crunch: Exclusivity to PDs in government issuance is expected to result in a rise in the secondary as well as when-issued market trading volumes. Under such a scenario, it is possible that the gross outstanding long positions of the PDs rise substantially. This would in turn increase the quantum of outflows on a gross basis. However, if on the date of issuance, the payments are netted off, it could result in lowering of the funding requirement by some margin. As a result, settlement of payment on net basis on the date of issue of auction security would partly allay the fears of a sudden liquidity crunch.

4) Cost of funding for standalone PDs: Another important issue is the cost of funding for standalone PDs vis-à-vis PDs that are essentially a department in a bank. Special liquidity support would be needed for the standalone PDs post issuance of auction securities. The additional liquidity support to standalone PDs could be in form of a special repo dealing only with the latest auction stock, that too for a limited period.

Conclusion
The slow development of the when-issued market has only reinstated the need for providing exclusivity to the primary dealers in government issuances through the primary market. This is obviously going to require changing the underlying mindset of participants and the initial fears over exclusivity; and the task is definitely going to be very daunting.

Nonetheless, we feel that a gradual approach towards the introduction of exclusivity is only going to aid the widening and deepening of the government securities market in India. A vibrant government securities market in turn would aid the development of other fixed income markets such as corporate bonds and swaps.