Can The Primary Dealers Deliver?

market seems to be over as RBI changes the rules, says S Chandrasekhar

The Reserve Bank of India (RBI) has taken the first step towards relinquishing its role as the underwriter of the borrowing programme of the central government. Last week, the RBI scrapped the system of commissions based on bids tendered by primary dealers and replaced it with an underwriting commission.

Primary dealers can now underwrite a minimum of 25 per cent in each issue of the Government of India dated securities and treasury bills. Once this scheme comes into effect from June 2, 1997, it is possible that the RBI may not have to pick up any portion of the devolvements in primary auctions. One may recall that when the RBI had instituted the system of primary dealers, it had stated that in due course it wanted to relinquish its role as an underwriter to the governments borrowing programme.

 

In another related move, the RBI revised the structure of commissions that it used to pay the primary dealers. Unlike earlier when primary dealers received commission on purchases of government securities in primary auctions, the RBI will from now on pay commissions only on their underwriting commitments.

The system of primary dealership became operational in mid-1995, with six primary dealers DFHI, STCI, Gilt Securities, I Sec, PNB Gilts and SBI Gilts kicking off operations. The primary dealers were expected to act as market makers and work towards providing depth to the gilts market. Their efforts at market making was expected to broadbase the market. Given that the primary dealers were going to offer two way quotes, the problem of illiquidity that is characteristic of the Indian debt markets would have been partially overcome.

Each primary dealer signed an agreement which specified, among other things, the bidding commitments i.e. the minimum quantum of bids that will be tendered by them at the auction of treasury bills as well as dated securities and the success ratio or the minimum quantum of successful bids. The agreement also specified the maximum exposure of the individual primary dealer, in percentage terms, in case the issue devolved.

In return, the primary dealer was entitled to commissions from the RBI on all successful bids. For every Rs 100 worth of successful bids tendered by them, they got 12.5 paise in case of 91day treasury bills, 50 paise in case of 364 day treasury bills and Re 1 in case of dated securities. They also got refinance from the RBI at the bank rate i.e. at 11 per cent. The extent of refinance was pegged at a percentage of their bidding commitments 10 per cent in the case of treasury bills and 16.6 per cent in the case of dated securities.

Under the new structure, the primary dealer will have to commit the extent to which he is willing to underwrite an issue and also mention the expected fee. Each one of them can underwrite upto five times its networth or to the extent of refinance that it can avail of from the RBI, whichever is higher. The RBI reserves the right to accept or reject the bids. The RBI will follow the Dutch Auction principle, wherein all eligible bids will get the same commission.

The first year of operations of the primary dealers can be termed as a fairy tale beginning, with all the primary dealers expected to post handsome profits. The commissions helped them quote finer prices at the auctions and procure a major chunk of the securities, which they offloaded in the secondary market to banks and other institutional investors at a premium. Initially, many banks routed their bids through the primary dealers and got to share a fraction of the commissions. However, this practice was discontinued, point out primary dealers, but in reality, banks still route their bids through them.

No inference on the viability of the primary dealer system can, however, be drawn from their track record in the past year. The reason is that they were helped by easy market conditions as well as easy commissions. In this context, it is surprising that the RBI decided to scrap commissions on all successful bids tendered at the auctions instead of phasing it out gradually. Commissions helped the primary dealers in their efforts at market making, as they could offer finer quotes. Now that commissions are gone, primary dealers may find the going tough.

They could find it a problem offloading securities in the secondary market after the auction. The problem would be further accentuated when liquidity tightens and banks are not willing to subscribe to government paper. Will they be willing to underwrite a portion of notified amount? There may not be any clear answer to this question, but it must be pointed out that they were instituted explicitly for this purpose. If they do not underwrite any portion of the issue, the entire exercise of instituting the primary dealer system will be self defeating. The RBI is expected to adopt a proactive approach and modify the scheme to facilitate the primary dealers.

It is now expected that with the change in the commission structure, primary dealers will not bid as aggressively as they used to earlier. In times of easy liquidity, they will bid in large numbers and obviously, underwrite a large amount, secure in the knowledge that they would be able to offload the securities at a later date. The converse would be true at times when liquidity is at a premium. They will cut back on their bids at the auctions and maybe underwrite a nominal amount.

However, Y P Narang, managing director, PNB Gilts, does not buy this argument. Says he: It is not necessary that the primary dealers will adopt a defensive strategy. What the new scheme implies is that the primary dealers will have to exercise greater caution, for the margin, for error is now reduced.

The new scheme announced by the RBI is a litmus test for the primary dealers, since they are now on par with all other players in the market and will not get any concessional treatment from the RBI.

The primary dealers, however, admit that the revision in the commission structure marks the end of the honeymoon that they had with the markets. The RBI expects us to shoulder the burden of the governments borrowing programme and this is a major responsibility, says an official with SBI Gilts. But this brings one back to the question that was asked when the system of primary dealers was instituted.

Can they survive in the initial phases without any concessions provided to them, either in the form of commissions on their successful bids or refinance at concessional rates? The primary dealers must be praying that easy market conditions prevail in the current financial year also, facilitating their operations. It is possible that an entity only in the business of primary dealership might not survive and hence, some of them are also exploring the possibilities of venturing into other related business in the debt market.

While these moves are part of the measures taken towards making the government borrow directly from the market, the RBI still reserves the right to determine the cut off price at the auctions. In this respect the underwriting agreement is peculiar. Unlike in an equity issue where the underwriter is fully aware of the price at which the commitment has been made, in case of primary dealers this is not true. This is the strange feature of the underwriting process in case of primary dealers.

While tendering the underwritten bid, the primary dealer will be quoting the amount and the fee but not the coupon at which it is willing to underwrite. The price at which the issue will be underwritten will be the weighted average price at the auction.

According to a primary dealer, one possible alternative is for the RBI to announce a reserve price. The other option would be for the RBI to resort to bookbuilding in order to facilitate the process of price discovery. While the merits of the above suggestion can be debated upon, there can be no arguments against the principle that the government should borrow at market determined rates. The issue in context is whether the price needs to be discovered by an auction or by the process of bookbuilding, and how this price can be made binding.

In the future, the RBI is expected to follow a twin-pronged strategy make underwriting compulsory and at the same time increase the number of primary dealers. But before that the RBI is expected to examine the impact of the new scheme on the operations of the primary dealers. It is now expected that with the change in the commission structure, primary dealers will not bid as aggressively as they used to earlier.