The soul of the debt market
The RBI announced that government securities will trade on exchanges through anonymous order-matching. This is a major milestone for the thought process at RBI, and for India's debt market.
India's equity and debt market have walked in very different directions in the decade of the 1990s. Both markets started out alike. As of 1992 or so, both markets were profitable clubs for a few intermediaries in Bombay, and were ridden with corrupt and fraudulent market practice. The scam of 1992 helped diminish the prestige of the status quo, and gave reformers in government the upper hand. The debt market made progress on blocking fraud and improving systemic integrity, but there was no fresh vision on market design. In the case of the equity market, we saw a complete revolution in market design: badla was banned, and NSE was created.
The contrast between the debt and equity markets is now embarassing. The debt market never crosses a thousand trades a day, while NSE has become the fifth largest exchange in the world (measured by trades per day) and is within striking reach of a million trades a day. The debt market languishes as a club of two dozen dealers in one square kilometre of South Bombay. The equity market has lively activity from Kashmir to Kanniyakumari; less than half of NSE's trades come from Bombay.
At first blush, it is glaringly obvious that RBI's vision for market design has been proved inferior when compared with the innovations which have delivered results on the equity market. Many observers are puzzled at RBI's unwillingness to learn from the success of the equity market, and abandon the non--transparent, clubby nature of the bond market. In this article, I will argue that the truth lies in between. There are some aspects where the equity market is clearly the role model for the debt market, and RBI should not hesitate in abandoning its existing vision for market design. At the same time, there are many aspects where RBI's concerns are well founded, where existing market practice on the equity market is dubious, and should not feature in the future of the debt market.
What the equity market does right.
- Anonymous order matching. The debt market uses bilateral transactions, where dealers bargain with each other. This is non--transparent (nobody other than the two dealers engaged in bargaining can observe the transaction or cut into it) and vulnerable to cartel formation. The equity market is dominated by anonymous order matching. Traders only focus on prices and quantities. Political considerations, cartels, play a much smaller role thanks to anonymity. Indeed, SEBI has made important progress on banning bilaterally negotiated trades, and on eliminating order types such as "All or nothing" which offer loopholes for injecting negotiated trades.
- Nationwide access. Using satellite technology, equities trading takes place from all over India. NSE has 3,000 VSAT terminals, and roughly 10,000 trading computers. The equity market has also opened up to Internet trading. This is a remarkable distribution channel. Today, the RBI is contemplating setting up a "negotiated dealing system" (NDS), but even the ambitions of this system are toy-like when compared with the equity market.
- Outsourcing of IT functions. SEBI has done an excellent job of positioning itself as a regulator / policy-maker, and not getting involved in market operations. NSDL runs the depository, NSE and other exchanges run the order-matching computer facilities, NSCC runs the clearing corporation. SEBI stands aloof from day-to-day market operations. In contrast, RBI is intimately involved in the clearing and settlement process, and through the NDS it will get involved in trading also. This is an inferior strategy, for two reasons. First, an entity like NSDL has a greater professional focus on the task of securities settlement, and is hence able to do a better job than RBI's SGL. RBI's focus is innately on monetary economics, and it is unlikely for teams at the RBI to match the IT capabilities that are found in the securities industry. Second, it is a cleaner arrangement when SEBI regulates NSDL. SEBI can be an external observer, and take NSDL to task when there are difficulties. It is hard for RBI to discipline it's own staff performing operations functions. It is easier for SEBI to be unsympathetic about NSDL's implementation problems; it is all too common for RBI to be tolerant towards "practical difficulties" in SGL.
- Eyeballs. The greatest thing which has worked on the equity market is the large number of individuals and firms in India who participate. NSDL has 3.2 million accounts, and it is estimated that hundreds of thousands of individuals and firms regularly trade on NSE. This community has learned how trading is done, and submits to the discipline of a strict clock for clearing and settlement activities. This is the community that knows how to trade, to bear risks, and to make markets. This community should be harnessed into making the debt market liquid. For this purpose, debt market operations should become like those presently known to this community.
What the equity market does wrong. At the same time, the equity market has certain important weaknesses. They constitute the reforms agenda for the future of the equity market, and they should not be accepted in a new debt market.
- Murky settlement systems. The equity market has not yet made the move to rolling settlement. SEBI continues to support badla, and engage in cosmetic measures which avoid rolling settlement. RBI should make sure that the debt market only works with T+5 rolling settlement, without badla.
- Fragile clearing systems. On the equity market, only NSE has a clearing corporation which takes legal responsibility with "novation". Other stock exchanges lack the umbrella of protection of the clearing corporation.
- Conflicts of interest. RBI has been discovering how limited the effectiveness of "self-regulating organisations" (SROs) is. The equity market is replete with the conflicts of interest that flow from stock brokers managing stock exchanges.
There are cultural differences between RBI and SEBI on the whole question of standards for systemic integrity. The equity market seems to lurch from crisis to crisis at the rate of roughly one crisis every two years. The fixed income market was deeply enmeshed in the scam of 1992, but it has a clean record after that for an eight--year period. SEBI would do well to adopt superior standards for the incidence of systemic crises.
In summary, I think that the truth lies somewhere in-between SEBI's notions of market design and RBI's traditional approach of having two dozen dealers in South Bombay. I think that both SEBI and RBI are overly influenced by the market intermediaries that they deal with : RBI worries about the interests of dealers, while SEBI worries about the interests of stock brokers.
RBI has made an important move in announcing that it would move towards order-matching instead of using bilaterally negotiated trades. There is much that the equity market can offer in terms of new dreams for market design for the debt market. At the same time, the equity market suffers from low aspirations on the question of systemic risk, where RBI can usefully apply higher standards, and ask for a cleaner and more robust market.
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