Financial sector reforms stalled?

In the article Time out for the financial sector, (Economic Times of 3 May), Mythili Bhusnurmath summarised a point of view which is widely prevalent amongst the cognoscenti: that the breakdown of the BJP government has been a major setback for financial sector reforms. In this article, we take stock of the situation, with an accent on financial markets, and suggest that the situation is not as gloomy as it seems.

The equity market. The early years of the 1990s were turbulent times, with the Scam, the empowerment of SEBI, the removal of badla (which was reversed in 1997), and the launch of NSE with all its multifaceted consequences. The recent years might seem to be equally confusing - especially owing to the furore created by the three scandals (M. S. Shoes, CRB and the payments crisis at BSE in 1998). However, the central issues on India's equity market had become remarkably simple by 1997. From 1997 onwards, the agenda for reforms on the equity market has crystallised around three questions: (a) adoption of the depository, (b) the transition to rolling settlement, and (c) index derivatives.

In 1999, it is possible to make major progress towards these goals, even though the next government might only fall into place towards the end of the year.

Depository: The process of steadily expanding the list of stocks where demat settlement is mandatory is likely to continue through 1999. NSDL is also at the centre of remarkable recent developments in lending money against shares as collateral, and in lending shares against collateral. Both these facilities will have a profound impact upon the equity market in 1999 and 2000 AD. The efficiency and integrity at NSDL, combined with the supportive policy environment created by SEBI, has made India a success story -- by world standards -- for a rapid adoption of the depository.

Rolling settlement: This same story can, and should, be repeated for rolling settlement. The conditions are now ripe for a replacement of the "futures style settlement" that is used on India's equity spot market by rolling settlement, which is much closer to a true spot market. SEBI should adopt a policy position whereby six months after a stock goes into compulsory demat settlement, it goes into compulsory rolling settlement. If such a policy position were taken, we would see the top hundred stocks (Nifty and Nifty Junior stocks) going into rolling settlement before year-end. The presence of a caretaker government at Delhi does not hinder such an effort.

Derivatives: The standing committee on finance had approved the SC(R)A amendment which paves the way for cash-settled derivative products, such as futures and options on the equity index. Implementing this through an ordnance might be possible under the caretaker government. Derivative products which do not require cash settlement could instead be used in the onset of exchange-traded financial derivatives.

Derivatives is an area which has been afflicted by myriad delays for the last four years. The lack of exchange traded derivatives is increasingly a major bottleneck in the progress of securities markets. Hence, even if an ordnance is not done now, preparatory work should be done by June, so that an ordnance can be promulgated in the first week of the next government.

Debt market The debt market is several years behind the equity market in terms of institutional sophistication. In all three areas - trading, clearing and settlement - the institutional arrangements on the debt market lag behind the best practices seen on India's equity market.

Hence, the discussions on the debt market are at a more conceptual level; they are reminiscent of the philosophical debates about anonymous electronic trading which took place in India's equity community in 1993. At that time, the optimality of anonymous, electronic trading was the subject of much debate in the equity community. The question was settled by the success of NSE: everyone involved with the equity market is now convinced about the value of anonymous, electronic trading. In the absence of direct experience with anonymous, electronic trading on the debt market, many existing dealers are keen to cling to their lifestyle of face-to-face bargaining and contracting.

The three most important issues faced in the debt market today are:

Realtime gross settlement (RTGS) and an electronic funds transfer (EFT) system are often viewed as very important goals on the debt market. However, it's useful to observe that on the equity market, the basic institutions of trading and clearing fell into place using the existing banking system and using physical certificates. The depository (NSDL) works without RTGS today. Hence, while RTGS and EFT are important issues, they are neither necessary nor sufficient for obtaining a sound market design.

In each of the three areas, legislation is indeed an important bottleneck. If parliament were in session, the SC(R)A amendment would help by clarifying the jurisdiction of the RBI over the debt market, the Government Securities Act could be taken up, etc. The fall of the Vajpayee government is clearly a setback in these terms. Yet, another activity - which is perhaps more important - can proceed through 1999: this is the process of thinking through the market design and the regulatory framework which is required to address these three issues.

RBI has already made significant progress on one issue, that of designing a market, and a regulatory framework, for repos and reverse repos. It is clear that these new modes of functioning on the repo market are months away from implementation; however, it is an important milestone when a market design and a regulatory framework is concretely articulated. Similar efforts can be undertaken on the other two problems in 1999.

As with the equity market, the SC(R)A amendment (or an ordnance) is required to enable cash settled derivative products. This would matter when thinking of futures on interbank rates such as MIBOR. However, if we discuss futures and options contracts based on delivery of government paper, such as treasury bill futures, the SC(R)A amendment is not essential. Market development in 1999 could be channeled in such directions.

To summarise, it is not time to hang up our shoes and wait for the next government to fall into place. There are important areas where SEBI and RBI can make progress through 1999, under the caretaker government. SEBI can make progress on depository adoption, and the top 100 stocks in India can go into mandatory rolling settlement within weeks. It is possible to make progress on equity derivatives through several paths. RBI can make progress in terms of thinking through the market design and regulatory framework for the interest rate spot market, the repo market and interest rate derivatives. For both SEBI and RBI, derivatives trading is possible even without the SC(R)A amendment as long as cash settlement is not required.

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