First steps in BCD Nexus

Business Standard, 1 March 2008

Financial sector policy in India traditionally worked on a `divide and conquer' principle, where finance was carved up into pieces which were held separate, into classes of financial firms which were held separate. This strategy has been an important source of the failures of financial sector policy in recent decades. In para 97, the finance minister sets out to talk about corporate bonds. The text of the paragraph correctly understands that there is no such thing as a separate corporate bond market.

The corporate bond market is deeply linked to the equity market, for when there is bad news about a company, the share price goes down and the corporate bond price goes down. The corporate bond market is also deeply linked to the government bond market, for if interest rates go up, bond prices of both markets go down. Finally, the Indian government bond market is connected to the global government bond market by the currency spot and derivatives markets.

In India, treating each of these as a distinct piece has been tried for many decades, and has failed. Making progress critically requires a unified perspective of the `Bond-Currency-Derivatives (BCD) Nexus', where all these markets work as a seamless whole. A well-functioning BCD Nexus is an integrated market featuring government bonds, corporate bonds and currencies -- across both exchange-traded and OTC market and across both spot and derivatives markets.

A sound bond market is obviously essential for Indian development - to finance the debt requirements of infrastructure projects, corporations and the government. Making correct monetary policy decisions requires information coming in from a sound BCD Nexus, and for monetary policy decisions to reach out and influence the economy, a sound BCD Nexus is required.

For India to achieve high domestic GDP growth, this gap needs to be addressed. In addition, the Mumbai International Financial Centre report has argued that for India to achieve any kind of export of financial services, the most important missing link is the lack of the BCD Nexus. Thus, for domestic finance and for aspirations of export revenues, the BCD Nexus is one of the biggest priorities in Indian financial sector policy.

The equity market has got the right foundations in terms of trading technology, nationwide outreach, reliable risk management, a massive number of participants, and a well structured regulator. It is the only success story in Indian finance, where India figures in top-10 international rankings. Around this kernel, the BCD Nexus can achieve liquidity.

The budget speech is on the right track with a series of moves on this front: (a) Strengthening the exchange-traded market for corporate bonds at NSE and BSE, (b) Setting up trading of currency futures and interest rate futures at NSE and BSE, (c) Setting up a transparent credit derivatives market, (d) Supporting stripping of the equity option embedded in a convertible bond, and (e) Solving the stamp duty problems that afflict the securities market.

Credit derivatives link the government bond market and the corporate bond market. The difference in the interest rate between a corporate bond and a government bond reflects the credit quality of the corporation. Credit derivatives are, ultimately, derivatives on this credit spread, which fluctuates with movements of the stock price. With a proper BCD Nexus, interest rate futures would allow trading on government bond interest rates, and credit derivatives would allow trading on credit spreads and defaults. These would be naturally linked with the stock futures and index futures which are already up and running.

Between SEBI, NSE and BSE, India has the ready technological and institutional capability to pull it off. The government has announced some of these things before. The difficulty lies in the internecine warfare between agencies that Indian finance is mired in. In 2003, trading in interest rate futures was begun. This was sabotaged by RBI, which banned bank participation in this market. There is no point in trying to do interest rate futures trading once again, if similar tactics will recur.

Currency futures have been in the air for a long time, but RBI has proposed many elements of a strategy to prevent them from working. These include preventing FIIs from participating on the market, requiring `hedging' transactions only, blocking interlinkages between the forward market and the futures market, forcing tiny position limits, blocking trading of currency futures on NSE / BSE, requiring a separate segment where currency futures trade separately from the rest of the BCD Nexus, etc.

Each of these sounds like a small technical matter. It seems like a reasonable person should agree to any of these earnest requests. Unfortunately, each of these modest proposals has the potential to ensure failure of the proposed markets.

There is a gulf between the instincts of reasonable bureaucrats and the requirements of launching markets. Bureaucrats are used to starting off with half-baked systems, and fixing them over time. However, when it comes to financial markets, a half-baked system leads to zero liquidity. And once a market fails, financial firms and individuals stop taking interest in it, which leads to a spiral of death.

To make a market work, it is crucial that no important mistake is present on the first date of trading. Only small mistakes can be safely remedied later on. Once a market works, a virtuous circle is set off. The more the liquidity of a market, the more financial firms and individuals desire participation in it. But rescuing a failed market is genuinely hard.

The challenge for the finance minister now lies in staying the course, in seeing this agenda through to fruition. His task has been made more difficult by the RBI Amendment Act of 2006, which was put through under his watch, under which RBI was given significant roles in financial regulation. However, even today, there is considerable room for maneuver, based on a careful reading of the Securities Contracts Regulation Act and the SEBI Act. In the medium term, India needs to undertake substantial re-engineering of these legislations, but in the short term, there is a lot that an effective Ministry of Finance can do, to get a BCD Nexus going with SEBI regulation.

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