Financial Benchmarks in India: A Coming of Age1
Smt. Usha Thorat, Chairperson, FBIL, Shri R.N. Kar, CEO, FBIL,
distinguished speakers, colleagues and friends. It is a pleasure to be
speaking today at the annual dinner of the Financial Benchmarks India
Limited. Over the last decade, following the LIBOR problems,
international attention to reform financial benchmarks has been a major
component of the post-GFC regulatory overhaul of financial systems.
Today, as we stand in the final stages of transition away from LIBOR
towards alternative benchmarks, is an opportune moment to look back at
the reforms undertaken in financial benchmark administration in India and
assess the progress.
Introduction
1. Financial benchmarks, used as reference for pricing, valuation and
settlement of financial instruments, are a key driver of price integrity of
financial markets. From deciding the interest rate on a retail loan to
determining the pay-off in a complex derivative, financial benchmarks are
ubiquitous and deeply embedded in financial systems. By promoting
standardisation, they facilitate liquidity in markets thereby lowering
transactions costs. Robust benchmarks promote financial stability by
improving transparency in pricing and reducing information asymmetry.
Use of benchmarks in valuation helps ascertain the fair value of a financial
instrument and incentivizes trading in the instrument. Financial
benchmarks also facilitate monetary policy transmission and help assess
the efficacy of such transmission.
2. Well-designed, robust benchmarks that are reliable and resistant to
manipulation are critical for the stability of the financial system. In a sense,
financial benchmarks can be seen as a public good. The BIS, in a 2013
report titled 'Towards better reference rate practices: a central bank
perspective2' highlighted reliability, robustness, frequency, ready
availability and representativeness as the desirable features of a
benchmark. Reliability is based on governance standards and
administration to protect from manipulation and errors; robustness relates
to maintaining integrity even during episodes of market stress; proper
frequency provides stability as well as relevance; representativeness
implies that the benchmark is rooted in appropriate prices; and ready
availability facilitates ease of pricing and contract verification.
3. All these above features contribute to standardisation and
comparability across markets with diverse instruments, participants,
location and venues. Critical to the emergence of financial benchmarks
and their use is credibility and trust that the benchmarks accurately reflect
the price of the referenced financial instrument. The core issue at the loss
of trust in the LIBOR lay in its measurement methodology - the fact that it
relied on estimates - as well as the inadequacy of its governance
framework. This triggered a series of reforms aimed primarily at changing
reliance to actual traded prices and improving the integrity of benchmark
administration. The resultant International Organization of Securities
Commissions (IOSCO) Principles for Financial Benchmarks is today the
overarching framework for ensuring best practices for benchmark
administrators and submitters.
Financial Benchmarks - The Indian experience so far
4. In the backdrop of the global developments, the Reserve Bank
constituted a committee in 2013 chaired by Shri P. Vijaya Bhaskar, then
Executive Director to recommend sturdy practices for financial
benchmarks. The Committee made several important recommendations
including creating an independent structure, separate from FIMMDA and
FEDAI, the then benchmark administrators for the Indian Rupee interest
rates and Forex benchmarks respectively, for administration of the
benchmarks. This, as we all know, led to the formation of FBIL.
5. The Committee also recommended that benchmark administrators
be subject to regulatory oversight. In 2019, the Reserve Bank issued the
Directions on Financial Benchmark Administrators putting in place a
regulatory framework for benchmark administrators in the markets
regulated by it. These Directions apply to 'significant benchmarks' taking
into consideration their use, efficiency and relevance in domestic financial
markets, while providing flexibility to the administrators with regard to
other benchmarks and to facilitate development of newer benchmarks.
The Directions set out the requirements for, inter alia, overall
responsibilities of benchmark administrators as well as the framework for
governance, controls and accountability in the benchmark administration
process.
6. RBI has notified the list of significant benchmarks in these markets
and put in place an oversight framework for the administrators of
significant benchmarks. Several enhancements have been carried out to
the benchmark computation and administration process by FBIL since its
inception.
7. FBIL played a pivotal role in modifying existing benchmarks to
conform to global standards. For example, the Mumbai Interbank Outright
Rate (MIBOR), first introduced by the National Stock Exchange (NSE) in
1998 and computed through a polling process, is now based on actual
transactions. The Mumbai Interbank Forward Outright Rate (MIFOR) has
been transformed into the Modified MIFOR using the alternate reference
rate, secured overnight financing rate (SOFR) instead of LIBOR in line
with the global transition away from the LIBOR. Modified MIFOR is now
being used for all new contracts. New benchmarks have also been
introduced in various market segments viz., Market Repo Overnight Rate
(MROR), T-bill rate and certificate of deposit (CD) rate.
8. Indian financial markets have witnessed substantial growth in the
last few years, facilitated, in part, by the availability of robust benchmarks.
The MIBOR benchmark is the underlying reference rate for MIBOR
overnight indexed swap (OIS) contracts. The open interest has increased
from ₹19 lakh crore in FY 2017 to ₹77 lakh crore in current FY 2023. There
is also a growing offshore market for MIBOR based OIS (ND-OIS). In the
currency market, the USD-INR Reference Rate is used by many domestic
users, including corporates. The reference rate is used for settlement of
non-deliverable forwards (NDFs) and exchange-traded futures as well.
The average daily turnover in INR NDFs has increased from around
US$16.4 billion in 2016 to US$ 46.4 billion in 2022. During the same
period, the average daily turnover in exchange traded currency futures in
India increased from US$ 2.8 billion to US$ 6.6 billion. As markets have
grown, the pool of assets using FBIL benchmark rates for valuation has
also grown.
9. An ideal benchmark is one which is anchored in observable
transactions in a liquid market with a diverse set of participants and which
remains robust in the face or market disruption and minimises scope for
market manipulation. But the realities of many markets - globally and in
India - are far from this utopian world. The reforms associated with
benchmarks over the last several years have, therefore, focussed on
effectively addressing the shortcomings in benchmark design and the
absence of robust governance processes that contributed to past abuses
and in instilling confidence in financial benchmarks through reforms in
benchmark governance, design, quality and accountability mechanisms.
Challenges with benchmark administration
10. All benchmarks are susceptible to weaknesses arising from the
nonzero probability of errors of omission and commission, the liquidity and
diversification of underlying markets, technology induced changes in
market microstructure, etc. There is a need for constant vigilance on all
these fronts even in the most liquid of markets. The need for vigilance is
stronger still in case of benchmarks in less liquid / illiquid markets where
benchmarks are based on polling and / or model-based rates. In the rest
of my speech, I will dwell upon some specific features of financial markets
in India which can pose challenges for effective benchmark development
and administration and which we will all need to be cognisant and watchful
about.
Money markets
11. Consider the overnight money market in India. In the call money
market - used for the calculation of MIBOR benchmark - non-banks were
phased out beginning from 2001. Prudential limits on borrowing and
lending in the call money market by banks and primary dealers were also
put in place in 2002. Synchronous with this, the repo markets were
developed and repo in government securities (g-secs) witnessed robust
growth in line with global trends towards collateralised overnight markets.
Amidst these developments, call money transaction volumes declined -
both relative to repo markets, as well as in absolute terms. The share of
call transactions in overnight money markets has gradually come down
from more than 20% in 2011-12 to below 2% in 2022-23 (Chart 1).
Meanwhile, daily turnover in the call money market declined from just over
₹19,000 crore at one stage and is currently at around ₹12,000 crore (Chart
2). The participant base in the market has also been shrinking.3
Chart 1 - Share of Call vs Repo Money
Chart 2 - Daily Turnover in Overnight
Markets
Call Money Markets
100% 20.0
17.5
80%
crore
15.0
60%
cent
12.5
per 40%
thousands
₹
10.0
20%
7.5
0%
5.0
Call Market Repo and CBLO/TREPS
12. Now consider the use of the MIBOR. The benchmark is used in the
OIS market. The MIBOR-OIS is the only liquid interest rate derivative
market in our country (apart from MIFOR) with, as I mentioned earlier, an
open interest of ₹77 lakh crore in the current financial year. The MIBOR
is also the benchmark for INR OIS trades in the global markets (ND-OIS).
I don't think I need to emphasize to this audience the importance of this
benchmark and the need for constant vigilance in maintaining its
robustness and reliability given dwindling transactions and shrinking
participant base in the call money market.
13. While volumes in the call money market have been declining, the
MIBOR benchmark continues to be determined based on actual
transactions. Further, its integrity is ensured given the fact that the call
money rate is the target rate for monetary policy transmission and
participants in the market have access to the liquidity facilities of RBI.
Among the other overnight benchmarks, the Market Repo Overnight Rate
(MROR) based on market repo transactions. Prima facie, this benchmark
being based on transactions in a more liquid market and one with a wider
participant base can normally be considered to be more robust. However,
the benchmark is not based on pure inter-bank market that can take the
place of MIBOR. Repo markets, while significantly larger, incorporate
entities that do not have access to central bank liquidity and therefore their
pricing is less robust than call rates for developing benchmark that tracks
possible policy rate actions.
14. In the term money market, FBIL is publishing term MIBOR
benchmarks. In the absence of a liquid term money market, these
benchmarks are based on polled submissions. The development of the
term money market remains elusive notwithstanding several reforms both
from a regulatory and a liquidity management perspective. Most of the
constraints have been addressed / removed in phases. The eligible
participant base in term money markets has been expanded. However,
liquidity in the term money market remains negligible and the development
of a robust term money benchmark curve remains a work in progress. Of
course, these are issues not unique to India and are observed in peer
nations as well. As LIBOR is getting phased out these problems are faced
even by developed markets.
15. The other segments of the money market - the markets for treasury
bills and CDs have witnessed impressive growth. But the growth has been
driven by the size of primary issuances while the secondary markets
continue to be characterised by low turnover. Here too, benchmark
computation methodologies rely on statistical techniques. Instances of
divergence between market prices and benchmark levels are, therefore,
not uncommon. The end-quarter phenomenon that besets yields of T-bills
and CDs, while not an infirmity of the benchmark per se, undermines their
efficiency.
16. The commercial paper (CP) market has also grown on the back of
primary issuances, but again, with low secondary market liquidity.
Issuances of similarly rated credit that take place at very different rates
display different market perceptions across types of issuers (e.g.,
corporates and NBFCs) but even among the same type of issuers (Chart
3). This is perhaps one of the reasons why there are difficulties in
developing and publishing a CP curve.
Chart 3: 91 day T-bill rates and 3 month CP issuances in October 2022
15.00
13.00
11.00
(%)
Yield
9.00
7.00
5.00
01-10-2022 06-10-2022 11-10-2022 16-10-2022 21-10-2022 26-10-2022 31-10-2022
T-Bill Corporates AIFIs HFCs NBFCs
Source: FBIL and FTRAC Platform, CCIL
Debt markets
17. Moving on to debt markets, the liquidity situation improves in
particular in the government securities market. Here too, as liquidity is
concentrated in a few benchmark tenors, use of models to arrive at the
benchmarks across all tenors becomes necessary. Given the importance
of government securities yields as the benchmark for pricing of most
financial assets, there is a need for a suitable methodology to ensure that
the benchmark yield curve remains robust and reliable. Idiosyncratic
factors pose challenges in the computation of benchmarks for State
Government Securities (SGSs). Similarly, thin secondary market activity
and lack of access to market for borrowers with lower credit rating make
benchmarking rather unwieldy in the corporate bond market. All these
factors reinforce the need for continuing efforts to evolve benchmarks that
remain relevant and representative of the market conditions and risk
perceptions of the underlying instruments.
Derivatives markets
18. A thriving derivatives market not only requires robust benchmarks,
it can also facilitate further development of the underlying markets. Limited
liquidity in derivative markets can therefore create distortions in
benchmark values. For example, OIS rates, which generally remain below
g-sec yields, have occasionally exceeded g-sec yields, impacted, in all
probability, by non-residents' trading interest (Chart 4). Similarly, there
have been episodes of negative spreads between near and far month
forward premia (Charts 5 and 6). Such episodes can engender large basis
risk and adversely impact the representativeness of benchmark rates.
Chart 4: Movement in 1 Year G-sec and OIS rates
8.00 60
40
7.00
20
6.00
cent
0-20
bps
per
5.00
-40
-60
4.00
-80
3.00 -100
10-Jan-18 10-Jan-19 10-Jan-20 10-Jan-21 10-Jan-22
Spread (RHS) 1Y G-sec 1Y OIS
Source: Bloomberg
Chart 5: One and Three month USD-INR Chart 6: Six and Twelve month USD-INR
Forward Premia Forward Premia
7.00 80
60
200
6.00
10.50
40
100
9.50
20
5.00
8.50
0
4.00
7.50
0-20
points
Cent
-100
cent points
6.50
-40
Per 3.00
Per
-200 Basis
5.50
-60
basis
4.50 2.00
-80
-300
3.50
-100
1.00
-400
2.50
-120
1.50 -500
0.00 -140
Spread (3M-1M) (RHS) 1M 3M
Spread(12M-6M), RHS 6M 12M
19. MIBOR OIS is the only pure interest rate derivative product in the
domestic markets that is characterized by good liquidity. While this
product has well served the purpose of allowing market participants to
express their view on the future movements in interest rates, its utility as
a tool to enable users to hedge their interest rate risks remains limited.
Globally, term money market rates are generally used as the benchmark
for interest rate swaps. In the domestic market too, there is a need for the
development of term benchmarks which can be referenced by interest rate
derivative products. This issue is becoming increasingly relevant with the
recent push towards linking loan pricing to external benchmarks.
Key Issues to Address
20. Beyond trading interest, there is a need to develop robust
benchmarks and products which meet the need of hedging asset side
requirements of institutional investors such as banks but also liability side
requirements of borrowers exposed to benchmark based interest rates on
borrowings and loan pricing. While the lack of adequate liquidity in some
instruments is the primary challenge, the reasons for the limited liquidity
vary. Growing offshore interest in INR products has resulted in
globalization of domestic benchmarks. Discussed below are some of the
issues that need attention to further the process of developing a robust
benchmark framework in India.
a. Diversified participation - A benchmark is as good as the price
discovered in the referenced market. Efficient price discovery
requires, on the one hand, the participation of investors with
varying requirements and diversified trading strategies, and on
the other, continuous price-making by market-makers. The
postGFC regulation has reduced the role banks traditionally played
in market-making, even in developed markets. The degree of
illiquidity seen in many traditionally liquid markets is partly
explained by this development. In the case of India, the
preponderance of buy-and-hold category of investors in the
gsec and corporate bond market (banks, insurance companies,
pension funds, provident funds) aligns trading activity in one
direction, leading to volatile overshoots. Such infirmities need to
be addressed to achieve price efficiency, and consequently,
robust benchmark. One way of diversifying participant base is to
open the markets to the larger global investor base.
b. Taxation, accounting and regulatory factors - One reason for the
limited response to retail participation in g-sec market is that it is
tax-inefficient compared to investing in mutual funds, as the latter
provides benefits of indexation. Similarly, asymmetric
accounting norms distort incentives for trading and may also
induce inefficiencies to hedging activities. Certain regulations
have the collateral effect of adversely affecting market liquidity.
There should be coordinated efforts to address the unintended
consequences of such taxation, accounting or regulatory
requirements without undermining the basic objective of such
policies.
c. Segmentation of markets - Market segmentation fragments
liquidity and leads to price differentials which erodes the efficacy
of benchmarks. Seen in the context of the need for investor
diversity, the fragmentation of Rupee markets between onshore
and offshore warrants prioritized attention. Internationalization of
Rupee interest rate and currency markets holds the promise of
wider investor base and global liquidity. To this end, measures
enabling non-residents to undertake transactions with
authorised dealer banks in India; providing Indian banks with
access to offshore markets to undertake non-deliverable
transactions etc., have been taken. For the benefits to accrue to
pricing (and therefore benchmarks) it is necessary that price
impulses move freely from onshore to offshore and vice versa.
Among other things, this may require linked and interoperable
infrastructure, common market-makers across the segments
and eventually a frictionless channel for investors to move from
one market to the other. There is a strong case to work towards
a long-term solution to this segmentation
d. Extra territoriality - A probably unintended consequence of the
post-GFC drive towards de-risking OTC derivatives markets has
been the tendency of developed economies to contain the risk of
their entities by attempting to maintain control of regulation and
risk management practices of third countries. Thus, for example,
European banks may not be able to operate through Indian
financial infrastructure entities (like CCPs, benchmark
administrators, etc.), unless their home regulator accords
"equivalence" treatment to the Indian infrastructure entities or
these entities are endorsed or recognized. Such treatment
involves ability to call for information, supervise, inspect and (at
least potentially) impose penalty on Indian entities. This amounts
to an unfortunate interference in the regulatory architecture in
India, especially given the fact that these Indian entities meet
relevant global best standards, set by Committee on Payments
and Market Infrastructures (CPMI)-IOSCO. Similar
extrajurisdictional overreach is hanging over FBIL as well. The
potential disruption to forex markets, both onshore and NDF, can
be rather serious. That such disruption flows from the action of
regulators is not in alignment with the post-GFC global
consensus on de-risking financial markets. All regulated entities
understand the costs and constraints of compliance. It cannot be
anyone's argument that replicating such obligations for every
regulator in every jurisdiction is an efficient arrangement. A
satisfactory solution to this impending complication needs to be
found quickly.
21. As we all understand, a benchmark is as good as the underlying
market. Developing good benchmarks is eventually dependent on
developing deep and liquid financial markets, which is an ongoing and
drawn-out process. Meanwhile, effort can focus on improving the integrity
and credibility of the benchmark process. This requires achieving a
balance between good statistical techniques and realistic subjective
judgement, of both market participants in their role as submitters and
benchmark administrators. And above all, recognizing that every system
is in a process of constant evolution. While a transition from polled rates
to actual traded rates is a justifiable trend in the post-GFC world, it may
serve us well to remember that a traded price is stale, its pricing
information is no longer relevant. Perhaps we would move towards a more
relevant basis for benchmarks in the future. And that would require all of
us to be constantly striving to create better benchmarks.