Y V Reddy: The roadmap for fixed income and derivatives markets
Inaugural address by Dr Y V Reddy, Governor of the Reserve Bank of India, at the Fixed Income and
Money Market & Derivatives Association of Indian and Primary Dealers Association of India, Mumbai,
11 March 2005.
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Friends,
I am thankful to the Fixed Income Money Market and Derivatives Association of India (FIMMDA) and
Primary Dealers Association of India (PDAI), the organisers, for inviting me to deliver the keynote
address today. I have had the pleasure of being closely associated with FIMMDA and PDAI since
their inception. Reserve Bank of India has been taking active interest in the development of fixed
income markets and the role of FIMMDA is becoming increasingly important in this regard. It has
played a pivotal role in the design of documentation of repos, Commercial Paper and Certificate of
Deposits, finalising the daily/annual valuation methodology for fixed income securities. RBI
consistently seeks its views on various G-Sec market related issues. It is also involved in
standardisation of market practices for fixed income securities/money market instruments/fixed income
derivatives. It has been emphasising the importance of best practices in the OTC interest rate
derivatives market and has circulated a Guidance Note for Best Practices to its members in this
regard. We, in the RBI, understand the need for continued collaborative relationship with FIMMDA and
PDAI. It is in this spirit that I look forward to the deliberations today in the sixth Annual Conference
being organised jointly by FIMMDA and PDAI.
I am somewhat reluctant to elaborate on the subject of the day, namely, the road map of fixed income
and derivatives market, in my keynote address for several reasons. My views in this regard were
articulated in a seminar and then published in a BIS paper titled "Issues and challenges in the
development of the debt market in India". The subject was subsequently updated, elaborated and
improved upon comprehensively by my friend and former colleague Dr.Rakesh Mohan, when he
addressed this gathering last year in Dubai. Dr. Mohan has already indicated the "Road Ahead",
which I fully endorse. Moreover, one should wait for free and frank discussion on the subject in this
conference, in which distinguished persons with several perspectives are participating. Let me assure
you that we in RBI do look forward to the deliberations of this conference and the suggestions made
will be, to the extent possible, examined by the various Technical Groups in the RBI that have been
set up recently. It is our intention to place the reports of the Groups on Money Market, Government
Securities Market and Forex Market in the public domain soon. Hence, the subject of the Sixth Annual
Conference is both well-timed and significant for us.
To justify my presence here, let me take this opportunity to mention some of the recent developments
which should be kept in view in the deliberations of the conference.
First, under the provisions of the Fiscal Responsibility and Budget Management Act, 2003, the
Reserve Bank will not be participating, in the normal circumstances, in the primary market for the
government securities from the start of 2006-07. The Technical Group that I referred to is currently
working on the operational, technological and institutional aspects of this. Hence, the market
perspectives on the implications of this development can best be articulated in the conference today.
Second, the Twelfth Finance Commission has made certain recommendations which would mean that
the State Governments would approach the market instead of obtaining loans from the Government of
India. Several operational and other issues will have to be addressed in the management of the
borrowing programme of the State Governments, in future. We are convening a Conference of the
State Finance Secretaries on 8th April 2005, which will be addressed by Dr. C. Rangarajan, Chairman,
Economic Advisory Council to the Prime Minister and the former Chairman, Twelfth Finance
Commission, to discuss these issues. The road map that this Conference would indicate in this regard
will be helpful for our discussions and further policy formulation in regard to debt-papers of the State
Governments.
Third, the Central Government budget has proposed a Special Purpose Vehicle (SPV) for raising
resources for investment in infrastructure. The issuance of debt-paper with relatively longer maturity,
outside the Government of India's normal borrowing programme, is yet another recent dimension
added to the debt-market developments in the country.
Finally, several legislative changes on the anvil provide new opportunities for further development of
fixed income markets. For example, the long awaited Government Securities Bill is at an advanced
stage of processing. The Finance Minister, in his budget speech, announced the intention of the
Government to bring about amendments to the RBI Act and the Banking Regulation Act and the
amendments relating to statutory pre-emptions could have implications for fixed income markets.
In this context, it is useful to recognise that the stake of the RBI in the fixed income and derivatives
market arises on account of several reasons. First, RBI as a monetary authority is most concerned
with the transmission of monetary policy. Second, it must be recognised that in the Indian conditions,
we are neither a closed economy nor an open economy. In reality, we are an opening economy and a
careful management of the process of opening is critical for growth and stability. Third, for the Reserve
Bank of India, as the central bank, financial stability is one of the increasingly important considerations
and an important subset of the financial stability is determined by the stability in the external sector.
Fourth, government securities market, which is currently the dominant segment of the fixed income
markets, is also a legitimate concern for the Central Bank, since it provides the benchmark interest
rates. The government securities market, in our setting, has policy signalling although the rates are
largely market determined. Fifth, the Reserve Bank of India is a regulator of the banks and also of the
primary dealers, which together constitute large holders of Government papers. Hence, there is a
significant linkage between RBI's prudential regulations and the fixed income markets. Finally, in an
economy like ours which is attempting structural transformation, RBI has to have a developmental role
also, apart from being a regulator of money markets, Government securities markets and forex
markets. It is in this context that the Reserve Bank of India goes into close interactive mode with
organisations like FIMMDA and PDAI.
RBI's developmental role in the context of Self Regulatory Organisations (SROs), is perhaps worth
exploring at some length. A good beginning may be the Report of the Advisory Group on Securities
Market Regulation, 2001 (Chairman: Shri Deepak Parekh) which made certain observations on self
regulation by the SROs and the RBI. The relevant extract from Section 2.4 reads as follows:
"Further, the slow evolution of the Association of Mutual Funds of India (AMFI) as a SRO has meant
continuation of substantial regulatory burden on SEBI. In this regard, the Group suggests that SEBI
assist the AMFI to develop into a full-fledged SRO. Similarly, in money and government securities
markets, Fixed Income Money Market and Derivatives Association of India (FIMMDA) and Primary
Dealers Association of India (PDAI) are operating as industry level associations, who are gradually
taking on the role of SROs. There is as yet no regulatory oversight of the RBI over these emerging
SROs. However, to facilitate these associations to emerge as full-fledged SROs, the RBI is engaging
them in a consultative process, which needs to be further intensified. On their part, to promote integrity
of the markets, FIMMDA and PDAI need to establish a comprehensive code of conduct and best
practices in securities transactions and also have a mechanism to enforce such codes. The RBI can
play a supportive role here".
There has been a recent review (December 2004) of the recommendations of the Advisory Groups
constituted by the Standing Committee on International Financial Standards and Codes published in
January 2005 RBI Bulletin. An extract from this "Report on the Progress and Agenda Ahead" is useful,
though, as the disclaimer says, it is an assessment by the professional staff of the RBI and not
necessarily the view of the Reserve Bank:
"The proposal to accord legal status as an SRO to FIMMDA has been examined in detail by RBI and
was not found feasible at present. However, FIMMDA has established a code of conduct and
undertaken related responsibilities appropriate to an industrial body. According self-regulatory status
to PDAI is a non-issue since all PDAI members are also members of FIMMDA".
There are several concepts which are addressed in the Reports cited, in particular, 'industry body';
'Self Regulatory Organisation' and 'legal status as SRO'. There is considerable merit in debating
these concepts and their relevance to FIMMDA, keeping in view the way forward that is being
contemplated in the conference today.
Self-regulation has a long history of working effectively. Some of the earliest signs of self-regulation
were evident in the utterance of the Hippocratic oath by the medical professionals at the time of their
graduation. Almost a thousand years ago, Maghribi traders had probably one of the first self-regulatory
schemes based on market incentives for regulating their trade. The Maghribi were Jewish traders who
lived in the Abbasasid caliphate (centered in Baghdad) until the first half of the tenth century, when
they emigrated to North Africa. They operated through business associates to handle some of their
business dealings abroad. Merchants could never be sure that agents actually handed over the entire
proceeds of business done abroad on their behalf. Courts were generally unable to verify agents'
claims and actions or track down an agent who absconded with the merchant's money. The Maghribi
traders solved the problem by organizing themselves into a coalition that served as a grapevine for
information on honest and dishonest agents. Any agents who treated a member unfairly could never
hope to do business again with other members. In Europe, in the eleventh and twelfth centuries, as
more and more rural folk moved to towns and cities, a new class of merchants emerged to meet the
demands of the growing urban population. It was during this period that the basic concepts and
institutions of modern Western mercantile law (lex mercatoria) were formed.
The self-regulation has evolved significantly since then and linkages with regulatory authorities, often
on a sound legal basis, were established mainly in the financial sector. Self-regulation generally
imposes lower cost than official regulation whenever a shift is feasible. SROs possess the flexibility to
adapt to regulatory requirements of rapidly changing business environment. They provide an intimate
knowledge of the markets and products. Self-regulation, typically involving a unique combination of
private interests with government or regulatory oversight over them, is an effective and efficient form of
regulation for the complex, dynamic and ever-changing financial services industry. The role of
selfregulation and, indeed, its very existence, differs from country to country, across market sectors and
across the developed and emerging markets. In its most complete form, self-regulation encompasses
the authority to create, amend, implement and enforce rules of conduct with respect to the entities
subject to the SRO's jurisdiction, and to resolve disputes through arbitration or other means.
The advantages of self-regulation are very clear, especially in terms of minimising the cost of
regulation as well as cost of compliance of regulation in the financial sector, while improving the quality
of regulation. However, there are a number of issues particularly in the financial sector which are often
cited. For instance, there is a well-known observation about the "regulatory capture", that is, the
regulated entities, in the organised form, have a tendency to capture the regulator to protect their own
interests. It is also argued that the SROs protect the interests of the members if they are in conflict
with interests of the system. In this regard, I find that the model for effective regulation, brought out in
the Report of the SRO Consultative Committee of the International Organization of Securities
Commissions in May 2000, is useful. Perhaps these issues will also be addressed in this Conference
as part of the way forward.
Let me again thank the organisers for giving me this opportunity and wish the Conference all success.