Shyamala Gopinath: Pursuit of complete markets - the missing
perspectives
Inaugural address by Ms Shyamala Gopinath, Deputy Governor of the Reserve Bank of
India, delivered in absentia, at the Foreign Exchange Dealers' Association of India (FEDAI)
Annual Conference, Nairobi, 28 February 2010.
* * *
1. It is my pleasure to be delivering the keynote address at the FEDAI conference
being hosted in this beautiful country. India and Kenya share a historical relationship and I
am delighted to have got an opportunity to visit this country.
2. I have been following some of the recent interesting initiatives by the Central Bank
of Kenya and was really impressed by the developments in the areas such as payment
systems, credit information sharing, currency management, financial inclusion, government
securities trading. These are some of the real issues in an emerging economy and the
Kenyan experience is reminiscent of the gradual process in India over the past couple of
decades in the direction of financial sector reforms - how piece by piece, at times forced by
events, the structural edifice for the financial system and market infrastructure was put in
place.
3. India's reform path in the financial sector has been different from most economies,
including other emerging markets. It has been a measured, gradual, cautious and steady
process, devoid of the many flourishes observed in other countries. From the outset, India
has resolved to attain standards of international best practice, but the endeavour has been to
fine tune the process keeping in view the underlying structural, institutional and operational
considerations.
4. In terms of broad stocktaking in respect of financial markets, we have today a deep
and liquid equity spot and derivatives market, a very large and liquid forex OTC spot and
derivatives market, a recently introduced exchange traded currency futures, a very large
Government securities market and interest rate swap market, a robust securitization market,
a large primary market in corporate bond and money market instruments, a repo market in
Government securities as well as corporate bonds. There is a functional regulatory
framework for each of these markets.
5. However, in my address today, for a change I want to focus on what we don't have
as yet: in terms of market segments, we do not have an active secondary market in
corporate bonds, a credit derivatives market, an active interest rate futures market (in spite of
a new product being re-launched on the exchanges few months back), an active structured
derivatives market. In terms of participants, we do not have an unrestricted access to foreign
investors in various markets and instruments.
6. Before addressing each of the above "missing" elements in our context, I would like
to dwell a little on the conception of the "complete markets" and talk about a few accepted
precepts related to financial markets that have been put to question post-crisis. In the last
conference, I remarked that we would continue to learn from the lessons as the crisis was
still evolving. As we are transiting from crisis to recovery, a few fundamental issues have
become clearer.
7. The pursuit of complete markets, before the crisis, was axiomatically believed to be
an unalloyed virtue and the policy and regulatory frameworks were expected to have this as
an explicit policy objective. It had become the holy grail of market regulation and everything
else followed from this fundamental truth. The gospel also became a convenient complement
to the idea of free cross-border capital mobility, with the logical conclusion that free capital
flows into the financial markets are necessary for efficient allocation of resources and for
completion of markets by providing more liquidity.
8. Technically speaking, a complete market is one in which the complete set of
possible gambles on future states-of-the-world can be constructed with existing assets1. In
other words, a financial market place is said to be complete when a market exists with an
equilibrium price for every asset in every possible state of the world. Derivatives are
expected to do precisely this, though subject to several simplistic assumptions. The
conception of "complete markets" essentially entails freedom to the arbitrageurs to operate
across cash and derivatives markets in each asset class to be able to enforce the equilibrium
price.
9. So far so good. However, the critical part from a regulatory and systemic stability
perspective is that sole pursuance of completion of markets may demand a certain kind of
cash markets, which fit into the theoretical construct required for an efficient derivatives
market. Thus the regulatory framework for cash markets gets driven by the demands of the
efficient derivatives market more than the underlying needs and systemic risk assessment. In
a perfect case of tail wagging the dog, the elusive search for market completion and efficient
derivatives markets drives the cash markets rather than the other way round. The risks
induced by this process of backward re-engineering could be serious, particularly in case of
key macroeconomic market variables such as interest rates and exchange rates.
10. The crisis has undoubtedly raised serious issues with regard to the above market
philosophy, as clearly evident in the explicit focus on financial stability which is being made
formal mandate for all regulators, as part of the restructured regulatory arrangements in
countries such as US and UK. While the crisis has not led to usurpation of the entrenched
belief in the neoclassical theory of markets, certain long-held axioms have certainly been
demolished. I would touch upon a few such issues in our context.
Financial markets are self-equilibrating and hence self-correcting
11. The pre-crisis paradigm pledged its faith in the acclaimed self-correcting nature of
markets, whereby self-regulation, internal risk management, assessments by credit rating
agencies or setting of standards by industry participants were felt sufficient for ensuring an
efficient configuration of outcomes in terms of price and quantity. The regulatory role
envisaged in this paradigm is confined to identifying the market imperfections and
improvising on disclosure and transparency requirements towards efficient outcomes. Any
divergence from the efficient configuration was thought to be transitory and self-correcting
led by anonymous competitive forces and dissemination of information.
12. The current crisis has, however, demonstrated that the financial markets may not
necessarily be driven to equilibrium by fundamental factors, but are often subject to divergent
disequilibria, manias, panics and crashes. The self-framed codes of conduct devised by the
financial industry also failed to activate the process of self-correction sufficiently. Similarly,
the internal risk management system in global financial institutions, which is supposed to
sensitize the senior management gave way to the risk takers in an atmosphere of high
returns and apparently low risks. In view of the deep inter-connectedness and externalities
posed by the markets, it is increasingly being felt that "no market, no territory and no
institution" should escape supervision (M. Barnier, Member, EC, February 16, 2010).
All financial innovation is useful and desirable
13. In the long lull of the NICE (non-inflationary consistent expansion) pre-crisis phase,
the financial sector came to be looked upon as the panacea for all ills and financial
innovation was taken as necessarily efficiency enhancing. In a clean, theoretical construct,
financial derivatives were perceived as pieces of a jigsaw puzzle that could be
combined/arranged in multiple ways to customize cash flows for hedging and managing risk.
However, as Mr. Satyajit Das has noted in a recent FT article, derivatives were mostly used
to "circumvent investment restrictions, accounting rules, securities and tax legislation". The
clearest example being the factory production of credit derivatives portending to convert,
quite literally, trash into gold. The recent case of Greek swaps is another instance. Without
going into the legitimacy of such deals, what comes out clearly is the use of derivatives to
suitably alter/manufacture cross-temporal cash flow profiles in a non-transparent manner.
Key parameters for market efficiency are turnover and liquidity
14. The crisis has clearly brought home the point that the size and liquidity of markets
are not sufficient conditions for protecting the markets from malfunctioning. The hitherto
perceived metrics for market performance - larger turnover, deeper liquidity - though
beneficial, need to be supplemented with the assessment of markets in terms of their role in
enhancing systemic risks, accentuating risk contagion, contributing to excessive volatility and
leading to excessive speculation.
15. As Lord Turner, Chairman, FSA, UK mentioned in a recent speech in Mumbai, "the
benefits of increased market liquidity have been an article of faith, frequently deployed to
argue against tighter regulation". However, he argues that beyond a point, the marginal
benefits from increased liquidity are minimal and are far outweighed by the destabilising and
harmful herd and momentum effects.
Financial risk can be accurately measured and managed
The myth of the
16. riskometer, a term used by Jon Danielsson of the LSE2, is an apt
description of the false sense of certainty provided by risk models and measurement
techniques which legitimized the "risk-based" paradigms in diverse areas such as regulatory
capital, performance evaluation, compensation etc. To paraphrase the Nobel Laureate, Paul
Krugman, we, "as a group, mistook beauty, clad in impressive looking mathematics, for
truth". While these methods can certainly be of an indicative value, the problem arises when
such measures are sought to be monetized. The scope for both errors as well as
manipulations is larger.
Free capital account imperative for deep, liquid financial markets
17. Much of the argument, pre-crisis, for free capital mobility was based, among other
things, on the potential benefits for the development of efficient and complete markets
domestically. Greater foreign participation in domestic markets was perceived to be
inherently beneficial for the financial system. Restrictions on foreign participation were
generally viewed as involving loss of welfare and antithetical to the free market mechanism.
However, there is now a greater appreciation of the need for strong domestic players in all
markets and the risks of excessive foreign dominance in any of the domestic market
segments are now being acknowledged.
18. While foreign-owned banks, the world over, generally contributed to the liquidity
crunch in the context of deleveraging during the crisis, the emerging Europe with heavy
dependence on foreign banking groups was particularly exposed, culminating in the Initiative
for Coordination of European Banks to induce parent banks to maintain exposures to their
subsidiaries. As chronicled by the BIS Annual Report, 2009, countries such as Hungary,
Indonesia, Mexico and Turkey faced huge problems when there were sudden reversals in
foreign investment in local bond market. Such volatile flows can exacerbate the situation
merely through the confidence channel. The time honoured principles that underlie opening
up of debt markets to foreign investment are convergence in nominal and real interest rates
on a sustainable basis, low public debt/GDP ratio and low fiscal deficit to GDP ratios on a
consistent basis. In the context of large sovereign debts, countries with large domestic
investors holding sovereign debt are considered to be less vulnerable to attacks by
speculators.
19. More generally on the issue of capital controls, there is a growing recognition of the
serious challenges for macroeconomic policy on account of large swings in capital inflows
over a very short period of time beyond the absorptive capacity of the economy. There are
also implications for financial stability in the forms of induced risks of currency mismatches,
asset price bubbles and crowding out of domestic financial institutions on the lending side,
increasing their risk appetite in search of returns. All these impose significant adjustment
costs and complicate monetary and exchange rate management. The recent IMF update on
the World Economy Outlook states that "Recognizing that inflows can be very large and
partly transitory, depending on circumstances, macro-prudential policies aimed at limiting the
emergence of new asset price bubbles, some build-up of reserves, and some capital controls
on inflows can be part of the appropriate response."
Completing the markets in India
I. Corporate bond market
20. The absence of active corporate bond market is generally perceived as one of the
key missing market which has also hindered the non-bank funding for infrastructure projects.
However, the reasons for this lie more with the deeper structural issues in the economy.
Traditionally, raising of resources through issuance of corporate bonds has not been a
preferred mode for Indian corporates. Bank finance, coupled with equity markets and
external borrowings have been the preferred funding sources. The public financial institutions
and financial intermediaries have been dominant issuers although in the recent past following
the lack of access to overseas markets the non-financial sectors are also raising funds in this
market.
21. The above issues are also not unique to India. Even internationally, other than few
markets like the US and Japan, there are very few liquid secondary bond markets. Most
corporate bond markets are used by large, highest rated issuers and the investors including
in India are typically buy and hold. Retail interest is typically low given the relatively low
returns compared to equities and aversion to credit risk.
22. Following the recommendations of the High Level Expert Committee on Corporate
Bonds and Securitisation (chairman: Dr. R H Patil) numerous steps have been taken both on
the primary issuance side as well as to smoothen the secondary market trading process for
corporate bonds. Going forward there is need to have uniform stamp duty, product
standardization, centralized database and more importantly the removal of restrictions on
long term investors such as insurance companies and pension funds. Action also needs to
be taken towards improving bankruptcy provisions.
23. Foreign investment in corporate bond market has been permitted up to a limit of
USD 15 billion, which remains substantially underutilized. Apart from this, clearing houses of
the exchanges have been given access to the RTGS for settling the OTC trades in corporate
bonds on DvP basis.
24. It has been argued that if banks are permitted to guarantee corporate bonds, the
market may attract more interest. However, such a move will ultimately hinder the
development of genuine corporate bond market and more importantly, result in risk
concentration within the banking system, which is not the purpose of market-based
disintermediation process.
25. Recently, repos in corporate bonds have been permitted. Only listed corporate debt
securities which are rated "AA" or above by the rating agencies have been made eligible for
repo. To contain leverage, a minimum haircut of 25 per cent has been stipulated and selling
of borrowed securities under repo has not been allowed during the period of repo.
26. The stance of the Reserve Bank towards introduction of repo in corporate bonds
needs to be viewed in the perspective of the role of repo in the recent financial crisis. Repo is
a convenient way for building up of leveraged positions especially during good times when
the haircuts are very low and liquidity is abundant. Institutions like investment banks
(Bear Sterns, Lehman Brothers) with good credit standing managed to borrow from the repo
market at very low rates thereby encouraging them to leverage excessively. In normal times,
the repo borrowing is cheap and rollover is easy whereas during periods of financial stress,
the rollover becomes difficult, leading to a liquidity crisis. The risk of the illiquidity of the
underlying asset leading to the drying up of repo markets is accentuated during periods of
financial crisis.
27. Further, in contrast to the repo transactions in Government securities, where the
inherent risks are low due to the nature of the underlying (sovereign bonds) and the
presence of a robust clearing and settlement system with CCP guarantee, the repo
transactions in corporate bonds do not lend themselves to a DVP III mechanism in view of
the heterogeneous nature of the bonds. Repos in corporate bonds, therefore, carry
considerable risks that get amplified in the light of the state of the underlying cash market in
corporate bonds.
28. In an interesting paper, Gary Gorton and Andrew Metrick in their Paper "Securitised
Banking and the Run on Repo"3 have examined the role of repo market in the recent
financial crisis. They show that the genesis of the crisis was a run on the "repo" market. This
market is as vulnerable to a run as an unsecured funding. This is especially the case when
the collateral is of a lower quality and markets are illiquid.
29. The RBI has therefore adopted a cautious approach in its regulation of repos in
corporate bonds. Going forward, RBI will closely monitor the performance of the repo market
for corporate bonds once it becomes operational and will review the directions at an
appropriate time.
II. Credit derivatives
30. Credit derivatives, in themselves, may be good risk management tools helping the
investors to transfer/hedge their credit risk. Such ability to hive off unwanted credit risk
encourages investors to hold bonds which otherwise they would have not been inclined to
hold, thus enhancing the liquidity in the markets. Credit derivatives also help participants to
exercise their view on the credit risk of an entity and help the credit risk to align itself to "fair"
levels. The problem, however, arises when the products do not remain what they are
originally intended to be. If these products disconnect themselves from the real sector and
start behaving as standalone products, they could set a perfect stage for perverse incentives
to set in, as we have been observing in the recent times.
31. Disconnect can happen because CDS does not involve an insurable interest.
Contrary to popular perception, CDS is neither fully an insurance contract nor a swap
contract like an interest rate swap (IRS). While in the normal insurance contract, having
insurable interest is a pre-requisite, the same is not the case with CDS. Further, unlike an
IRS contract, the payoffs in a CDS to the protection seller are the "fees" for assuming a
contingent liability and not actually an income. The accounting treatment of recognizing fees
as income, while the contingent liabilities are relegated to "below the line", might prompt
participants reckon the CDS as a pure income generating strategy, oblivious to the
embedded risks.
32. While the facility of buying protection even when not having an insurable interest
increases the universe of protection buyers thus increasing the market liquidity, it may result
in adverse incentives. If the lenders have protection via CDSs, they may have more to gain
from the company failing than they would gain if the company survives. If this is the case, the
creditors with CDS protection could have incentives to push troubled companies into
bankruptcy instead of working out the troubled debt. Recently in the context of CDS on
Greece debt, it is reported that the US regulators will look into the matter of CDS trader
destabilizing not only companies but also countries.
33. The CDS contracts involve a complex chain of counterparty risks and any default at
any point can potentially become a systemic issue on account of gridlocked market. It is
often assumed that once the credit risk is hived off by purchasing the protection, the risk is
really out of the books. What is forgotten is, CDS is substituting the credit risk of the issuer
with that of the protection seller and the comfort is only as good as the credit worthiness of
the protection seller. As observed in the case of AIG, the AAA status of AIG (protection
seller) is taken too much for granted, without regard for possibility of credit events. Further,
unlike a normal insurance business, the credit events in a CDS transaction are highly
correlated, thus exacerbating the paying pressure on the protection seller in the case of a
credit event. The incident firmly conveys the importance of fully understanding the dynamics
of CDS transactions as different from a normal insurance business and also of a robust
counterparty credit risk management while undertaking CDS transactions.
34. The CDS market is envisaged to complete the market by providing to the
participants the information pertaining to credit risk. CDS spreads are expected to
dynamically, and in real time, reflect the true credit quality of the issuer. It is however,
interesting to note that CDS spreads for major international financial groups did not provide
any forewarning of the impending disaster, reaching a historical low in the early summer of
2007, the very eve of the worst financial crisis since the 1930s. In hindsight, this has been a
case of extreme under pricing of credit risk, which had significant adverse impact on the real
sector. There are inherent dangers in implying the spot fundamentals from the derivative
markets, especially in shallow and illiquid segments. The CDS spreads which could have
moved either on credit perceptions or on liquidity perceptions, prompt participants to revise
their views on the credit quality of the issuer, which may be misplaced, but at times self
fulfilling. Such "tail wagging the dog" tendencies may, even result in escalation of borrowing
costs for the issuers such as corporates and banks, even when the fundamentals have not
changed.
35. You may recall that RBI had issued draft guidelines on CDS in 2007 but in the light
of the crisis had kept in abeyance issuance of these guidelines. As per these guidelines it
was proposed to permit single name plain vanilla CDS on resident reference obligations for
resident entities. It was stipulated that the underlying asset/ obligation, the reference asset/
obligation, the deliverable asset/ obligation shall be to a resident and denominated in Indian
Rupees. Further, the credit derivative contract was required to be denominated and settled in
Indian Rupees.
36. With the benefits of lessons learnt from the global crisis, an Internal Group in
Reserve Bank is revisiting the issues related to introduction of CDS in the Indian markets.
Some of the issues that are pertinent, besides the above general issues, in this context are:

Rating requirement for the underlying: There are mixed views, as regards
requirement of rating for the underlying of CDS. Internationally, it is observed that
while there is a greater liquidity for publicly traded credits, there is no requirement of
ratings. It may be argued that ratings are not required as CDS itself will act as a
proxy for rating and is a more dynamic and closer reflection of the credit rating than
the ratings issued by the rating agencies. On the other hand others could view the
requirement of rating as a means to bring in more information dissemination and
transparency about the underlying, which may, otherwise not be available to the
participants. Especially in the context of Indian markets, where secondary market
liquidity is dormant, to provide the participants, information required for considering
entering/continuing/ unwinding their CDS positions, the requirement of rating of the
underlying may be necessary, at least to start with.

Insurable interest: The crisis has clearly demonstrated the need to ensure
existence of insurable interest for buyers of credit protection. The issue is whether
banks that are market makers should be allowed to trade CDS without an underlying
subject to limits. If so, we need to determine how to compute such limits.

Centralized reporting: The opacity of OTC markets, especially those of derivatives,
has also been cited as one of the contributors of the global turmoil. The need for
centralized reporting, enabling the regulators to track the built-up of positions and
the participants to track the markets, has been flagged by many and already there
have been some systems put in place. A centralized reporting system is being
contemplated in the Indian context when the CDS are introduced.

Centralized clearing and settlement: Internationally, centralised clearing and
settlement is also being proposed as a measure to address the risk management
issues in OTC derivatives. It would be a challenging task to devise a centralized
clearing and settlement framework for single name CDS. The RBI is examining
international practices in this regard.
37. The revised draft guidelines will be put in public domain in due course. Meanwhile
we welcome any feedback on the above issues even at this stage.
III. Interest rate futures
38. Interest Rate Futures (IRF) contracts on 10-year notional coupon bond were
launched on NSE on August 31, 2009. Persons resident in India and FIIs have been
permitted to participate in the market. The FIIs participation in the market is subject to the
condition that the total gross long position in the cash and futures market taken together
does not exceed their limit for investments in Government and corporate bonds. The product
witnessed activity and increasing volume during the initial period, but the liquidity tapered off
subsequently. The discussion in respect of the IRF is about factors inhibiting the growth. I
shall like to briefly discuss some of the issues being raised in this regard.
39. Suggestions have been voiced in some quarters that requirement of physical
settlement is a major hindrance for liquidity of the IRF market and cash settlement could
provide a way out. Now, IRF contracts settled by cash as well as by physical delivery co-exist
in the global financial markets. The well established IRF markets in US, UK, Eurozone and
Japan use contracts based on physical delivery. Some of the recent IRF markets, notably in
Australia, Brazil and Singapore have cash-settled contracts. Korea, which introduced cash
settlement, has opted for physical settlement for the 10 year futures. It should be noted that
in many of these markets the fiscal position is strong and there are supply constraints leading
to fear of short squeeze.
40. The proponents of cash settlement mode point out that in the illiquid market, the
"longs" would end up with illiquid securities. On the other hand, the view against the cash
settlement mode is that it does not ensure arbitrage-free cash futures price linkage. Hence,
both physically-settled as well as cash-settled IRF contracts have supporting arguments.
41. Notwithstanding the debate in favor and against the cash settlement mode, the
physical settlement mode should not pose great difficulties for market participants in taking
positions in the IRF market as an insignificant percentage of IRF contracts are carried to the
expiration date internationally, as also seen domestically in the first cycle. While the
speculators can close out their positions before expiry to book profit, the hedgers can either
close-out or roll-over the positions depending upon the tenor of hedging. The arbitrageurs
can carry the positions till expiry in order to crystallize the arbitrage profits.
42. Another view is to provide the choice to the participants to settle physically or in
cash mode. This may not be an appropriate solution, as it may make it difficult for the "long"
to chalk out his strategy, when he remains unclear till the settlement date as to whether he is
going to get the cash, or the physical securities.
43. There is also a view that the option of choosing the security may be given to the
"long" which may help him to avoid taking delivery of illiquid CTD bonds. In such case, the
buyers will naturally prefer the expensive security to be delivered to him. This practice may
further stifle the growth of the IRF market, as the traders, especially the arbitrageurs may shy
away from taking "short" futures position as he may end up in delivering the most expensive
security.
44. It has also been argued that extending the period of short selling to be synchronous
with the tenor of the futures contracts, may impart liquidity to the futures market by facilitating
efficient arbitrage. However, the view that short selling, directly or indirectly, could pose
potential risks and can easily destabilize the markets can't be overlooked. In India, with
public sector spending being one of the dominant drivers of the economic growth and in the
backdrop of heavily loaded government borrowing programme, and with a rather shallow
market, it would need careful consideration to allow free short selling in the government
securities market.
IV. Currency futures market
45. Recently, the recognized stock exchanges have been permitted to offer currency
futures contracts in the currency pairs of Euro-INR, Japanese Yen (JPY)-INR and Pound
Sterling (GBP)-INR, in addition to the USD-INR contracts. Two exchanges have already
introduced other currency pairs which has increased the volumes greatly.
46. While the volume of trade in the currency futures has increased sharply, the open
interest has remained low and stagnant and constitutes only a small percentage of the
outstanding OTC contracts. The above trend reflects that the exchange traded markets are
still not being used for hedging purposes by different participants. It is largely the day-traders
taking intra-day positions and closing by day-end which dominate the market.
47. It may be pertinent to mention that the cash settlement mode was accepted for
currency futures because physical settlement was not a feasible option since Rupee is not
fully convertible on the capital account. In the OTC market, there is an elaborate framework
for regulating transactions, including derivatives, in foreign currency and presence of an
underlying exposure is a basic requirement. It was not possible to carry over this requirement
onto the exchange traded market. Hence our reluctance to allow FIIs to trade in this market.
It is not considered opportune to remove the requirement of underlying commercial
transactions in the OTC market.
V. Structured derivatives
48. The structured derivative market in India is of nascent origin and most of the
structures are equity linked structures. The RBI guidelines clearly prohibit any structured
derivative product with another derivative as an underlying. However, many exotic currency
derivatives have been popular, primarily involving zero-cost strategies. As part of policy
rationalization, the draft guidelines on forex derivatives have suggested permitting writing of
covered options while prohibiting zero-cost structures.
49. The cost reduction structures, introduced in 1996 have been used by the corporates
in hedging their currency exposures. The products inherently involve a trade-off between
reduction in the cost of hedging and a corresponding increase in risk. The concerns relating
to proper valuation, mis-selling of such products and other irregularities that emerged in the
recent past, have forced the Reserve Bank to re-evaluate the propriety of allowing such
products in India.
50. In response to the draft Guidelines, many corporates and industry associations
FEDAI and FIMMDA have represented that prohibiting cost reduction structures will seriously
impede the dynamic forex risk management operation of corporates and that their
competitiveness in the global markets, as their counterparts have flexibility in using such
products internationally. Additionally, if such structures are banned, some corporates may
not hedge their exposures due to costs, and this may result in aggregation of open currency
risk in the system, which is riskier than allowing hedging within a range. It has been
suggested that structures may be allowed with safeguards, such as the pay off of such a
strategy lies between an unhedged exposure and an exposure hedged through a forward
contract, allowing the products only against underlying exposures, not allowing leverage
structures, limiting to corporate with threshold turnover and net worth, etc.
51. We are examining the suggestions and the FEDAI conference would be an
appropriate forum to debate on the concerns and possible safeguards for such structures.

Suitability and appropriateness - The complex products s