Report of The Technical Group On Money Market: Reserve Bank of India May 2005
Report of The Technical Group On Money Market: Reserve Bank of India May 2005
Report of The Technical Group On Money Market: Reserve Bank of India May 2005
on
Money Market
Contents
Introduction
Section I
Section II II.1 Call/Notice Money Market
II.1.1 Prudential Limits on Call/Notice Money Market Operations: Review of
Benchmark
II.1.2 Feasibility of Migrating from Owned Funds (OF) to Capital Funds (Sum of
Tiers I & II)
II.1.3 Dealings on an Electronic Negotiated Quote Driven System
II.1.4 Participation in Call/Notice Market
II.1.5 Borrowing Limit
II.1.6 Lending Limit
II.2 Collateral for Repo and CBLO Markets
II.2.1 Dealings on an Electronic Anonymous Order Driven System
II.3 Term Money
II.4 Certificates of Deposit
II.5 Commercial Paper
II.1.5 Asset Backed Commercial Paper
II.6 Forward Rate Agreement/Interest Rate Swap
II.7 MIBOR - Linked Short-term Papers
Section III III.1 Deregulation and Rationalisation of Economic Policies
Introduction
1. Money market constitutes an important segment of the financial market
by providing an avenue for equilibrating the surplus funds of lenders and the
requirements of borrowers for short periods ranging from overnight upto an year.
In this process, it also provides a focal point for central bank’s intervention in
influencing the liquidity in the financial system and thereby transmitting the
monetary policy impulses.
5. There are three broad policy objectives that are being pursued now for
the development of the Indian money market which include (a) ensuring stability
in short-term interest rates, (b) minimising default risk and (c) achieving a
balanced development of various segments of money market.
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
29-Jun-03
29-Jul-03
28-Aug-03
27-Sep-03
26-Nov-03
26-Dec-03
25-Jan-04
23-Jun-04
23-Jul-04
22-Aug-04
21-Sep-04
21-Nov-04
21-Dec-04
20-Jan-05
30-Apr-03
27-Oct-03
24-Feb-04
24-Apr-04
22-Oct-04
19-Feb-05
20-Apr-05
30-May-03
25-Mar-04
24-May-04
21-Mar-05
Call Money Reverse Repo Rates Market Repo CBLO
7. With regard to the second objective, i.e., minimising default risk in the
money market, RBI has implemented a number of prudential measures such as
prudential limits on call/notice money transactions, encouraging growth of
collateralised market, dematerialisation of CP and CD etc. Consequently, within
a short period of time from April 2000, the characterisation and the dynamics of
functioning of the Indian money market have changed markedly.
CD
Market
CD
Repo
12% Call
3%
CP 1% 29%
15%
CP
23%
Call Market
CBLO Repo
81%
14% 22%
8. Reflecting this, the relative turnover in various segments of money
market has undergone significant changes over the years. This is partly policy
driven and partly on account of the substantial improvement in underlying
liquidity condition in the economy during this period. While the relative share of
call/notice money market has declined from as high as 81 per cent during 2000-
01 to only 29 per cent during 2004-05, that of market repo has increased from
only 1 per cent to as much as 22 per cent over this period (Charts 2 and 3).
CBLO, after a slow start, has been gathering significant momentum and now
accounts for about 14 per cent during 2004-05. The situation, however, changes
if the average volume accepted under RBI's reverse repo window is taken into
account along with these instruments. It is evident from Charts 4 and 5 that with
substantial improvement in liquidity, the share of RBI's reverse repo rose from 8
percent to 48 percent over this period.
CD CD
Market Repo Call
2% 7%
CP 1% CP 17%
14% 14% Market
Repo
7%
CBLO
8%
RBI Reverse
Repo RBI -
Call Turnover
8% Reverse
75%
Repo
48%
10. In order to identify the further expected changes in money market over a
medium-term period based on cross-country practices and the changing
dynamics of the Indian financial market, RBI constituted an internal Technical
Group on Money Market (Annex I). The Report thus prepared was discussed
with members of the Technical Advisory Committee (TAC) on Money, Foreign
Exchange and Government Securities Markets on April 12, 2005. The Group
places on record the valuable contributions made by the members during their
deliberations on the Report.
11. The Report is organised into four Sections. Section I discusses the
importance of money market and related issues in the conduct of monetary
operations against the backdrop of sustained capital inflows. Against this macro
scenario, Section II explores the expected future transformation in various
segments of money market over a medium-term horizon. Section III captures the
macro issues and their consequent implications for money market. A summary
of recommendations of the Group is given in Section IV.
Section I
12. The money market, particularly the overnight market, is important from
the point of view of any central bank. This is because a vibrant, deep and broad-
based money market is the key for efficient distribution of liquidity among various
economic agents in the economy. Therefore, it is through this segment, the
central bank attempts to influence the systemic liquidity and stabilise short-term
interest rates. In the process, it transmits the impulse of monetary policy.
However, the pre-requisites for achieving a vibrant, deep and efficient money
market are that there should be adequate number of liquid instruments, wider
base of participants with diverse liquidity needs and sound institutional
infrastructure including efficient payment and clearing mechanism. Further, the
financial market in general, and money market in particular, perform best when
the enabling environment is conducive in that the economy runs on a low fiscal
deficit and the regulatory and prudential regime incentivises the functioning of the
market and makes the economic agents accountable for their actions. These
issues have become particularly important as the Indian economy has become
progressively more globalised.
13. Assessing the status of Indian money market against the above-
mentioned perspective, one may maintain that the market has not only been
transformed markedly, particularly during the last five years in terms of depth and
more varied instruments, it has also brought in a wider level of participation in
these markets. The institutional infrastructure, particularly with the upgradation
of payment system infrastructure, viz., operationalisation of Clearing Corporation
of India Ltd. (CCIL), Negotiated Dealing System (NDS), real-time gross
settlement (RTGS) system and the Centralised Funds Management System
(CFMS) has brought about immense benefit to the financial market at large. The
substantial growth of collateralised market vis-à-vis uncollateralised market as
mentioned earlier is reflective of the combined result of the developmental
process set in motion by RBI and adapted by the market.
15. With the ensuing enabling environment within the domestic economy
expected to be more conducive, it is envisaged that the money market in India is
poised for a big leap. However, the principal challenge that the economy may
experience over the medium-term following its increasing openness could be the
management of liquidity in the face of strong capital inflows. This is particularly
important because if India could sustain the present high level of growth rate
combined with a benign inflation environment, lower fiscal deficit and other strong
macro-economic fundamentals, the economy could be expected to receive more
than its normal share of capital inflows, notwithstanding changes in policy stance
in major advanced economies.
16. The challenges before RBI in managing capital flows had been dealt with
extensively in the Report of the Internal Group on Liquidity Adjustment Facility
(November 2003) and the RBI Working Group on Instruments of Sterilisation
(December 2003). It was underscored therein that "In order for the LAF to
function as the principal monetary policy instrument for signalling the Reserve
Bank's stance on interest rates, it is desirable that LAF operates to primarily
manage liquidity at the margin on a day-to-day basis". The dilemma before any
central bank under that situation was put forth as "while operationally it is difficult
to distinguish between the sterilisation operations and liquidity management
operations under LAF, conceptually there is a need to distinguish surplus liquidity
of 'temporary' nature from surplus liquidity of a somewhat 'enduring' nature".
Considering these issues, the LAF Group recommended that in order to improve
the effectiveness of LAF, introduction of additional instruments of sterilisation
against the backdrop of declining stock of government securities with RBI should
be explored. Accordingly, the RBI Working Group on Instruments of Sterilisation,
after considering pros and cons of various instruments, recommended that
"Government may consider setting up of a Market Stabilisation Fund (MSF) ….
for mopping up enduring surplus liquidity from the system". Taking into account
all these issues, the revised LAF scheme as well as the Market Stabilisation
Scheme were operationalised in April 2004.
22. An exercise has been carried out here to examine the feasibility of
migrating from owned funds to capital funds as the benchmark in an effort to
standardise the benchmarking of norms. Accordingly, the limits with respect to
the new benchmark of capital funds vis-a-vis those under Owned Fund (OF) for
different classes of eligible participants in the call/notice money market are
examined below.
Scheduled Commercial Banks
a) Lending Limit
23. It is evident that if the lending limit at 25 percent is linked to the capital
funds (sum of Tiers I & II), then the aggregate lending limit of scheduled
commercial banks would increase by Rs.2,440 crore (Table 1). Though there
would be a decline in the lending limit of foreign banks by Rs.95 crore, they
would not be affected much since they are generally net borrowers.
Table 1: Lending Limit
(Rs. Crore)
Current Proposed Differenc
25% of Capital e
25% of Funds between
Type of Bank OF 2&1
1 2 3
Public Sector 19806 21503 1697
Foreign 3594 3499 -95
Private Sector 5502 6340 838
Total 28902 31342 2440
b) Borrowing Limit
24. As with lending limit, if the norm of 100 per cent of OF is changed to
the alternate norm of 100 percent of capital funds, then apparently there
would be a sharp jump in the aggregate borrowing limit of scheduled
commercial banks by Rs.10,031 crore (Table 2). While foreign banks would
have marginally lower limits than their current limits, the entitlements of
public sector banks and private sector banks would increase by Rs.6,788
crore and Rs.3,622 crore respectively in the process. However, since
public sector banks are generally surplus, the effective increase in
borrowing limit should be around the level of that of private sector banks,
i.e., about Rs.3,500 crore.
Table 2: Borrowing Limit
(Rs.
Crore)
Current Proposed Difference
Type of Bank 100% of OF 100% of between
Capital Funds 2& 1
1 2 3
Public Sector 79224 86012 6788
Foreign 14377 13998 -379
Private Sector 22008 25630 3622
Total 115609 125640 10031
Co-operative Banks
25. At present, borrowings by Urban Co-operative Banks (UCBs)/State
Co-operative Banks (SCBs) and District Central Co-operative Banks
(DCCBs) in call/notice money market on a daily basis should not exceed 2.0
per cent of their aggregate deposits as at end-March of the previous
financial year. To bring it in line with the norms applicable to scheduled
commercial banks, their borrowing limit could be linked to their capital
funds also. However, the capital adequacy norms as applicable for
scheduled commercial banks have not been made applicable for District
Central Co-operative Banks and State Co-operative Banks though the same
has been extended to UCBs. Hence, it may not be desirable to prescribe
different benchmarking norms for different types of banks within the co-
operative segment. Accordingly, the Group recommends for continuing
with the current benchmark of 2 percent of aggregate deposits for these
banks in call/notice money market.
Primary Dealers
1 2 3
I. Lending 1493 1525 32
II. Borrowing 11944 12186 242
Non-bank Entities
27. Currently, the non-bank participants are now allowed to lend, on average
in a reporting fortnight, upto 30 per cent of their average daily lending in
call/notice money market during 2000-01. Since they are in an advanced stage
of being phased out from call/notice money market, the Group suggests that the
present norm may not be changed.
II.1.3 Dealings on an Electronic Negotiated Quote Driven System
28. At present, call/notice money transactions are essentially voice based. In
order to improve transparency and facilitate real-time dissemination of
information, the Group suggests that dealings in call/notice market transactions
should be conducted on a screen based negotiated quote driven platform.
II.1.4 Participation in Call/Notice Market
29. The process is underway to make the call/notice market a pure inter-bank
one by phasing out non-bank participants from this market following the
recommendations of the Narasimham Committee (1998). Accordingly, the
process commenced after due consultations with market participants in May
2001 as non-bank participants were allowed to lend, on average in a reporting
fortnight, upto 85 per cent of their average lending in 2000-01. This limit was
brought down in successive stages following full scale oprationalisation of CCIL
and reasonable development in alternative markets such as repo and CBLO. In
view of market developments, the Group recommends that non-bank participants
may be encouraged to move out of the call/notice market completely by the
middle of 2005-06 and this market would then be purely an inter-bank one. In
such a scenario, there could be a case for further review of prudential guidelines
for banks and PDs for their transactions in call/notice money market.
30. The main reason for placing limit on the borrowing in call/notice market is
that an entity should not borrow an unsustainable amount from this market
relative to the size of its balance sheet. Ideally, the implementation of an efficient
ALM framework should be the first best solution to manage exposure to such
uncollateralised market. During the last four years, major changes have taken
place in risk management guidelines being followed by banks and PDs. This is
also reflected in the market behaviour as co-operative banks intending to borrow
have virtually moved out of the call market to the collateralised CBLO segment.
Similarly, some banks, perceived to be weak by the market, have been
apparently finding it difficult to borrow from call market. In such a scenario, the
Group felt that, as underscored by RBI earlier, there could be a need to allow
more flexibility to banks/PDs to borrow in call/notice market provided they have
appropriate risk management systems in place and such need is warranted by
their balance sheet structure.
32. Increasing use of collateral, both in India and the major economies in the
world, has been becoming the most important tool for mitigation of risk in the
wholesale financial market. The motivation for increasing use of collateral could
come from three areas. First, it could be “security–driven”, e.g., for compliance
with statutory liquidity ratio (SLR) norm or “cash-driven” in order to reduce
funding costs as borrowing under the collateralised repo/CBLO is cheaper than
that under uncollateralised call/notice market. Second, increasing use of
collateralisation of positions in derivatives market has been coming in place to
offset counterparty risk. Third, higher demand for collateral is expected to
emanate from more sophistication in payment and settlement system, particularly
in the wake of full scale operationalisation of RTGS system which is very liquidity
intensive. Due to all these reasons, cross-country experiences show that the
volume of repo transactions have been increasing markedly in major markets
such as in the US, the UK, Euro area and Japan. A notable trend in these
economies is that with the reduction in fiscal deficit and consequent decline in
stock of government bonds, high quality corporate papers such as mortgage–
backed securities and Pfandbriefe (i.e., bonds issued by German mortgage
banks and collateralised by either loans to the public sector or mortgages) are
increasingly being used as the underlying assets in repo transactions. Further,
equities belonging to major indices in stock markets are also being increasingly
accepted for repos on account of their high quality.
37. It is widely accepted that the banking sector needs a deep and liquid term
money market for managing its liquidity as also a smoother rupee yield curve. In
order to improve transparency and strengthen efficiency in the term money
market, the Group recommends that the reporting of term money deals on NDS
may be made mandatory. Further, in order to improve transparency and facilitate
a better price discovery process, the Group recommends that dealings in term
money transactions should be conducted on a screen based negotiated quote
driven platform.
II.4 Certificates of Deposit
38. Certificates of Deposit (CDs) were introduced in India in 1989 as a short-
term unsecured promissory note. It has a maturity period ranging from 15 days
to 365 days for banks. In this context, it may be noted that in the mid-term
Review of annual policy Statement for the year 2004-05, the minimum tenor of
retail domestic term deposits (under Rs. 15 lakh) was reduced from 15 days to 7
days. Apart from bulk deposits (Rs. 15 lakh and above), with effect from
November 1, 2004, banks at their discretion can also reduce the minimum tenor
of retail term deposits from 15 days to 7 days. Further, minimum maturity period
of commercial paper (CP) was also reduced from 15 days to 7 days in the mid-
term Review of annual policy Statement for the year 2004-05. In view of
reduction of minimum maturity period for fixed deposits and CP, the Group
recommends that the minimum tenure of CD for banks may be reduced from 15
days to 7 days.
II.5 Commercial Paper
39. With a view to developing the commercial paper (CP) market further, a
Status Paper was prepared by RBI and placed on its website in July 2003. After
deliberating on the suggestions of the Status Paper with market participants and
experts, three measures, viz., (i) reduction of minimum maturity period from 15
days to 7 days, (ii) reporting of issuance of CP on the negotiated dealing system
(NDS) platform by issuing and paying agents (IPAs) and (iii) constitution of a
Group comprising market participants to rationalise and standardise, wherever
possible, various aspects of processing, settlement and documentation of CP
issuance with a view to achieving the settlement at least on T+1 basis, were
announced in the mid-term Review of annual policy Statement for the year 2004-
05. The position in this regard is as follows:
43. In order to examine all these issues, following the announcement in the
mid-term review for the year 2002-03 on October 29, 2002, the Reserve Bank
had constituted a Working Group. The Group was required to suggest the
modalities for introducing dealing in the derivatives having explicit option features
such as caps/collars/floors in the rupee derivative segment and also the norms
for capital adequacy, exposure limits, swap position, asset liability management,
internal control and other risk management methods for these derivatives.
Thereafter, due to various issues relating to OTC derivatives such as ambiguity
over legality of OTC derivative contracts, absence of netting laws, etc., further
relaxation could not be afforded so far.
44. In this regard, in the Union Budget 2005-06, the Honourable Finance
Minister has stated “ Over the Counter (OTC) derivatives play a crucial role in
mitigating the risks of corporates, banks and other financial entities. There is
however, some ambiguity regarding the legality of OTC derivative contracts,
which has inhibited their growth. I, therefore, propose to take measures to
provide clear legal validity of such contracts”. In view of the above, the Group
proposes that the Government should amend appropriately the RBI Act, 1934 to
provide legality to OTC derivatives. Further, it is felt that the recommendations
given by the Jaspal Bindra Group can be implemented in a phased manner after
putting in place the revised risk reporting system by market participants and the
robust accounting standards, and legality of OTC derivatives is clarified.
Section III
47. Though the money market has transformed markedly during the
course of the last five years, it is expected to witness more remarkable changes
in the coming years. The principal macro drivers of such changes could be the
following:
• Sustained effort in deregulation and rationalisation of economic
policies and
48. All these changes are expected to have profound implications for
the Indian money market in future. The Report has attempted to capture the
possible progression of some of these major changes and their consequent
implications for Indian money market below.
III.1 Deregulation and Rationalisation of Economic Policies
49. Since money market is part of the overall financial market, any
change in the broader macro scenario is expected to impact the money market
also. Though it is difficult to gauge how the money market would evolve in
future, it is likely that there could be two macro factors that might affect this
market significantly in future, viz., i) increasing concentration of activities of
market players arising out of mergers, acquisition and consolidation and ii)
increasing activity in fixed income market.
51. The fixed income market, particularly the corporate debt segment,
is expected to witness greater activity in future. Additional demand is expected
to emanate from deregulation in the pension and insurance sectors, financing
demand arising on account of consolidation/merger/acquisition, foreign portfolio
capital, phasing out of non-bank participants from call/notice money market as
also from the payment system, in particular the RTGS system vis-à-vis expected
shrinkage in supply of government papers following implementation of the FRBM
Act, 2003. Further, there could be substantial demand for asset-backed
securitised instruments due to increased awareness in credit risks, especially
from the pension, insurance and mutual funds segments.
52. In the pension sector, it is likely that the pressure to migrate from
defined benefit plan to defined contribution plan would increase in coming years.
This coupled with the liberalisation of investment norms for pension funds
permitting them to invest a part of their corpus in equity and fixed income
corporate papers facilitated recently, would create a large pool of savings which
would demand both long-term and short-term assets for investment. Since a part
of savings from insurance players might come through mutual funds, the demand
for both capital market and money market instruments would most likely increase
significantly.
55. The implications are that market participants have been exploiting
the arbitrage opportunities existing in different segments of money market and
thereby aiding the convergence of different money market rates subject to only
the degree of credit risk prevalent in these instruments. This is clearly evident in
recent period when not only a large part of call borrowing has migrated to repo
and CBLO due to relatively cheaper funding costs in the latter two markets vis-à-
vis call market but also select participants have been borrowing cheaper in
call/repo/CBLO and placing them in RBI’s reverse repo window so long as the
latter rate is higher than the other rates. All these have led to marked reduction
in the spread among call, repo and CBLO rates vis-à-vis RBI’s reverse repo rate
under LAF (Chart 1, p. 2).
57. The Group noted that intra-day liquidity (IDL) would be available to
eligible participants under RTGS system till 5.00 p.m. as of now. Since it has
been mandated that IDL has to be extinguished by the end of the day, a dilemma
arises with regard to holding of late hour repo auction. This is because
conversion of IDL into overnight facility would have an unanticipated money
supply impact. Further, IDL should be availed of by market participants against
assured cash flows. Therefore, if IDL is allowed to be extinguished through
borrowing from RBI’s repo window, it would tantamount to shifting of cash
management responsibilities of market participants on to RBI and unwarranted
expansion of money supply in the economy. On balance, the Group felt that
there is merit in exploring late hour intra-day LAF as and when warranted in
future. Ideally, late hour intra-day LAF towards the closing hours of the market
should aim at absorption of residual resources (i.e., reverse repo).
Section IV
Summary of Recommendations
58. The Group maintained that the policy thrust should be to encourage
collateralised market, develope the rupee yield curve, ensure transparency and
better price discovery, provide avenues for better risk management and
strengthen monetary operations. Recommendations of the Group in this regard
have been summarised below:
IV.1 Call/Notice Money Market
• RBI may migrate from OF (Owned Fund) to capital funds (sum of Tier I
and Tier II capital) as the benchmark for fixing prudential limits for
call/notice money market for scheduled commercial banks. RBI may,
however, continue with the present norm associated with co-operative
banks (i.e., Aggregate Deposit), PDs (i.e., Net Owned Fund) and non-
banks (i.e., 30 per cent of their average daily lending during 2000-01).
• Call/notice money market transactions should be conducted on an
electronic negotiated quote driven platform.
• Banks and PDs with appropriate risk management systems in place and
balance sheet structure may be allowed more flexibility to borrow in
call/notice money market.
• There is merit in exploring late hour intra-day LAF as and when warranted
in future. Ideally, late hour intra-day LAF towards the closing hour of the
market should aim at absorption of residual resources (i.e., reverse repo).
Annex I : Constitution of Technical Group on Money Market
3. The Group is expected to submit its report within a fortnight from its first
meeting.
(Shymala Gopinath)
Deputy Governor
February 23, 2005
Annex II