Chapter 12: Development and Regulation of Financial Markets PDF

# Chapter 12: Development and Regulation of Financial Markets Financial markets play a key role in transmitting monetary policy signals by the central bank in a market-oriented policy environment. Financial markets in India, which broadly comprise of money market, government securities (G-Sec) mark...

# Chapter 12: Development and Regulation of Financial Markets Financial markets play a key role in transmitting monetary policy signals by the central bank in a market-oriented policy environment. Financial markets in India, which broadly comprise of money market, government securities (G-Sec) market, foreign exchange market and equity market, have developed within the framework of a predominantly bank-centric financial system. In the pre-reform period, the financial markets functioned in an environment of financial restrictions, driven dominantly by fiscal compulsions. It was only after the financial sector reforms began in the early 1990s, along with the alignment of banking regulations with international best practices, that various market components were gradually introduced as part of a broader market development agenda. This agenda primarily concentrated on developing the necessary market microstructure, including institutions, technology, market participants, and suitable regulations. While the equity market is broadly regulated by the Securities and Exchange Board of India (SEBI), The Reserve Bank regulates the Money market, Government Securities (G-Sec) market, Foreign Exchange market, and related derivatives markets (including credit derivatives) under the provisions of Chapter III D of the RBI Act, 1934. These markets are predominantly Over The Counter (OTC) in nature. With regard to exchange-traded instruments, which supplement OTC products with the aim to enhance market transparency, improve price discovery process and encourage broader retail participation. RBI issues the regulatory framework for introduction of such instruments following which SEBI issues the operational instructions pertaining to the procedure for execution and settlement of trades on exchanges, in accordance with the provisions set out in Section 45W of the RBI Act for exchange-traded instruments. The RBI has been discharging both the developmental as well as regulatory roles for these markets. While the developmental role aims at aiding orderly growth of the markets, the regulatory role focusses on framing appropriate prudential and conduct regulations for ensuring market integrity and stability. The Reserve Bank's efforts in recent years to develop the financial markets have focused on meeting the needs of a more confident and aspirational economy. The reform endeavors have fostered trust, stability and innovation by (i) making capital raising more efficient; (ii) removing segmentation between onshore and offshore markets; (iii) expanding the participation base by easing access to markets; (iv) promoting innovation through a larger suite of products; (v) ensuring the integrity and resilience of markets and market infrastructure; and (vi) ensuring fair conduct by market participants. Due to these regulatory initiatives, financial markets have experienced significant transformation. This has resulted in a broader range of market participants and an increase in trading volumes (liquidity). With rising participation, there is a greater need for enhanced market surveillance to ensure that participants uphold principles of fair conduct. Over the years, Reserve Bank has assigned greater responsibilities to the market representative bodies, viz. Fixed Income, Money Market and Derivatives Association of India (FIMMDA), Foreign Exchange Dealers' Association of India (FEDAI) and the Primary Dealers' Association of India (PDAI). These bodies have been tasked with developing various market segments and establishing self-regulatory mechanisms including codes of conduct, broker oversight and arbitration of trading disputes. The Bank has also facilitated creation of an independent Benchmark Administrator, Financial Benchmarks India Private Limited (FBIL), which was jointly established by FIMMDA, FEDAI and the Indian Banks' Association (IBA). FBIL is responsible for administering key financial benchmarks relating to Money, G-sec, Foreign Exchange markets and associated derivative markets. Over the past several years, the Reserve Bank has undertaken numerous steps to establish robust financial market infrastructures. A key milestone that dates back to 2001 is the establishment of Clearing Corporation of India Limited (CCIL) which began operations in February 2002. CCIL was created to provide an institutional mechanism for clearing and settlement of G-Sec, Money Market and Foreign exchange transactions. Since its inception, CCIL has expanded its operations to cover Central Counter Party (CCP) based settlement in several cash market and derivative products and has also set up a Trade Repository for all OTC foreign exchange, interest rate and credit derivatives. In order to have a more focused approach towards market development and regulation, a new department called Financial Markets Regulation Department (FMRD) was set up carving out functions from various other departments. The key developmental and regulatory functions related to financial markets carried out by the Reserve Bank are outlined below: ## Money Market The money market is a market for short-term financial assets that are close substitutes of money. Money markets perform the pivotal role of acting as a conduit for equilibrating short-term demand for and supply of funds, thereby facilitating the conduct of monetary policy. A freely operating money market is a sensitive barometer of the prevailing and evolving conditions in the financial markets and facilitates management of short-term surplus funds by lenders and short-term funding deficits by borrowers. In India, the strengthening of the money market and its structure was an integral component of the overall deregulation process of financial sector reform. The important developmental and regulatory role performed by the RBI in the Money Market are mentioned below: ### Developmental Role The RBI significantly promoted the development of the Indian money market through various reforms and innovations. It removed interest rate ceilings on inter-bank call/notice money in 1989 and introduced new instruments like Treasury Bills (T-Bills), Certificates of Deposit (CD), Commercial Paper (CP), and Repurchase Agreement (Repo) between 1986 and 1992. The RBI also increased market participation by reducing barriers to entry, establishing institutions like the Discount and Finance House of India (DFHI) in 1988, and introducing primary and satellite dealers. Market-determined rates were encouraged by transitioning from a cash credit to a loan-based system, and by phasing out fixed-rate Treasury Bills. Additionally, the RBI strengthened the connection between the money market and the foreign exchange market, particularly after adopting a market-based exchange rate system in 1993. The DFHI played a key role in these reforms through its active participation in the market. Some notable committees whose recommendations shaped the development of Financial Markets in India include Chakravarty Committee (1985), Vaghul Committee (1987) and Narasimham Committees (1991 and 1998). Market infrastructure for trading, reporting, clearing and settlement of money market transactions were strengthened keeping in pace with the development of the market. State-of-the-art electronic trading systems viz. Negotiated Dealing System-Call (NDS-Call), Clearcorp Repo Order Matching System (CROMS), Triparty Repo Dealing System (TREPS), straight-through-processing (STP) of transactions, Real Time Gross Settlement (RTGS), and creation of CCIL for guaranteed settlement were among the steps taken by the RBI over the years. Apart from financial institutions such as Commercial banks, Co-operative banks, Primary Dealers (PDs), Insurance companies, Mutual Funds, Non-banking financial companies (NBFCs), etc., RBI also permitted corporates to participate in collateralized segments of the Money Market. Other important developmental measures undertaken include: (i) Introduction of Re-Repo and Tri-party Repo; (ii) Strengthening the determination process for Mumbai Inter-bank Outright Rate (MIBOR) and; (iii) allowing participation of new entrants such as Payment Banks, Small Finance Banks (SFBs) and Regional Rural Banks (RRBs) in Call/Notice/Term money market both as borrower and lenders. ### Regulatory Role RBI has laid down prudential norms for various money market instruments, viz. Call/Notice/Term Money, Repo, CP, CD, Non-Convertible Debentures (NCDs) of original or initial maturity up to one year and derivative products linked to Money Market interest rate/benchmark. #### Call, Notice and Term Money Call, Notice, and Term Money refer to the uncollateralized lending and borrowing of funds among Scheduled Commercial Banks (SCBs), SFBs, Payments Banks, RRBs, Cooperative Banks, and PDs. These transactions serve as a key liquidity management tool for these entities. Call Money involves lending/borrowing for one day, Notice Money covers a period of two to fourteen days, and Term Money spans from fifteen days to up to one year. These transactions occur OTC and on NDS-Call, an electronic trading system managed by the CCIL. OTC trades must be reported on the NDS-Call platform within a specified timeframe after execution. Regarding prudential limits, participants are allowed to set their own limits for outstanding lending transactions in the Call, Notice, and Term Money Markets, subject to their Board's approval and within the regulatory framework established by the Reserve Bank's Department of Regulation. For borrowing, SCBs (excluding small finance and payment banks) can determine their own limits with internal board-approved guidelines, in line with the prudential limits for inter-bank liabilities. Specific prudential limits for outstanding borrowing transactions have been prescribed by RBI for SFBs, Payments Banks, RRBs, Cooperative Banks, and PDs. #### Repurchase Agreement (Repo) Market Repo is an instrument for borrowing (lending) funds by selling (purchasing) securities with an agreement to repurchase (resell) the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed (lent). In essence, Repo is short term collateralized borrowing against securities. The transaction is called Repo from the point of view of the borrower of funds (seller of securities) and Reverse Repo from the point of view of the lender of funds (buyer of securities). The Repos undertaken with RBI are categorized as 'Liquidity Adjustment Facility (LAF)-Repo' while the Repos undertaken among market participants are known as 'Market Repo'. Currently Government securities issued by the Central Government or a State Government, Treasury Bills, Commercial Papers, Certificates of Deposits, Units of Debt Exchange Traded Funds (Debt ETFs) and listed Corporate bonds and debentures are permitted as eligible securities for Market Repo. Permitted participants in market repo include SCBs, PDs, NBFCs, Housing Finance Companies (HFCs), All India Financial Institutions (AIFIs), Insurance companies, listed and unlisted companies etc. with certain conditions. The Repo transactions can be traded on any recognized stock exchanges, or an Electronic Trading Platform (ETP) duly authorised by the Reserve Bank or in the OTC market. Currently, the repo transactions on Government Securities generally take place either on CCIL's anonymous CROMS, through TREPS or bilaterally through OTC., The OTC Repo transactions on Government Securities are required to be reported on CROMS within the specified timeframe after execution of the trades. Securities purchased under the repo cannot be sold during the period of the contract except by entities permitted to undertake short selling. Re-repo is permitted in securities acquired under reverse repo. Tri-party Repo means a repo contract where a third entity (apart from the borrower and lender), called a Tri-Party Agent, acts as an intermediary between the two parties to the repo to facilitate services like collateral selection, payment and settlement, custody and management during the life of the transaction. In case of the Tri-party Repo, RBI has specified various aspects of the product including the eligibility criteria and roles and obligations of the Tri- party agent. In July 2018, comprehensive directions for repo in G-sec and corporate debt were issued to simplify and harmonise the regulations across different types of collateral and to encourage wider participation, especially for corporate debt repos. With a view to develop an active corporate debt securities market, RBI has accorded approval to AMC Repo Clearing Limited to act as a tri-party repo agent and to offer tri-party repo in corporate debt securities. #### CPs and NCDs of original maturity up to 1 year Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note, while Non-Convertible Debenture (NCD) is a secured money market instrument with an original or initial maturity up to one year. These instruments allow highly rated corporate borrowers to diversify their short-term borrowing sources and offer additional instruments to investors. The following entities are allowed to issue CPs and NCDs provided that all fund-based facilities they have availed, from banks/ AIFIs / NBFCs are classified as "Standard" at the time of issuance: * Companies * NBFCs including HFCs * Infrastructure Investment Trusts (InvITs) and Real Estate Investment Trusts (REITs) * AIFIs * Any other body corporate with a minimum net-worth of ₹100 crore, provided that the body corporate is statutorily permitted to incur debt or issue debt instruments in India * Any other entity specifically permitted by the Reserve Bank * Co-operative societies and limited liability partnerships with a minimum net-worth of 100 crore, may also issue CPs under these Directions, subject to the condition that all fund-based facilities availed, if any, by the issuer from banks/ AIFIs / NBFCs are classified as Standard at the time of issue. The end use of the issue proceeds has to be disclosed in the offer document at the time of issuance of a CP/NCD. The minimum credit rating required for the issuance of CPs and NCDs, as assigned by a Credit Rating Agency (CRA), is 'A3' according to the rating symbol and definition prescribed by SEBI. All primary issuance of CPs and NCDs as well as OTC trades in these instruments must be reported within the specified timeframe after execution of the trades to the Financial Market Trade Reporting and Confirmation Platform ("F-TRAC") of CCIL. The duties and obligations of the Issuer, Issuing and Paying Agent (IPA), Debenture Trustee and CRA are outlined in the RBI's guidelines. #### Certificate of Deposits (CD) CD is a negotiable, unsecured money market instrument issued by a bank/AIFI as a Usance Promissory Note against funds deposited at the bank or the AIFI for a specified time period. CDs can be issued by (i) scheduled commercial banks, including RRBs and SFBs), and (ii) AIFIs that have been permitted by the RBI to raise short-term resources within the umbrella limit fixed by the RBI. The maturity period of CDs issued by banks should not be less than 7 days and not more than one year, while that by AIFIs should not be less than 1 year and not exceed 3 years. Banks / AIFIs cannot grant loans against CDs unless specifically permitted by the RBI. All primary issuances of a CD and OTC trades in CD are required to be reported within the specified timeframe after execution of the trades to the F-TRAC of CCIL. ## Government Securities (G-Sec) Market G-Sec market is an extremely critical segment of any financial system. The G-sec market is distinct from other financial markets in a fundamental way - it is the market in which the risk-free interest rate, a key macroeconomic variable, is determined. G-sec yields act as the benchmark for pricing of most financial assets. It is a market where debt instruments issued by the Government, such as Treasury bills, government bonds, and other securities, are traded. These securities are issued by the Government to raise funds for financing its expenditures, including infrastructure projects, social programs, and other public services. The development of the primary segment of this market allows public debt managers to raise funds from the market in a cost-effective manner, with appropriate consideration of the associated risks. A robust secondary market of the G-Sec market aids in the effective implementation of monetary policy by regulating the money supply in the economy through use of instruments, such as Open Market Operations (OMOS). OMOs refers to the buying and selling of government securities in the open market as mentioned above, the G-Sec market is also considered as the foundation of fixed income securities markets, as it provides the benchmark yield curve and enhances liquidity in other financial markets. The existence of an efficient government securities market is seen as an essential precursor for development of the corporate debt market. There are other distinctive features of the G-sec market. First, globally the G-sec market is predominantly an institutional market, with the major participants being banks and long-term investors, including investment funds, insurance funds, pension funds. Second, different G-sec instruments are highly substitutable, the only differentiating factor being tenor of instruments. This is one of the reasons why the G-sec yield curve may be viewed as a public good. Third, G-secs provide the most widely used high quality collateral for payment and settlement systems, liquidity management operations and other financial sector transactions. Fourth, virtually all monetary operations are executed in the G-sec market. Effective monetary policy transmission is fundamentally linked to an efficient G-sec market in any market economy. G-Secs may be issued by the Central Government as well as various state governments. In India, the Central Government issues both, treasury bills and bonds (or dated securities) while the State Governments issue only bonds (or dated securities) called as State Government Securities (SGSs). Dated Government securities are long term securities (longer than 1 year of original maturity) and carry a fixed or floating coupon (interest rate) which is paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated securities can be very long (currently up to 50 years in India). The important developmental and regulatory roles performed by RBI in the G-Sec Market are mentioned below: ### Developmental Role The G-Sec market in India in the past had been narrow principally due to low coupon rates. Moreover, the captive market was dominated by institutional investors who had to compulsorily invest in government and other approved securities to comply with statutory requirements. The Reserve Bank realised that a strong and vibrant government securities market was a sine qua non for discharging its responsibilities as debt manager and regulator, as also for effective monetary and public debt management for the reason explained above. Since the onset of financial sector reforms in India, RBI has taken several important measures for development of the G-Sec market. The development of the G-sec market was greatly facilitated by the abolition of automatic monetization of government debt, introduction of the auction process for primary issuance and enactment of Fiscal Responsibility and Budget Management (FRBM) Act, 2003. Transparency in supply was enhanced through the introduction of issuance calendars for auctions in G-secs since April 2002. Auctions are conducted electronically, which ensure transparency as well as efficiency. These have helped better price discovery and improved participation and depth of the primary market. When Issued (WI) trading in the G-Secs was permitted in 2006 to facilitate the distribution process of G-Secs by stretching the actual distribution period for each issue, allowing the market more time to absorb large issues of G- Secs without disruption and facilitating the price discovery by reducing uncertainties surrounding auctions. RBI also introduced short selling in Government securities in Feb 2006 and has brought in lot of improvements in the instrument over the years keeping in view the market developments and demands from market participants. Over the years, Product diversity has been ensured through introduction of new instruments such as Floating rate bonds, Capital indexed bonds, Inflation indexed bonds, Separate Trading of Registered Interest and Principal of Securities (STRIPS), etc. Niche products targeted at retail investors also include sovereign gold bonds (a government security denominated in gold) and savings bonds. The Bank has taken various measures to boost liquidity in Repo in G-Secs which includes introduction of ETPs, revision in accounting guidelines in alignment with international standards, introduction of Re-Repo, and the like. Further, to promote integrity, transparency and fair access in markets, the Reserve Bank has introduced global best practices with the issuance of the Electronic Trading Platforms (ETP) (Reserve Bank) Directions, in 2018, directions for Prevention of Market Abuse in 2019 and the Financial Benchmark Administrators (Reserve Bank) Directions in 2019. As a consequence of these efforts, the legal and regulatory framework for the G-sec markets has evolved over the years to facilitate efficient management of public debt and development of secondary markets. A sound, robust and safe market infrastructure increases the resilience of the G-Sec market against external shocks and contributes to price discovery. Market infrastructure for trading and post-trade services, including clearing, settlement, reporting, and timely dissemination of traded information pertaining to both outright and repo markets in G-Sec market has been developed and strengthened keeping in pace with the development of the market. The upgraded primary issuance process with electronic bidding and straight-through-processing capabilities, completely dematerialized depository system within RBI, Delivery-versus-Payment (DvP) mode of settlement, Real Time Gross Settlement (RTGS), electronic trading platform (Negotiated Dealing Systems - Order Matching) (NDS-OM) and a separate CCP in CCIL for guaranteed settlement of government securities transactions are among the initiatives that were taken by the Bank over the years. The NDS-OM trading platform is an anonymous screen-based order matching platform owned by RBI and operated by CCIL. The system facilitates secondary market trading in all kinds of Central Government Securities, SGSs, Special Securities and Treasury Bills. Permitted participants can log into the system and place their bids/offers or accept the quotes already available in the order book. The settlement is on a STP basis, and the deal information flows directly to CCIL for guaranteed settlement. Direct access to the NDS-OM system is currently available only to select financial institutions like Commercial Banks, Primary Dealers, Insurance Companies, Mutual Funds, NBFCs etc. Other participants can access this system through their custodians, i.e., with whom they maintain Gilt Accounts. The system ensures complete anonymity among participants as counterparty information is not available to any of the system participants either pre or post trade, thus facilitating integrity without impeding fair pricing. The anonymity offered by the system enables large ticket execution without distorting market sentiment and/or price equilibrium which would normally be prevalent in a bilateral market. NDS-OM Web Based System is an internet access-based utility for use by the various Gilt Account Holders (GAH) for directly accessing NDS-OM. Even Foreign Portfolio Investors (FPIs) have been given direct access to NDS-OM through this web module. While the GAH can access and trade on the NDS- OM, such activities would be within the permitted threshold of their custodians (primary members). This gives a greater operational freedom for marginal players to trade directly on the NDS-OM. Individual investors having demat accounts with depositories have also been allowed to trade directly on NDS-OM. The Bond Turnover Ratio, a measure of bond market liquidity which shows the extent of trading in the secondary market relative to the amount of bonds outstanding, compares well with many developed countries. The bid-ask spread of the on-the-run securities remains narrow with increased liquidity in these securities. The sovereign yield curve now spans up to 50 years with some well-developed benchmark points. A significant milestone achieved in the development of the G-sec market was the launch of the Reserve Bank of India-Retail Direct (RBI-RD) Scheme which brings G-Secs within easy reach of the common man by simplifying the process of investment. The scheme provides a one-stop solution to facilitate investment in G-Secs by retail investors. After the launch of the scheme, a market making scheme for the PDs to support the Retail Direct Scheme was announced. In May 2024, mobile application of Retail Direct was launched to facilitate seamless and convenient access to the retail direct platform for retail investors. ### Regulatory Role Regulation of Government securities market has evolved over the years keeping in view the systemic imperatives and institutional prudence at the center. Large sovereign borrowings impact the yield curve through the expectation channel. Apart from direct balance sheet effects on the financial sector, interest rate volatility has a critical bearing on sovereign balance sheet which could translate onto financial sector balance sheets. It, therefore, becomes imperative to be watchful of volatility in interest rates on account of activities of various market players. To ensure orderly condition in the G-Sec market, the RBI has prescribed regulations on various aspects of the market. Some of the major aspects are listed below. * **Short Selling:** Short sale provides participants with a tool to express two-way views on interest rates and thereby enhance price discovery. The regulation on short selling specifies the eligible participants, limits for short sale, maximum time period for holding short sale position, etc. For smoother settlement of short sale transactions which is necessary for orderly functioning of the market, the RBI stipulated in 2017 that (i) a short seller need not borrow securities for 'notional short sales', and is permitted to deliver security held in its held-for- trading/available-for-sale/held-to-maturity portfolios; In 2018, the participants' base was liberalised and entity-wise and security category-wise limits for short selling in G-secs were relaxed to further develop and deepen the G-sec and repo market. * **Investment by FPIs:** The FPIs have been allowed greater access to the G-Sec market. In 2015, the Medium-Term Framework (MTF) for FPI investment limits in rupee debt securities was announced to provide a more predictable regime. With the objective of having a more predictable regime for investment by FPIs, the FPI limits are revised on a half yearly basis under the MTF. In terms of the MTF, the limit for FPI investment in government securities is linked to the outstanding stock of government securities and the limit has been increased in phases (6 per cent for Central Government Securities and 2 per cent for SGS). The limit is specified in Indian Rupee (in place of USD) which eliminates the complication arising out of exchange rate fluctuations. The FPI investment in G-Secs is subject to various macro-prudential and other regulatory prescriptions as notified by RBI from time to time. The regulatory regime for FPIs debt investments was reviewed in 2018 to provide FPIs greater latitude in managing their portfolios in terms of increased investment limits, eligible instruments, tenor and duration management, etc. The cap on aggregate FPI investments in any central government security was revised upward from 20 per cent to 30 per cent of the outstanding stock of that security. The minimum residual maturity requirement of three years for investment in Government Securities has been withdrawn, subject to certain conditions. Other macro- prudential measures put in place include concentration limits for FPI investment as a percentage of overall investment limit in each debt category, short-term investment limits, and single as well as group investor-wise limit in corporate bonds. Subsequently incremental changes were made periodically in this regime. Various measures to facilitate operational ease of investment by FPIs have also been undertaken, including permitting banks to lend to FPIs for meeting margin requirements for their transactions in G-secs, and providing an extended window post closure of onshore market hours for reporting of trades. In parallel, access of non-residents, including FPIs, to domestic derivative markets was enabled/eased to facilitate hedging of interest rate, foreign exchange and credit risks by these entities. In pursuance of the Union Budget 2021-22 announcement, FPIs were permitted to invest in debt securities issued by Infrastructure Investment Trusts (InvITs) and Real Estate Investment Trusts (REITs). A separate channel called the Voluntary Retention Route (VRR) was introduced in 2019 with more operational flexibility in terms of both instrument choices as well as exemptions from regulatory limits to encourage FPIs to undertake long-term debt investment in India. In March 2020, a separate channel, called the 'Fully Accessible Route' (x) for Investment by non-residents was introduced by RBI to enable non-residents to invest in specified Government of India dated securities. Eligible investors can invest in specified Government securities without being subject to any macroprudential limits and investment ceilings. All fresh issuances of 5-,7- and 10-year securities and sovereign green bonds issued by the Central Government in FY 2022-23 and 2023-24 are included under this route. This scheme operates along with the two existing routes, viz., the MTF and the VRR. Following the introduction of the FAR in 2020 and related market reforms, Indian Government Bonds (IGBs) have been under consideration for inclusion in major global bond indices. In September 2023, one index provider announced the inclusion of IGBs in its emerging markets suite of indices with effect from June 2024, with government bonds issued under FAR subject to some inclusion criteria eligible for inclusion in the index. In March 2024, another index provider announced inclusion of the India FAR bonds in its emerging market index. * **When Issued (WI) Trading:** The WI market refers to a market for trading government securities that have been announced but not yet issued. In this market, investors can buy and sell these securities during the period between the announcement of the issuance and the actual issuance date. The WI market has enhanced the distribution process for G-Secs by extending the distribution period for each issue, allowing the market more time to absorb large issues without disruption. It also facilitates in price discovery process by reducing uncertainties surrounding auctions. Initially, the WI market was limited to trades on the NDS. However, over time, the application of WI guidelines was expanded to include non-NDS trades, with the eligible participant base broadened and the limits on short and long positions for various participant categories increased to encourage more trading in this segment. * **Separate Trading of Registered Interest and Principal of Securities (STRIPS):** STRIPS is a type of financial instrument created by separating the interest payments (coupons) and the principal repayment of a G-Sec into individual components, which can then be traded separately. The Reserve Bank introduced STRIPS in Government Securities in April 2010. The securities that are eligible for stripping/reconstitution, the minimum amount of securities that needs to be submitted for stripping/reconstitution, the discount rates to be used for valuation of STRIPS, etc. was specified by the RBI. After some initial interest, the product did not find much favour with the market. With a view to encouraging trading in STRIPS by making it more aligned with market requirements and to meet the diverse needs of the investors, revised directions were issued in 2018 in terms of which all fixed coupon securities issued by Government of India, irrespective of the year of maturity, are eligible for Stripping/ Reconstitution, if such securities are eligible for Statutory Liquidity Ratio (SLR) and transferable. * **Introduction of Securities Lending and Borrowing in G-secs:** To deepen and enhance liquidity in the G-Sec market, facilitate efficient price discovery, augment 'special repo' market and provide investors with an avenue to utilize their idle securities for better portfolio returns, securities lending and borrowing in G-secs was permitted in 2023. Under this mechanism, all entities authorized to undertake repo transactions in G-Secs are eligible to lend, while entities authorized to conduct short sale transactions in G-Secs are allowed to borrow. The borrowing/lending tenor ranges from one day to the maximum period prescribed by the RBI to cover short sales in G-Secs. ## Corporate Bond Market An active and well-developed corporate bond market offers borrowers an alternative to bank financing, helping to lower the cost of long-term funding. Since banks often face limitations in providing long-term loans due to their shorter-term liabilities, a corporate bond market can offer a more efficient and cost-effective source of long-term capital for companies. It also provides institutional investors, such as insurance companies, provident funds and pension funds, with long-term financial assets, aiding in better matching of their assets and liabilities. From a macro-financial perspective, a developed corporate bond market helps distribute risk away from the banking system, which is crucial for financial stability. By spreading risk across a broader range of investors, the corporate bond market supports overall financial stability. This market thus plays a vital role in both corporate financing and the broader financial ecosystem. There has been substantial growth in both primary and secondary corporate bond markets during the recent years though it still lags in comparison with global peers. SEBI, the primary regulator of the corporate bond market, has taken significant steps over the years to improve the market microstructure for corporate bonds. RBI has also been taking measures to develop the corporate bond market - permitting banks to provide partial credit enhancement (PCE) to incentivise a larger investor base; requiring large borrowers to raise a share (about 50%) of their incremental borrowings through market instruments; encouraging FPI investment by raising investment caps, introduction of Voluntary Retention Route; etc. RBI regulates only certain aspects of the Corporate Bond Market, viz. participation of banks and other RBI regulated entities in Corporate Bond market, FPI investments in Corporate Bonds, Repo in Corporate Bonds and Credit Derivatives on Corporate Bonds. As entity regulator, the RBI, has encouraged its regulated entities to invest in corporate debt securities. The important developmental and regulatory roles played by the RBI with respect to Corporate Bond Market in India are described below: ### Developmental Role Increasing Participation: RBI has permitted banks to issue long-term bonds with minimum maturity of seven years to fund loans for long term projects in various infrastructure sub-sectors and affordable housing. Additionally, funds raised through these bonds are exempt from CRR/SLR requirements. Banks and PDs have been allowed to become members of stock exchanges to trade in corporate bonds, with relaxed investment norms facilitate such investments FPIs have been provided greater access to the secondary market with increased investment limits and a simplified limit allocation methodology. Increasing market liquidity: Repo in corporate bonds was introduced to enable the institutional buyers to fund their long positions. RBI's guidelines on enhancing credit supply for large borrowers through bond market route are envisaged to augment the market liquidity. Market Infrastructure: Delivery versus Payment (DvP) mode of settlement was introduced for OTC corporate bond trades to eliminate settlement risk (2009). The RBI has mandated banks, PDs and other entities regulated by it to report corporate bond trades to the designated reporting platform for improving market transparency (2007). Risk Management: RBI permitted introduction of Credit Default Swaps (CDS) in December 2011 and further revised the directions in 2022 to facilitate hedging of credit risk by the holders of corporate bonds. Banks were li provide partial credit enhancements on corporate bonds subject to limits. ### Regulatory Role Repo in Corporate Bond: RBI has laid down guidelines on eligible securities, hair-cut and valuation methods, etc. for Repo transactions in corporate bonds. Credit Derivatives: CDS is permitted on money market debt instruments, Rated INR corporate bonds and debentures, unrated INR corporate bonds and debentures issued by the Special Purpose Vehicles set up by infrastructure companies, Bonds with call/put options as reference obligations. The scheduled commercial banks with some exceptions, stand-alone PDs, NBFCs with minimum net owned funds of ₹500 crore and subject to specific approval of the Department of Regulation, Reserve Bank and any other institution specifically permitted by the Reserve Bank, EXIM Bank, NABARD, NHB and SIDBI are eligible to act as market makers in CDS. The Guidelines permit non-retail users such as regulated financial entities and FPIs to sell protection. They also allow non-retail users to buy protection for hedging or expressing their views on credit risk while retail users are permitted to buy protection only for hedging underlying exposure. Credit Enhancement by Banks: Banks have been allowed to provide PCE to a project as a non-funded subordinated facility in the form of an irrevocable contingent line of credit which will be drawn in case of shortfall in cash flows for servicing the bonds. PCE improves credit rating of the bond issue. The RBI has prescribed limits for PCE by individual banks as well as the aggregate PCE that can be provided by all banks for any particular bond issue. FPI Investments: The RBI prescribes the limit for FPI investment in corporate bonds. The MTF and VRR for FPI investment in rupee debt securities, as previously discussed, also encompass FPI investment limit in corporate bonds. Investment in corporate bonds has been streamlined by discontinuing its various sub-categories and prescribing a single limit for FPI investment in all types of corporate bonds. The limit for FPI investment in corporate debt is linked to 15 percent of the outstanding stock under the MTF and revised on half yearly basis. ### Interest rate derivatives (IRDS) The Interest Rate Swaps (IRS)/ Forward Rate Agreements (FRA) were introduced in 1999 to further deepen the money market and enable market participants to hedge their interest rate risks. The FRA and IRS were introduced in July 1999 to help banks and PDs better manage interest rate risk following the deregulation of interest rates. In March 2011, the RBI permitted futures on 91-day T-Bill. Later, in December 2016, the RBI allowed futures based on other money market instruments or money market interest rates. In the same year, Rupee Interest Rate Options (IROs) were introduced, initially limited to plain vanilla IROS. However, in 2018, the RBI reviewed the directions on Rupee IROs leading to the introduction of rupee interest rate swaptions. In the OTC IRD market, electronic trading platforms are available for trading IRD contracts and CCIL provides guaranteed settlement for IRS contracts. In June 2019, the RBI issued the Rupee Interest Rate Derivatives (Reserve Bank) Directions, 2019 to consolidate regulations on individual products and provide flexibility for exchanges and market-makers in the design and innovation of products. This was done while ensuring that less sophisticated participants in these derivatives markets are adequately protected. Currently, the IRDs allowed in India include FRA, IRS and European IROS (including caps, floors, collars and reverse collars), swaptions and structured derivative products (excluding leveraged derivatives). Both residents and non-residents can undertake IRD transactions. Indian or non-resident parent companies, group companies, or centralised treasuries can transact in IRDs on behalf of their wholly owned subsidiaries or group companies. Transactions are permitted for both hedging and other purposes, subject to certain conditions. IRD transactions can be undertaken in both OTC markets (including transactions on ETPs) and recognized exchanges. Exchanges have been authorized to offer any standardized IRDs product, with the product design, eligible participants and other details being determined by the exchanges. However, prior approval from the RBI is required before introducing any new IRD product or making modifications to an existing product. In 2022, to further deepen the IRDs in India, remove segmentation between onshore and offshore markets and improve price discovery efficiency, the RBI allowed market-makers with an Authorised Dealer Category-I (AD Cat-I) license and standalone primary dealers, authorized under Foreign Exchange Management Act (FEMA), 1999 to engage in transactions in the offshore Foreign Currency Settled Overnight Indexed Swap (FCS-OIS) market with non-residents and other market-makers through their branches in India, foreign branches or International Financial Services Centre (IFSC) Banking Units (IBUs). Any floating interest rate, price or index used in IRDs in the OTC market must be a benchmark published by an Financial Benchmark Administrator (FBA)