The US bond market 'scam'

As we liberalise the short selling of bonds, one recent case attracting the attention of regulators in the US market is worth taking note of. This is not the first time that a few US banks have "cornered" a particular issue of treasury securities, and used their quasi-monopoly holdings to borrow funds at well below market rates. In a somewhat over-simplified recounting of the steps involved, the "scam" works as follows:

• A bank corners most of the floating stock in a particular issue.
• Any short seller of that bond has, therefore, necessarily to come to this bank to borrow it.
• Such borrowings of bonds are typically in the form of reverse repos, that is, buy/sell.
• Since the specific bond is needed, the short seller has two choices - either do not deliver the bond and lose interest, or gain possession of it by doing a reverse repo. The holder exploits the situation by effectively borrowing money at well below market rates.

My memory is that many years back, Solomon, now a unit of Citigroup, had indulged in similar practices and was penalised. This time also the regulators have become concerned and have cautioned the banks involved.

The UK market has systems which preclude such squeezes taking place - the UK government Debt Management Office itself lends the bond to the market participant needing it. But, London apart, such squeezes have been exploited in other European centres and in the Tokyo market in the 1990s.

Given the relative ill-liquidity and limited floating stock in many issues in the Indian market, for short selling to function smoothly, we need, in effect, a "lender of last resorts" for lending bonds.

To my mind, the agency in the best position to play the role is the bank-owned Clearing Corporation of India Ltd. It has securities borrowing arrangement with State Bank of India, and the risk management systems, as the settlement agency for all G-Sec transactions.

Turning now to the corporate bond market, it has now been a year since the Patil Committee report was submitted, and about 10 months since its acceptance, in principle, by Delhi. However, few concrete steps have been taken to implement the various recommendations. The key problem seems to be that the two regulators, namely, Sebi and the RBI, seem to be have different views on the trading platform.

Sebi seems to favour monopoly trading on BSE, while the RBI would prefer competing platforms, leaving it to the user community to declare the winner as recommended by the Patil Committee.

In a larger context, an active bond market is badly needed if the growing needs of corporate and other infrastructure investments are to be met. In H1 2006-07, private placement of bonds rose more than 40 per cent compared to the corresponding period of the previous year, to about Rs 50,000 crore (Rs 500 billion). But much of this fund raising (more than 90 per cent) was by the financial services sector. (One question: have some cooperative banks been tempted to buy bank-issued perpetual bonds?)

In effect, therefore, the bond market is not open to the manufacturing or infrastructure companies, except a few AAA names.

A senior civil servant recently said that there are 78 different laws/regulations, which need amendments for a properly functioning corporate bond market! But without waiting for all these pieces to fall in place, it is time for the two regulators to come to an agreement rather than allow the matter to drift. Surely, a few reforms could be instituted immediately:

• A compulsory reporting of all trades, so that there is price transparency and information.
• Introduction of electronic trading platforms. The RBI's NDS OM (for G-Secs) and CCIL's settlement services are already functioning smoothly. CCIL could extend the latter for corporate bonds.
• An actual/actual day count convention in the secondary market, instead of the artificial 30/360 market practice (I have argued the point in an earlier article).

The introduction of a credit derivatives market, or at least the plain vanilla credit default swaps. These would permit separation of the credit and interest rate risk inherent in corporate bonds, allowing investors to limit themselves to the risk they are comfortable with.

My memory is that the RBI had appointed a group on the subject of credit derivatives a few years back, and its report is with the central bank for the last few years. It is time that action is taken on the report.

Tailpiece: Milton Freidman, the author of Freedom and Capitalism, who died recently, has been described by free market enthusiasts as the most influential economist of the second half of the 20th century. It is ironical that the most faithful disciple of his economic doctrine turned out to be Augustus Pinochet's Chile, then one of the least free countries.

Perhaps equally ironically, the economy Freidman, the father of monetarism, admired most was Hong Kong's – which has a currency board system, with the money supply being determined by foreign currency reserves, and no monetary policy!