MONEY MARKET INSTRUMENTS Secondary Market in Government Securities

Prof. Neelam Tandon

Trading in Government Securities

There is an active secondary market in

Government securities. The securities can be bought / sold in the secondary market through: (i) Over the Counter (OTC) or (ii) through the Negotiated Dealing System (NDS) or (iii) the Negotiated Dealing System-Order Matching (NDS-OM)

Over the Counter (OTC)/ Telephone Market

In this market, a participant, who wants to

buy or sell a government security, may contact a bank / Primary Dealer / financial institution either directly or through a broker registered with SEBI and negotiate for a certain amount of a particular security at a certain price. Such negotiations are usually done on telephone and a deal may be struck if both counterparties agree on the amount and rate.

Example :URBAN-CO-OPERATIVE BANK AS A BUYER

In the case of a buyer, like an urban co-operative bank

wishing to buy a security, the bank's dealer (who is authorized by the bank to undertake transactions in Government Securities) may get in touch with other market participants over telephone and obtain quotes. Should a deal be struck, the bank should record the details of the trade in a deal slip and send a trade confirmation to the counterparty. The dealer must exercise due diligence with regard to the price quoted by verifying with available sources. All trades undertaken in OTC market are reported on the secondary market module of the NDS.

Negotiated Dealing System

The Negotiated Dealing System (NDS) for electronic dealing and reporting of transactions

in government securities was introduced in February 2002. It facilitates the members to submit electronically, bids or applications for primary issuance of Government Securities when auctions* are conducted. Membership to the NDS is restricted to members holding SGL and/or Current Account with the RBI, Mumbai.

*Types of Auctions for sale of T-Bills

Multiple Price Auction : The RBI invites bids by price, the bidders have

to quote the price (per Rs. 100 face value) of the stock which they desire to purchase. The bank then decides the cut-off price at which the issue would be exhausted. Bids above the cut-off price are allotted securities. In other words, each winning bidder pays the price it bid.

Advantage of Multiple Price Auction

The advantage of this is that RBI obtains the

maximum price each participant is willing to pay. It can encourage competitive bidding because each bidder is aware that it will have to pay the price it bid, not just the minimum accepted price.

Disadvantage of Multiple Price Auction

The disadvantage is that bidders bid more

cautiously (offer lower prices) in these auctions. This is so because it may happen that bidders who paid higher prices could face large capital losses if the trading in these securities starts below the marginal price set at the auction. This is known as Winners Curse. The winners curse can be a problem in those markets where price volatility is high.

Uniform Price Auction

In this method , the RBI invites bids in

descending order and accepts those that fully absorb the issue amount. Each winning bidder pays the same (uniform) price as decided by the RBI. In other words, all winning bidders are awarded the auctioned amount at the same price.

Uniform-Price Auction
The advantages of uniform price auction are

that they tend to minimize uncertainty and encourage broader participation. On the other hand, it may be possible the uniform price auctions could reduce the need to prepare for auction as allotment at uniform price reduces the incentive to bid. Individuals can buy government securities from the RBIs Public debt Office-Negotiated Dealing System(PDO- NDS) during auctions.

Measures to Promote Retail Trading in Govt. Securities

Banks are allowed to freely buy and sell govt.

securities at the prevailing market prices. The interest income on govt. securities is exempted from provision of tax deduction at source. Setting up the primary dealer system to increase the distribution channels and encourage voluntary holding of govt. securities among a wider investor base.

Cont--- To enable dematerialization of securities of

retail investors , the National Securities Clearing Corporation Ltd(NSCCL) were allowed to open SGL accounts with the RBI. The RBI encouraged the setting up of mutual funds dealing exclusively in government securities, called Gilt funds, with a view to create a wider investor base for them.

Cont-- A primary dealer sells gilts with a minimum

investment of rupees 25,000 while gilt funds provide access to an individual investor with a low investment minimum of rupees 5,000. PNB Gilts is using the Punjab National Bank branch network to popularize government securities with retail investors.

Negotiated Dealing System Order Matching

In August, 2005, RBI introduced an

anonymous screen based order matching module on NDS, called NDS-OM. This is an order driven electronic system, where the participants can trade anonymously by placing their orders on the system or accepting the orders already placed by other participants. NDS-OM is operated by the Clearing Corporation of India Ltd. (CCIL) on behalf of the RBI

Access to NDS-OM
Direct access to the NDS-OM system is currently available only to select financial institutions like

Commercial Banks, Primary Dealers, Insurance Companies, Mutual Funds, etc. Other participants can access this system through their custodians, i.e., with whom they maintain Gilt Accounts. The custodians place the orders on behalf of their customers like the urban co-operative banks. The advantage are of NDS-OM are price transparency and better price discovery.

Stock Exchanges
Facilities are also available for trading in

Government securities on stock exchanges (NSE, BSE) which cater to the needs of retail investors.

Factors affecting the price of Government security

The price of a Government security, like other financial instruments, keeps fluctuating in the

secondary market. The price is determined by demand and supply of the securities. Specifically, the prices of Government securities are influenced by the level and changes in interest rates in the economy and other macroeconomic factors, such as, expected rate of inflation, liquidity in the market, etc.

Cont-------- Developments in other markets like money, foreign exchange, credit and capital markets also

affect the price of the Government securities. Further, developments in international bond markets, specifically the US Treasuries affect prices of Government securities in India. Policy actions by RBI (e.g., announcements regarding changes in policy interest rates like Repo Rate, Cash Reserve Ratio, Open Market Operations, etc.) can also affect the prices of Government securities.

shut period
Shut period means the period for which the securities can not be delivered. During the period

under shut, no settlements/ delivery of the security which is under shut will be allowed. The main purpose of having a shut period is to facilitate servicing of the securities viz., finalizing the payment of coupon and redemption proceeds and to avoid any change in ownership of securities during this process.

 Currently the shut period for the securities

held in SGL accounts is one day. For example, the coupon payment dates for the security 6.49% GS 2015 are June 8 and December 8 of every year. The shut period will fall on June 7 and December 7 for this security and trading in this security for settlement on these two dates is not allowed.

Clearing Corporation of India Limited (CCIL)

The CCIL is the clearing agency for Government securities. It acts as a Central Counter Party (CCP) for all transactions in Government securities by interposing itself between two counterparties. In effect, during settlement, the CCP becomes

the seller to the buyer and buyer to the seller of the actual transaction. All outright trades undertaken in the OTC market and on the NDS-OM platform are cleared through the CCIL.

Cont-- Once CCIL receives the trade information, it works out participant-wise net obligations on

both the securities and the funds leg. The payable / receivable position of the constituents (gilt account holders) is reflected against their respective custodians. CCIL forwards the settlement file containing net position of participants to the RBI where settlement takes place by simultaneous transfer of funds and securities under the Delivery versus Payment system.

 CCIL also guarantees settlement of all trades

in Government securities. That means, during the settlement process, if any participant fails to provide funds/ securities, CCIL will make the same available from its own means. For this purpose, CCIL collects margins from all participants and maintains Settlement Guarantee Fund.

Risks Involved In Holding Government securities

Government securities are generally referred to as risk free instruments as sovereigns are not

expected to default on their payments. However, as is the case with any financial instrument, there are risks associated with holding the Government securities. Hence, it is important to identify and understand such risks and take appropriate measures for mitigation of the same. The following are the major risks associated with holding Government securities.

Major risks associated with holding Government securities

Market risk Market risk arises out of adverse movement of prices of the securities that are

held by an investor due to changes in interest rates. This will result in booking losses on marking to market or realizing a loss if the securities are sold at the adverse prices. Small investors, to some extent, can mitigate market risk by holding the bonds till maturity so that they can realize the yield at which the securities were actually bought.

Reinvestment risk
Reinvestment risk Cash flows on a

Government security includes fixed coupon every half year and repayment of principal at maturity. These cash flows need to be reinvested whenever they are paid. Hence there is a risk that the investor may not be able to reinvest these proceeds at profitable rates due to changes in interest rate scenario.

Liquidity risk
Liquidity risk refers to the inability of an

investor to liquidate (sell) his holdings due to non availability of buyers for the security, i.e., no trading activity in that particular security. Due to illiquidity, the investor may need to sell at adverse prices in case of urgent funds requirement. However, in such cases, eligible investors can participate in market repo and borrow the money against the collateral of the securities.

Risk Mitigation
Holding securities till maturity could be a

strategy through which one could avoid market risk. Rebalancing the portfolio wherein the securities are sold once they become short term and new securities of longer tenor are bought could be followed to manage the portfolio risk.

 However, rebalancing involves transaction

and other costs and hence needs to be used judiciously. Market risk and reinvestment risk could also be managed through Asset Liability Management (ALM) by matching the cash flows with liabilities. ALM could also be undertaken by matching the duration of the cash flows.

Advanced Risk Management Techniques

Advanced risk management techniques involve use

of derivatives like Interest Rate Swaps (IRS) through which the nature of cash flows could be altered. However, these are complex instruments requiring advanced level of expertise for proper understanding. Adequate caution, therefore, need to be observed for undertaking the derivatives transactions and such transactions should be undertaken only after having complete understanding of the associated risks and complexities.

FIMMDA
The Fixed Income Money Market and Derivatives Association of India (FIMMDA), an association of

Scheduled Commercial Banks, Public Financial Institutions, Primary Dealers and Insurance Companies was incorporated as a Company under section 25 of the Companies Act,1956 on June 3rd, 1998. FIMMDA is a voluntary market body for the bond, money and derivatives markets. FIMMDA has members representing all major institutional segments of the market.

FIMMDA
The membership includes Nationalized Banks such as State Bank of India, its associate banks

and other nationalized banks; Private sector banks such as ICICI Bank, HDFC Bank, IDBI Bank; Foreign Banks such as Bank of America, ABN Amro, Citibank, Financial institutions such as IDFC, EXIM Bank, NABARD, Insurance Companies like Life Insurance Corporation of India (LIC), ICICI Prudential Life Insurance Company, Birla Sun Life Insurance Company and all Primary Dealers.

Functions of FIMMDA
The FIMMDA represents market participants

and aids the development of the bond, money and derivatives markets. It acts as an interface with the regulators on various issues that impact the functioning of these markets. It also undertakes developmental activities, such as, introduction of benchmark rates and new derivatives instruments, etc.

Cont-- FIMMDA releases rates of various

Government securities that are used by market participants for valuation purposes. It also plays a constructive role in the evolution of best market practices by its members so that the market as a whole operates transparently as well as efficiently