Shri Shaktikanta Das, Governor, Reserve Bank of India, gave a lecture on ‘Accelerating Financial Market Reform in India’ at the 4th Annual Day of Foreign Exchange Dealers’ Association of India (FEDAI) on November 26, 2020, at Mumbai. Though the title involves an overhaul of total financial reforms in recent times in India, I studied its detailed analysis of the latest developments in foreign exchange/government bonds, in the Indian context. Let us look at the speech on the following website from RBI.

I shall summarize his initial introduction of the Indian economy, particularly, after the impact of the pandemic in the following sentence:

“The year 2020 has been one like never before. Despite this, regulatory and institutional reforms in the country have moved the domestic financial markets to the next trajectory. Cutting across market segments, these reforms are ushering in a simplified, principle-based regulatory framework that seeks to broad-base markets by easing access, enhancing participation, facilitating innovation, protecting users, and promoting fair conduct.”

RBI Governor s recent speech from foreign exchange government bonds angle

Yes, I could hear that after witnessing a sharp contraction in GDP by 23.9% in Q1:2020- 21 and a multi-speed normalization of activity in Q2, the Indian economy has exhibited a much stronger pickup. This augurs well for our country.

Financial market developments

Govern bonds and their reaction in recent times

Rarely the government bonds sector under the Indian economy occupied a more envious position than today. One could easily notice that the bond markets in our nation got broad-based in terms of participation, availability of instruments, and development of repo and derivative markets. The sovereign yield curve with its 40 years of historical information, provides a solid corporate bond market. Significant improvements in the market infrastructure encompassing state-of-the-art primary issuance process for government securities, an efficient and completely dematerialized depository system within the central bank, electronic trading platforms, trade reporting, and central counterparty settlement engulfed the process. Yes, the government bonds scene with sleepy notes got vibrant.

Secondary market liquidity in government securities increased but was confined to a few benchmark tenors, as per the expectations of experts.

Some developments can be summarized:

  • The participation base grew but the diversity of views remained limited with a predominance of “buy and hold” and “long-only” investors.
  • Interest rate derivative markets grew but remained limited to one product – the Overnight Indexed Swap – and to a small set of market participants.
  • Domestic foreign exchange markets also grew but so did the offshore markets, fragmenting the global market for the Indian Rupee and impairing market efficiency.
  • New product development remained constrained, in part, due to limited participation and also due to regulatory restrictions which had developed in response to the past experience with complex products and concerns about valuations and mis-selling.

To a pointed question of how did RBI react with its slew of reforms, I may answer with the recent reform measures, many of which are in the works, have been fashioned around the four major themes of

 (i) liberalizing financial markets and simplifying market regulation;

 (ii) internationalizing financial markets;

 (iii) safeguarding the “buy-side” – user protection; and

 (iv) ensuring resilience and safety. (I have quoted from the speech liberally to prove my arguments).

RBI Governor develops his speech freely on the above four points in a detailed form.

What does liberalizing financial markets and simplifying market regulations mean to us?

Let me narrate his arguments in detail.

  • In simple terms, anyone with a need to access financial markets can do it at minimum cost. Principle-based regulations for interest rate derivatives and foreign exchange derivatives help in achieving this broad objective.
  • The governor explained how detailed procedural prescriptions have been replaced with basic principles, thereby allowing – greater operational flexibility for market participants.
  • Earlier restrictions on the design of derivative contracts and cancellation and rebooking of foreign exchange derivatives have been dispensed with.
  • Distinctions based on residency have been removed or reduced, bringing foreign participants at par with domestic entities in terms of market entry and exit.
  • While retaining the existence of underlying exposures as the basis for access, greater flexibility and ease of hedging have been brought in by allowing anticipated exposures to be hedged.
  • Users with limited/small hedging requirements can now enter into contracts equivalent of USD 10 million without the need to establish the existence of underlying exposures.
  • During his elaborate speech, he mentioned the passing of the Bilateral Netting of Qualified Financial Contracts Act, 2020, which addresses the absence of legal recognition for bilateral netting that in turn discouraged the use of derivatives for effective risk management. The legislation provides the enabling framework for cash and derivative market transactions to be off-set.
  • He opined that this would enable optimization of capital requirements for financial institutions and act as an impetus for the development of derivative markets.

Let us deal with how did he explain the internationalization of financial markets in his candid discussion. Kindly bear with me that his speech was intended for those who are dealing with the most sophisticated instruments for derivatives and international foreign exchange markets.

Detailed facts about the internationalization of financial markets

What are the factors which enabled India, a sleeping economic giant to attract the best FDI investments from the eagerly investing international customers?

1. Today, one may recollect that the capital account is convertible to a greater extent. Allowing Inward Foreign Direct Investment (FDI) in most sectors and encouraging outbound FDI by Indian incorporated entities as a multiple of their net worth changed the situation.

2. The external commercial borrowing framework has also been significantly liberalized to include more eligible borrowers, even as maturity requirements have been reduced and end-use restrictions have been further relaxed. Expansion of portfolio investment in the Indian debt market with an increase in limits under the medium-term framework for foreign portfolio investors has given the required assurance.

3. Introduction of a voluntary retention route with restrictions from macro-prudential controls and allowing non-residents under the fully accessible route also helped. Non-residents can now easily invest in specified government securities without any restriction.

4. Yes, the tremor has been felt all around the world that India means business for international investors with its ears to the ever-changing international investment scene.

Not many of you are old enough to know that when India was struggling with funds from international agencies with stringent conditions, nonresident Indians came forward to invest billions of US dollars in India as deposits and SBI broke the shackles of Indian banks by offering huge funds for Indian entities to expand abroad when we were known to be in socialistic regions.

Let me hint you with the courageous statement from the RBI governor.

“Capital account convertibility will continue to be approached as a process rather than an event, taking cognizance of prevalent macroeconomic conditions. A long- term vision with short- and medium-term goals is the way ahead.”

Let me satiate you with further forthright statements for looking forward to bolder times in the economic scene.

  • Banks are now permitted to deal with offshore rupee derivative markets. Reducing segmentation between onshore and offshore markets, avoiding volatility, and the cost of hedging are expected to be the future courses of action for Indian banks.
  • When I notice the statement, banks have also been permitted to undertake foreign exchange transactions beyond the usual onshore market hours, thus fostering real-time market activity, any one will welcome liberalization of rules to benefit our economy.
  • In a complementary measure, exchanges and banking units in the GIFT City have also been permitted to undertake Over the Counter (OTC) and exchange-traded Rupee derivatives. This will immediately silence those critics who questioned the establishment of GIFT city itself as a concept.

Let us now concentrate on” safeguarding the “buy-side” – user protection” which attracted the governor to deal with as the next topic.

Safeguarding the “buy-side” – user protection

When he uttered “Safeguarding the interests of the users – the “buy” side of financial markets – is an imperative especially in the context of liberalized markets and introduction of newer and more sophisticated products”, I was wondering about the new products introduced in this regard.

  • With a view to providing greater protection to less sophisticated users, a User Classification Framework segregating users into ‘retail’ and ‘non-retail’ has been introduced for OTC foreign exchange and interest rate derivative transactions.
  • Retail users can be offered simple derivative products while product innovation has been permitted for nonretail users as per their business needs.
  • The issue of fair and transparent pricing of foreign exchange products, especially for MSMEs and other smaller users, has been under discussion for quite some time.
  • Market-makers are now mandated to separately disclose fees /charges when dealing with retail users.
  • We were further informed of an anonymous order matching electronic trading platform, called FX-Retail, launched by the Clearing Corporation of India (CCIL), at the behest of the RBI. This platform allows users with small transaction sizes to undertake transactions at the best available market rates.
  • These measures are expected to ensure greater transparency and protection of the retail user.
  • No doubt that concerted efforts by banks will be needed to transfer the benefits of transparent and competitive pricing to reach every user of the foreign exchange markets.
  • As derivative markets are liberalized, regulatory requirements in this regard would need further strengthening with overall changes to the regulatory approach.

RBI Governor further informed of the issue of a draft framework for variation margin for OTC derivatives aimed at reducing counterparty risks from non-centrally cleared derivatives, the introduction of a Legal Entity Identifier (LEI) which uniquely identifies financial market participants and enables aggregation of risks.

We further understand that Reserve Bank has also mandated the use of the LEI for participants in the markets it regulates. In fact, one feels enlightened that we are one of the few countries that have implemented LEI beyond derivative markets to cover transactions in government securities and money markets as well as the credit market (large loans).

The transition from the LIBOR regime to make alternate reference rates which would ensure robust governance frame works and process controls is another right step ahead. We are happy to know the Indian Banks’ Association has been working closely with market participants to facilitate the transition to alternate benchmarks and create customer awareness. Quoting various foreign exchange rates on day to day and transaction to transaction basis without any hidden cost and with fair play is going to be the most challenging task ahead of Indian banks.

He concluded his address as under:

“The simplification and flexibility provided in the regulations must reach the end-user. In designing new products and new market segments, risk management systems, and responsible market conduct should evolve in tandem as we open up to global players. Market participants and their associations including FEDAI will have to play a critical role in this.”

Our observations

Having one of the best Governors as our RBI Governor, our nation is in safe hands. Even understanding the message conveyed in this address requires a lot of foreign exchange and government bonds transaction knowledge. However, India today boasting the best inward FDI investments has to prove to the world of a robust governance standard which would safeguard the investments and also offer world-class service with the best products which change on day to day basis on real-time basis for its customers and the nations involved in these transactions. We are on the correct path to achieve our goal to be among the top five economies in the world.

Privacy statement

Having quoted extensively from RBI Governor’s address, as a student of foreign exchange and government business for the past 5 decades, these are my personal views. Neither legal nor consulting in nature,, RBI or I am not responsible for anyone. One should refer to legal consultation for proper guidance.

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September 2021