Money MarketsSession 1

What is the money market?A market for short-term funds and financial instruments that are close substitutes for moneyMaturity period varies from one day to less than one yearEarlier predominantly telephone market; now moved to screen-based Not a physical location; more of an activityA wholesale market

Features of the marketA very liquid marketAn equilibrating mechanism for demand and supply of short-term funds Enables borrowers and lenders of short-term funds to fulfill their borrowing and investment requirements at an efficient market-clearing priceMain avenue for intervention by the central bank for influencing liquidity and level of interest rates in the economy

*

Participants in money marketRegulated by the RBIPrimary DealersBanksMutual Funds, Insurance Companies, Provident funds, NBFCs, PSUs, Corporate Investors

Benefits of efficient money marketProvides banks a stable source of funds other than depositsA well-developed inter-bank market enables development of secondary markets for CPs and CDsEncourages growth of non-bank intermediariesA liquid money market supports growth of capital market, government securities market, market for swaps and forwards A liquid money market enables more effective monetary control by the central bank through repos and Open market operations

Money market instrumentsCall/Notice moneyTreasury Bills (T-Bills)Commercial Paper (CPs)Certificates of Deposit (CDs)Collateralised Borrowing and Lending Obligation (CBLO)

History of Money Market till mid-1980sHistorically, call money market has been the core of the Indian money marketCall money market was purely an inter-bank market till 1971 In 1971 the UTI and LIC were allowed to participate as lendersCall money rates were freely decided till 1973 but administered rates came into force since December 1973Treasury Bills were the main short-term borrowing instrument of the governmentT-Bills were issued on a tap basis with the discount rate administratively fixed at 4.6%System of ad hoc T-Bills was created to automatically monetize the governments deficits

History of Money Market till mid-1980sParticipation certificates (PCs) and Commercial Bills introduced in 1970PCs utilized by financial institutions to park surplus funds for longer maturitiesUnder the bill rediscounting scheme RBI rediscounted genuine trade bills at the Bank Rate or other specified rateGrowth of Commercial Bills market was hampered by factors such as lack of a bill culture, non-availability of stamp papers of requisite denominations, absence of specialized credit information agencies and an active secondary marketBoth instruments did not develop and had insignificant activity

History of Money Market since mid-1980sChakravarty Committee (1985) and Vaghul Working Group (1987) recommendations for development and widening and deepening of money market as a result of which:Discount and Finance House of India (DFHI) set up in 1988 New instruments such as CDs, CPs and inter-bank Participation Certificates introduced in mid 1980s to increase range of instrumentsCall money rates were freed by 1989 to enable price discoveryAuction system introduced in 182-day T-Bills with a view to moving towards a system of market-determined yieldsAd hoc T-Bills were abolished and replaced by a system of Ways and Means Advances

History of Money Market since mid-1980sNarasimham Committee (1998) stressed need to make call money market a pure inter-bank market including only PDsAlso stressed need for prudential limits for banks and PDs accessing call money marketRecommended that RBI operations in money market should be market-based through repo and reverse repo auctions which would form a corridor for the marketNon-bank participants to be provided free access to rediscounting of bills, CPs, CDs, T-Bills and money market mutual funds

History of Money Market since mid-1980sFollowing recommendations of Narasimham Committee :Non-bank participants in call money market phased out in 4 stages from May 2001 till August 2005New instruments such as market repo and CBLO created to provide avenues for deployment of short-term funds for non-bank participantsMaturity of existing instruments like CDs and CPs gradually shortened to align maturity structure and facilitate emergence of a rupee yield curveRBI operations in money market through Open Market Operations (OMOs) including Liquidity Adjustment Facility (LAF) auctions

History of Money Market since mid-1980s contdNew money market derivatives like Interest rate swaps (IRS) and Forward Rate Agreements (FRAs) introduced in 1999Payment system infrastructure was strengthened with introduction of Negotiated Dealing system (NDS) and setting up of the Clearing Corporation of India (CCIL) in 2002 and implementation of Real-time Gross Settlement (RTGS) in 2004

What is call money?Money borrowed/ lent for a dayUnsecured borrowing/ lendingMain purpose is to meet shortfall in cash reserve requirements (CRR)

DefinitionsCall money overnight funds Notice money funds for 2-14 daysTerm money funds for 15 days - 1 year

Prudential limits for call borrowing/ lending by banksFor Scheduled Commercial Banks: Outstanding borrowing (on a fortnightly average basis)

Prudential limits for PDsMaximum borrowing

Determination of call ratesFreely determined by forces of demand and supplyDemand side factors: Tax outflows, size of government borrowing in a particular week/fortnight, non-food credit offtake, seasonal fluctuationsSupply-side factors: deposit mobililization, capital flows etcChanges in CRR affect the liquidity in the system and hence the call rates as well

Volatility in call money ratesCall money market characterized by a few predominant lenders and a large number of chronic borrowersVolatility high in the 1990s when call rates touched a peak of 35 per centHigh call rates in 1990s were due to high statutory pre-emptions like the CRR and SLRCRR and SLR progressively reduced by the RBIAlso inter-bank liabilities were freed from reserve requirements which reduced the volatilityLiquidity Adjustment Facility (LAF) auctions introduced from 2000 whereby RBI injects and absorbs liquidity on a daily basis

Size of Call money marketDaily average turnover in call money market declined from Rs.35,144 crore in 2001-02 to Rs. 14,170 crore in 2004-05 and incerased to Rs.21,725 crore in 2006-07PDs are the largest borrowersReduced activity after transformation into pure inter-bank marketCBLO and market repo share a combined 70 per cent of the turnover in the money market

Term Money MarketMaturity ranges from 15 days to 1 yearDormant due to various factors such asStatutory pre-emptions on inter-bank liabilities (CRR)Regulated interest ratesCash credit system of financingHigh volatility in call ratesAvailability of sector-specific refinanceInadequate Asset-liability Management (ALM) discipline among banksScarcity of money market instruments of varying maturities

Measures to activate Term money marketAdministered interest rates in term money market dismantled in 1989Select financial institutions were allowed to borrow in term money for 3-6 months maturityTerm money of original maturity of 15 days to 1 year exempted from CRR in 2001No prudential limits for transactions in term money market

Reasons for continued low activityTerm money market turnover increased moderately from Rs.195 crore in 2001-02 to Rs.1012 crore in 2006-07Inability of participants to build interest rate expectations over the medium term Skewed distribution of liquidity Corporates preference for cash credit rather than loansSteady reduction in minimum maturity of term deposits offered by banksTendency of banks to deploy short-term funds in RBI LAF instead of money market

CBLO segmentInstrument launched by the CCIL to provide liquidity to non-bank entities barred from call marketCCIL provides the trading platform for CBLO and guarantees settlementCBLO rates aligned with repo rates due to collateralized nature of borrowingNumber of participants increased steadily from 30 in July 2003 to 153 by March 2007PDs and nationalized banks predominant borrowers while mutual funds and insurance companies major lenders in CBLO

Treasury Bills Short-term instruments issued by RBI on behalf of governmentPurpose is to tide over short-term liquidity shortfallsIssued at a discount and repaid at par on maturityNo TDS on discount

Features of T-BillsNegotiable securitiesHighly liquid due to short maturityNo default riskAssured yield, low transaction cost, eligibility for including in securities for SLRIssued and traded through the Subsidiary General Ledger (SGL) account

Types of T-BillsOn-tap T-Bills : available at any time at a fixed discount 4.66 per centAd hoc Bills issued to monetize governments budget deficitAuctioned T-Bills introduced in 1992

Participants in T-Bill marketThe RBI BanksPrimary DealersMutual Funds, financial institutions, provident funds, foreign banks, corporates and FIIs

Method of sale of T-BillsAuction methodMultiple-price auctionAllotment takes place at price bid by the bidderWinners curseUniform-price auctionAllotment takes place at a uniform cut-off priceTends to minimize uncertainty and encourages broader participationReduces incentive to bid and risks of irresponsible bidding or collusion

Method of sale of T-Bills contd..Currently three maturities: 91days, 182 days and 364 daysAll issued by Multiple-price auctionFixed calendar for auctions of all t-BillsRBI announces date and time of auction through a press release 3-4 days prior to auctionAuction takes place on the Public Debt Office NDS (PDO-NDS) platformAnnounced and processed on-lineAuction results announced by RBI

Non-competitive biddingEntities such as state governments, state-run pension funds and eligible provident funds allowed to submit non-competitive bidsNon-competitive bidders receive allotment at the weighted average price determined in competitive bidding

Development of T-Bills marketSystem of Primary Dealers developedPDs required to bid for minimum amount of t-Bills at each auctionPDs regularly trade in secondary marketDates of payment of auctions synchronized on Friday following the auction in order to build up fungible stock of T-Bills and activate secondary market

T-Bill yieldsYields on T-Bills are market-determinedFluctuate according to liquidity conditionsTight liquidity conditions due to seasonal demand for liquidity (festival season), quarterly tax outflows, strong credit demand, higher government borrowings etc lead to hardening of T-Bill yieldsNot completely market-determined because:PDs have to compulsorily bid at T-Bill auctionsRBI accepts devolvement at times in order to keep yields under control and signal its interest rate stance

Commercial PaperIntroduced in January 1990 on Vaghul Committee recommendations Unsecured, short-term promissory note Issued by leading and highly rated corporate bodiesIssued either directly to investors or sold through intermediaries like merchant banksNegotiable and transferable by endorsement and deliveryFixed maturity period Issued at a discount and repaid at parCorporates, PDs and all-India Fis allowed to issue CPs

Measures to develop CP marketEligibility criteria specified for issuersCredit rating requirement made mandatoryGradual reduction in maturity and minimum amountMaturity period brought down from 91 days to 15 days and currently to 7 daysMinimum size reduced from Rs. 1 crore to Rs. 5 lakhStand-by facility provided by banks for CPs issued by the corporate was withdrawn in order to make CPs an independent instrument

Measures to develop CP marketCP issuance delinked from the Cash-credit limit of corporatesCP investments permitted in demat form only enabling cost reduction Banks permitted to provide credit enhancement by way of stand-by assistance/credit, back-stop facility etc for a CP issue based on their commercial judgementNon-bank entities may provide unconditional and irrevocable guarantee for the CP issue

Procedure for issuance of CPsIssuer to appoint an Issuing and paying Agent (IPA)IPA must be a scheduled commercial bankIPA to verify all documentation and issue an IPA certificate to all subscribers of the CPIPA may issue physical certificates to investor or credit CP to investors demat accountCompulsory reporting of all CP issuances on the NDS within 2 days of the issueRedemption may be by presentation of the CP to the IPA (if held in physical form) or through depository

Growth of the CP marketCP issuances tend to increase during easy liquidity conditions becauseBorrowers are able to raise money at lower effective rates than bank lending ratesBanks prefer to invest in CPs during conditions of lower credit offtake as CP rate is higher than call money rateDiscount rates on CPs move in line with general money market rates Leasing and Finance Companies are major issuers of CPs while MFs are major investors

Hurdles to growth of CP marketLittle scope for retail investorsIssue procedure is complexNon-bank institutional investors like LIC focus on T-Bill market due to RBI directivesNo underwriting facility and roll-over facility permittedStamp duty levy makes it unattractiveStamp duty not uniform for banks and non-bank entitiesMinimum maturity period of 7 days inhibits growth

Features of Certificates of DepositNegotiable instruments issued in demat form or usance promissory noteCan be issued by scheduled commercial banks (excluding RRbs and LDBs) and select all-india FisMinimum amount Rs.1 lakhMaturity : 7 days to 1 yearIssued at discount to face valueBanks have to maintain CRR and SLR on issue amount of CDs

Features of Certificates of Deposit Banks cannot grant loans against CDsBanks cannot buy back own CDs before maturityCDs to be issued in demat form onlyFreely transferable by endorsement and delivery

Hurdles to growth of CD marketLimited number of participants and non-listing of CDsNo facility of loans against CDsBuy-back not permittedStamp duty levyHigh minimum level of investment

*