I have a piece in today's Economic Times suggesting a 19th century medicine to a most modern problem - of developing the corporate bond market. More innovation, more competition and less transparency. I also strongly argue against accepted wisdom of replicating the equity markets - that would hurt the bond market rather than develop it.
Both the trades and traders are very different beasts from equity trades and traders and treating unlike as like will dramatically hurt the marketplace and the economy. A readable piece is linked here.
It’s easy to be disappointed in the growth of the corporate debt market. Not because there is no growth, but because of the nature of the growth. Overall, the issuance or primary market and also the secondary market have grown robustly over the past 15 years, in fact at compounded growth rates of well over 15% per annum. The problem however is that the entire growth has been only with the safest bonds. The joke goes that banks only lend you money if you can prove that you don’t need it. This joke is even more harshly applicable to the bond markets. Raising debt capital if you aren’t the safest company, is close to impossible. The numbers are brutal, 95% of all corporate debt is rated either AAA or AA. All other ratings fall in the balance 5%. Contrast this to the US markets which are the mirror image – 5% for the AAA and AA and the balance 95% distributed below them.
It’s also easy to see why this is not just a problem for the airy-fairy financial market, but for the real economy and has unseen but very severe costs on you and me. A corporate debt market supports the backbone of any economy – the medium mittlestand companies, it also supports infrastructure growth, which by its nature is debt fuelled. Banks and NBFCs which borrow money from the shorter maturities, are loathe to lend to long dated assets which pay back after a decade or more.
Sometimes the most obvious reforms are those easily missed. The poor development of the secondary markets for corporate debt is an example. It is also an area where trying to replicate the equity markets will hurt rather than help development. While many of the micro issues, highlighted by half a dozen committee reports have been implemented in fair measure, the bigger picture issues are often overlooked. These are obvious and probably because of that, overlooked. These are competition, flexibility and less transparency. Yes, less transparency.
A piece in ET quoted a source as saying “An automatic order-driven system and seamless settlement will bring in transparency and liquidity to the corporate bond market,”. The piece also talks about guaranteed settlement like in equity markets, straight through processing (in plain English 'look ma, no hands'). The piece then talks about the equivalent of 'don't you want the best for your child' argument that many of us face as parents. In the bond market, it is the need for a deep and liquid electronic market. None of these are good ideas. This is not a way to help, but non intuitively, would hurt the debt markets. And it’s been tried repeatedly.
Few remember, that NSE was first set up as a debt platform, which didn’t go anywhere. The problem with creating an equity like market is that the nature of the traders and trades is different. Most trades are large or very large, they are very time sensitive, and the traders are highly sophisticated people. This means that most traders, say a mutual fund, will move prices significantly, if they disclose that they are buying, say a hundred crore rupees worth of a certain security. Unlike equity, they cannot dribble out the sale order over a week or two. The paper may have a life only of a few days. Unlike equity, a company may have dozens of securities of debt, making the market and pricing highly fragmented. A mandatory electronic, anonymous marketplace may not be the panacea. But it should co-exist with request for quote systems , hit and take bilateral platforms, voice broking to name a few. Competition among marketplaces should be encouraged, while the backend can be handled more frequently by the clearing corporations ensuring guaranteed trades for many if not all trades.
The second area is transparency. While the traders want more transparency with respect to the underlying company’s health, they want less transparency with respect to their trades. With so many frauds unravelling over the past several years, with ratings going from AAA to junk on the exposure of the fraud, people are becoming more sceptical. Add to that we are the world’s only jurisdiction which imposes a ‘non-cooperative rating’ mandate, what we get is garbage in garbage out. In other words, a rating company is obliged to rate a security even though a company despite an agreement, simply refuses to cooperate and provide data. With the result, rating agencies have no option but to put out ratings based on publicly available data, which would be meagre in such cases. This weakens the trust in the system edging investors to the safest securities.
Conversely, a trader with a thousand crore rupee sell order will want less transparency and will not want to disclose its position or its identity. If you are LIC, your order is most likely a buy order, and your order size will likely be huge, allowing everyone to front run you, so that every single time you punch an order, you will get inferior price. This is the reason a large part of the market is a phone market, where players give two-way quotes through a broker, who does not disclose whether the counter party is a buyer or a seller till the very end. This sophisticated trade, can be automated to a large extent, but sometimes, it is best to permit this non-transparent market to co-exist with other forms of trading venues.
There are several other reform measures like credit enhancement, repo and CDS market development, G-Sec market reforms and pushing large public institutions towards even a tiny sliver of riskier debt, which have been much discussed by experts and need to be implemented. While I make the case of a sceptic, I will be the happiest to be proven wrong and the utopia of an anonymous, order matching, electronic system would be an impressive first in the world.
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