SynopsisSometimes, 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.
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 the secondary market have grown over the past 15 years at compounded rates of well over 15% a year. 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 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 5%. Contrast this to the US markets that are the mirror image — 5% for the AAA and AA, and the balance 95% distributed below them.
A corporate debt market supports the backbone of any economy, as it does infrastructure growth, which by its nature is debt-fuelled. Banks and non-banking financial companies (NBFCs), which borrow money from the shorter maturities, are loath to lend to long-dated assets that 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 have been implemented in fair measure, the bigger picture — and obvious — issues are often overlooked: competition, flexibility and less transparency. Yes, less transparency. The National Stock Exchange (NSE) was first set up as a debt platform that 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, 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 Rs 100 crore 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 coexist with request for quote systems, hit and-take bilateral platforms, voice broking, etc. 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 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 fraud’s exposure, people are becoming more sceptical. Also, India is the world’s only jurisdiction that imposes a ‘non-cooperative rating’ mandate. What we get is ‘garbage in, garbage out’. So, a rating company is obliged to rate a security even though a company, despite an agreement, refuses to cooperate and provide data.
With the result, rating agencies have no option but to put out ratings based on publicly available data that would be meagre in such cases. This weakens trust in the system, edging investors to the safest securities. Conversely, a trader with a Rs 1,000 crore sell order will want less transparency and won’t want to disclose its position or its identity. If you are the Life Insurance Corporation (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 coexist with other forms of trading venues.
There are several other reform measures like credit enhancement, repo and credit default swap (CDS) market development, government security (G-sec) market reforms, and pushing large public institutions towards even a tiny sliver of riskier debt that needs to be implemented. While I make the case of a sceptic, I will be the happiest to be proven wrong.
The writer is managing partner, Finsec Law Advisors