RBI Recent Guidelines on Government Securities Market

Ashish M. Shaji

26 Jun, 2020

On April 1, 2020, the Reserve Bank of India (RBI) published few questions along with its answers for an easy understanding of the information under the Government Securities market in India. Let us take a look at some of them.

What is LAF, and whether Re-repo in the Government Securities market is permitted?

Liquidity Adjustment Facility (LAF) is a facility provided by the Reserve Bank of India to scheduled commercial banks on a daily basis to deposit or withdraw funds. The operations of the Liquidity Adjustment Facility^[1] are conducted through repurchase agreements with RBI being the counterparty to all transactions. RBI fixes the interest rate in LAF. 

How does the G-secs (Government security) transaction settle?

• In Primary Market-

Successful allotments are told about their allotment when the allotment process is completed and the consideration amount to be paid informed. The settlement cycle for all types of G-secs is T+1, which means that funds and securities are settled on the next working day from the conclusion of the trade. On the settlement date, the total amount shall be duly debited, and the securities account duly credited with the number of securities.  

• In Secondary Market-

The transactions of G-Secs are settled through the member’s securities or the current accounts maintained by the Reserve bank of India. The securities and the funds are settled on a net basis that means Delivery vs. Payment System-III. CCIL (Clearing Corporation of India) guarantees settlement of trades on the settlement date.

CCIL and its role

Clearing Corporation of India is the clearing agency for G-Secs. It acts as a Central Counter Party for all transactions in G-Secs by interposing it between two counterparties. During settlement, the Central Counter Party becomes the seller to the buyer and buyer to the seller of the transaction.

All outright trades undertaken in the OTC (Over the Counter) market and on NDS-OM (Negotiated Dealing System- Order Matching) platform are cleared through CCIL, thereby ensuring accuracy, secrecy, and reliability.  Allowing the monetary operations seamlessly, it ensures participant wise net obligations on the securities and funds. All gilt account holders receive their receivable or payable position easily.

Relationship between yield and the price of a bond

Where the market interest rate levels increase, the price of bond falls, and on the contrary, where the interest rates or market yields fall, the price of the bond increases. The yield of a bond is inversely related to its price.

What is Duration?

Duration is the payback period of the bond to break even, which means the time taken by the bond to repay its purchase price. A businessman would want to know the duration of the recovery of the capital.

RBI had earlier notified that FBIL (Financial Benchmark India Limited) had been advised to assume the responsibility of administering the valuation of government securities from March 31, 2018.

Similarly, the RBI in another notification decided that securities issued by each state government shall be valued in a way which shall objectively reflect their fair value based on observed prices/ yields and Financial Benchmark India Limited shall make available prices for valuation of SDLs (State Development Loans) based on the above principles.

Risks involved in holding G-Secs (Government Securities)

G-Secs (Government Securities) are referred to as risk-free instruments as sovereigns occasionally default on their payments. However, just in case of any financial instrument, there are certain risks withholding the G-Secs. Therefore, it is pertinent to identify and understand those risks and take proper measures for mitigating the risks. You may have never heard of the Indian Government not able to honor its securities. With the perfect economic conditions despite worldwide pandemic or crisis situation in the world, the Indian Government Securities market is at its strongest level.

Some of the significant risks associated with the holding of G-Secs are mentioned below-

• Market Risk

Market risk pops out of an adverse movement of prices of the securities owing to a change in interest rates. It may result in valuation losses on the market to market or realizing a loss if the securities are sold at an adverse price.  Market risk is intrinsic in all types of investments.

• Re-investment Risk

Cash flows on a G-Sec involve a coupon every half year and repayment of principal at maturity. Such cash flows are required to be reinvested whenever they are paid.

• Liquidity Risk

The necessity of buying and selling the G-Secs on a narrow band of time always remains there.

What are the techniques for mitigating such risks?

Holding securities till maturity can be a strategy of avoiding market risk. Rebalancing the portfolio where the securities are sold when it becomes short term, and new securities of longer tenor are brought, could be followed to counter the portfolio risk. However, rebalancing involves transaction and other costs; therefore, it must be used judiciously. Market risks and re-investment risks can also be managed through ALM (Asset Liability Management) by matching the cash flows with the liabilities.

An advanced risk management method involves the use of derivatives such as Interest Rate Swaps (IRS) by which the nature of cash flows can be altered. However, these are sophisticated instruments that require an advanced level of expertise for proper understanding. Therefore adequate caution must be exercised for undertaking the derivatives transactions, and such transactions should be undertaken after having full knowledge and understanding of the associated risks and complexities.

Conclusion