An Update on the Recommendations for Developing the Indian Corporate Bond Market

An Update on the Recommendations for Developing the Indian Corporate Bond Market March 2014

Content CONTENTS Objectives....1 Indian corporate Bond Market...2 Recommendations Scorecard........4 Table I: Recommendations Implemented..5 Table II: Recommendations to be implemented.....9

Objectives In recent years, multiple committees and reports have looked into the issue of the development of a robust corporate bond market in India, principally: Government of India, Ministry of Finance, Dr RH Patil Committee 2005. Report of the High Level Expert Committee on Corporate Bonds and Securitisation. Government of India, Ministry of Finance, Investment Commission 2007.The Report of the Committee on Infrastructure Financing. Government of India, Ministry of Finance 2007. The Report of the High Powered Expert Committee (HPEC) on Making Mumbai an International Financial Centre. City of London report 2008. The Development of India s Corporate Debt Market. Government of India, Ministry of Finance, Rajan Committee 2008. The Report of the Committee on Financial Sector Reform. Government of India, Ministry of Finance and Reserve Bank of India, The Report of the Committee on Financial Sector Assessment, March 2009. The aim of this paper is to tabulate the recommendations made by the above reports for developing the Indian corporate bond market and the current status of implementation of those recommendations. ACKNOWLEDGEMENTS 1

Indian corporate bond market According to a recent study by the Reserve Bank of Australia, East Asian corporate bond markets have grown significantly since the start of the century. The value of corporate bonds outstanding in Asia has risen fivefold over this period, to around US$3 trillion. Relative to GDP, the stock of Asian corporate bonds outstanding has also increased from 16 per cent in 2000 to 24 per cent in 2012. According to the Reserve Bank of India, the size of the India s corporate bond market is 11.8% of the GDP as of 2012, lower than the average for Emerging East Asia and for Japan at 17.2 and 19.8 per cent respectively. Although there has been a substantial growth in the corporate bond issuances in the post 2008 period, lack of liquidity is cited as the main challenge for corporates for raising capital through bonds. TH: Thailand; CN: China; PH: Philippines; ID: India; VN: Vietnam Source: DB Research Financial institutions (banks, insurance, mutual funds and pension funds) are required to invest in higher rated bonds thereby making government securities a beneficiary of the bulk of the debt investments. This causes liquidity issues due to the crowding out by government s capital raising methods, thus leading to lack of demand for lower rated bonds (< AA) increasing the reliance on bank lending. These issues have a detrimental effect on increasing the issuer and investor base in corporate bonds. In India 80% of the bonds issued are placed privately due to the less stringent disclosure requirements and lower costs of issuances. Also, since the bulk of the bonds traded are primary issuances, a move towards exchange traded bonds will help in bringing more transparency and improve liquidity in the secondary market. During the last decade, a number of committee reports have made several recommendations and provided for developing a vibrant corporate bond market in India. Progress has been made by the government and regulators in implementing some of the recommendations; notably the introduction of a new clearing system and the relaxation of limits imposed on foreign institutional investment into domestic corporate bonds to $51 billion in 2013 from $15 billion in 2008 and the introduction of credit default swaps (CDS) for unlisted rated corporate bond. That said, a number of recommendations are awaiting implementation. A fundamental challenge to the development of the Indian corporate bond market is the number of regulators, government agencies and ministries involved with its regulation. Corporate bonds are regulated by the Securities and Exchange Board of India (SEBI), which is responsible for authorising the public issue prospectus and for setting standards regarding private placements. SEBI also regulates the brokers and mutual funds. Banks and primary dealers are regulated by the Reserve Bank of India (RBI). Insurance companies are regulated by the Insurance Regulation and Development Authority (IRDA). Pension funds are regulated by the Pension Fund Regulation and Development 2

Efforts are being made by the regulators and policymakers such as setting up of the Corporate Bonds & Securitization Advisory Committee (COBOSAC) at SEBI, the Technical Advisory Committees (TAC) at RBI to help develop the corporate bond market in India. However, the challenges are manifold and cohesive and collaborative actions need to be taken by policy makers, central and state governments for creating a vibrant corporate bond market. 3

Recommendations Scorecard 2014 Sr. No. Recommendations FI BI PI NI Responsible Authority 1 Stamp duty MoF, State Finance Ministers 2 TDS (Tax Deducted at Source) --- 3 Increasing issuer base RBI 4 Market maker MoF, SEBI 5 Listing of issues --- 6 Enhancing investor base SEBI, RBI, IRDA, PFRDA, SROs 7 Consolidation of privately placed bonds SEBI 8 Primary issuance database SEBI, NSE, BSE 9 Development of the secondary market trade reporting system --- 10 Order matching trading system RBI 11 Reduction of shut period SEBI 12 Unified market convention --- 13 Repos or repurchase agreements in corporate bonds RBI 14 Interest rate derivatives --- 15 Reduction in market lot --- 16 Stamp duty on securitized debt MoF, State Finance Ministers 17 Taxation MoF 18 Securitized debt listing MoF 19 SARFAESI act issues MoF, SEBI 20 Credit Enhancement mechanism MoF, RBI, IRDA, PFRDA 21 Creation of specialized debt fund for funding infrastructure projects 22 Mutual fund regulation MoF, SEBI Total 6 4 6 6 MoF, SEBI, RBI, IRDA, PFRDA (FI Fully implemented, BI Broadly implemented, PI - Partially implemented, NI Not Implemented) (MoF Ministry of Finance, SEBI Securities and Exchange Board of India, RBI Reserve Bank of India, IRDA Insurance Regulatory Development Authority, PFRDA Pension Fund Regulatory Development Authority, SRO Self Regulating Organisation) 4

TABLE 1: Recommendations implemented The recommendations in Table 1 and 2 have been compiled from the following reports: Report of the High Level Expert Committee on Corporate Bonds and Securitisation (Dr. R.H.Patil), Report of the Committee on Infrastructure Financing, Report of the High Powered Expert Committee (HPEC) on Making Mumbai an International Financial Centre, City of London report on Development of India s Corporate Debt Market, Report of the Committee on Financial Sector Reform and Report of the Committee on Financial Sector Assessment. List of Recommendations TDS (Tax Deductions at Source) Similar TDS rules for corporate bonds as the ones applicable to Government securities or G-Secs. Actions taken The February 2008 Union Budget removed taxes on interest from corporate bonds. TDS applicable to corporate bonds to be removed. Increasing the issuer base Simplify and reduce disclosure and listing requirements for private placements. Reduce the cost and time for public issues. Listing of Issues Abridge the disclosure requirements for listed entities; only incremental disclosures needed. SEBI Notification in May 2009 simplified the listing procedure and reduced disclosure requirements for listed entities (whether by way of public issue or a private placement), thereby reducing the cost and time for public issues. SEBI circular dated May 11, 2009 on Simplified Listing Agreement of Debt Securities provides for minimal incremental disclosures related to the debt security issuance for listed issuers. Entities with privately placed bonds or no prior issues are required to provide detailed disclosures. Stringent disclosure norms for unlisted entities. Stringent action against promoters of firms not complying with listing agreement. Role of debenture trustees to be strengthened. The Securities Contract Regulation Act (SCRA) has been amended empowering SEBI to take action against the promoters of firms not complying with the listing agreement. 5

List of Recommendations Privately placed bonds listing to be made compulsory within 7 days of placement. Mandatory guideline to credit the dematerialised account within 2 days from the date of allotment. Actions taken SEBI has included these suggestions in its Disclosure and Investor Protection (DIP) guidelines. Circular informing the same for privately placed bonds was also issued. Enhancing the investor base Retail participation to be encouraged through exchanges, and mutual funds investing in corporate bonds. SEBI has implemented an investor education program to address this issue. Separate FII investment limit in corporate bond market. All FIIs and QFIs have been categorised as Foreign Portfolio Investors (FPI). FPIs are currently allowed a limit of $30 billion in government securities and $51billion in corporate bonds. Primary issuance Database Centralized database of bonds issued by corporates that will track rating migration, to be maintained. This is to be made available free of cost to all the investors. Development of the secondary market trade reporting system Reporting platform to gather information regarding corporate bond market trades and disseminate the same in real time. In January 2014, SEBI issued a circular directing all trades in Securitised Debt Instruments to be reported on the trade reporting platform of either NSE, BSE or MCX-SX, within fifteen minutes of the trade. SEBI has permitted both BSE & NSE to establish a trade reporting platform and information decimation system to inform investors regarding trades executed. The exchanges also hold a primary issuance database with the exchanges apart from holding information regarding rating migrations. FIMMDA s common reporting platform has been operational since November 2007. 6

List of Recommendations Order matching trading system Clearing mechanism should be in place to develop online order matching. Requisite approvals to enable free participation on the trading platform for the purpose of proprietary trading. Reduction of Shut Period The shut period in corporate bonds is to be aligned with that of G-Secs. For trades nearing coupon dates, part of the cash needs to be transferred during shut period by the sellers. Unified Market Convention Standardization of 30/360 day count convention for corporate bonds to be brought in place, in line with G-Secs. Actions taken Three settlement modes have been introduced by SEBI: Delivery versus Payment (DvP) I, II and III between April 2009 and September 2013. Under DvP I: pay-in and payout of funds as well as securities are done transaction-by-transaction Under DvP II: the funds are settled on the net basis (payments minus receipts), while securities are settled on transaction-bytransaction basis. Under DvP III: funds and securities are settled on net basis. For securities the net is arrived by subtracting the quantity of sale from purchase. SEBI issued notification in April 2007 to this extent and the shut period for corporate bonds, like G-Secs, is 3 days. Adoption of 30/360 standard, in line with G-secs in November 2007. Eventually they are to be move to an actual/actual platform. Sebi notification of Apr 13, 2007 provides for actual/actual day convention to be mandatory for all new issues of corporate bonds. 7

List of Recommendations Repos or Repurchase Agreements in corporate bonds Repos in corporate bonds to be allowed, provided investors have illiquid corporate bonds to go in for repos. The entity that will provide the trade matching system could also provide a repo facility on lines of Collateralized Borrowing and Lending Obligations (CBLOs) for government securities. Interest rate derivatives Currently an OTC market with limited players. A system to decimate the information regarding these trades is needed. Reduction in Market Lot Rs. 10 Lakh ($12,500) is the minimum market lot size. To attract smaller investors, the minimum market lot size should be Rs. 1 lakh ($1250). Actions taken The Reserve Bank of India has approved corporate bond repos w.e.f. March 01, 2010. RBI said, adding that only listed corporate debt securities which are rated AA or above by the rating agencies can be used for repo. In January 2013 the RBI added commercial papers (CPs), certificate of deposits (CDs) and nonconvertible debentures (NCDs) of less than one year; to qualify as collateral for undertaking repo auction route in corporate bond market. In January 2014 Interest Rate Future (IRF) were re-launched by NSE, BSE and MCX. G-secs will act as the underlying to these IRFs and the contracts will be cash settled. In April 2007, SEBI issued notifications that all entities including Qualified Institutional Buyers (QIBs), shall trade in corporate bonds subject to a minimum value of Rs.1 lakh. Exchanges may also have a limited segment for transactions in smaller market lots. Market Maker Permission to undertake repos. The Reserve Bank of India has approved corporate bond repos w.e.f. March 01, 2010. RBI said, adding that only listed corporate debt securities which are rated AA or above by the rating agencies can be used for repo. In January 2013 the RBI added commercial papers (CPs), certificate of deposits (CDs) and nonconvertible debentures (NCDs) of less than one year; to qualify as collateral for undertaking repo auction route in corporate bond market. 8

TABLE 2: Recommendations awaiting implementation List of recommendations Awaiting action Actions required Authority Responsible Stamp Duty on partly / unsecured debt The stamp duty on partly secured, and unsecured debentures should be made uniform across states and be linked to the tenor of securities. Rationalisation of stamp duties across all states. Government of India and State Governments. Market Maker Lack of market maker scheme for corporate bonds. Incentives for intermediary to evolve a efficient market maker support mechanism for these market makers. In January 2013, RBI revised the guidelines for Credit Default Swaps (CDS) permitting it for all rated corporate bonds (listed & unlisted). Further steps needed to be taken by RBI, SEBI and Ministry of Finance to encourage market players to take part in market making (exclusive buy-sell operations). Ministry of Finance, SEBI. Increasing the issuer base Banks to be allowed to issue bonds of maturity greater than 5years(ALM purpose). RBI action pending. RBI. Regulatory limits to be set for banks, when they subscribe for bonds issued by other banks. RBI action pending. RBI. 9

List of recommendations Awaiting action Actions required Authority Responsible Listing of Issues Encourage growth of trustee companies. SEBI working group is considering this. No SEBI. timeline given. Timely payment of interest and redemption amounts with regard to corporate bonds issued by firms to the depositories. Following which depositories will pass them on to the investors through ECS/warrants. Transparency with respect to soft default will improve. SEBI to issue notification in this regard. SEBI. Consolidation of privately placed bonds Enhance liquidity in the market by creating a large floating stock. Limiting the fresh issuances, include reissuances and move to a system where most new issuances are re-issuances rather than fresh issues. Primary issuance Database Centralized database of bonds issued by corporates that will track rating migration, to be maintained. This is to be made available free of cost to all the investors. Non-competitive bidding to be allowed. Limits for the same to be set. Privately placed bonds have dominated the market, and to create a large number of floating stocks by consolidating the privately placed bonds would help create secondary market liquidity and subsequently reissuances maybe encouraged. Legal issues to be examined by SEBI. Stock exchanges maybe encouraged to setup online trading platforms, with SEBI s regulatory guidelines. BSE launched the trading platform for the retail segment with NSE s software, but it only covers G-secs. It would help the corporate bond market to have such systems in place for debt issues from the corporate sector; also enabling electronic bidding for primary issue. Markets internationally have provisions for non-competitive bidding and order collections. Provisions to this extent would help issuers. The Exchanges are in the process of implementing this. SEBI. SEBI, NSE, BSE. SEBI, NSE, BSE. 10

List of recommendations Awaiting action Actions required Authority Responsible Enhancing the Investor base Ratings of issue to form the basis of investment for gratuity, pension, provident funds, instead of category of investor as the basis for investment. Insurance, Pension funds, provident fund and gratuity funds to have a wider investment scope. IRDA, PFRDA, SEBI. Consider banks investment in corporate bonds as part of total bank credit, for creditdeposit ratio. The Insurance Regulatory Development Authority (IRDA), The Pension Fund Regulatory Development Authority (PFRDA) and other SROs (Self Regulating Organisations) to consider the matter. IRDA, PFRDA, SROs. Regulation to allow banks to classify bank investments in corporate bonds, to be part of total bank credit could also increase the fund supply from major players. RBI. Stamp duty on securitized debt Consensus across states to be evolved to develop affordable rates for stamp duty on securitized products. Taxation Explicit tax pass for securitized Special Purpose Vehicles (SPVs) and Non-Performing Assets (NPA) securitization for central government, similar to the SEBI registered Venture capital funds. Reduction in withholding tax (WHT) on interest earned from 20% to 5% There is a need to rationalise the stamp duty across all states and the Ministy of Finance will need to work with State Governments on this. Currently the hindrance is the loss of revenue concerns from state governments. Securitized SPVs and NPA securitization could benefit from a tax pass through treatment and place them on par with SEBI recognized VC funds. This is being considered by Ministry of Finance. In May 2013 reduced the WHT rates to 5% Ministry of Finance and State Finance Ministers. Ministry of Finance. Ministry of Finance. 11

List of recommendations Awaiting action Actions required Authority Responsible Mutual Fund regulation Modify MF regulation to permit wholesale investors to invest in and hold units of a closed -ended passively managed fund scheme whose sole purpose is to invest funds into Pass through Certificates (PTCs) and Security Receipts (SRs) of the respective mortgage backed securities MBS. SPV Trust/ NPA Securitization Trust. MF regulation to be amended by SEBI. SEBI. Recognize the wholesale and QIB character of investors in securitization trusts; there should be no withholding tax on interest earned. The requirement of withholding tax on distributions made by the trust to its PTC, SR holders. Annual returns to be filed by the trust with IT department, including all particulars of the distribution of income and identity of its PTC, SR holders. Securitized debt listing Modify The Securities Contract Regulation Act (SCRA) Section 2(h) (id), to include Pass through Certificates (PTCs) and other securities issued by securitized SPVs and Trusts as securities under SCRA. SEBI to take this up with the Ministry of Finance. Ministry of Finance to take up this issue: New legislation is required. SEBI, Ministry of Finance. Ministry of Finance. 12

List of recommendations Awaiting action Actions required Authority Responsible SARFAESI act issues The definition of Security Receipt (SR) in Sec 2(zg) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act to be amended to allow SR holders to use SR as evidence to claim right on cash flows from realization of the securitized asset. Legislation is needed, Ministry of Finance to take up the issue. After which action from SEBI is needed. Ministry of Finance. Allow Qualified Institutional Buyers (QIBs) to invest in SRs. Large sized NBFCs and Non-NBFC corporate in India to be permitted to invest in SRs and QIBs. Other SR investors could include PE funds registered with SEBI as VC funds, within limits. Legislation is needed, Ministry of Finance to take up the issue. After which action from SEBI is needed. Ministry of Finance. Develop the wholesale market for securitized assets (not including QIBs). Allow wholesale investors in MF who solely invest in PTCs and SRs of designated MBS SPV Trust/NPA Securitization Trust. Securitized trust SPVs to be allowed to issue PTCs and SRs to mutual funds. Legislation is needed, Ministry of Finance to take up the issue. After which action from SEBI is needed. Ministry of Finance. 13

List of recommendations Awaiting action Actions required Authority Responsible Credit Enhancement Mechanism Securitized structure provides credit Ministry of Finance to consider the proposal. Ministry of Finance. enhancements with pooling of assets and selling trenches of these assets with various ratings, allowing investors to acquire assets based on their risk preference. Allow bonds issued by state government or SPVs for the purpose of infrastructure financing, to bring in such enhancements. Willing participants may take part in the under writing process. SPVs floated by Planning Commission and Ministry of Finance could also be considered for such enhancements. Capital adequacy guideline from RBI needs to be reviewed to reduce the double counting of capital requirements for credit enhanced debt instruments. Investors have only 20% weightage on debt instruments, with guarantees from banks and FIs. Guarantor would need to provide 100% risk weightage. RBI to review these suggestions. RBI. Where the issuers of securitized standard assets are banks and FIs and the same institution is also the credit enhancer, the current draft guidelines indicate that the issuer would require more capital to securitize assets than otherwise. Capital requirements being proposed need review. PFRDA, IRDA to provide guidelines in this regard. IRDA, PFRDA. Credit enhanced Collateralized Loan Obligations (CLOs) and Collateralized Debt Obligations (CDOs) to be considered as approved investment avenues. Insurance firms and PF are not part of the investor base of such debt instruments; their inclusion would improve the demand for such paper. PFRDA, IRDA to provide guidelines in this regard. IRDA, PFRDA. 14

List of recommendations Awaiting action Actions required Authority Responsible Creation of specialized debt fund for funding infrastructure projects Within the SEBI VC framework, allowing the Rupee Debt funds to register would be beneficial for the infrastructure sector. Regulation to limit investments in listed debt funds to a third of the fund size similar to SEBI VC funds. These funds could have the option of getting listed after a year from financial closure, giving investors the option of opting out, given that sufficient liquidity in the market would be present. They could receive the same tax treatment as VC funds. Allow bank participation in these funds; capital market exposure limits should not be applied in these cases. The Finance Minister in his budget speech of 2011-12 announced setting up of dedicated Infrastructure Debt Fund (IDF) to enhance the flow of long term debt in infrastructure projects. In June 2011, the Ministry of Finance issued the proposed structure of the IDF; either as Non-Banking Finance Company (NBFC) to be regulated by RBI or as a Mutual Fund to be regulated by SEBI. Subsequently RBI and SEBI have issued guidelines for the formation of Infrastructure Debt Fund (IDF) through the two routes in 2011 Although both SEBI & RBI have relaxed certain norms for investing in IDFs, there has not been enough uptake as expected. RBI, SEBI, Ministry of Finance. At a stage considered appropriate by RBI, foreign debt should also be allowed to participate in these funds. Amending the foreign VC regulation of 2000, maybe needed, (RBI consent also needed). Encourage PF, insurance, pension funds to participate in these infrastructure debt funds. PFRDA issued a circular in July 2013 allowing pension fund managers to invest in IDFs units or bonds having a rating of AA or more. IRDA has also allowed insurance companies to invest in infrastructure bonds. 15

City of London The City of London Corporation is the local authority of the business district of London, known as the 'Square Mile'. The City of London has a unique concentration of international expertise and capital, with a supportive legal and regulatory system, an advanced communications and information technology infrastructure and an unrivalled concentration of professional services. The City of London is apolitical and it works on behalf of the UK-based financial services industry. In order to strengthen direct links with India, one of the world s largest and most vibrant emerging markets, the City of London has established the India Office in Mumbai, to promote all UK-based financial and related business services. The City of London India Office works to further strengthen trading and investment links in both directions between India and the UK through the provision of world class financial services and products. The City of London India Advisory Council steers the work of the India Office and provides guidance on the City of London s engagement with India. Members include: Mukesh Ambani (Chairman of Reliance); C.B. Bhave (Former Chairman of the Securities and Exchange Board of India); Jaspal Bindra (Group Executive Director & Chief Executive Officer Asia, Standard Chartered Bank); Naina Lal Kidwai, Country Head India and Director HSBC Asia Pacific; Rajiv Lall (Executive Chairman of Infrastructure Development Finance Company (IDFC)); Rajiv Luthra (Founder and Managing Partner of Luthra & Luthra Law Offices); Rajiv Memani (Chief Executive Officer & Country Managing Partner of Ernst & Young); Zia Mody (Senior Partner of AZB & Partners); Nasser Munjee (Chairman of Development Credit Bank); Ravi Narain (Vice Chairman of the National Stock Exchange of India Ltd); Deepak Parekh (Chairman of the HDFC Group); Jairaj Purandare (Chairman of JMP Advisors Pvt. Ltd); Ajay Shah (Senior Fellow of the National Institute of Public Finance and Policy, New Delhi); Shardul Shroff (Managing Partner Amarchand & Mangaldas & Suresh A Shroff & Co) and Ajay Srinivasan (Chief Executive Officer (Financial Services) and Director of Corporate Strategy and Business Development - Aditya Birla Group).

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Disclaimer An Update on the Recommendations for Developing the Indian Corporate Bond Market 2014 by City of London is intended as a basis for discussion only. Whilst every effort has been made to ensure the accuracy and completeness of the material in this paper, City of London give no warranty in that regard and accept no liability for any loss or damage incurred through the use of, or reliance upon, this report or information contained herein. City of London, India Liaison office DBS House, Prescott Road Fort, Mumbai 400 001 Phone : +91 22 40779217 Telefax : +91 22 6636 4717 Email: india@cityoflondon.gov.uk www.cityoflondon.gov.uk/india