One of the key financial sector reform proposals in the 2019-20 budget relates to promoting greater retail participation in government securities and treasury bills. This is sought to be achieved by allowing interoperability of RBI and SEBI depositories. At present, the depository arrangement for government securities is separate from that of other securities. In addition, the arrangements governing exchanges and clearing systems are also separate for government securities. Why is the market infrastructure for government securities separate and not part of the mainstream financial market infrastructure? In a paper, Ila Patnaik and I describe the developments that led to a separate market infrastructure for government securities.
In the early nineties, the infrastructure for trading in government securities was archaic. The Harshad Mehta scam of the early 1990s essentially involved manipulation of the archaic paper-based tracking of ownership of government bonds. The scam and its after effects necessitated a movement towards a modern market infrastructure. RBI began improving its operational controls and modernising market infrastructure in response to the failures of the early nineties. However the then legal framework, did not allow electronic transfer of securities. An RBI instituted committee recommended a move towards a modern market infrastructure through the enactment of the Government Securities Act, 2006.
At present, the depository function is governed by the Government Securities Act of 2006. Any entity desirous of investing in government securities has to open an SGL account with the RBI. Government securities are held in a dematerialised form in the SGL accounts. The RBI, specifies the conditions for opening and maintaining SGL accounts. Primarily, the RBI regulated entities can maintain an SGL account with the RBI. Entities who are not eligible to maintain an SGL account with the RBI have to follow an indirect route of investment through CSGL accounts. Separate requirements need to be followed by the regulated entities and their clients for maintaining CSGL accounts. These increase transaction and compliance costs and deter retail investment in government securities.
For the mainstream financial markets, the Depositories Act provides a framework for regulation of depositories for the general class of securities. However the Government Securities Act—the legal sanction behind the SGL contains a provision that bars the applicability of the Depositories Act to government securities. Thus, the depository arrangement for government securities is not part of the mainstream depository arrangement for securities. This primarily meant that retail investors holding demat accounts with DPs could not invest in government securities. Developments of the early nineties shaped the present arrangement where the market infrastructure for government securities was carved out of the financial market infrastructure.
In July 2016, RBI made attempts to ease frictions of investing in Government securities by retail investors. It allowed demat account holders to trade in G-secs through their depository participant (DP) who inturn needs to be a SGL account holder and a member of the RBI's exchange-- Negotiated Dealing System (NDS-OM) and the clearing corporation (CCIL). This move allowed retail investors access to Government securities without maintaining a CSGL account. However this is possible only if the depository participant has access to the RBI depository infrastructure. Potentially, a DP who does not maintain a SGL account with the RBI cannot deal in G-secs on behalf of her retail client.
The Budget speech acknowledges that efforts by the RBI need to be supplemented by additional measures. Towards this, the Budget proposed inter-operability of RBI depositories and SEBI depositories to encourage greater retail participation in Government securities. Household financial savings have been largely stagnant in recent years. The proposal signals the intent of the Government to encourage household financial savings by offering them a safe avenue to invest.
However this intent can be translated into action more effectively by harmonising the market infrastructure for government bonds with the mainstream securities market infrastructure. A stream of expert committees in the past have highlighted the gains from unification of market infrastructure across bonds, equities, derivatives and currencies. Exchanges, firms and investors would be able to harness economies of scale if all organised financial trading uses a common infrastructure.
International experience also suggests that the infrastructure for government bonds is broadly a part of the mainstream financial market infrastructure. This essentially would mean that the provisions in the various legislations that create a carve-out for government bond infrastructure need to be reconsidered.
Lower levels of fragmentation in market infrastructure would make the Government securities market more liquid. This would encourage more heterogeneous investor base in government securities and in the long run may bring down financial repression in government securities market.
Radhika Pandey is a Fellow at National Institute of Public Finance and Policy (NIPFP)