Sebi bats for participation of NBFCs, MFs, insurance firms in corporate bond market

AIFs nomenclature comes under the Sebi scanner.

The Securities and Exchange Board of India (Sebi) has taken out a consultation paper outlining a novel 'client model' where entities like corporates, NBFCs, insurance companies, and mutual funds can directly participate in tri-party repo transactions in the corporate bond market.

Before we unpack what exactly is a tri-party repo, we need to understand the scope of a repo agreement.

A repo agreement is a short-term secured loan where one of the parties to the transaction agrees to sell the securities to the other party, and agrees to repurchase the securities later at a higher price. In such a transaction, the securities serve as collaterals. The difference between the initial price paid on the securities and the price at which the securities are repurchased is deemed to be the interest paid on the loan, in other words, known as the repo rate.

An easier way to understand the repo agreement is to think of banks and NBFCs tapping the repo market for funds. Banks and NBFCs own a lot of securities which can be parked with other entities in the money market to raise funds. The transaction is a two-way street, in which the banks and NBFCs can borrow at competitive interest rates, whereas organisations flush with cash can earn interest on the money lent.

According to Reserve Bank of India (RBI) regulations, mutual funds can only lend in the repo market, while banks and NBFCs can lend as well as borrow in the repo market.

In a tri-party repo agreement, a third party - apart from the lender and the borrower - plays the role of an intermediary or facilitator that helps in services like picking collaterals, acting as the custodian of collaterals as well as ensuring payment and settlement. These entities are called the tri-party agent.

A proprietary model is in play in the corporate bond market. Any entity willing to enter a tri-party repo transaction needs to take trading membership of stock exchanges and clearing membership of the Limited Purpose Clearing Corporation (LPCC). In this model, trading, clearing and settlement are undertaken by corporates, non-bank financiers, insurance companies, and mutual funds in their proprietary account.

In the proposed client model, Sebi had pitched two approaches - direct and indirect participation.

According to the Sebi proposition, the NBFC or insurance company or fund house will transfer the collateral (debt securities) directly from its account to the account of the LPCC. The fund settlement, in case of the client model indirect participation, will be carried out through a clearing member, whereas in case of the client model direct participation, the fund settlement will be carried out directly by the participant without the involvement of the clearing member.

The need for the ‘client model’ for tri-party repo in corporate bonds stems from the fact that Rule 8(1)(f) 1 of the Securities Contracts (Regulation) Rules, 1957 restricts bodies corporate, NBFCs, insurance companies, mutual funds, etc. from taking membership of stock exchange/ clearing corporation. Tis restriction stops these entities from participating in the tri-party repo segment except through a clearing member.

The restriction becomes all the more problematic in the repo market. Repo is a very short-term money market instrument with most transactions with a tenure of a single day. Obtaining funds on the same day is quite crucial for the borrowers to use such funds. Thus, the timing of the settlement is critical to ensure that funds reach the bank accounts of market participants. If settlement is done through a clearing member, it might cause a delay in the settlement of funds between the clearing member and its clients/participants which could lead to disputes between the clearing members and the clients/participants. This, in turn, may impact the smooth functioning of the LPCC.

A peculiar problem arises under the proposed direct approach of the client model. The client/ participant is expected to settle funds directly with the clearing corporation. Unfortunately, the prevailing regulations make no explicit provision of enabling contribution to the Core SGF (Settlement Guarantee Fund) by clients/ participants directly.

"Absence of such enabling provision in the SECC Regulations would give rise to a situation where the client/ participant would settle funds directly without adequate risk management measures and in the event of a default, the LPCC will have to make good the shortfall on account of default by itself," the market regulator observed.

"In order to strengthen the risk management system of the LPCC," Sebi said in its circular, "to meet the contingencies arising on account of possible failure of the clients/ participants as well, it is essential that the contribution to the core SGF can also be made by clients/ participants directly in cases where the clearing member is not involved in the tri-party repo transactions."

Sebi has sought suggestions from the stakeholders by May 29.