Reserve Bank of India (RBI) Deputy Governor T Rabi Sankar said that there is a need to develop robust benchmarks for the development of financial markets.
"Developing good benchmarks is eventually dependent on developing deep and liquid financial markets, which is an ongoing and drawn-out process," the deputy governor said.
"Meanwhile, effort can focus on improving the integrity and credibility of the benchmark process," he said.
Sankar was delivering a speech at a seminar organised by Financial Benchmarks India Private Limited (FBIL) in Mumbai.
"While the lack of adequate liquidity in some instruments is the primary challenge, the reasons for the limited liquidity vary. Growing offshore interest in INR products has resulted in the globalisation of domestic benchmarks," he added.
Sankar discussed some of the issues that need attention for developing a robust benchmark framework in India.
Financial benchmarks, used as references for pricing, valuation and settlement of financial instruments, are a key driver of the price integrity of financial markets.
From deciding the interest rate on a retail loan to determining the pay-off in a complex derivative, financial benchmarks are ubiquitous and deeply embedded in financial systems.
To discover price efficiently, the participation of investors with varying requirements and diversified trading strategies is required along with continuous price-making by market-makers.
"The post-GFC regulation has reduced the role banks traditionally played in market-making, even in developed markets. The degree of illiquidity seen in many traditionally liquid markets is partly explained by this development," Sankar added.
Further on the taxation front, he said that the limited participation by the retail investors in the government securities market is because it is tax-inefficient compared to investing in mutual funds, as the latter provides benefits of indexation.
"Certain regulations have the collateral effect of adversely affecting market liquidity. There should be coordinated efforts to address the unintended consequences of such taxation, accounting or regulatory requirements without undermining the basic objective of such policies," Sankar said.
Even though the liquidity in government securities has improved, the concentration still remains in a few benchmark securities and the use of models to arrive at the benchmarks across all tenors becomes necessary.
"Given the importance of government securities yields as the benchmark for pricing of most financial assets, there is a need for a suitable methodology to ensure that the benchmark yield curve remains robust and reliable," he added.
Market segmentation fragments liquidity and leads to price differentials which erode the efficacy of benchmarks.
Sankar said that a probably unintended consequence of the post-GFC drive towards de-risking OTC derivatives markets has been the tendency of developed economies to contain the risk of their entities by attempting to maintain control of regulation and risk management practices of third countries.
"All regulated entities understand the costs and constraints of compliance. It cannot be anyone’s argument that replicating such obligations for every regulator in every jurisdiction is an efficient arrangement," he said. "A satisfactory solution to this impending complication needs to be found quickly."
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