The Securities and Exchange Board of India (Sebi) has released a consultation paper outlining a novel “client model” whereby entities such as corporates, NBFCs, insurance companies and mutual funds can directly participate in tri-party repo transactions in the corporate bond market.
A repo agreement is a short-term secured loan in which one party agrees to sell securities to another party and agrees to buy them back later at a higher price. In such transactions, securities serve as collateral. The difference between the price initially paid for the security and the price at which the security was repurchased is considered the interest paid on the loan, in other words, known as the repo rate.
A simpler way to understand repo agreements is to think of banks and NBFCs using the repo market for funding. Banks and NBFCs own large amounts of securities that can be deposited with other entities in the money market to raise funds. The transaction is two-way, banks and NBFCs can borrow at competitive rates, and cash-rich organisations can earn interest on the money lent.
Mutual funds can only lend in the repo market, while banks and NBFCs can lend in the repo market, as per the Reserve Bank of India (RBI) rules.
In a tri-party repo agreement, in addition to the lenders and borrowers, a third-party act as an intermediary or facilitator, helping to provide services such as picking collateral, acting as a custodian for the collateral, and ensuring payment and settlement. These entities are called third-party proxies.
The corporate bond market operates on a proprietary model. Any entity willing to conduct a tri-party repo transaction will need to be a trading member of the stock exchange and a clearing member of the Limited Purpose Clearing Corporation (LPCC). Under this model, trading, clearing, and settlement are carried out by corporations, non-bank financial institutions, insurance companies, and mutual funds in their own accounts.
In the proposed customer model, Sebi proposes two approaches – direct and indirect engagement.
Under Sebi’s proposal, NBFCs, insurance companies, or fund houses would transfer the collateral (debt securities) directly from their accounts to those of the LPCC. The settlement of funds indirectly involved in the customer mode will be carried out through clearing members, while the fund settlement directly involved in the customer mode will be directly carried out by the participants without the participation of clearing members.
The need for a “client model” of tri-party repos of 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 of member firms/clearing firms, etc. The restriction prevents these entities from participating in the tri-party repo portion except through clearing members.
This restriction becomes even more problematic in the repo market. Repos are a very short-term money market instrument, with most transactions lasting one day. Same-day withdrawals are critical for borrowers to access such funds. Therefore, settlement time is critical to ensuring that funds reach market participants’ bank accounts. If a settlement is done through a clearing member, it may result in a delay in the settlement of funds between the clearing member and its clients/participants, resulting in disputes between the clearing member and its clients/participants. In turn, this may affect the smooth functioning of the LPCC.
A particular problem arises under the proposed direct approach to the client model. Clients/Participants should settle funds directly with the clearing firm. Unfortunately, current regulations do not clearly state that customers/participants can contribute directly to the core SGF (Settlement Guarantee Fund).
“The absence of such an authorisation clause in the SECC regulations would result in direct settlement of funds by clients/participants without taking appropriate risk management measures, and in the event of a default, LPCC would have to fill the gap due to self-default,” markets regulators observed.
“To strengthen the risk management system of LPCCs,” SEBI said in its circular, “to meet contingencies arising out of the possible failure of clients/participants”. 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 transaction.”
Sebi has solicited proposals from stakeholders by May 29.