Money, Banking and Financial Markets

Project

Mechanism for introducing CBLO as an instrument for Retail Investors

There are a range of money market instruments available for corporates, financial institutions, banks, mutual funds, insurance companies etc. This includes Certificate of Deposit, Commercial Paper, Treasury Bills, Call/notice/term money, CBLO, Market Repo etc. All these instruments help in sorting out mismatch in funds availability and funds demand. In case of funds shortage, it allows raising money by issuing these instruments, whereas in case of surplus, it provides an opportunity to invest in these instruments But there is almost no money market instrument available for a retail investor. In case of funds requirement, he can avail overdraft facility provided by bank. But the charges for this temporary service may be very high, way above interest rate prevailing in the call market for financial institutions. Similarly, investor with surplus money can invest it in liquid mutual funds. But, it may not be a quick exercise to select a liquid mutual fund and get the money invested immediately. CBLO (Collateralized Borrowing and Lending Obligation) is one option, which can help one retail investor to borrow or lend money to other retail investor for very short period on a daily basis. CBLO offers trading facility to its owner if need of liquidity arises. Unlike repo, it can be even redeemed before maturity date. Therefore, a market can be developed for retail investors to buy and sell CBLO under the regulation of CCIL. Currently, daily average volume of transactions through CBLO is of the order of Rs 50000 Crore. It has gained popularity since its inception in 2003 in India. It had close to 2% share in average daily transactions in overnight money market in 2003. Currently, it is contributing to approx 60% of average daily transactions. CBLO is a discounted instrument issued for the period ranging from one day to one year as per RBI guidelines. It is available in electronic book entry form and CCIL provides the dealing system through internet gateway to all those entities which do not hold current account with RBI. Hence, a mechanism can be devised to develop market for CBLO to retail investors. Need for a separate trading platform There will be a separate trading platform controlled by CCIL, for all the retail investors due to following reasons:

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Amount involved in each transaction will be very little compared to existing transactions among banks, corporates, FIs etc. Number of retail participants will be huge. Collaterals required by retail investors will be different from existing one (explained later). Operating procedure will be different for retail investors due to different initial margin, transaction charges, penalty charges etc. This platform will allow only retail investors to borrow or lend money. No other participant from existing members of CCIL will be allowed to participate in CBLO trading. It will be highly inconvenient for CCIL to segregate the large amount received from one lender (e.g. bank) to hundreds of retail borrowers or collect the money from several retailers to lend it to one borrower.

Membership Any retail investor can become member of CBLO trading segment, provided he holds current account with a bank, approved by CCIL for credit and debit of money. Each investor will have to provide CCIL with his bank account number with an instruction to his bank to credit or debit the amount as informed by CCIL. Eligible Securities Currently, CCIL accepts only Central Government securities including Treasury Bills, as collaterals. But in India, depth of G-sec market among retail investors is very poor. G-secs [1] are mainly traded among banks, financial institutions, corporates etc. Therefore, if CBLO facility is to be made available to retail investors, CCIL would have to include other investment instruments in collaterals. These instruments may include Indra Vikas Patrika (IVP), Kisan Vikas Patrika (KVP), National Saving Scheme, fixed deposits, mutual funds, equities, corporate bonds etc. Govt. is already planning to make corporate bonds repoable. This will allow CBLO members to use them as collaterals. CCIL would have to assign rating to each instrument to take care of risk associated with it. This will help CCIL do the valuation of each security.

[1]

Retail market for G-sec can be developed by making them available with banks or online. This will increase retailers accessibility to it and make it more liquid. Making G-sec available with stock exchanges didnt do well due to limited number of stock exchange in India and lack of accessibility.

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Each investor will have to open an account with CCIL, wherein all the securities will be deposited by him. A member will have to maintain securities worth Rs 5000 even if he has not borrowed or lent money through CBLO. This will help only genuine investor to become member of this facility. A borrower will have to deposit enough securities with CCIL to allow him to borrow desired amount. Borrowing Limit and Initial Margin Borrowing limit for the members shall be calculated every day. Assessment of value of securities in their account shall be done after marking them to market and applying appropriate hair-cuts.[2] The amount already borrowed by the members shall be deducted from the post hair-cut Mark-to-Market value. The residual amount will be the borrowing limit, which, in effect, denotes the drawing power up to which the members can borrow funds. Currently, CCIL has mandated for members to deposit some initial margin before a deal to take care of interest rate risk and settlement risk. This margin money is generally kept in the form of cash and government securities. Current procedure for calculating initial margin is to consider higher of 0.50% on the total amount borrowed/lent by the members and Rs 1 Lac. Retail investors will also have to keep some initial margin with CCIL for the same purpose. But, margin amount shall be revised to higher of 0.50% on the total amount borrowed/lent by the members and Rs 1 thousand. CBLO members can be provided with the facility of intraday enhancement in borrowing limit and initial margin. They can also withdraw unencumbered portion of borrowing limit intraday, but intraday cash withdrawal will not be possible. Type of Market Retail investors shall be allowed to execute all their deals in normal market for settlement on T+0 and T+1 basis. Two operations can be performed in normal market by a retail investor i.e. borrowing funds to the extent of his borrowing limit and selling CBLO held by him to meet his liquidity demand rather than holding it till maturity. Members intending to sell CBLOs (borrow funds) can place their offers directly through order entry form on the CBLO

[2]

Hair-cut is stipulated by CCIL to protect itself from potential losses arising on account of decline in market value of security held as collateral.

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system indicating the amount and rate [3] for a specific CBLO. Like-wise, members willing to buy CBLOs (lend funds) place their bids through order entry form specifying the amount and rate for a particular CBLO. The matching of bids and offers takes place on Best Yield Time Priority basis.[4] The normal market session for retail investors can be opened from 9.00 A.M. to 4.00 P.M. for T+0 and 9.00 A.M. to 5.30 P.M. for T+1 settlement on weekdays and from 9.00 A.M. to 2.00 P.M for both settlements on Saturday. Clearing and settlement procedure After the trading session, all the matched deals in the CBLO market will be taken up for processing and settlement. The CBLO obligation is generated by combining all the matched deals of the concerned member in the CBLO market i.e. regardless of the number of transactions entered in the day, there is only one net fund obligation either payable or receivable. Funds to be paid in or funds to be paid out will be generated by the CCIL system and sent electronically to the members bank for effecting credits or debits in the members current account through the settlement account of CCIL. The member entities will have to ensure that sufficient funds to the extent of their obligations are available in their account for the purpose of settlement. Once the settlement is done, settlement bank will send the receipt of confirmation. Upon receipt of confirmation, CCIL will transfer the CBLOs to the respective buyer members CBLO account. Risk Management The major risks that CCIL will face with regards to settlement are credit risk, liquidity risk and operational risk. Credit risks are of two types- principal risk and pre-settlement risk. Principal risk will arise when one of the parties to the settlement will fail to meet its full obligations under the contract on the settlement date. Pre-settlement risk is risk of loss resulting from replacement cost that may have to be incurred by CCIL and will arise when, one of the parties to the settlement becomes insolvent before settlement. Liquidity risk refers to entitys inability to make payment to its counter party on account of shortage of funds. The risk however can be managed if the settlement is done through a settlement agency that has suitable mechanisms, such as stand by line of credit or security lending and borrowing

[3]

This is the maximum rate up to which the borrower is willing to pay. The best bid yield for an offer order shall be the bid yield equal to or less than the Offer Yield. The best offer yield for a bid order shall be the offer yield equal to or more than the bid yield. In case there is more than one bid/offer order with the same bid/offer yield, then the system shall follow the Time Priority principle based on the time stamp given by the dealing system to the orders.
[4]

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arrangement. Operational risk refers to risk arising from deficiencies due to system or human failure. A centralized settlement system will help to tackle this type of risk. Since, CCIL will act as central counter party for all the transactions, members of CCIL will not have to worry about the risks they face while dealing with any other market player as soon as their transaction is accepted by CCIL for settlement. In the process of settlement guarantee, the CCIL will upgrade credit rating of all its members irrespective of their inherent credit rating. The confidence in the settlement process of CCIL will increase as ability of CCIL to contain the risks inflicted by weak members increase. The skill and efficiency of CCIL will therefore lie in its competence to quantify with a high degree of accuracy the risks involved in accepting members transactions for guaranteed settlement. The risk associated with trading and settlement can be mitigated by adopting stringent membership norms by restricting membership only to those entities which meet minimum eligibility criteria. Members will be allowed to borrow only to the extent of limit fixed after MTM valuation of securities deposited. The securities deposited by the members will be subjected to daily valuation and any deficit in the value of securities viz-a-viz borrowed amount will be collected from the concerned members. If the member fails to deposit the deficit amount, it will be treated as default and appropriate penalty will be levied. Default Handling Funds Shortage: There can be shortfall in the funds when the lenders on the day of lending and borrowers on the day of redemption fail to meet the obligation on the day of settlement. In such cases CCIL will meet the shortfall by utilizing lines of credit extended by member banks and complete the settlement. It will then initiate default handling process by withholding the CBLO receivable by the lenders. In case of borrower failure to meet the redemption funds at the maturity of CBLO, underlying securities of the borrower will be withheld until all the funds are replenished along with charges. CBLO Shortage: There can be shortage of CBLOs when the members sell CBLOs without having sufficient borrowing limit or concerned CBLOs in their account. In such cases CCIL will withhold the funds receivable by the defaulting members and create CBLOs to the extent of CBLO shortfall quantity by using the withheld funds and credit the same to the concerned buyers CBLO accounts.

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Fees and Charges One time membership fee of Rs 5000 shall be payable by retail investor. Other charges are as follow: a) Transaction Charges: Rs 5/- per 10000 of face value per deal per member subject to minimum of Rs 5/- and a maximum of Rs 250/- per trade. b) Settlement Charges: Rs 10/- per 10000 of face value per deal per member subject to minimum of Rs 10/- and a maximum of Rs 500/- per deal Plus Applicable Service Tax. c) Default Charges: Delayed deposit of Margin- 5 basis points per day on the amount of shortfall till the shortfall is met. Default- 5 basis point per day on the amount of shortage/default till the shortage/default is fully met; of which, 3 basis point per day will be payable to the non-defaulting Member on the shortfall. (Minimum charges would be Rs. 100/-) Taxation Since, CBLO is issued at discounted price and redeemed at face value; the difference between two shall not be considered as interest paid on it. Therefore, the discount income shall not be subject to tax payment like it is exempted for current CBLO members. Following Issue and Trading Norms shall be observed by CCIL CBLO shall be issued in electronic book-entry form only. The rate at which CBLO is issued and traded in the secondary market will be decided by market participants. CBLO could be traded in the secondary market without any lock-in period. CCIL will provide the trading platform for trading CBLOs to the satisfaction of the market participants. Dissemination of traded prices to all market participants as well as to RBI has to be enabled by CCIL. There are other requirements such as hardware and software requirement for CBLO dealing system, digital certificate, RBI regulatory provisions, which are typical for all the participants i.e. NDS members, Non-NDS members and retail investors.

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References www.ccilindia.com www.rbi.org.in www.bankingindiaupdate.com/cblo.htm http://www.financialexpress.com/printer/news/66616/ http://www.thehindubusinessline.com/2009/08/26/stories/2009082651700100.htm

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