THE negotiated dealing system (NDS) for government securities does not have customers but hostages. It uses a monopoly on gilt clearing and settlement to deny competitors like NSE straight-through-processing. Competing bilateral electronic platforms have not been allowed. Its deals are exempt from stamp duty. It has a waiver for the 5% volume cap for voice intermediaries. Banks received a not-so-subtle regulatory nudge for usage. Most importantly, the NDS uses the clearing and settlement toll gate (a monopoly that gives it a 55% net margin) to cross subsidise and offer the illusion of trading for free.
Putting aside whining about fair competition, we argue that the most dangerous consequence of NDS is reduction in gilt volumes, depth and breadth. The emergence of an arbitrage-free yield curve in government securities is a prerequisite for fixed income market development.Liquid gilts across maturities are pricing benchmarks for money markets, credit spreads,forward foreign exchange and corporate bonds.
However, as NDS has greatly reduced market breadth (smaller number of securities traded frequently enough to be called liquid), depth (volume concentration in a small number of securities) and volumes. Gilt volumes are down 40% off their peak while secondary equity volumes are 174% higher and secondary foreign exchange volumes are 254% higher during the same period.
NDS has undoubtedly exploded liquidity in a few securities,but a few maturities don’t make a yield curve. Market makers have responded to the lower incentives of making two-way quotes on NDS by lowering the number securities in which they make on-demand prices. This phenomenon is closely linked to the exchange Vs over-the-counter (OTC) market micro structure debate since NDS has forced gilt volumes onto an unlicensed exchange. Debt volumes often gravitate to the structure and incentives of a OTC market since institutional market makers use two-way prices to give and receive information.
The introduction of NDS has worsened liquidity for many maturity buckets in what was a shallow gilt market to start with. Liquidity risk (the inability to find a price of a specific maturity) is a self-fulfilling prophesy that amplifies volume in a few securities. But this volume concentration makes the yield curve a theoretical extrapolation that traders distrust and they start pricing liquidity (rather than risk). Consequently, the lack of an arbitrage free benchmark compounds the pricing and issuing complexity of dependent fixed income securities and derivatives like corporate bonds, swaps, etc.
Sixty years ago India obtained political freedom but economic freedom was stunted. Reforms since 1991 have begun reversing the damage; not wholly, or in full measure but substantially. Economic freedom means freedom of choice and monopolies are the enemy of choice.
Regulators are discouraging competition among gilt systems so that they can navigate to their desired destination. But policy must be agnostic between request for quote systems, single order book exchanges, hit and take bilateral platforms, voice broking, matched principal or namegive-up order matching offerings as long as price discovery is orderly, transparent and efficient.
There are few areas where regulatory fatwa’s to create a monopoly are justified and trading in government securities is certainly not one of them. More so when the NDS monopoly gives it abnormal profit margins and sabotages the development of a corporate bond market that will finance infrastructure and transparently price credit.