Capital Markets: Challenges and Developments

Capital Markets: Challenges and Developments

What are Electronic Gold Receipts?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Electronic Gold Receipts

Mains level : NA

The board of the Securities and Exchange Board of India (SEBI) has approved the framework for a gold exchange as well as for vault managers. This approval paves the way for gold exchanges to be set up for trading in ‘Electronic Gold Receipt’ (EGR).

What is EGR?

  • SEBI’s concept paper proposes issuing an electronic gold receipt in exchange pf physical gold (similar to equity shares), deposited with a vault manager (like a depositary participant) and this receipt can then be traded.
  • The government wants India’s outsized influence in the physical market for gold to be visible in the financial market for gold as well.

Why need EGRs?

  • EGI is a way of getting people to not hoard gold, by creating an exchange that provides transparent pricing and liquidity (to cash or back to gold).
  • India is a net importer of gold. We are price takers and not price setters. The whole idea is to move from being price takers to be price setters.
  • Price discovery at the exchanges will thus lead to transparency in gold pricing.
  • The gold exchanges would provide transparent price discovery, investment liquidity and assurance in the quality of gold.

What is the SEBI regulation?

  • SEBI has also proposed a regulatory framework for setting up a gold exchange.
  • Existing stock exchanges will be allowed to provide the platform for trading of EGRs.
  • The denomination for trading of EGR and conversion of EGR into gold will be decided by the stock exchange with the approval of SEBI.
  • The clearing corporation will settle the trades executed on the stock exchanges by way of transferring EGRs and funds to the buyer and seller, respectively.

How will EGR work?

  • EGR holders, at their discretion, can withdraw the underlying gold from the vaults after surrendering the EGRs.
  • SEBI-accredited vault managers will be responsible for the storage and safekeeping of gold deposits, creation of EGRs, withdrawal of gold, grievance redressal and periodic reconciliation of physical gold with the records of depository.
  • The vault manager will have a networth of at least ₹50 crore.

Back2Basics: Securities and Exchange Board of India (SEBI)

  • The SEBI is the regulatory body for securities and commodity market in India under the jurisdiction of Ministry of Finance Government of India.
  • It was established on 12 April 1988 and given Statutory Powers on 30 January 1992 through the SEBI Act, 1992.

Jurisdiction of SEBI

  • SEBI has to be responsive to the needs of three groups, which constitute the market:
  1. Issuers of securities
  2. Investors
  3. Market intermediaries

SEBI has three powers rolled into one body: quasi-legislative, quasi-judicial and quasi-executive.

  • It drafts regulations in its legislative capacity, it conducts investigation and enforcement action in its executive function and it passes rulings and orders in its judicial capacity.
  • Though this makes it very powerful, there is an appeal process to create accountability.
  • There is a Securities Appellate Tribunal which is a three-member tribunal and is currently headed by Justice Tarun Agarwala, former Chief Justice of the Meghalaya High Court.
  • A second appeal lies directly to the Supreme Court.

 

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Capital Markets: Challenges and Developments

SEBI introduces T+1 Settlement System

Note4Students

From UPSC perspective, the following things are important :

Prelims level : T+1, T+2 settlement

Mains level : NA

The Capital markets regulator Securities and Exchange Board of India (SEBI) has introduced T+1 settlement cycle for completion of share transactions on optional basis in a move to enhance market liquidity.

What is T+1 Settlement System?

  • T+1 means that settlements will have to be cleared within one day of the actual transactions taking place.
  • Currently, trades on the Indian stock exchanges are settled in two working days after the transaction is done (T+2).
  • In April 2002, stock exchanges had introduced a T+3 rolling settlement cycle. This was shortened to T+2 from April 1, 2003.

What has Sebi allowed?

  • SEBI has allowed stock exchanges to start the T+1 system as an option in place of T+2.
  • If it opts for the T+1 settlement cycle for a scrip, the stock exchange will have to mandatorily continue with it for a minimum 6 months.
  • Thereafter, if it intends to switch back to T+2, it will do so by giving one month’s advance notice to the market.
  • Any subsequent switch (from T+1 to T+2 or vice versa) will be subject to a minimum period.
  • A stock exchange may choose to offer the T+1 settlement cycle on any of the scrips, after giving at least one month’s advance notice to all stakeholders, including the public at large.

Why T+1 settlement?

  • Reduced settlement time: A shortened cycle not only reduces settlement time but also reduces and frees up the capital required to collateralize that risk.
  • Quick settlement: T+1 also reduces the number of outstanding unsettled trades at any instant, and thus decreases the unsettled exposure to Clearing Corporation by 50%.
  • Speedy recovery of assets: The narrower the settlement cycle, the narrower the time window for a counterparty insolvency/bankruptcy to impact the settlement of a trade.
  • Risk reduction: Systemic risk depends on the number of outstanding trades and concentration of risk at critical institutions such as clearing corporations, and becomes critical when the magnitude of outstanding transactions increases.

How does T+2 work?

  • If an investor sells shares, settlement of the trade takes place in two working days (T+2).
  • The broker who handles the trade will get the money, but will credit the amount in the investor’s account only.
  • In effect, the investor will get the money only after three days.
  • In T+1, settlement of the trade takes place in one working day and the investor will get the money on the following day.
  • The move to T+1 will not require large operational or technical changes by market participants, nor will it cause fragmentation and risk to the core clearance and settlement ecosystem.

Why are foreign investors opposing it?

  • Foreign investors operating from different geographies would face time zones, information flow process, and foreign exchange problems.
  • Foreign investors will also find it difficult to hedge their net India exposure in dollar terms at the end of the day under the T+1 system.
  • In 2020, SEBI had deferred the plan to halve the trade settlement cycle to one day (T+1) following opposition from foreign investors.

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Back2Basics: SEBI

  • The SEBI is the regulatory body for securities and commodity market in India under the jurisdiction of Ministry of Finance Government of India.
  • It was established on 12 April 1988 and given Statutory Powers on 30 January 1992 through the SEBI Act, 1992.

Jurisdiction of SEBI

  • SEBI has to be responsive to the needs of three groups, which constitute the market:
  1. Issuers of securities
  2. Investors
  3. Market intermediaries

SEBI has three powers rolled into one body: quasi-legislative, quasi-judicial and quasi-executive.

  • It drafts regulations in its legislative capacity, it conducts investigation and enforcement action in its executive function and it passes rulings and orders in its judicial capacity.
  • Though this makes it very powerful, there is an appeal process to create accountability.
  • There is a Securities Appellate Tribunal which is a three-member tribunal and is currently headed by Justice Tarun Agarwala, former Chief Justice of the Meghalaya High Court.
  • A second appeal lies directly to the Supreme Court.

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Capital Markets: Challenges and Developments

National Financial Reporting Authority (NFRA)

Note4Students

From UPSC perspective, the following things are important :

Prelims level : NFRA

Mains level : Not Much

Audit regulator National Financial Reporting Authority (NFRA) wants to be positioned as a regulator for the entire gamut of financial reporting, covering all processes and participants in the financial reporting chain.

What is NFRA?

  • NFRA is an independent regulator to oversee the auditing profession and accounting standards in India under Companies Act 2013.
  • It came into existence in October 2018.
  • After the Satyam scandal took place in 2009, the Standing Committee on Finance proposed the concept of the National Financial Reporting Authority (NFRA) for the first time in its 21st report.
  • Companies Act, 2013 then gave the regulatory framework for its composition and constitution.

Functions

  • NFRA works to improve the transparency and reliability of financial statements and information presented by listed companies and large unlisted companies in India.

Powers & duties

  • NFRA is responsible for recommending accounting and auditing policies and standards in the country.
  • It may undertake investigations, and impose sanctions against defaulting auditors and audit firms in the form of monetary penalties and debarment from practice for up to 10 years.
  • Since 2018, the powers of the NFRA were extended to include the governing of auditors of companies listed in any stock exchange, in India or outside of India, unlisted public companies above certain thresholds.

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Capital Markets: Challenges and Developments

Indian bond trading is in need of better market making

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Bond market

Mains level : Paper 3- Issues with bond markets in India

Context

The Indian market for corporate debt needs buoyancy and this has been high on the agenda of our regulator

Background

  • The Reserve Bank of India (RBI) stopped the automatic monetization of the fiscal deficit in 1997 and made the government borrow money from the market.
  • There are primary dealers or PDs, who pick up the Centre’s bond and provide buy and sell quotes in the secondary market for government bonds and thus help ensure sufficient liquidity.
  • The PDs came to be known as market makers and are paid a commission for playing that role.

Liquidity challenge in the corporate bond market

  • Unlike the market for government bonds,  in the case of the country’s corporate bond market, the challenge is different.
  • It’s typically remunerative for a buyer to buy a security and hold on to it till its maturity.
  • Therefore, insurance companies, provident funds, and pension funds hold such long-term paper, as they can match the tenure of their assets with liabilities.
  • But this does not add liquidity to the market, and anyone buying a corporate bond today may not find someone to sell it to tomorrow as this market has little trading depth.
  •  Even in the G-Sec market, where we assume plenty of liquidity, it is a thinly-traded market, even though the perception is that it is very liquid.

Why do we need market makers for the corporate bond market

  • To deal with the lack of depth and liquidity in the corporate debt market, the Securities and Exchange Board of India’s (Sebi) idea of creating market makers holds immense significance.
  • The fundamental problem here is that a bond is different from a share.
  • A company’s share can be exchanged seamlessly because every share in the market is the same slice of ownership.
  • Lack of quotes for different bonds of different tenure: In the case of bonds, however, there are several issuances of a company.
  • A single financial institution or non-bank financial company could have as many as 10 issuances a year of varying maturities and interest rates, making each of them a unique instrument.
  • Company XYZ may have issued in October 2015 a bond with a face value of 100 that pays 6% interest and is due for redemption in 2030, which will be quoted on exchanges for trading (if it’s being traded).
  • But, in 2021, it is no longer a 15-year bond, but a 9-year paper.
  • Therefore, the security loses importance, as the market normally uses benchmarks like 5 or 10 or 15 years; and every bond drops in the pecking order once it crosses these thresholds.
  • Therefore, we need to have market makers who will offer quotes for all major securities and thereby ensure that critical bonds are still available for trading.

Suggestions

  • Provide waivers: Playing market maker will involve a cost and hence there should be certain waivers provided to them on trading fees.
  • Preferential access: They can be given preferential access to new issuances, so as to build up an inventory.
  • Waiver of mark-to-market: The mark-to-market (MTM) rules could be waived for a specified period, as valuation differences can affect their profit and loss accounts.
  • Capital at lower cost: Capital can be made available at a lower cost to market makers, as they require funding for the same.
  • Fifth, trade among market makers can be awarded benefits in terms of fees or easier taxes on gains made.
  • Create bond index: We need to have tradable-bond indices that reflect the price movements of a basket of bonds that they track.
  • Made public, such indices will provide appropriate arbitrage opportunities for investors to come in, and this should generate liquidity in the market for these bonds.

Consider the question “Why bond market in India lacks the depth as compared to equity markets. What are the factors responsible for this? Suggest the way forward.”

Conclusion

Market makers are a way out. While success cannot be guaranteed, the idea should be adopted nonetheless, as with credit default swaps. It’s a work-in-progress. Let’s speed it up.

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Back2Basics: Automatic monetization of deficit

  • The monetization of deficit was in practice in India till 1997, whereby the central bank automatically monetized government deficit through the issuance of ad-hoc treasury bills.
  • Two agreements were signed between the government and RBI in 1994 and 1997 to completely phase out funding through ad-hoc treasury bills.
  • And later on, with the enactment of the FRBM Act, 2003, RBI was completely barred from subscribing to the primary issuances of the government from April 1, 2006.

Capital Markets: Challenges and Developments

[pib] International Bullion Exchange

Note4Students

From UPSC perspective, the following things are important :

Prelims level : International Bullion Exchange

Mains level : Not Much

The International Financial Services Centres Authority (IFSCA) has inaugurated the pilot run/soft launch of the International Bullion Exchange scheduled to go live on October 1, 2021.

What is Bullion?

  • Bullion is gold and silver that is officially recognized as being at least 99.5% and 99.9% pure and is in the form of bars or ingots.
  • Bullion is often kept as a reserve asset by governments and central banks.
  • To create bullion, gold first must be discovered by mining companies and removed from the earth in the form of gold ore, a combination of gold and mineralized rock.
  • The gold is then extracted from the ore with the use of chemicals or extreme heat.
  • The resulting pure bullion is also called “parted bullion.” Bullion that contains more than one type of metal, is called “unparted bullion.”

The Bullion Market

  • Bullion can sometimes be considered legal tender, most often held in reserves by central banks or used by institutional investors to hedge against inflationary effects on their portfolios.
  • Approximately 20% of mined gold is held by central banks worldwide.
  • This gold is held as bullions in reserves, which the bank uses to settle the international debt or stimulate the economy through gold lending.
  • The central bank lends gold from their bullion reserves to bullion banks at a rate of approximately 1% to help raise money.
  • Bullion banks are involved in one activity or another in the precious metals markets.
  • Some of these activities include clearing, risk management, hedging, trading, vaulting, and acting as intermediaries between lenders and borrowers.

What is International Bullion Exchange?

  • This shall be the “Gateway for Bullion Imports into India”, wherein all the bullion imports for domestic consumption shall be channelized through the exchange.
  • The exchange ecosystem is expected to bring all the market participants to a common transparent platform for bullion trading.
  • It would provide efficient price discovery, assurance in the quality of gold, enable greater integration with other segments of financial markets and help establish India’s position as a dominant trading hub in the World.

Answer this PYQ:

What is/are the purpose/purposes of the Government’s ‘Sovereign Gold Bond Scheme’ and ‘Gold Monetization Scheme’?

  1. To bring the idle gold lying with India households into the economy
  2. To promote FDI in the gold and jewellery sector
  3. To reduce India’s dependence on gold imports

Select the correct answer using the code given below:

(a) 1 only

(b) 2 and 3 only

(c) 1 and 3 only

(d) 1, 2 and 3

 

Post your answers here.
1
Please leave a feedback on thisx

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Capital Markets: Challenges and Developments

India’s equity market bubble

Note4Students

From UPSC perspective, the following things are important :

Prelims level : FPI and FDI

Mains level : Paper 3- Equity market bubble

Context

Even as the real economy returns to the doldrums after being hit by the second wave of COVID-19 infections, the continuing bull run in India’s equity market in the April-June quarter has baffled many observers.

V-shaped recovery of equity market

  • The benchmark BSE Sensex had nosedived to below 28,000 in March-April 2020, following the nationwide lockdown.
  • The equity market posted a sharp V-shaped recovery in 2020-21.
  • The Sensex surged beyond 50,000 in February 2021 and is currently closing on the 53,000 level.

Factors suggesting bubble in equity market

  • There was an 81%-plus growth in the Sensex between April 2020 and March 2021 in the backdrop of real GDP growth plummeting to -7.3% during the same period.
  • While output contraction had reversed from the third quarter of 2020-21, the inflation rate also rose and remained way ahead of the real GDP growth rate in the last two quarters (Chart 1).
  • It is difficult to find any rationality behind the skyrocketing BSE Sensex in the context of such stagflation in the real economy.
  • Just like the fall in the equity prices was driven by the exit of foreign portfolio investors (FPI), the return of massive FPI inflows has driven the Indian equity bubble since then (Chart 2).
  • Net FPI inflows clocked an unprecedented ₹2.74 lakh crore in 2020-21, the previous high being ₹1.4 lakh crore in 2012-13.
  • The Reserve Bank of India (RBI)’s annual report (2020-21) to state stated that: “This order of asset price inflation in the context of the estimated 8 per cent contraction in GDP in 2020-21 poses the risk of a bubble.”

Global factors

  • The global liquidity glut, following the expansionary, easy money policies adopted by the fiscal and monetary authorities of the OECD and G20 countries, has led to equity price inflation in several markets driven by FPIs, especially in Asia.
  • Following cues from the U.S. and the U.K., Asian equity markets in Singapore, India, Thailand, Malaysia and Hong Kong are currently witnessing price-earnings (P/E) ratios significantly above their historic means.
  • The BSE Sensex’s P/E ratio of 32 in end-June 2021 is way above its historic mean of around 20.

What could burst the bubble?

  • Change in monetary policy: With COVID-19 vaccination and economic recovery proceeding apace in the U.S., the U.K. and Europe, fiscal and monetary policy stances will change soon.
  • Exit of FPIs: Once the U.S. Federal Reserve and other central banks start raising interest rates, the direction of FPI flows will invariably change bringing about corrections in equity markets across Asia.
  • India remains particularly vulnerable to a major correction in the equity market because of two reasons.
  • Low pace of vaccination: The pace of COVID-19 vaccination in India, given the vast population, lags behind most large countries.
  • In the absence of a substantial increase in the vaccination budget and procurement, large segments of the Indian population will remain vulnerable to a potential third wave of COVID-19, with its attendant deleterious impact on the real economy.
  • Weak fiscal stimulus: India’s economic recovery from the recession will remain constrained by the weak fiscal stimulus that has been delivered by the Central government.
  • Data from the IMF clearly show that while the total global stimulus consisted of additional public spending or revenue foregone measures amounting to 7.4% of global GDP, India’s fiscal measures amounted to 3.3% of GDP only.

Consider the question “What are the factors driving equity market boom globally? What are the factors that could threaten such boom with a major correction?” 

Conclusion

With all agencies, including the RBI, downsizing India’s growth projections for 2021-22, it remains to be seen how long India’s equity bubble lasts.


Back2Basics: P/E ratio

  • The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS).
  • The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
  • To determine the P/E value, one simply must divide the current stock price by the earnings per share (EPS).

P/E Ratio=Earnings per share / Market value per share

 

Capital Markets: Challenges and Developments

SEBI needs to adopt dual approval system for independent directors

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Independent director

Mains level : Paper 3- Dual approval system for independent directors

Context

While the regulators have taken giant strides to enhance board independence in India, one significant conundrum persists about appoint and removal process of the independent directors.

How appointment and removal process affects the independence of independent directors?

  • Independent directors are appointed just like other directors through shareholder voting by a simple majority.
  • This confers a significant power in the hands of significant shareholders to handpick the independents.
  • In case of family-owned companies, it is not uncommon to appoint “friendly” independent directors.
  • As for public sector undertakings, there is a demonstrable affiliation between independent directors and the ruling political parties.

Dual Approval System: Way forward

  • The above trends suggest that unless independent directors owe their allegiance to the shareholder body as a whole, independence is likely to remain largely in form and not function.
  • In its consultation paper, SEBI proposed a “dual approval” system.
  • Under this system, the appointment of an independent director required the satisfaction of two conditions:
  • First, the approval by a majority of all shareholders.
  • Second, the approval of a “majority of the minority”, namely the approval of shareholders other than the promoters.
  • SEBI recommended the same “dual approval” system for the removal of independent directors as well.
  • SEBI drew inspiration from Israel and the premium-listed segment of the United Kingdom, which confers greater power to minority shareholders in installing or dethroning independent directors.
  • SEBI has not yet made any mention of implementing the dual approval system.

Issues with Dual Approval System

  • The first issue is that it militates against the majority rule principle that is intrinsic in a corporate democracy.
  • While understandable, that is hardly an immutable rule as corporate law does make exceptions in cases involving oppression of minority shareholders.
  • The second concern is that placing too much power in the hands of minority shareholders would be counterproductive, as it could result in a tyranny of the minority.
  • However, the dual approval system instead represents the best of both worlds. It does not negate the promoter’s involvement in the process of appointing or removing independent directors.
  •  Only consensus candidates would end up becoming independent directors.
  • The third issue is one of shareholder apathy: Will minority shareholders be motivated to exercise an informed and meaningful choice?
  • Minority shareholders tend to be passive when they are unable to influence the outcome of shareholding voting.
  • However, where they do have a significant say, like in the “majority of the minority” process, they are likely to be more active in exercising their franchise.

Consider the question “How far has the provision of appointing independent directors to safeguard the interest of minority shareholders succeeded in its objectives? Suggest the changes to improve the challenges faced by the independent directors.”

Conclusion

In all, the appointment and removal system continues to undermine the independence and efficacy of corporate boards. The SEBI needs to implement the dual approval system at the earliest.

Capital Markets: Challenges and Developments

Investors should not be tempted to ignore macroeconomic factors

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Not much

Mains level : Paper 3- Stock market and risks involved for individual investors

Despite gloom in the economy, financial markets are scaling new highs. The situations calls for diligence on the part of individual investors. The deals with this issue.

What influences investors’ decision

  • Investors may not necessarily be always sensible or even capable of perceiving the larger picture.
  • Nobel laureate Daniel Kahneman argues that humans usually use the ‘first system’ of ‘fast thinking’ to hurriedly act and perceive their environment.
  • Consequently, they are susceptible to the ‘priming effect’, ‘framing bias’, ‘anchoring effect’, ‘overconfidence bias’ and ‘availability heuristic’.
  • These phenomena, thus, play their part in pervading optimistic market conditions.
  • As a result, investors often end up ignoring or overlooking uncertainties and risks involved in their decision.
  • At the same time, investors’ decision choices could be significantly influenced by ‘nudging’.
  • It is a deliberate tactics and method of behaviour modification by which it is the ‘choice architect’ that decides who does what and who does so, as argued by the Nobel laureate, Richard H. Thaler.
  • The present surge in the Indian stock market is indeed nudging individual investors to trade more.

What makes individual investors vulnerable

  • National Stock Exchange data indicate following trends:
  • The share of the non-institutional individual investors in equity trading volume has risen to one half of the total turnover. in 2021.
  • It was around a third in 2016.
  • In contrast, the share of Foreign Institutional Investors (FIIs) in the total trading volume has shrunk to just about a tenth, it used to be one fifth in 2016.
  • Trading in the stock market, the sudden rise, the intraday moves, etc., are, thus, attributable largely to individual traders now. 
  • However, despite their large trading volumes, individual investors have actually contracted their holding of the market capitalisation.
  • The FIIs currently own around half of the free float of all Indian companies.
  • Apparently, the retail investors have constantly sold their stake to end up holding less than 20% shares now.
  • Trading, thus, seems to be the mainstay of retail investors and this is what makes them more vulnerable to the vagaries of the market.

Market is ignoring macroeconomic factors

  • Centre for Monitoring Indian Economy Pvt. Ltd. data of the listed companies reveal a rise in their profit, due to rationalisation and cost-cutting.
  • Investors might be tempted to ignore macroeconomic factors and invest in such stock believing that it is the profit that impels the stock prices.
  •  In reality, however, share price is expected to ascend if a company declares to cut its wage bill.
  • This probably explains why stock markets around the world have been on the rise amidst the novel coronavirus pandemic; demand may have declined but profits have been least impacted.
  • At the larger economic level, however, real wages have plunged.
  • Clearly, the market has not entirely decoupled itself from the economic indicators.
  • Established wisdom suggests that corporates cannot sustain contraction in the economy for long.
  • Sustained decline in demand caused by waning disposable household income would catch them soon.
  • Robert J. Shiller attributes this phenomenon of creating a possible bubble to irrational exuberance.
  • When bubbles burst, they cause a kind of financial earthquake, in turn destabilising public trust in the integrity of the financial system.
  • Critically, as the past portrays, individual investors, with all their vulnerabilities, suffer the most devastating consequences.
  • Retail investors are as well susceptible to overreaction when negative news hits the market.

Consider the question “What are the factors driving the financial markets up despite the weak macroeconomic foundations? What are the risks involved in such situation for the individual investors?”

Conlcusion

History of financial markets is replete with bubbles and bursts. Most affected in such burst are the individual investors. Informed decisions based on information and risks involved should form the basis of investment by individual investors.

Capital Markets: Challenges and Developments

SEBI proposes framework for Gold Exchange

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Gold Exchange

Mains level : Gold Exchange and its trading

The Securities & Exchange Board of India (SEBI) has floated a consultation paper on the proposed framework for Gold Exchange in India.

Why such a move?

  • According to SEBI, the proposed exchange would bring in more transparency in the gold trading market in terms of spot price discovery, quality of the gold and enable greater integration with the financial markets.

What is a Gold Exchange?

  • As the name suggests, this would offer trading facilities in the precious metal.
  • Entities like retail investors, banks, foreign portfolio investors (FPIs), jewellers and bullion dealers among others would be allowed to trade on the exchange.
  • While there are existing commodity exchanges that offer trading in gold contracts, those are derivative instruments while the proposed gold exchange would allow trading akin to the spot market.
  • This move assumes significance as India is the second-largest consumer of gold – after China – with an annual demand of around 800-900 tonnes.

Answer this PYQ:

Q.What is/are the purpose/purposes of the Government’s ‘Sovereign Gold Bond Scheme’ and ‘Gold Monetization Scheme’?

  1. To bring the idle gold lying with India households into the economy
  2. To promote FDI in the gold and jewellery sector
  3. To reduce India’s dependence on gold imports

Select the correct answer using the code given below

(a) 1 only

(b) 2 and 3 only

(c) 1 and 3 only

(d) 1, 2 and 3

What are the ways in which one can invest in gold now?

  • For those wanting to buy physical gold, a visit to the neighbourhood jeweller would suffice.
  • Meanwhile, there are online platforms such as Paytm, Kuvera and Indiagold among others that allow an individual to buy gold in digital form.
  • The advantage of buying gold in digital form is that one can put in a very small amount as well with some platforms allowing a minimum investment of just Rs 100.
  • Digital gold products have become quite popular among millennials. Then there are sovereign gold bonds issued by the government.
  • One can even look at Gold ETFs or gold funds by mutual funds.
  • Even gold derivative contracts traded on the exchanges have the option of physical settlement, which means investors can get physical delivery of gold.

How can one trade on a gold exchange?

  • The SEBI has proposed an instrument called ‘Electronic Gold Receipt’, or EGR.
  • The gold exchange, along with intermediaries like the vault manager and the clearing corporation, would facilitate the creation of EGR and its trading.
  • So, participants can convert their physical gold into EGR, which can then be bought or sold on the exchange like any normal equity share of a listed company.
  • The EGR can even be converted back into physical gold. As part of the draft regulations, SEBI has proposed three denominations of EGR – one kilogram, 100 grams and 50 grams.
  • It has, however, added that EGRs of five grams or 10 grams can also be allowed for trading to increase the liquidity of the market and attract more participants.

How can one convert physical gold into EGRs?

  • An entity that intends to convert physical gold into EGR will have to go to a ‘Vault Manager’.
  • According to the proposed framework, any entity registered in India and with a net worth of at least Rs 50 crore can apply to become a vault manager.
  • After the receipt of the gold, the vault manager would create an EGR for which the depository will assign an International Securities Identification Number, or ISIN, which is a unique code to identify the specific security.
  • Once the ISIN is issued, the EGR can be traded on the gold exchange just like any other tradable security.

Can EGRs be again converted into physical gold?

  • To convert an EGR into physical gold, the owner of the EGR will have to surrender the EGR to the vault manager who will deliver the gold and extinguish the electronic receipt.
  • Considering the logistics and delivery challenges, it has been proposed that conversion of an EGR into physical gold should be allowed only if a minimum of 50 grams of gold has been accumulated in electronic form.

Issues with gold exchange

  • Since the EGRs would be traded on an exchange, Securities Transaction Tax (STT) would be levied. Also, GST would be applicable when EGRs are converted into physical gold for withdrawal.
  • If in case the buyer and seller are from different states then levying state GST could be cumbersome. SEBI is mulling if only IGST or Integrated Goods and Services Tax can be levied to resolve this issue.
  • As far as transactions are concerned, SEBI working groups have suggested that an entire transaction be divided into three tranches.

Capital Markets: Challenges and Developments

SEBI tightens rules for provisional debt rating

Note4Students

From UPSC perspective, the following things are important :

Prelims level : SEBI

Mains level : Paper 3- Regulation of credit rating agencies

New framework for debt instrument

  • The new framework requires that a rating will be considered provisional in cases where certain compliances that are crucial to the assignment of credit rating are yet to be complied with at the time of rating.
  • Under the new framework, all provisional ratings (‘long term’ or ‘short term’) for debt instruments need to be prefixed as ‘provisional’ before the rating symbol.
  • In no case shall a rating, including provisional rating, be assigned by a credit rating agency for an issuer or client evaluating strategic decisions such as funding mix for a project, acquisition, debt restructuring, scenario-analysis in loan refinancing,” SEBI said.
  • On validity period, SEBI said provisional rating will be converted into a final rating within 90 days from the date of issuance of the instrument.

Capital Markets: Challenges and Developments

Understanding the issues with bond market in India

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Not much

Mains level : Paper 3- Issues with bond market in India and its effect on cost of borrowing of the government

What explains the Indian government borrowing at a higher interest rate than the interest rates for a home loan? The answer lies in the structural shortage in demand for government bonds. 

How the government’s cost of borrowing matter

  • Interest on government debt is a transfer from taxpayers to savers who own government bonds.
  • As the government bondholders are primarily domestic, interest paid by the government is just a transfer from one hand to the other within the economy.
  • However, the government’s cost of borrowing does matter.
  • The large increase in interest costs limits the government’s ability to spend elsewhere.
  • But more importantly, this rate also affects the cost of borrowing for large parts of the economy.

Understanding the term premium and credit spread

  • The RBI sets the repo rate, which is the short-term risk-free rate.
  • That is, the loan must be repaid in a few days and there is almost no risk of default.
  • The rate at which the government borrows is the long-term risk-free rate.
  • But the lender wants higher returns given the longer duration of the loan.
  • The difference between the repo rate and government’s borrowing cost, say on a 10-year loan, is called the term premium.
  • When a private firm takes a 10-year loan, it would have some credit risk too, which means a credit spread is added to the 10-year risk-free rate.

Challenge posed by term premium

  • From an average rate of 73 basis points since 2011 (one basis point is one-hundredth of a per cent), and 120 basis points in 2018 and 2019, the 10-year term premium is currently 215 basis points.
  • In other words, the interest rate for a 10-year period borrowing is 2.15 per cent higher than the current repo rate.

How this is related to dysfunction in bond market in India

  • Financial markets are forward-looking, and as the collective expression of the views of thousands of participants, efficient ones can occasionally “predict” what comes next.
  • But the Indian bond market is not one such: The view some hold, that the rise in term premium reflects future rate hikes by the monetary policy committee (MPC), is mistaken.
  • The Indian bond market is still too illiquid and not diverse enough to predict future trends.
  • Even though some pandemic-driven measures are being withdrawn, the MPC continues to be accommodative, and for several months at least, headline inflation is unlikely to force an abrupt change.
  • In any case, the spurt in yields after the budget points to the causality being fiscal instead of inflation-related.
  • But even the fiscal rationale seems weak.
  • The Centre’s tax collection for FY2020-21 has been substantially ahead of target, and state governments have also borrowed Rs 60,000 crore less than expected.
  •  Also, the14 states, accounting for three-fourths of all state deficits, have budgeted FY2021-22 deficits at 3.3 per cent, far lower than the 4 per cent average expected earlier.
  • Just these factors suggest that total bonds issued by the central and state governments should be lower than what the market had feared before the union budget was presented.
  • And yet, government borrowing costs have not returned to pre-budget levels.
  • This reflects dysfunction in the market.
  • Why else would a government be borrowing at a higher cost than a mortgage on a house?

What is the reason for dysfunction in bond market

  • Dysfunction can be traced to residential mortgages being among the most competitive of loan categories.
  • On the other hand, there is a structural shortage in demand for government bonds.
  • In such a market where there is a structural shortage in demand the marginal buyer holds all the cards, and as any buyer would, demands higher returns.
  • Over 15 years,  the share of banks in the ownership of outstanding central government bonds has fallen from 53 per cent to 40 per cent now.
  • But no alternative buyer of size has emerged to fill the space vacated.
  • The RBI sometimes buys bonds to inject money into the economy, but of late this space has been used to buy dollars to save the rupee from appreciation.

Solutions

  • The solution to the problem of bond market may lie in getting new types of buyers.
  • The RBI opening up direct purchases by retail investors is a step in this direction, though it may not become meaningful for a few years.
  • That leaves us with tapping foreign savings.
  • The limit on share of government bonds that foreign portfolio investors (FPIs) can buy has been raised steadily.
  • But without Indian bonds being included in global bond indices, these flows may not be meaningful, and would be volatile, as they have been over the past year.
  • To enable inclusion in bond indices, the RBI and the government have earmarked special-category bonds which are fully accessible (FAR) by foreign investors.
  • The FTSE putting India on a watch-list for “potential future inclusion” in the Emerging Markets Government Bonds Index is a step forward, and, one hopes, triggers similar actions by other index providers.

Consider the question “How the lack of retailness in the bond market affects the cost of borrowing of the government as well as the private borrowers? Suggest the measures to deal with the issues.”

Conclusion

The issues with bond markets in India highlights the urgency to find new buyers for government bond as it has implications not just for the government’s own fiscal space, but also for the cost of borrowing in the economy.

Capital Markets: Challenges and Developments

What are AT1 Bonds?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : AT1 Bonds

Mains level : Not Much

The decision of the Securities and Exchange Board of India (SEBI) to slap restrictions on mutual fund (MF) investments in additional tier-1 (AT1) bonds has raised a storm in the MF and banking sectors.

What are AT1 Bonds?

  • AT1 Bonds stand for additional tier-1 bonds. These are unsecured bonds that have perpetual tenure. In other words, the bonds have no maturity date.
  • They have a call option, which can be used by the banks to buy these bonds back from investors.
  • These bonds are typically used by banks to bolster their core or tier-1 capital.
  • AT1 bonds are subordinate to all other debt and only senior to common equity.
  • Mutual funds (MFs) are among the largest investors in perpetual debt instruments and hold over Rs 35,000 crore of the outstanding additional tier-I bond issuances of Rs 90,000 crore.

What action has been taken by the Sebi recently and why?

  • In a recent circular, the Sebi told mutual funds to value these perpetual bonds as a 100-year instrument.
  • This essentially means MFs have to make the assumption that these bonds would be redeemed in 100 years.
  • The regulator also asked MFs to limit the ownership of the bonds to 10 per cent of the assets of a scheme.
  • According to the Sebi, these instruments could be riskier than other debt instruments.

Try this PYQ:

Consider the following statements:

  1. The Reserve Bank of India manages and services the Government of India Securities but not any State Government Securities.
  2. Treasury bills are issued by the Government of India and there are no treasury bills issued by the State Governments.
  3. Treasury bills offer are issued at a discount from the par value.

Which of the statements given above is/are correct?

(a) 1 and 2 only

(b) 3 Only

(c) 2 and 3 only

(d) 1, 2 and 3

How MFs will be affected?

  • Typically, MFs have treated the date of the call option on AT1 bonds as the maturity date.
  • Now, if these bonds are treated as 100-year bonds, it raises the risk in these bonds as they become ultra long-term.
  • This could also lead to volatility in the prices of these bonds as the risk increases the yields on these bonds rises.
  • Bond yields and bond prices move in opposite directions and therefore, the higher yield will drive down the price of the bond, which in turn will lead to a decrease in the net asset value of MF schemes holding these bonds.
  • Moreover, these bonds are not liquid and it will be difficult for MFs to sell these to meet redemption pressure.

What’s the impact on banks?

  • AT1 bonds have emerged as the capital instrument of choice for state banks as they strive to shore up capital ratios.
  • If there are restrictions on investments by mutual funds in such bonds, banks will find it tough to raise capital at a time when they need funds in the wake of the soaring bad assets.
  • A major chunk of AT1 bonds is bought by mutual funds.

Why has the Finance Ministry asked Sebi to review the decision?

  • The FM has sought withdrawal of valuation norms for AT1 bonds as it might lead to mutual funds making losses and exiting from these bonds, affecting capital raising plans of PSU banks.
  • The government doesn’t want a disruption in the fund mobilization exercise of banks at a time when two PSU banks are on the privatization block.
  • Banks are yet to receive the proposed capital injection in FY21 although they will need more capital to face the asset-quality challenges in the foreseeable future.
  • Fitch’s own estimate pegs the sector’s capital requirement between $15 billion-58 billion under various stress scenarios for the next two years, of which state banks account for the bulk.

Capital Markets: Challenges and Developments

What are Government Securities (G-Secs)?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Government Securities (G-Secs), T-Bills etc

Mains level : Government Securities (G-Secs)

The RBI has said that it would allow retail investors and other small investors direct access to its government securities trading platform.

What are G-Secs?

  • These are debt instruments issued by the government to borrow money.
  • The two key categories are:
  1. Treasury bills (T-Bills) – short-term instruments which mature in 91 days, 182 days, or 364 days, and
  2. Dated securities – long-term instruments, which mature anywhere between 5 years and 40 years

Note: T-Bills are issued only by the central government, and the interest on them is determined by market forces.

Why G-Secs?

  • Like bank fixed deposits, g-secs are not tax-free.
  • They are generally considered the safest form of investment because they are backed by the government. So, the risk of default is almost nil.
  • However, they are not completely risk-free, since they are subject to fluctuations in interest rates.
  • Bank fixed deposits, on the other hand, are guaranteed only to the extent of Rs 5 lakh by the Deposit Insurance and Credit Guarantee Corporation (DICGC).

Retail investors and G-Secs

  • Small investors can invest indirectly in g-secs by buying mutual funds or through certain policies issued by life insurance firms.
  • To encourage direct investment, the government and RBI have taken several steps in recent years.
  • Retail investors are allowed to place non-competitive bids in auctions of government bonds through their Demat accounts.
  • Stock exchanges act as aggregators and facilitators of retail bids.

Try this PYQ:

Consider the following statements:

  1. The Reserve Bank of India manages and services the Government of India Securities but not any State Government Securities.
  2. Treasury bills are issued by the Government of India and there are no treasury bills issued by the State Governments.
  3. Treasury bills offer are issued at a discount from the par value.

Which of the statements given above is/are correct?

(a) 1 and 2 only

(b) 3 Only

(c) 2 and 3 only

(d) 1, 2 and 3

Why the current proposal?

  • The g-sec market is dominated by institutional investors such as banks, mutual funds, and insurance companies. These entities trade in lot sizes of Rs 5 crore or more.
  • So, there is no liquidity in the secondary market for small investors who would want to trade in smaller lot sizes.
  • In other words, there is no easy way for them to exit their investments.
  • Thus, currently, direct g-secs trading is not popular among retail investors.

What will the current proposal do?

  • The details are not out yet. However, the RBI’s intention is to make the whole process of g-sec trading smoother for small investors.
  • By allowing people to open accounts in RBI’s e-kuber system, it is hoping to create a market of small investors who will invest in these instruments.

Why such a move?

  • The RBI is the debt manager for the government.
  • In the forthcoming financial year, the government plans to borrow Rs 12 lakh crore from the market.
  • When the government demands so much money, the price of money (i.e., the interest rate) will move up.
  • It is in the government’s and RBI’s interest to bring this down.
  • That can only happen by broadening the base of investors and making it easier for them to buy g-secs.

Capital Markets: Challenges and Developments

Mutual Funds Risk-o-Meter

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Mutual Funds

Mains level : Mutual Funds and associated market risks

The capital markets regulator Securities and Exchange Board of India (SEBI) has made it mandatory for mutual funds to assign a risk level to schemes, based on certain parameters.

Try this PYQ:

Q.Which of the following is issued by registered foreign portfolio investors to overseas investors who want to be part of the Indian stock market without registering themselves directly?

(a) Certificate of Deposit

(b) Commercial Paper

(c) Promissory Note

(d) Participatory Note

What are Mutual Funds?

  • A Mutual Fund is a trust that collects money from a number of investors who share a common investment objective.
  • Then, it invests the money in equities, bonds, money market instruments and/or other securities.
  • Each investor owns units, which represent a portion of the holdings of the fund.
  • The income/gains generated from this collective investment are distributed proportionately amongst the investors after deducting certain expenses, by calculating a scheme’s “Net Asset Value or NAV.
  • It is one of the most viable investment options for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.
  • All funds carry some level of risk. With mutual funds, one may lose some or all of the money invested because the securities held by a fund can go down in value.

What is the risk-o-meter?

  • All mutual funds shall beginning January 1, assign a risk level to their schemes at the time of launch, based on the scheme’s characteristics.
  • SEBI’s decision on the “risk-o-meter”, characterizes the risk level of the schemes on a six-stage scale from “Low” to “Very High”.
  • The risk-o-meter must be evaluated on a monthly basis.

A compulsory mandate

  • Fund houses are required to disclose the risk-o-meter risk level along with the portfolio disclosure for all their schemes on their own websites as well as the website of the Association of Mutual Funds in India (AMFI) within 10 days of the close of each month.
  • Any change in the risk-o-meter reading with regard to a scheme shall be communicated to the unit-holders of that scheme.

How will the level of risk be assigned?

  • Which one of the six risk levels — low, low to moderate, moderate, moderately high, high, and very high — would apply, would depend upon the risk value (less than 1 for low risk to more than 5 for very high risk) calculated for the scheme.
  • So if the risk value of a scheme is less than 1, its risk level would be low, and if it is more than 5, the risk will be very high on the risk-o-meter.

Capital Markets: Challenges and Developments

What are Municipal Bonds?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Municipal Bonds

Mains level : Fund raising mechanisms for local bodies

Bonds issued by the Lucknow Municipal Corporation (LMC) got listed on the Bombay Stock Exchange. It’s the ninth city in the country to raise capital through municipal bonds.

Find out the rest eight cities issuing Municipal Bonds in India. Do let us know in the comment box.

What are Municipal Bonds?

  • A municipal bond or muni bond is a debt instrument issued by municipal corporations or associated bodies.
  • These local governmental bodies utilise the funds raised through these bonds to finance projects for socio-economic development through building bridges, schools, hospitals, providing proper amenities to households, et al.
  • Such bonds come with a maturity period of three years, whereby municipal corporations provide returns on these bonds either from property and professional tax collected or from revenues generated from specific projects or both.
  • The Securities and Exchange Board of India (SEBI) revised the guidelines related to the issuance of municipal bonds in 2015 in an attempt to enable ULBs or local government bodies to raise finances from such sources.
  • Following this measure, different cities have capitalized on the new guidelines to fund initiatives such as Atal Mission for Rejuvenation and Urbanisation Transformation (AMRUT) and Smart Cities Mission.

Their types

There are primarily two types of municipal bonds in India, categorised as per their usage. These are –

(1) General Obligation Bonds

  • These are issued to raise finances for general projects such as improving the infrastructure of a region.
  • Repayment of the bond, along with interest, is processed through revenue generated from different projects and taxes.

(2) Revenue Bonds

  • These are issued to raise finance for specific projects, such as the construction of a particular building.
  • Repayment of such bonds (principal and accrued interest) shall be paid through revenues explicitly generated from the declared projects.

Advantages of such Bonds

There are multiple advantages of investing in municipal bonds which include –

(1)Transparency

Municipal bonds that are issued to the public are rated by renowned agencies such as CRISIL, which allows investors transparency regarding the credibility of the investment option.

(2)Tax benefits

In India, municipal bonds are exempted from taxation if the investor conforms to certain stipulated rules. In addition to such conformation, interest rates generated on such investment tools are also exempt from taxation policy.

(3) Minimal risk

Municipal bonds are issued by municipal authorities, implying involvement of minimal risk with these securities.

Their limitations

The disadvantages of municipal bonds are enumerated below –

(1) Long maturity period

  • Municipal bonds come with a lock-in period of three years, imposing a burden on the liquidity requirements of investors.

(2) Low-interest rates

  • Even though interest rates on municipal bonds, in some cases, are higher than other debt instruments, these rates are considerably low when compared to returns from market-linked financial instruments such as equity shares.

Capital Markets: Challenges and Developments

What are Negative-Yield Bonds?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Negative-Yield Bonds

Mains level : Not Much

China recently sold negative-yield debt for the first time, and this saw high demand from investors across Europe.

Try this PYQ:

Q.Which of the following is issued by registered foreign portfolio investors to overseas investors who want to be part of the Indian stock market without registering themselves directly?

(a) Certificate of Deposit

(b) Commercial Paper

(c) Promissory Note

(d) Participatory Note

What are Negative-Yield Bonds?

  • These are debt instruments that offer to pay the investor a maturity amount lower than the purchase price of the bond.
  • These are generally issued by central banks or governments, and investors pay interest to the borrower to keep their money with them.

Why do investors buy them?

  • Negative-yield bonds attract investments during times of stress and uncertainty as investors look to protect their capital from significant erosion.
  • At a time when the world is battling the Covid-19 pandemic and interest rates in developed markets across Europe are much lower.
  • Hence, investors are looking for relatively better-yielding debt instruments to safeguard their interests.

Why is there a huge demand?

  • While Europe, the US and other parts of the world are facing a second wave of Covid-19 cases, China has demonstrated that it has controlled the spread of the pandemic and is therefore seen as a more stable region.
  • Many feel that European investors are also looking to increase their exposure in China, and hence there is a huge demand for these bonds.
  • The fact that the 10-year and 15-year bonds are offering positive returns is a big attraction at a time when interest rates in Europe have dropped significantly.
  • As against minus —0.15% yield on the 5-year bond issued by China, the yields offered in safe European bonds are much lower, between –0.5% and —0.75%.

Capital Markets: Challenges and Developments

What are Hybrid Funds?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Hybrid funds

Mains level : Not Much

This newscard is an excerpt from an originally FAQ published in TH.

Try this PYQ:

Q.Which of the following is issued by registered foreign portfolio investors to overseas investors who want to be part of the Indian stock market without registering themselves directly?

(a) Certificate of Deposit

(b) Commercial Paper

(c) Promissory Note

(d) Participatory Note

Hybrid Fund

  • A hybrid fund is one that invests in both equity and bonds. So, such funds ought to help investors with their asset allocation decision.
  • This refers to how you allocate your annual savings between equity and bond investments.
  • Suppose you are unsure of the proportion of equity and bond investments to have in your portfolio.
  • By investing in a hybrid fund, you could outsource your asset allocation decision to the manager of the fund, so the argument goes.
  • The issue is that each goal you pursue requires different asset allocation. For instance, the asset allocation for your child’s education portfolio must be different from your retirement portfolio.
  • Hybrid funds cannot consider your individual goal requirement as it is a collective investment vehicle.

Tax efficiency of the fund

  • Based on current tax laws, a hybrid fund that holds 65% or more in equity is considered as an equity fund.
  • So, if you redeem your units in such hybrid funds after a holding period of more than 12 months, you have to pay long-term capital gains tax of 10%.
  • If a hybrid fund holds less than 65% in equity, you have to pay 20% capital gains tax with indexation if you sell your units after a holding period of more than 36 months.

Back2Basics: Stocks vs. Bonds vs. Equity

  • A stock represents a collection of shares in a company which is entitled to receive a fixed amount of dividend at the end of the relevant financial year which are mostly called Equity of the company.
  • Bonds term is associated with debt raised by the company from outsiders which carry a fixed ratio of return each year and can be earned as they are generally for a fixed period of time.
  • Bonds are actually loans that are secured by a specific physical asset.
  • It highlights the amount of debt taken with a promise to pay the principal amount in the future and periodically offering them the yields at a pre-decided percentage.
  • Equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of an asset.

Capital Markets: Challenges and Developments

What are the ESG funds?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : ESG funds

Mains level : Not Much

ESG funds are witnessing a growing interest in the Indian mutual fund industry these days.

Try this PYQ:

Sustainable development is described as the development that meets the needs of the present without compromising the ability of future generations to meet their own needs. In this perspective, inherently the concept of sustainable development is intertwined with which of the following concepts?

(a) Social justice and empowerment

(b) Inclusive Growth

(c) Globalization

(d) Carrying capacity

What are the ESG funds?

  • ESG means using Environmental, Social and Governance factors to evaluate companies and countries on how far advanced they are with sustainability.
  • ESG investing is used synonymously with sustainable investing or socially responsible investing.
  • While selecting a stock for investment, the ESG fund shortlists companies that score high on the environment, social responsibility and corporate governance, and then looks into financial factors.
  • So, the scheme focuses on companies with environment-friendly practices, ethical business practices and an employee-friendly record.
  • They imbibe the environment, social responsibility and corporate governance in their investing process.

Why so much focus on ESG now?

  • Modern investors are re-evaluating traditional approaches and look at the impact their investment has on the planet.
  • As a result of this paradigm change, asset managers have started incorporating ESG factors into investment practices.
  • Companies with good ESG scores tick most of the checkboxes for investing, tend to mitigate environmental and social risks and tends to have stronger cash flows, lower borrowing costs and durable returns.

Capital Markets: Challenges and Developments

What is Infrastructure Investment Trusts (InvITs)?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : REITs, INVITs

Mains level : Not Much

The National Highways Authority of India (NHAI) has come up with its Infrastructure Investment Trust (InvIT) issue.

Try this PYQ:

Q.Which of the following is issued by registered foreign portfolio investors to overseas investors who want to be part of the Indian stock market without registering themselves directly?

(a) Certificate of Deposit

(b) Commercial Paper

(c) Promissory Note

(d) Participatory Note

Significance of the issue

  • The issue will enable NHAI to monetize its completed National Highways that have a toll collection track record of at least one year.
  • The NHAI reserves the right to levy a toll on identified highways and it will help the company raise funds for more road development across the country.

What are InvITs?

  • Infrastructure investment trusts are institutions similar to mutual funds, which pool investment from various categories of investors and invest them into completed and revenue-generating infrastructure projects, thereby creating returns for the investor.
  • Structured like mutual funds, they have a trustee, sponsor(s), investment manager and project manager.
  • While the trustee (certified by Sebi) has the responsibility of inspecting the performance of an InvIT, sponsor(s) are promoters of the company that set up the InvIT.
  • In the case of Public-private partnership (PPP) projects, it refers to the infrastructure developer or a special purpose vehicle holding the concession.
  • While the investment manager is entrusted with the task of supervising the assets and investments of the InvIT, the project manager is responsible for the execution of the project.

How will it work for NHAI?

  • NHAI’s InvIT will be a Trust established by NHAI under the Indian Trust Act, 1882 and SEBI regulations.
  • The InvIT Trust will be formed the objective of investing primarily in infrastructure projects.
  • The fund raised can be invested in the project SPVs by way of an issue of debt.
  • The trust can utilise it to repay their loans or even for prepayment of certain unsecured loans and advances.

Why does NHAI need fund?

  • At a time when private sector investment in the economy has declined, fund-raising by NHAI and spending on infrastructure will not only provide a fillip to the economy but will also crowd-in private sector investment.
  • So NHAI’s InvIT offer is a way for the government to tap alternative sources of financing to boost public spending in the roads and infrastructure sector.
  • It is important to note that in October 2017, the Centre had launched Bharatmala Pariyojana, its flagship highway development programme, for development of 24,800 km of roads.
  • In order to complete the projects, NHAI needs adequate funds and one of the options is to monetize the completed and operational NH assets.

How does it benefit the investor?

  • Retail or even large financial investors may not be typically able to invest in infrastructure projects such as roads, power, energy etc.
  • InvITs enable these investors to buy a small portion of the units being sold by the fund depending upon their risk appetite.
  • Given that such trusts comprise largely of completed and operational projects with positive cash flow, the risks are somewhat contained.
  • The investors can benefit from the cash flow that gets distributed as well as in capital appreciation of the units.
  • Unitholders also benefit from favourable tax norms, including exemption on dividend income and no capital gains tax if units are held for more than three years.

Capital Markets: Challenges and Developments

What are Interest Rate Derivatives (IRDs)?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Foreign portfolio investment (FPI)

Mains level : Not Much

The RBI has proposed allowing foreign portfolio investors (FPIs) to undertake exchange-traded rupee interest rate derivatives transactions subject to an overall ceiling of ₹5,000 crores.

Every year, there is a question on a capital market instruments. Make note of all such separately. Also, try this PYQ:

Q. Which of the following is issued by registered foreign portfolio investors to overseas investors who want to be part of the Indian stock market without registering themselves directly? (CSP 2019)

(a) Certificate of Deposit

(b) Commercial Paper

(c) Promissory Note

(d) Participatory Note

Interest Rate Derivatives (IRDs)

  • An IDR is a financial instrument with a value that is linked to the movements of an interest rate or rates.
  • These may include futures, options, or swaps contracts.
  • They are often used by institutional investors, banks, companies, and individuals to protect themselves against changes in market interest rates.
  • The proposed directions by RBI are aimed at encouraging higher non-resident participation, enhance the role of domestic market makers in the offshore market, improve transparency, and achieve better regulatory oversight, according to the central bank.

Back2Basics: Foreign portfolio investment (FPI)

  • FPI involves holding financial assets from a country outside of the investor’s own.
  • FPI holdings can include stocks, ADRs, GDRs, bonds, mutual funds, and exchange-traded funds.
  • Along with foreign direct investment (FDI), FPI is one of the common ways for investors to participate in an overseas economy, especially retail investors.
  • Unlike FDI, FPI consists of passive ownership; investors have no control over ventures or direct ownership of property or a stake in a company.

FPI vs FDI

  • With FPI—as with portfolio investment in general—an investor does not actively manage the investments or the companies that issue the investments.
  • They do not have direct control over the assets or the businesses.
  • In contrast, foreign direct investment (FDI) lets an investor purchase a direct business interest in a foreign country.

Capital Markets: Challenges and Developments

What is the Business Responsibility Report?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : BRR

Mains level : Not Much

In efforts to have a single source for all non-financial disclosures by corporates, a government-appointed panel has made various proposals on business responsibility reporting, including putting in place two formats for disclosing information.

Try this PYQ:

Which one of the following is not a feature of Limited Liability Partnership firm? (CSP 2010)

(a) Partners should be less than 20

(b) Partnership and management need not be separate

(c) Internal governance may be decided by mutual agreement among partners

(d) It is corporate body with perpetual succession

What is the Business Responsibility Report (BRR)?

  • Business Responsibility  Report is a disclosure of the adoption of responsible business practices by a  listed company to all its stakeholders.
  • This is important considering the fact that these companies have accessed funds from the public, have an element of public interest involved, and are obligated to make exhaustive disclosures on a regular basis.
  • BSR is to be submitted as a part of the Annual Report.
  • It contains a standardized format for companies to report the actions undertaken by them towards the adoption of responsible business practices.
  • It has been designed to provide basic information about the company, information related to its performance and processes, and information on principles and core elements of the BSR.

SEBI recommendations for BSR

  • As per the report, reporting may be done by top 1,000 listed companies in terms of their market capitalization or as prescribed by markets regulator SEBI.
  • The reporting requirement may be extended by MCA (Ministry of Corporate Affairs) to unlisted companies above specified thresholds of turnover and/ or paid-up capital.
  • The panel has suggested two formats for disclosures — a comprehensive format and a “lite version” — and also called for the implementation of the reporting requirements in a gradual and phased manner.
  • Smaller unlisted companies may adopt a lite version of the format, on a voluntary basis.

Capital Markets: Challenges and Developments

What are Social Stock Exchanges?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Social Stock Exchanges (SSEs)

Mains level : NGOs and their funding issues

A working group constituted by the Securities and Exchange Board of India (SEBI) on Social Stock Exchanges (SSEs) has recommended allowing non-profit organisations to directly list on such platforms.

Practice questions for mains:

Q. What are Social Stock Exchanges? Discuss how it will help finance social enterprises in India.

What are Social Stock Exchanges (SSEs)?

  • An SSE is a platform which allows investors to buy shares in social enterprises vetted by an official exchange.
  • The Union Budget 2019 proposed setting up of first of its kind SSE in India.
  • The SSE will function as a common platform where social enterprises can raise funds from the public.
  • It will function on the lines of major stock exchanges like BSE and NSE. However, the purpose of the Social Stock Exchange will be different – not profit, but social welfare.
  • Under the regulatory ambit of SEBI, a listing of social enterprises and voluntary organizations will be undertaken so that they can raise capital as equity, debt or as units like a mutual fund.

Why SSEs?

  • India needs massive investments in the coming years to be able to meet the human development goals identified by global bodies like the UN.
  • This can’t be done through government expenditure alone. Private enterprises working in the social sector also need to step up their activities.
  • Currently, social enterprises are very active in India. However, they face challenges in raising funds.
  • One of the biggest hurdles they face is, apparently, the lack of trust from common investors.

Benefits

  • There is a great opportunity to unlock funds from donors, philanthropic foundations and CSR spenders, in the form of zero-coupon zero principal bonds. These bonds will be listed on the SSE.
  • At first, the SSE could become a repository of social enterprises and impact investors.
  • The registration could be done through a standard process.
  • The SEs could be categorized into different stages such as- Idea, growth stage and likewise, investors can also be grouped based on the type of investment.

Capital Markets: Challenges and Developments

Minimum Public Shareholding (MPS) Requirement

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Minimum Public Shareholding (MPS)

Mains level : Not Much

The Securities and Exchange Board of India (SEBI) has relaxed the 25 per cent minimum public shareholding norm and advised exchanges not to take penal action till August 2020 in case of non-compliance.

A statement based question can be asked about the SEBI in the prelim asking-

If it is a statutory or quasi-judicial body ; Scope of its regulation; Appointment of its chairman etc..

What is a Public Shareholding Company?

  • A Public Shareholding Company is a company whose capital is divided into shares of equal value, which are transferable.
  • Shareholders of a Public Shareholding Company are not liable for the company’s obligations except for the amount of the nominal value of the shares for which they subscribe.

What is MPS requirement?

  • The 25 per cent MPS norms were introduced in 2013, whereby no listed company was permitted to have more than 75 per cent promoter stake.
  • The rules were aimed at improving liquidity and better stock price discovery by making higher float available with public.
  • The average promoter holding in India is among the highest globally.
  • Last year, the government had proposed to increase the minimum public float from the current 25 per cent to 35 per cent. It had met with opposition, forcing the government to drop the plan.

Why ease MPS norms?

  • The Sebi move is aimed at easing such compliance rules amid the disruptions caused by the coronavirus pandemic.
  • The decision has been taken after receiving requests from listed entities and industry bodies as well as considering the prevailing business and market conditions.
  • As per the norms, exchanges can impose a fine of up to Rs 10,000 on companies for each day of non-compliance with MPS requirements.
  • Besides, exchanges can intimate depositories to freeze the entire shareholding of the promoter and promoter group. This circular will come into force with immediate effect.

Back2Basics: Securities and Exchange Board of India (SEBI)

  • The SEBI is the regulator of the securities and commodity market in India.
  • It was first established in 1988 as a non-statutory body for regulating the securities market.
  • It became an autonomous body on 12 April 1992 and was accorded statutory powers with the passing of the SEBI Act 1992.
  • SEBI has to be responsive to the needs of three groups, which constitute the market:

1) issuers of securities

2) investors

3) market intermediaries

Capital Markets: Challenges and Developments

Sovereign Gold Bonds: A substitute for physical gold

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Sovereign Gold Bonds

Mains level : Not Much

Gold bond prices rise to near record highs after the second tranche of subscription were closed.

Questions based on capital markets are quite frequent these years.  Consider this-

Which of the following is issued by registered foreign portfolio investors to overseas investors who want to be part of the Indian stock market without registering themselves directly? (CSP 2019)

(a) Certificate of Deposit

(b) Commercial Paper

(c) Promissory Note

(d) Participatory Note

What is a Sovereign Gold Bond (SGB)?

  • SGB is a substitute for holding physical gold.
  • The bonds are issued by the RBI on behalf of the government and are a bond denominated in gold.
  • The government issues such bonds in tranches at a fixed price that investors can buy through banks, post offices and also in the secondary markets through the stock exchange platform.

What are the benefits of buying SGB?

  • These bonds are backed by a sovereign guarantee and can also be held in Demat form.
  • Further, they are priced as per the underlying spot gold prices.
  • Hence, investors who want to invest in gold can buy the bonds without worrying about the safekeeping of physical gold along with locker charges, making charges or purity issues.
  • Plus, these bonds offer interest at the rate of 2.5% per annum on the principal investment amount.
  • While the interests on the bonds are taxable, the capital gains at the time of redemption are exempt from tax.
  • These bonds can also be used as collateral for availing loans from banks and NBFCs.

How are the bonds structured?

  • SGB has a fixed tenure of eight years, though early redemption is allowed after the fifth year from issuance.
  • Since the bonds are listed on the exchange, these can be transferred to other investors as well.
  • The bonds are priced in rupees based on the simple average of the closing price of gold of 999 purity which published by the India Bullion and Jewellers Association.
  • At the time of redemption, cash equivalent to the number of units multiplied by the then prevailing price would be credited to the bank account of the investor.

Are there any risks in investing in SGB?

  • A capital loss is a risk since the bond prices would reflect any change in gold prices.
  • If gold prices fall, the principal investment would fall proportionately.

Why need such bonds?

  • The gold demand rises in times of uncertainty or high inflation.
  • Gold demand is mostly met through imports
  • Years of high imports are ones of high current account deficits which, in turn, have weakened the rupee.
  • It is to reduce this huge import bill that, in November 2015, the government tried to introduce gold bonds.

Capital Markets: Challenges and Developments

 Indian Debt market, that never was

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Asset-to-liability mismatch, Types of debt markets, Priority sector lending certificates, roll-over etc.

Mains level : Paper 3- What is the importance of debt market for the economy of a country? What are the factor responsible for the shallowness of the India's debt market?

India’s bond market suffers from several issues. This article discusses such issues, and also highlights the recent positive trends seen in the debt market owing to several steps taken by the government.

The Indian debt market, primarily of the fixed-income variety, can be broadly classified into:

  • 1. Money Market
  • Where the borrowing is for a tenor of less than a year.
  • Different types of money market instruments: Inter-Bank Term Money, repo transactions, Certificate of Deposits, Commercial Papers, T-Bills, etc. are some of the money market instruments.
  • Through these instruments, short term requirement of funds is met by banks, institutions and the state and central governments.
  • 2. Bank and Corporate Deposits
  • Bank fixed deposits (FDs) have been popular and widely subscribed to, as the feeling of no-default-risk.
  • Corporate deposits are FDs issued by a company (non-bank).
  • 3. Government Securities
  • G-Secs are sovereign-rated debt papers, issued by the government with a face value of a fixed denomination.
  • 4. Corporate & PSU Bond Market
  • Corporate bonds are issued by public sector undertakings (PSUs) and private firms.
  • These bonds are issued for a wide tenor between 1 year – 15 years.
  • These bonds carry a different risk profile and hence will have associated rating.

Debt market plays a significant role in the economy of a country. But India’s debt market suffers from shallowness. Some of the steps taken by the government to improve the situation have been showing positive trends. In the light of this development, the UPSC can frame a direct question, for ex. “What are the factors responsible for the shallowness of the debt market in India? Suggest ways to increase the depth of the debt market in India.”

What are the problems of India’s debt market?

  • Wholesale market: The Indian debt market is largely a wholesale market.
  • It is a wholesale market in a sense that a majority of institutional investors comprises of mainly banks, financial institutions, mutual funds, EPFO, insurance companies and corporates.
  • The concentration of these large players has resulted in the debt markets being fairly skewed, evolving into a wholesale & bilaterally-priced trades.
  • Lack of retail sell and transparency: It also lacks the retailness and the contractual transparency that the Indian capital markets have been able to build in the past 2 decades.
  • Skewed towards G-secs: Structurally, the debt market remains firmly skewed towards government securities (G-secs).
  • Also, the largest investor group in the G-secs market are the banks, due to their regulatory requirement to invest in SLR.
  • Low and unstable trading in the corporate bond market: The Indian corporate bond market has low & unstable trading volumes.
  • Sadly, the corporate bond market remains largely about top-rated financial and public sector issuances.
  • The domestic debt managers have forgotten that the logic of the business of finance is “to price the risk”.

Regulation and comparison with other countries

  • RBI regulates money markets & G-secs.
  • SEBI regulates the Corporate debt market & bond markets.
  • The domestic debt market in India amounts to about 67% of GDP.
  • The size of India’s corporate bond market is a mere 16% of GDP — compared with 46% in Malaysia, and 73% in South Korea.

The recent positive trend in the debt market

  • In the past few years, the domestic corporate bond market had seen increasing volumes, largely due to financial investments going into it, including retail participation.
  • Also, the banks had ceded space to NBFCs over past many years.
  • This is because banks found it easier to buy securitisation pools to achieve their PSL targets rather than develop competencies that NBFCs had built-in serving affinity groups, in smaller cities & towns.
  • And post the ILFS crisis, the markets have started shunning non-banks again.
  • Policy initiative by the government: The various policy initiatives undertaken in the last few years would take time to fructify and to stabilise.
  • These include the IBC, SEBI’s bond market policies, RBI’s large borrower framework for enhancing credit supply.
  • Some of these have already seen changes/addendums to the original draft, with the intent being to course-correct, for the stability of the markets.

Roll over of debt papers in India

  • We have seen liquidity problems in our markets every few years.
  • The concept of “roll-over” of debt paper was usual as our markets did not build long term papers.
  • With the ILFS slowdown, it was easy for name-calling on “ALM mismatch” concept.
  • Not much had been anyways done before and later to address the availability of debt to reduce the Asset-to-Liability mismatches.
  • Also, we have played it safe so far by even lending for large infra projects with shorter paper and hoped to roll it over at the end of the debt term.

Conclusion

This is the time that our regulators need to work along with the various governments, especially the states, for smoother ironing of fiscal hiccups and use this to redress any structural glitches. It’s time that there is actual intent to deepen the domestic debt market and to listen to the industry about their requirements.


Back2Basics: What is ASM?

  • Banks’ primary source of funds is deposits, which typically have short- to medium-term maturities.
  • They need to be paid back to the investor in 3-5 years.
  • In contrast, banks usually provide loans for a longer period to borrowers.
  • Home loans, for instance, can have a tenure of up to 20 years.
  • Providing such loans from much shorter maturity funds is called an asset-liability mismatch.
  • It creates risks for banks that need to be managed.
  • The most serious consequences of asset-liability mismatch are interest rate risk and liquidity risk.
  • Because deposits are of shorter maturity they are repriced faster than loans.
  • Every time a deposit matures and is rebooked if the interest rates have moved up the bank will have to pay a higher rate on them.
  • But the loans cannot be repriced that easily. Because of this faster adjusting of deposits to interest rates asset-liability mismatch affects net interest margin or the spread banks earn.

Priority Sector Lending (PSL)

  • Priority Sector Lending is an important role given by the (RBI) to the banks for providing a specified portion of the bank lending to few specific sectors like agriculture and allied activities, micro and small enterprises, poor people for housing, students for education and other low-income groups and weaker sections etc.

Roll over of debt

  • When debt becomes due there is a need to either repay the principal or alternatively, to enter into a new agreement.
  • Structurally, funds from the second debt are used to repay the first debt.
  • Then you repay the second debt as required. Quite often these new terms will be agreed with the initial lender.
  • In essence, you’re ‘rolling’ the repayment obligation from one period into the next.
  • This all leads to rollover risk, which is the risk you that you won’t be able to find anyone willing to lend the value of the outstanding debt and/or offer a comparable rate as the first principle repayment obligation approaches.
  • This may be due to either movement in the borrowers perceived credit status and/or changes to the broader credit environment.
  • This was a key theme during the financial crisis of 2007 – 2008.
  • The reasons for refinancing may include the above, but also other themes such as debt consolidation (which doesn’t directly imply a change to the debt term).

Capital Markets: Challenges and Developments

What is Operation Twist?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Operation Twist, OMOs

Mains level : Operation Twist

The Reserve Bank of India (RBI) has announced simultaneous purchase and sale of government bonds in a bid to soften long-term yields under its Operation Twist.

Operation Twist

  • Operation Twist is a move taken by U.S. Federal Reserve in 2011-12 to make long-term borrowing cheaper.
  • It first appeared in 1961 as a way to strengthen the U.S. dollar and stimulate cash flow into the economy.
  • It is the name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds.
  • The operation describes a form of monetary policy where the bank buys and sells short-term and long-term bonds depending on their objective.

Its genesis

  • The name “Operation Twist” was given by the mainstream media due to the visual effect that the monetary policy action was expected to have on the shape of the yield curve.
  • If we visualize a linear upward sloping yield curve, this monetary action effectively “twists” the ends of the yield curve, hence, the name Operation Twist.
  • To put another way, the yield curve twists when short-term yields go up and long-term interest rates drop at the same time.

 Back2Basics: Open Market Operations

  • Open market operations are the sale and purchase of government securities and treasury bills by RBI or the central bank of the country.
  • The objective of OMO is to regulate the money supply in the economy.
  • When the RBI wants to increase the money supply in the economy, it purchases the government securities from the market and it sells government securities to suck out liquidity from the system.
  • OMO is one of the tools that RBI uses to smoothen the liquidity conditions through the year and minimise its impact on the interest rate and inflation rate levels.

Capital Markets: Challenges and Developments

How a dollar swap line with US Fed can help in uncertain times?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Currency Swap

Mains level : Currency Swap and its significance

India is working with the US to secure a dollar swap line that would help in better management of its external account and provide an extra cushion in the event of an abrupt outflow of funds.

What are Currency Swaps?

  • A currency swap, also known as a cross-currency swap, is an off-balance sheet transaction in which two parties exchange principal and interest in different currencies.
  • The purpose of a currency swap is to lower exposure to exchange rate risk or reduce the cost of borrowing a foreign currency.

Why do we need dollars?

  • According to RBI data, 63.7% of India’s foreign currency assets — or $256.17 billion — are held in overseas securities, mainly in the US treasury.
  • While FPIs investors looking for safer investments, the current global uncertainty over COVID outbreak have led to a shortfall in Indian stock markets.
  • This has pulled down India’s foreign exchange reserves.
  • This means that the government and the RBI cannot lower their guard on the management of the economy and the external account.

How does a swap facility work?

  • In a swap arrangement, the US Fed provides dollars to a foreign central bank, which, at the same time, provides the equivalent funds in its currency to the Fed, based on the market exchange rate at the time of the transaction.
  • The parties agree to swap back these quantities of their two currencies at a specified date in the future, which could be the next day or even three months later, using the same exchange rate as in the first transaction.
  • These swap operations carry no exchange rate or other market risks, as transaction terms are set in advance.

Benefits of currency swap

  • The absence of an exchange rate risk is the major benefit of such a facility.
  • This facility provides India with the flexibility to use these reserves at any time in order to maintain an appropriate level of balance of payments or short-term liquidity.
  • currency swaps between governments also have supplementary objectives like promotion of bilateral trade, maintaining the value of foreign exchange reserves with the central bank and ensuring financial stability (protecting the health of the banking system).

Recent examples

  • India already has a $75 billion bilateral currency swap line with Japan, which has the second-highest dollar reserves after China.
  • The RBI also offers similar swap lines to central banks in the SAARC region within a total corpus of $2 billion.

Note: Relate all other terminologies related to USD-INR convertiblity viz. Current Account, BoP etc.

Capital Markets: Challenges and Developments

Euro Zone ‘Coronabonds’

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Coronabonds, Eurozone

Mains level : Not Much

The coronavirus pandemic has revived the acrimonious debate between euro zone countries about jointly issuing debt through instruments called Coronabonds.

Coronabonds

  • Coronabonds are proposed debt instruments amongst EU member states, with the aim of providing financial relief to Eurozone countries battered by the coronavirus.
  • They aim to meet healthcare needs and address the deep economic downturn that is set to follow.
  • The funds would be mutualised and supplied by the European Investment Bank, with the debt taken collectively by all member states of the European Union.
  • The euro zone jointly issues debt through its bailout fund, the European Stability Mechanism, which borrows on the market against the security of its paid-in and callable capital provided by euro zone governments.

Back2Basics

What is Eurozone?

  • The Eurozone officially called the euro area is a monetary union of 19 of the 27 European Union (EU) member states which have adopted the euro as their common currency and sole legal tender.
  • The monetary authority of the Eurozone is the Eurosystem.
  • It consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.

Capital Markets: Challenges and Developments

India VIX Index

Note4Students

From UPSC perspective, the following things are important :

Prelims level : India VIX Index

Mains level : Impact of coronovirus outbreak on Economy

The  India VIX Index, an indicator of the volatility of the stock market has been plunging after the outbreak of novel coronavirus.

What is Volatility Index?

  • Volatility Index is a measure of the market’s expectation of volatility over the near term.
  • Volatility is often described as the “rate and magnitude of changes in prices” and in finance often referred to as risk.
  • It is a measure, of the amount by which an underlying Index is expected to fluctuate, in the near term, (calculated as annualized volatility, denoted in percentage e.g. 20%) based on the order book of the underlying index options.

India VIX Index

  • India VIX is a volatility index based on the NIFTY Index Option prices.
  • From the best bid-ask prices of NIFTY Options contracts, a volatility figure (%) are calculated which indicates the expected market volatility over the next 30 calendar days.
  • “VIX” is a trademark of Chicago Board Options Exchange, Incorporated (“CBOE”) and Standard & Poor’s.
  • The firm has granted a license to NSE to use such mark in the name of the India VIX and for purposes relating to the India VIX.

Capital Markets: Challenges and Developments

Short Selling of Stocks

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Short selling of stocks

Mains level : Stock prices volatility: Various causative factors

The stock exchanges have clarified that the Securities and Exchange Board of India (SEBI) was not considering any proposal regarding a ban on short selling to curb the ongoing volatility and equity sell-off.

What is Short Selling?

  • Short-selling allows investors to profit from stocks or other securities when they go down in value.
  • In order to do a short sale, an investor has to borrow the stock or security through their brokerage company from someone who owns it.
  • The investor then sells the stock, retaining the cash proceeds.
  • The short-seller hopes that the price will fall over time, providing an opportunity to buy back the stock at a lower price than the original sale price.
  • Any money left over after buying back the stock is profit to the short-seller.

When does short-selling makes sense?

  • Most investors own stocks, funds, and other investments that they want to see rise in value.
  • Over time, the stock market has generally gone up, albeit with temporary periods of downward movement along the way.
  • For long-term investors, owning stocks has been a much better bet than short-selling the entire stock market.
  • Sometimes, though, you’ll find an investment that you’re convinced will drop in the short term (as in case of COVID 19 outbreak).
  • In those cases, short-selling can be the easiest way to profit from the misfortunes that a company is experiencing.
  • Even though short-selling is more complicated than simply going out and buying a stock, it can allow making money when others are seeing their investment portfolios shrink.

The risks of short-selling

  • Short-selling can be profitable when one makes the right call, but it carries greater risks than what ordinary stock investors experience.
  • When we buy a stock, the most we can lose is what you pay for it. If the stock goes to zero, we suffer a complete loss, but will never lose more than that.
  • By contrast, if the stock soars, there’s no limit to the profits one can enjoy. With a short sale, however, that dynamic is reversed.

Example:

  • For instance, say you sell 100 shares short at a price of $10 per share. Your proceeds from the sale will be $1,000.
  • If the stock goes to zero, you’ll get to keep the full $1,000. However, if the stock soars to $100 per share, you’ll have to spend $10,000 to buy the 100 shares back.
  • That will give you a net loss of $9,000 — nine times as much as the initial proceeds from the short sale.

Capital Markets: Challenges and Developments

The circuit breaker in the stock market

The stock markets in India are witnessing historic single-day falls with an increase in the number of COVID-19 cases.  Since the indexes plunged more than 10 per cent each day earlier, a circuit breaker was triggered for the first time since 2009 halting trading.

What are circuit breakers?

  • In June 2001, the SEBI implemented index-based market-wide circuit breakers.
  • Circuit breakers are triggered to prevent markets from crashing, which happens when market participants start to panic induced by fears that their stocks are overvalued and decide to sell their stocks.
  • This index-based market-wide circuit breaker system applies at three stages of the index movement, at 10, 15 and 20 per cent.
  • When triggered, these circuit breakers bring about a coordinated trading halt in all equity and equity derivative markets nationwide.

 

Capital Markets: Challenges and Developments

AT-1 bonds

Note4Students

From UPSC perspective, the following things are important :

Prelims level : AT-1 Bonds

Mains level : Read the attached story

India’s fourth-largest private lender YES bank was placed under a moratorium by RBI and its perpetual debt additional tier-1 (AT1 bonds) would become worthless if RBI does ask mutual funds to write down their value.

What are AT1 bonds?

  • AT-1, short for Additional Tier-1 bonds, are a type of unsecured, perpetual bonds that banks issue to shore up their core capital base to meet the Basel-III norms.
  • AT-1 bonds are complex hybrid instruments, ideally meant for institutions and smart investors who can decipher their terms and assess if their higher rates compensate for their higher risks.
  • They carry a face value of ₹10 lakh per bond.
  • There are two routes through which retail folk have acquired these bonds — initial private placement offers of AT-1 bonds by banks seeking to raise money; or secondary market buys of already-traded AT-1 bonds based on recommendations from brokers.

Why are they important?

AT-1 bonds have several unusual features lurking in their fine print, which make them very different from plain bonds.

  • One, these bonds are perpetual and carry no maturity date. Instead, they carry call options that allow banks to redeem them after five or 10 years. But banks are not obliged to use this call option and can opt to pay only interest on these bonds for eternity.
  • Two, banks issuing AT-1 bonds can skip interest payouts for a particular year or even reduce the bonds’ face value without getting into hot water with their investors, provided their capital ratios fall below certain threshold levels. These thresholds are specified in their offer terms.
  • Three, if the RBI feels that a bank is tottering on the brink and needs a rescue, it can simply ask the bank to cancel its outstanding AT-1 bonds without consulting its investors. This is what has happened to YES Bank’s AT-1 bond-holders who are said to have invested ₹10,800 crore.

Capital Markets: Challenges and Developments

Dividend Distribution Tax (DDT)

Note4Students

From UPSC perspective, the following things are important :

Prelims level : DDT

Mains level : Not Much

 

Finance Minister announced abolition of DDT to be paid by companies in her budget speech.

What is DDT?

  • A dividend is a return given by a company to its shareholders out of the profits earned by the company in a particular year.
  • Dividend constitutes income in the hands of the shareholders which ideally should be subject to income tax.
  • However, the income tax laws in India provide for an exemption of the dividend income received from Indian companies by the investors by levying a tax called the DDT on the company paying the dividend.

Who were required paid DDT?

  • Any domestic company which is declaring/distributing dividend is required to pay DDT at the rate of 15% on the gross amount of dividend as mandated under Section 115O of the Income Tax Act.
  • DDT was also applicable on mutual funds.

Why it is scrapped?

  • Every MNE investing in India is faced with the question of tax-efficient repatriation of profits that accumulate here.
  • The dividend that the holding company would receive would have already suffered substantial tax in India, although indirectly.
  • The foreign company would normally be required to pay tax on the dividend so received in its home jurisdiction.
  • DDT being a tax in the Indian company and the foreign company not paying taxes directly on such dividend income in India, it would not be able to claim foreign tax credit in its home jurisdiction.
  • This resulted in a double whammy for foreign companies as, at a group level, they suffered double taxation.

Capital Markets: Challenges and Developments

InvITs and REITs

Note4Students

From UPSC perspective, the following things are important :

Prelims level : InvITs and REITs

Mains level : Not Much

 

Markets regulator SEBI has put in place a framework for the rights issue of units by listed REIT and InvITs.

What are InvITs and REITs?

Infrastructure Investment Trusts (InvIT)

  • An Infrastructure Investment Trust (InvITs) is like a mutual fund, which enables direct investment of small amounts of money from possible individual/institutional investors in infrastructure to earn a small portion of the income as return.
  • InvITs work like mutual funds or real estate investment trusts (REITs) in features.
  • InvITs can be treated as the modified version of REITs designed to suit the specific circumstances of the infrastructure sector.
  • They are similar to REIT but invest in infrastructure projects such as roads or highways which take some time to generate steady cash flows.

Real Estate Investment Trusts (REIT)

  • A REIT is roughly like a mutual fund that invests in real estate although the similarity doesn’t go much further.
  • The basic deal on REITs is that you own a share of property, and so an appropriate share of the income from it will come to you, after deducting an appropriate share of expenses.
  • Essentially, it’s like a group of people pooling their money together and buying real estate except that it’s on a large scale and is regulated.
  • The obvious pitch for a REIT is that it enables individuals to generate income and capital appreciation with money that is a small fraction of what would be required to buy an entire property.
  • However, the resemblance to either mutual funds or to owning property ends there.
  • According to Indian regulation on REITs, these are meant to primarily own finished and rented out commercial properties –– 80 per cent of the investments must be in such assets. That excludes a real estate that is under development.

Why need InvITs and REITs?

  • Infrastructure and real estate are the two most critical sectors in any developing economy.
  • A well-developed infrastructural set-up propels the overall development of a country.
  • It also facilitates a steady inflow of private and foreign investments, and thereby augments the capital base available for the growth of key sectors in an economy, as well as its own growth, in a sustained manner.
  • Given the importance of these two sectors in the country, and the paucity of public funds available to stimulate their growth, it is imperative that additional channels of financing are put in place.

What did SEBI rule?

  • SEBI said the issuer will have to disclose objects of the issue, related-party transactions, valuation, financial details, review of credit rating and grievance redressal mechanism in the placement document.
  • The SEBI had first notified REITs and InvIT Regulations in 2014, allowing setting up and listing of such trusts which are popular in some advanced markets.

Capital Markets: Challenges and Developments

[op-ed of the day] Revisiting the NBFC Crisis

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Types of NBFC.

Mains level : Paper 3- NBFC crisis.

Context

While India was trying to deal with the problems arising out of the large NPA accumulated by the commercial banks, the Indian financial sector was dealt with another blow in the form of the NBFC crisis.

Effects of IL&FS and DHFL collapse:

  • Balance sheets affected: The collapse of these two big entities affected the balance sheets of banks and mutual fund companies.
  • Credit crunch: It also resulted in a credit crunch that dampened demand and pushed a slowing economy towards recession.
  • Tarnished image of NBFCs: Being leaders in the industry, their failure has tarnished the image of the NBFC sector as a whole.

Types of NBFCs and their numbers

  • Total number: As of September 2019 there were a total 9,642 NBFCs in India.
  • Deposit-taking NBFC (NBFCs-D): Only 82 of India’s NBFCs were deposit-taking institutions (NBFCs-D) permitted to mobilise and hold deposits.
  • Non-deposit taking NBFCs (NBFCs-ND): The rest of the NBFCs which are not deposit-taking, are categorised as non-deposit taking NBFCs.
    • They did not have access to the savings of ordinary households.
    • For this reason, the majority of these institutions were not considered to be entities that needed strict regulation
  • Systematically important (NBFCs-ND-SI): Of a large number of non-deposit taking NBFCs (NBFCs-ND), only 274 were identified as being systematically important (NBFCs-ND-SI), by virtue of having an asset size of ₹500 crores or more.

Significance of NBFCs as expressed by assets holdings

  • A significant player in the financial markets: As at the end of March 2019, these two sets-NBFCs-D and NBFC-ND-SI- held assets that amounted to almost a fifth of that held by the scheduled commercial banks.
    • This made them significant players in the web of credit, as well as large enough as a group to affect the health of the financial sector.
  • Non-deposit taking NBFCs must rely on resources garnered from the “market,” including the banking system, besides the market for bonds, debentures, and short-term paper.
  • Extension of financial entities: Individual investors would only be marginally involved in direct investment in these instruments.
    • So, the NBFCs are essentially extensions of the activity of other financial entities such as banks, insurance companies, and mutual funds.

Concentrated lending by NBFCs

  • Industry getting lion’s share: Industry accounted for the biggest chunk of lending, amounting to 57% of gross advances in September 2019.
    • Much of this lending to industry went to the infrastructural sector.
  • At second place-retail sector: A second major target for lending by the NBFCs was the retail sector, with retail loans accounting for 20% of gross advances.
    • Within the retail sector, vehicle/auto loans accounted for as much as 44% of loans.

What went wrong?

  • Diversification by commercial banks: Following a surge in capital flows into India which began in 2004, banks were flush with liquidity.
    • Under pressure to lend and invest to cover the costs of capital and intermediation and earn a profit, banks were looking for new areas into which they could move
    • Increase in retail lending by banks: The pressure resulted in a significant increase in retail lending, with lending for housing, automobiles and consumer durables.
    • There was also a substantial increase in lending to the infrastructural sector and commercial real estate.
  • Why NBFCs flourished even in the face of competition by banks? What the growth of the NBFCs indicates is that banks were unable to exhaust the liquidity at their disposal.
    • Banks were also unable to satisfy the potential for lending to these sectors, providing a space for NBFCs to flourish.
  • The willingness of NBFCs suited the banks: The willingness of the NBFCs to enter these areas suited the banks in two ways.
    • First, it permitted the banks to use their liquidity even when they themselves were stretched and could not discover, scrutinise and monitor new borrowers.
    • Banks could lend to the NBFCs, which could then take on the tasks associated with expanding the universe of borrowers to match the increased access to liquid funds.
    • The second was that it helped the banks to move risks out of their own books.
  • Short term lending to NBFCs, and long-term lending by NBFCs: Banks accepts short term deposits, so there is limit in their ability to lend that short term deposits as a long term debt.
    • On the other hand, these were the sectors to which additional credit could be easily pushed.
    • Lending to NBFCs that in turn lent to these sectors, appeared to be a solution to the problem.
    • Bank lending to the NBFCs was short term, and the latter used these short-term funds to provide long-maturity loans
    • NBFCs expected that they would be able to roll over much of these loans so that they were not capital short.
    • Role of rating agencies: What they needed for the purpose were ratings that ranked their instruments as safe.
    • The ratings companies were more than willing to provide such ranks.
  • The two risks involved in this model: The NBFC-credit build-up was an edifice that was burdened with two kinds of risks.
    • First risk: A possible default on the part of borrowers.
    • The probability of which only increases as the universe of borrowers is expanded rapidly to exhaust the liquidity at hand.
    • The second risk: The second was the possibility that developments in the banking sector and other segments of the financial sector would reduce the appetite of these investors for the debentures, bonds and commercial paper issued by the NBFCs
    • Since the NBFCs banked on being able to roll-over short-term debt to sustain long-term lending.
    • A slowdown in or halt to the flow of funds would lead to a liquidity crunch that can damage the balance sheet of these institutions.
  • Which of the two risks is involved in the present crisis? The crisis that affected the NBFCs was a result of both kinds of setbacks.
    • First setback: Loans to areas like infrastructure, commercial real estate and housing went bad.
    • Second setback: With the non-performing assets problem in the commercial banking sector curtailing their access to bank lending.
  • Why the problem turned systemic? Given the importance of ratings and “image” in ensuring access to capital, some firms with the requisite image were able to mobilise large sums of capital and expand their business.
    • When entities like that go bust, the response of lenders and investors to the event tends to be drastic, with systemic effects on the sector as a whole.

Conclusion

The episode was a shadow banking crisis that has had far-reaching consequences for the economy as a whole. Therefore, its high time that measures are taken to avoid the occurrence of such a crisis in the future.

Capital Markets: Challenges and Developments

[pib] Bharat Bond Exchange Traded Fund (ETF)

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Bharat Bond Exchange Traded Fund (ETF)

Mains level : Not Much

The Union Cabinet has given its approval for creation and launch of Bharat Bond Exchange Traded Fund (ETF).

Bharat Bond ETF

  • Bharat Bond ETF would be the first corporate Bond ETF in the country.
  • It aims to create an additional source of funding for Central Public Sector Undertakings (CPSUs) Central Public Sector Enterprises (CPSEs), Central Public Financial Institutions (CPFIs) and other Government organizations.
  • ETF will be a basket of bonds issued by CPSE/CPSU/CPFI/any other Government organization Bonds.
  1. Tradable on exchange
  2. Small unit size Rs 1,000
  3. Transparent NAV (Periodic live NAV during the day)
  4. Transparent Portfolio (Daily disclosure on website)
  5. Low cost (0.0005%)

Bharat Bond ETF Structure:

  • Each ETF will have a fixed maturity date
  • The ETF will track the underlying Index on risk replication basis, i.e. matching Credit Quality and Average Maturity of the Index
  • Will invest in a portfolio of bonds of CPSE, CPSU, CPFI or any other Government organizations that matures on or before the maturity date of the ETF
  • As of now, it will have 2 maturity series – 3 and 10 years. Each series will have a separate index of the same maturity series.

Index Methodology

  • Index will be constructed by an independent index provider – National Sock Exchange
  • Different indices tracking specific maturity years – 3 and 10 years

Benefits to investors

  • Bond ETF will provide safety (underlying bonds are issued by CPSEs and other Government owned entities), liquidity (tradability on exchange) and predictable tax efficient returns (target maturity structure).
  • It will also provide access to retail investors to invest in bonds with smaller amount (as low as Rs. 1,000) thereby providing easy and low-cost access to bond markets.
  • This will increase participation of retail investors who are currently not participating in bond markets due to liquidity and accessibility constraints.
  • Tax efficiency compared to Bonds as coupons from the Bonds are taxed at marginal rates. Bond ETFs are taxed with the benefit of indexation which significantly reduces the tax on capital gains for investor.

Benefits for CPSEs

  • Bond ETF would offer CPSEs, CPSUs, CPFIs and other Government organizations an additional source of meeting their borrowing requirements apart from bank financing.
  • It will expand their investor base through retail and HNI participation which can increase demand for their bonds. With increase in demand for their bonds, these issuers may be able to borrow at reduced cost thereby reducing their cost of borrowing over a period of time.
  • Further, Bond ETF trading on the exchange will help in better price discovery of the underlying bonds.
  • Since a broad debt calendar to assess the borrowing needs of the CPSEs would be prepared and approved each year, it would inculcate borrowing discipline in the CPSEs at least to the extent of this investment.

Capital Markets: Challenges and Developments

Bharat 22 ETF

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Bharat 22

Mains level : Disinvestment processes in India


  • The Further Fund Offer 2 (FFO 2) of Bharat 22 Exchange-Traded Fund (ETF), which is part of the government’s divestment programme, will be open for subscription for investors.

Bharat 22

  • Bharat 22 is an ETF that will track the performance of 22 stocks, which the government plans disinvest.
  • The ETF unit represents a slice of the fund, issued units are listed on exchanges for anyone to buy or sell at the quoted price.
  • The B22 will span six sectors, such as basic materials, energy, finance, FMCG, industrials and utilities.
  • Besides public sector banks, miners, construction companies, and energy majors, the ETF will also include some of the government’s holdings in SUUTI (Specified Undertaking of Unit Trust of India).
  • The B22 ETF will be managed by ICICI Prudential AMC while Asia Index will be the index provider.
  • The index will be rebalanced annually.

About Exchange Traded Funds (ETFs)

  • ETFs are mutual funds listed and traded on stock exchanges like shares.
  • The ETF simply copies an index and endeavors to accurately reflect its performance.
  • In an ETF, one can buy and sell units at a prevailing market price on a real-time basis during market hours.
  • There are four types of ETFs already available — Equity ETFs, Debt ETFs, Commodity ETFs and Overseas Equity ETFs.
  • The Bharat 22 ETF to be offered now allows the Government to park its holdings in selected PSUs in an ETF and raise disinvestment money from investors at one go.

Capital Markets: Challenges and Developments

[op-ed snap] Go easy on the public float rule

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Budget decision on public shareholding and its impact

The government’s budget decision to raise the minimum public shareholding in listed companies to 35% from 25% has worried the markets.

Impact

  1. The number of companies that would be affected by this proposal is quite large. As many as 1,100 listed companies currently have a promoter stake of more than 65% – reduction to the prescribed limit could entail as much as a trillion rupees worth of share sales.
  2. This may lead the promoters to rush through the sales at low prices since share prices are mostly in a slump. 
  3. A slowdown in the economy and a pullout by foreign investors are also pressuring markets.

Way ahead

  1. Defer the implementation of the proposal to a day when the economy is in better shape
  2. Companies should be allowed a few years to comply so that fire sales are avoided. This way, promoters would get the best value for their shares. It will ensure markets face the least disruption.

Capital Markets: Challenges and Developments

[op-ed snap] Rupee matters

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Offshore trading

Mains level : Impact of offshore trading on rupee

CONTEXT

Over the past few years, there has been a concern over the sharp rise in offshore rupee trading volumes. 

Facts

  1. Data from the Bank of International Settlements pegs daily offshore rupee trading at around $16 billion in 2016, almost equal to onshore trading. 
  2. Recent data from the Bank of England pegs offshore rupee trades at $23 billion in 2018.

Positive

  1. This indicates greater investor interest in the rupee

Challenges

  1. Which forces determine the rupee’s value?
  2. What is the ability of the central bank to ensure “currency stability”?
  3. Offshore markets allow participants to trade in non-convertible currency. These markets have evolved for currencies where restrictions are imposed in domestic markets on foreign exchange convertibility.
  4. The constraints on foreign participation in domestic currency markets stem from cumbersome documentation and KYC requirements, restrictions on products, inconvenient trading hours. These restrictions push investors into the trade offshore markets to hedge their currency risks.
  5. These markets have begun to play a critical role in “price discovery”, more so during “periods of uncertainty” like the taper tantrum in 2013 and 2018 emerging market crises — when the offshore market was driving the onshore exchange rate. This has reduced the efficacy of foreign currency intervention by the central bank.

Recommendations 

  1. Incentivize market participants to shift to onshore markets, like extending onshore market hours, examining issues of taxation.
  2. Allowing market participants to take exposure up to $100 million, without any need to establish the existence of an underlying risk 
  3. Incentivize greater participation in rupee-denominated bonds
  4. As the economy grows, expand onshore currency markets in a calibrated manner
  5. The ability to hedge currency risks will increase the rupee’s attractiveness for trade invoicing and portfolio diversification

This can lead to the gradual internationalization of the currency.

Capital Markets: Challenges and Developments

Explained: Overseas Bond

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Overseas bond

Mains level : Financial implications of Overseas bonds

Context

  • Finance Minister announced in her Budget speech plans to raise a portion of its gross borrowing from overseas markets.
  • The government and the RBI will reportedly finalise the plans for the overseas issue of sovereign bonds by September.
  • While several commentators have argued that this is a risky move, the government itself is convinced that it will help boost private investment in the country.

Bonds

  • A bond, also known as a fixed-income security, is a debt instrument created for the purpose of raising capital.
  • They are essentially loan agreements between the bond issuer and an investor, in which the bond issuer is obligated to pay a specified amount of money at specified future dates.

Overseas Bond

  • A government bond or sovereign bond is a form of debt that the government undertakes wherein it issues bonds with the promise to pay periodic interest payments and also repay the entire face value of the bond on the maturity date.
  • So far, the government has only issued bonds in the domestic market.
  • According to FM, India’s sovereign external debt to GDP ratio is among the lowest around the world, at less than 5%.
  • Against this background, the government will start raising a part of its gross borrowing programme in external markets in external currencies.

Why issue such bonds?

  • Government borrowing is at such a level that there are not enough funds available for the private sector to adequately meet its credit and investment needs.
  • If the private sector cannot borrow adequately, then it cannot invest as it wants to, and that cripples one major engine of economic growth.
  • Government borrowing accounts for about 80-85% of domestic savings.
  • The overseas borrowing programme allows the government to maintain its gradual reduction of the fiscal deficit.
  • Borrowing overseas allows the government to raise funds in such a way that there is enough domestic credit available for the private sector.

Pricing of the bonds

  • The appetite of the international market for Indian bonds and their price will say a lot about how India is viewed globally on the risk factor.
  • For example, if the rate at which India can borrow overseas is low, then this would mean the global market assigns a low risk to India defaulting.

Risks associated

  • Several economists have expressed their concerns over the fact that India might follow the path of some Central and South American countries such as Mexico and Brazil.
  • In the 1970s, several of these countries borrowed heavily overseas when the global market was flush with liquidity.
  • But then, when their currencies depreciated sharply a decade later, these countries were in big trouble as they could not repay their debt.
  • India is not likely to be viewed as a risky proposition by the international market and so is likely to fetch an attractive rate for the bonds.

I. Limitations on borrowing

  • Cheap and plentiful funds should not encourage the government to borrow too heavily from abroad.
  • Another risk to India from overseas borrowings is that this would lead to a quicker increase to its foreign exchange reserves, which would lead to a stronger rupee at a time when it is already appreciating against the dollar.
  • This would be an adverse outcome.

II. Uncontrolled Imports

  • A stronger rupee would encourage imports at a time when the government is trying to curb them, and discourage exports at a time when they are being encouraged.
  • On the other hand, rupee depreciation for whatever external reason would prove even more disastrous as it would make it far more expensive for India to repay its external debt.

III. Less Control over Inflation

  • Another problem with an overseas bond issue is that the government would not be able to inflate itself out of trouble.
  • That is, in the domestic market, if the government does ever reach the stage where it is finding it difficult to repay its debt, it can simply print more money, let inflation rise quickly and repay its debt.
  • This is not an option in an overseas bond issue. The Indian government cannot print foreign currency to repay its debt.

IV. Impact on Domestic market

  • According to the government’s own reasoning, there are not enough funds in the domestic market to cater to its needs as well as those of the private sector.
  • This shallowness of the bond market is not a good thing, especially at a time when the government needs the bond market to finance several of its commitments.
  • The Ujwal Discom Assurance Yojana (UDAY) scheme, for example, involves State governments taking over the debt of State power distribution companies and issuing bonds to repay that debt.
  • A shallow bond market would make it difficult for the government to expand any of these schemes.

Conclusion

  • Ideally, the government should have enough revenue that it does not need to borrow as much.
  • However, at a time when both direct and indirect tax collections have disappointed, the government is forced to borrow to finance its expenditure.
  • In such a scenario, it is a welcome move for the private sector that the government is leaving it room to borrow in the domestic market.

Capital Markets: Challenges and Developments

SEBI, MCA sign pact for more data scrutiny

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Not Much

Mains level : Curbing corporate frauds

  • The Securities and Exchange Board of India (SEBI) and the Ministry of Corporate Affairs (MCA) signed a MoU to facilitate seamless sharing of data and information for carrying out scrutiny, inspection, investigation and prosecution.

A move for data scrutiny

  • The MCA has the database of all registered firms while SEBI only regulates listed entities that may have unlisted subsidiaries, with the MCA having access to all the data of such unlisted entities.
  • The MoU comes in the wake of increasing need for surveillance in the context of corporate frauds affecting important sectors of the economy.
  • As the private sector plays an increasingly vital role in economic growth, the need for a robust corporate governance mechanism becomes the need of the hour.

Impact of the MoU

  • Incidentally, there is already a protocol of sharing of data between the capital markets regulator Ministry and, in many cases; the regulator has also sent its orders against various entities to the MCA for further action.
  • The MoU will facilitate the sharing of data and information between the regulator and the MCA on an automatic and regular basis.
  • It will enable sharing of specific information such as details of suspended companies, delisted firms, shareholding pattern from the SEBI and financial statements filed with the Registrar by corporates, returns of allotment of shares and audit reports relating to corporates.
  • The MoU will ensure that both the MCA and the SEBI have seamless linkage for regulatory purposes.
  • In addition to regular exchange of data, the two will also exchange with each other, on request, any available information for scrutiny, inspection, investigation and prosecution.
  • A Data Exchange Steering Group will meet periodically to review the data exchange status.

Capital Markets: Challenges and Developments

[op-ed snap] Deserved penalty

Note4Students

From UPSC perspective, the following things are important :

Prelims level : SEBI

Mains level : SEBI's imposition of fine on NSE will restire invetor's confidence in the market.

CONTEXT

The Securities and Exchange Board of India (SEBI) last week ordered the National Stock Exchange of India (NSE) to pay a fine of about ₹1,000 crore within 45 days for its supervisory laxity that led to some of its broker-clients gaining preferential access to certain market data.

Details of order

1.Payback from NSE Chiefs – Two former NSE chiefs have been ordered to pay back a part of their past salaries as punishment for their failure to ensure that the exchange was fully compliant with all provisions of the norms governing securities exchanges.

2.Use of tick by tick protocol is responsible for data breach – In its order, SEBI noted that the NSE’s use of the tick-by-tick server protocol had allowed certain high-frequency trading firms using the exchange’s secondary server to receive important market data before other market participants, who were thus put at a disadvantage.

3.Doubts regarding market fairness – While it has not yet been proven decisively that the firms with preferential access to data from the exchange managed to profit from such data, the episode raised serious questions about market fairness.

4.No fraudulent activity but lack of diligence – SEBI ruled that it did not find sufficient evidence to conclude that the NSE committed a fraudulent act, but was unequivocal in ruling that the Exchange had failed to exercise the necessary due diligence to ensure that it served as a fair marketplace.

5.Switch to new data system worked in favour – The fact that the NSE had opted to switch to a new data transmission system, which relays data to all market participants at the same time, prior to a whistle-blower’s complaint in 2015 may have worked in the NSE’s favour.

The relevance of the verdict

1.Relief to stock exchange –

  • Despite the sizeable fine that it imposes on the NSE, the SEBI verdict must surely come as a relief to the erring stock exchange for at least two reasons.
  • First, the fact that it has not been found to have intentionally favoured certain market players over others should help it retain investor confidence.
  • Also, the exchange, which had been barred from proceeding with its initial public offering during the pendency of the SEBI probe, will now finally be able to tap the capital markets to fund its growth, after a six-month moratorium.

2.Welcome regulatory Action

  • While there is bound to be debate about the magnitude of the fine, overall the financial penalty is a welcome regulatory action.
  • Millions of investors choose to do their trading on market platforms like the NSE every year in the belief that the marketplace offers an equitable environment to carry out their trades.

Conclusion

As the markets regulator, SEBI must deal with breaches of their supervisory brief by exchanges in an exemplary manner to ensure that small investors retain confidence in the fairness and soundness of key institutions that enable a market economy.

Capital Markets: Challenges and Developments

[pib] Investor Education and Protection Fund (IEPF)

Note4Students

From UPSC perspective, the following things are important :

Prelims level : IEPF

Mains level : Investers education

  • In a major success, the IEPF Authority has been able to enforce a company to transfer deposits worth about Rs 1514 Cr to IEPF.
  • This depositor’s money was pending with the company for the last 15 years.

Investor Education and Protection Fund (IEPF)

  • IEPF is a fund where unclaimed dividend, refunded application money, matured company deposits and debentures, as well as the interest on them, is used, provided it is not claimed within seven years.
  • It is a fund set up under the Ministry of Corporate Affairs to help promote investor awareness and protection of investor interests.

About IEPF Authority

  • IEPF Authority has been set up under the Ministry of Corporate Affairs, Government of India as a statutory body under Companies Act 2013 to administer the IEPF with the objective of promoting Investor’s Education, Awareness and Protection.
  • The Authority takes various initiatives to fulfil its objectives through Investor Awareness Programmes and various other mediums like Print, Electronic, Social Media, and Community Radio etc.
  • Secretary Ministry of the Corporate Affairs is the Chairperson of the Authority.
  • Joint Secretary Ministry of the Corporate Affairs is the Chief Executive Officer of the Authority.

Capital Markets: Challenges and Developments

[op-ed snap] Capital high

Note4Students

From UPSC perspective, the following things are important :

Prelims level : FDI,FPI

Mains level : Foreign Investment is high and how to maintain flow in Indian Economy

CONTEXT

The inflow of foreign capital into India’s stock market in the month of March hit a high of $4.89 billion, the biggest foreign inflow into Indian stocks since February 2012.

Foreign Investment  Situation in India

  • Foreign investment in Indian equities stood at $2.42 billion in February, as against a net outflow of $4.4 billion during the same month a year earlier, and is expected to be strong in April as well.
  • Both cyclical and structural factors are behind this sudden uptick in foreign investment that has helped the rupee make an impressive comeback.
  • Last year, India received more foreign direct investment than China for the first time in two decades
  • While the Chinese economy has been slowing down considerably in the last one year, India has emerged as the fastest-growing major economy.

Reasons

  • Other short-term reasons may also be behind some of the recent inflow of capital into the country.
  • For one, there is a sense among a section of investors that their fears of political instability are misplaced.
  • More important, there are clear signs that western central banks have turned dovish.
  • Both the Federal Reserve and the European Central Bank, for instance, have promised to keep interest rates low for longer.
  • This has caused investors to turn towards relatively high-yielding emerging market debt.
  • Indian mid-cap stocks, which suffered a deep rout last year, are now too attractive to ignore for many foreign investors.

Need for a cautious approach

  • The return of foreign capital is obviously a good sign for the Indian economy.
  • But policymakers need to be careful not to take foreign investors for granted.
  • Other emerging Asian economies will be competing hard to attract foreign capital, which is extremely nimble.
  • Any mistake by policymakers will affect India’s image as an investment destination.
  • To retain investor confidence, whichever government comes to power after the general election this summer will need to increase the pace of structural reforms and also ensure proper macroeconomic management with the help of the Reserve Bank of India.

Challenges

  • Long-pending reforms to the labour and land markets are the most pressing structural changes that will affect India’s long-term growth trajectory.
  • The high fiscal deficit of both the Centre and the State governments and the disruptive outflow of foreign capital are the other macroeconomic challenges.
  • These are some issues that need to be solved sooner rather than later.

Capital Markets: Challenges and Developments

SEBI mulls SRO for investment advisers

Note4Students

From UPSC perspective, the following things are important :

Prelims level : SRO and its mandate

Mains level : Regulation of capital markets in India

  • The SEBI has proposed a self regulatory organisation (SRO) for the growing number of investment advisers to address issues related to the quality of advice given to investors by such entities.

What is Self Regulatory Organisation?

  • An SRO is the first-level regulator that performs the crucial task of regulating intermediaries representing a particular segment of securities market on behalf of the regulator.
  • An SRO would be seen as an extension of the regulatory authority of the SEBI and would perform the tasks delegated to it by the SEBI.
  • The role of an SRO is developmental, regulatory, related to grievance redressal and dispute resolution as well as taking disciplinary actions.

Why need SRO?

  • SEBI is in receipt of a large number of complaints alleging charging of exorbitant fees, assurance of returns, misconduct etc. by investment advisers.
  • Incidentally SEBI has said that there was a need for an SRO for mutual fund distributors — that currently register with Association of Mutual Funds in India (AMFI).
  • It was aimed to bring in consistency in industry practices and also to take disciplinary action against alleged malpractices such as mis-selling of products and churning of portfolio.

Expected functions

  • SEBI has proposed the strengthening of the existing regulatory framework for SROs by introducing features such as a governing board with public interest directors and a clear policy for arbitration and dispute resolution.
  • The regulator has proposed a governing board with at least 50% public interest directors along with 25% representation each of shareholder directors and elected representatives.
  • Further, the governing board can appoint a managing director or chief executive officer to manage the daily affairs of the SRO.

Capital Markets: Challenges and Developments

Systematic Investment Plan (SIP)

Note4Students

From UPSC perspective, the following things are important :

Prelims level : SIP

Mains level : Not Much

What is SIP?

  • A SIP is a way to invest in mutual funds wherein a fixed sum of money is put into a mutual fund scheme at a specified date every month.
  • It is considered to be investor-friendly and an efficient manner of investing in the capital markets as one can start investing with small monthly contributions instead of first building a huge investment corpus.
  • It is a hassle-free manner of investment as well since one can issue standing instructions to the bank for a specified amount to be transferred to the fund house/distributor every month at a pre-determined date.

How can one start a SIP?

  • There are two ways of starting an SIP. One can use the direct way of investing though the fund house or go through a distributor.
  • For direct plans, an investor can go to the website of the fund house for the scheme in which the SIP has to be started.
  • All the fund houses have a link on their portals for investors who want to start an SIP.
  • Typically, only the PAN and/or Aadhaar is needed to open an account.
  • Thereafter, one can select the scheme, SIP amount, starting date and duration of SIP.
  • If one opts for a distributor, then the same process can be done online on the distributor’s portal.

Benefits of a SIP

  • Timing the market is the most difficult thing when it comes to equity investment. SIPs, in a way, address this issue.
  • SIPs capture every rise and fall of the market and hence, an investor need not worry about the level of the market.

Capital Markets: Challenges and Developments

India’s first Real Estate Investment Trust subscribed 2.58 times

Note4students

From the UPSC perspective, the following things are important:

Prelims level: REIT

Mains level: Not Much


News

  • The initial public offering (IPO) of India’s first Real Estate Investment Trust (Embassy REIT) was subscribed 2.5 times, with the share sale generating a demand of over Rs 5,300 crore.

What is REIT?

  • REITs provide a way for individual investors to earn a share of the income produced through commercial real estate ownership – without actually having to go out and buy commercial real estate.
  • It is a company that owns, and in most cases operates, income-producing real estate.
  • REITs own many types of commercial real estate, ranging from office and apartment buildings to warehouses, hospitals, shopping centers, hotels and timberlands.

How does it work

  • Unlike shares, investors in a REIT get units, somewhat similar to units in a mutual fund.
  • A REIT owns a number of rent-yielding commercial and hotel properties, and the unit-holders get a portion of this rental income in the form of dividend and interest income in proportion to their equity contribution.
  • It gives the investor an option to buy partial stake in rent-yielding commercial properties, with the benefit of a professional manager managing these assets.
  • Increase in rentals of underlying assets, improvement in occupancy rate and commencement of under construction properties are the growth drivers that an investor can
  • The net distributable cash flows of the Embassy REIT are based on the cash flows generated from the assets.
  • In terms of the REIT Regulations, at least 90 per cent of the net distributable cash flows are required to be distributed to the Embassy REIT.
  • The trust distributes the cash flow to unit-holders in the form of dividend and interest income, generally, once every quarter.

Associated risks

  • Since this is the first REIT issue, there is no comparable data in terms of pricing and attractiveness of the issue.
  • Real estate properties are always prone to litigation and operational challenges.
  • Even though its assets are in cities offering good rental clients, the rate of occupancy is always a critical factor.
  • Also, with future development of new office spaces in upcoming areas, the old buildings lose their charm and thereby their premium to get higher rental.
  • The management fee and operating expenses can rise, eating into the returns of investors. The biggest concern is the valuation of the units.
  • Since the Net Asset Value of the REIT is based on estimated future cash flows and certain assumptions, it is difficult to gauge the margin of safety for an investor.

Capital Markets: Challenges and Developments

[op-ed snap]Credit rating firms came under criticism from RBI

Note4students

Mains Paper 3: Economy | Mobilization of resources

From the UPSC perspective, the following things are important:

Prelims level: Credit ratings

Mains level: Problems being faced due to credit rating sector in India & need for revamping the market structure for same.


NEWS

CONTEXT

Credit rating firms came under sharp criticism from the Reserve Bank of India (RBI) for failing to identify financial troubles in various companies, especially in the case of IL&FS.

Concerns over rating agencies
  • Inability to assess credit risk and take timely rating actions.
  • Ratings are supposed to be forward-looking, but they are always a laggard.
  • The central bank is said to have told credit ratings officials that the abrupt ratings downgrades in recent months have hurt investors and banks.
  • Credit Rating agencies have been criticised for being late in identifying the stress in the IL&FS Group, which defaulted on its loans from banks, mutual funds and provident funds.
  • Various debt mutual fund schemes saw erosion in their net asset values, or NAVs, because of the defaults.
  • The crisis soon spread to other non-banking finance companies — mainly housing finance — which have been struggling to sort out their asset-liability mismatches.
  • RBI said one third of the total NPAs (non-performing assets) in the system stemmed from investment grade ratings.
  • Total stressed assets are about Rs 12 lakh crore in the banking system.

Conflict of Interest

  • Globally, rating agencies limit themselves to ratings and research related to credit ratings.
  • All other businesses like market research, training, risk solutions are carried out under separate entities with no common directors, employees and shareholding from the rating entity.
  • In India, the same rating agency rates and provides valuation opinions to the same set of securities to investors like mutual funds and provides advisory services.
  • The central bank governor disapproved of the practice of “rating shopping”— where companies migrate from one rating agency to another for better ratings.
  • RBI was also concerned about issues such as rating agency CEOs being part of rating committees and rating advisors who promise better ratings to an issuer due to their special relationship with rating agencies.

Conclusion

  • RBI is examining the matter and along with Sebi, it will bring out regulations to address this.
  • Though credit rating agencies are registered with the capital market regulator Sebi, they are jointly regulated by both Sebi and RBI as these firms rate bank loans which constitute 70% of their business.
  • On short-term instruments like commercial paper, RBI feels that the ratings do not reflect the pricing these papers command.

Capital Markets: Challenges and Developments

[op-ed snap] Wiggle space: on SEBI’s new rules

Note4students

Mains Paper 3: Economy | Mobilization of resources

From the UPSC perspective, the following things are important:

Prelims level: Not much

Mains level: Need for better regulation of CRAs to maintain investor confidence in Indian markets


NEWS

CONTEXT

According to new regulations issued by the Securities and Exchange Board of India (SEBI), liquid mutual funds holding debt securities with a maturity term of more than 30 days will have to value these securities on a mark-to-market basis.

Changes in rules

  • Until now, liquid mutual funds could report the value of debt instruments with a maturity term of up to 60 days using the amortisation-based valuation method.
  • Only debt securities with a maturity term of over 60 days were to be valued on a mark-to-market basis. So the new rule seemingly narrows the scope for amortisation-based valuation.
  • Amortisation-based valuation, which is completely detached from the market price of the securities being valued, allowed mutual funds to avoid the volatility associated with mark-to-market valuation.

Impact

  • By exempting securities with a maturity period of up to 30 days from mark-to-market valuation, however, SEBI may be doing no favour to individual investors.
  • this helps avoid the volatility of mark-to-market accounting and the need to provide a fair account of the value of their investments.
  • What is likely is a decrease in the yields received on securities maturing in 30 days or less and an increase in the yields on debt instruments with a maturity period of 31 to 60 days.
  • It will, however, do nothing to make investors in mutual funds become more informed about the real value of their investments.

Contrast with earlier arrangements

  • The latest SEBI rules are also in direct contrast to the usual accounting practices when it comes to the valuation of securities.
  • Generally accepted accounting principles mandate securities with the least maturity to be reported on a mark-to-market basis while allowing the amortisation-based method to be employed to value other securities with longer maturity periods.
  • This makes sense as the profits and losses associated with securities with shorter terms are closer to being realised by investors when compared to longer-term securities.

Conclusion

  • SEBI would do well to mandate that all investments made by liquid mutual funds should be valued on a mark-to-market basis. Simultaneously, it should work on deepening liquidity in the bond market so that bond market prices can serve as a ready reference to ascertain the value of various debt securities.

 

 

Capital Markets: Challenges and Developments

Unregulated deposit schemes to be banned

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level:  Particulars of the Bill, Ponzi Schemes,

Mains level: The new bill seeks to protect investors from rising instances of scams


News

  • The Union Cabinet has approved the official amendments to an Act that classifies any deposit scheme not registered with the government as an offence and bans it.
  • The Banning of Unregulated Deposit Schemes Bill 2018 was introduced in Parliament on July 18, 2018 and was referred to the standing committee.

Banning of Unregulated Deposit Schemes Bill, 2018

  1. The Bill contains a substantive banning clause which bans deposit takers from promoting, operating, issuing advertisements or accepting deposits in any unregulated deposit scheme.
  2. The amendment bill aims to effectively tackle the menace of illicit deposit-taking activities, and prevent such schemes from duping poor and gullible people of their hard-earned savings.
  3. The principle is that the bill would make the activities an offence ex-ante rather than the existing legislative-cum-regulatory framework which only comes into effect ex-post with considerable time lags.
  4. It bans deposit takers from promoting, operating, issuing advertisements or accepting deposits in any unregulated scheme.

Provisions of the Bill

  1. The Bill has adequate provisions for disgorgement or repayment of deposits in cases where such schemes nonetheless manage to raise deposits illegally.
  2. The Bill provides for attachment of properties/assets by the competent authority, and subsequent realization of assets for repayment to depositors.
  3. The Bill provides for “severe punishment and heavy pecuniary fines” to act as a deterrent.
  4. The penalties could involve jail term as well as the sale of the offenders’ assets to pay back the defrauded party within set timelines.

Definition of Deposit Takers

  • Deposit Takers include all possible entities (including individuals) receiving or soliciting deposits, except specific entities such as those incorporated by legislation.

Types of Offences

The Bill creates three different types of offences:

  • Running of unregulated deposit schemes,
  • Fraudulent default in regulated deposit schemes, and
  • Wrongful inducement in relation to unregulated deposit schemes.

Capital Markets: Challenges and Developments

[op-ed snap] Account aggregators and e-consent for credit markets

Note4students

Mains Paper 3: Economic Development| Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

From UPSC perspective, the following things are important:

Prelims level: Basic knowledge of Public credit registry (PCR).

Mains level: The news-card analyses the issues and challenges in the establishment of a public credit registry (PCR), in a brief manner.


Context

  • There has been demand by experts for the establishment of a public credit registry (PCR) in India.
  • According to them, building a robust and centralized credit information system will be able to bring transparency to the credit market that will allow borrowers to build up their “reputational collateral”, reward good borrowers and encourage credit discipline.

Issue with credit information system in India

  • India has a multiplicity of credit information repositories.
  • As a result, it is very difficult for lenders to form a comprehensive view of the indebtedness of potential borrowers as their credit information is dispersed across multiple entities.
  • Additionally, as the formats in which the data is required to be reported to each of these entities varies widely, there is no assurance about the quality of the data, even if it were to be aggregated.

Public Credit registry would remove these inconsistencies

  • A PCR that operates as the single point of mandatory reporting of credit information, would remove these inconsistencies.
  • And leading to improvements in data quality and offering a mechanism by which borrowers of all levels can establish the reputational collateral that is needed.
  • It would additionally allow lenders to distinguish between different types of borrowers, avoiding the pitfall of adverse selection where lenders overcharge low-risk borrowers and undercharge high-risk borrowers simply because they don’t have accurate data.

Establishing PCR: only one part of the solution

  • A registry of credit gives lenders an accurate snapshot of only the indebtedness of a borrower.
  • It provides no information as to that person’s financial assets.
  • In determining whether or not to grant a loan, lenders need to evaluate both the existing debt burden of the individual as well as the details of her financial asset portfolio to assure themselves that she will be able to service the loan.
  • At present, lenders meet this second requirement by asking for copies of bank statements and other financial assets of the borrower and then physically verifying the copies presented to them against original records.
  • The process is time-consuming and runs the risk of fraud.
  • What is required is a trusted, electronic system through which borrowers can provide lenders with verifiable information about their financial assets in an auditable, electronic format that is both accurate and up to date.

RBI’s Account aggregator infrastructure

  • It is with this in mind that the Reserve Bank of India is establishing the account aggregator infrastructure.
  • It is a digital architecture that offers borrowers a mechanism by which potential lenders can view their financial assets without compromising privacy and confidentiality.
  • Central to this construct is the account aggregator, a regulated third-party entity whose sole function will be to maintain and operate a trusted platform on which registered users can link details of their financial accounts, such as bank accounts, mutual funds and insurance accounts.

How this will work?

  • Whenever potential lenders need evidence of the financial assets of a potential borrower, they will have to issue an electronic request setting out details of the data sought and the purpose for which it will be used.
  • To limit the risk of over-consenting, lenders will only be able to request limited information for specified purposes using templates that have been designed keeping in mind principles of data minimization and purpose limitation.
  • Once this request has been received, the borrower can digitally consent to the specific request, thereby authorizing the account aggregator to extract the relevant information from the financial asset portfolio that has been linked.
  • Based on the authority of the digital consent artefact, the account aggregator will instruct the relevant financial institutions to issue digitally signed copies of the required information to the lender.

Implications

  • Some experts have aversion to an over-reliance on consent as a mechanism to safeguard privacy.
  • However, the electronic consent artefact contemplated in the account aggregator framework is not the same as the over-broad, confusingly worded terms of service that we most frequently encounter.
  • It is, to the contrary, a specific, one-time request for limited information, intended to be used for a clearly defined purpose.
  • As such, consent deployed in this manner is highly unlikely to be misconstrued and, as only a limited amount of data is provided, the risk of misuse is contained
  • As much as this construct achieves the objective of purpose limitation, there is no way to ensure that once financial data has been provided, the recipients will only use it for the purposes for which it was requested.

Conclusion

  • At present, there is no technological construct by which the data that has been provided using the account aggregator framework will automatically expire once its original purpose has been served.
  • Nothing stops lenders from retaining, and using, data long after its purpose is served.
  • It is for this reason that the account aggregator architecture needs to be firmly ensconced within an extended regulatory framework that imposes restrictions over and above that which is contained within the technological framework of the consent artefact.
  • While technology offers new means by which results can be achieved, it is critically important that we remember to ground these solutions in appropriately robust legal frameworks.
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