53727969 money market project in finance

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ProjectON

MONEY MARKET AND ITS

INSTRUMENTS

Submitted By:

Sapna Sharma

Bsc. Physical Science(2nd year)

To:

Mr. Sanjay

DAYAL SINGH COLLEGE

DELHI UNIVERSITY

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Acknowledgement

I, Sapna Sharma, student of Bsc. Physical Science (2nd year), in Dayal Singh

College, University of Delhi, hereby declare that i have made this academic project

titled Money Market And Its Instrumentsas a part of the assessment for the

subject Economics, for academic year 2010-11. The project is submitted for the

first time and here only and the information submitted therein is true to the best of

my knowledge.

I sincerely thank Mr. Sanjay for the help extended by him for the successful

completion of the project report.

Countersigned Candidates signature

Sapna Sharma

(Mr. Sanjay)

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What are Money Market Instruments?

By convention, the term Money Market refers to the market for short time

requirement & deployment of funds. Money market instruments are those

instruments, which have a maturity time of less than 1 year.The most active part of

the money market is the market for overnight call and term money between the

banks, institutions as well as call money transactions. Call Money or Repo are very

short term Money Market products. The below mentioned instruments are

normally termed as money market instruments:

The slice of the financial market where instruments with high liquid and shortmaturities are traded is called money market. It is a generic definition. The

players who indulge in short time from several days to less than one year. It is

generally used for borrow & lend over this short term. Due to the highly liquid

nature of the security and short maturities, money market are perceived as a safe

place to lock in money.

The participants in the financial market perceive a thin line, differentiating

between the capital market & the money market. Capital market refers to stock

markets where the common stocks are traded, and bond markets where bonds are

issued and traded. This is in sharp contrast to money markets which provide shortterm debt financing and investment. In money market, there is borrowing and

lending for periods of a year or less.

Treasury Bills are highly liquid short-time instruments that yield attractive returns.

Short- term borrowing instruments of the Central Govt, it is a promise to pay a said

sum after expiry of a specified period. It is a zero-risk instrument available in both

primary and secondary markets. Money market instruments are characterised by

high degree of safety of the principal.

Commercial paper is a short-term unsecured promissory note issued by corporates

and financial institutions. Commercial Paper is short-term loan that is issued by a

corporation use for financing accounts receivable and inventories. Issued at

discount to the face value, they yield attractive returns. The Government of India

securities are sovereign coupon bearing instruments that are issued by the Govt. of

India. They are available both for short-term and long tenures.

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A savings certificate entitling the bearer to receive interest. Certificate of deposit is

short-term borrowings that are more like bank term deposit accounts. They are

transferable by endorsement and are to be stamped. Investors can consider moneymarket funds. These invest in government securities, certificates of deposits,

commercial paper of companies, and other highly liquid and low-risk securities.

These funds are required by law to invest in low risk securities. Investors with low

risk appetite can opt for money market funds.

The Money market instrument meets the short-term requirements of borrowers and

provides liquidity to lenders. Short-term surplus funds at the disposal of

institutions and individuals are bid by borrowers, who could be in the same

category.

Debt instrument which have a maturity of less than a year at the time of issue are

called money market instruments.Types of debt instruments include notes, bonds,certificates, mortgages, leases or other agreements between a lender and a

borrower. These instruments are highly liquid and have negligible risk. The major

money market instruments are Treasury bills, certificates of deposit, commercial

paper, and repos. The money market is dominated by the government, financial

institutions, banks, and corporate. Individual investors scarcely participate in the

money market directly. A brief description of money market instruments is given

below.

1) Certificate of Deposit (CD)

2) Commercial Paper (C.P)

3) Inter Bank Participation Certificates

4) Inter Bank term Money

5) Treasury Bills

6) Call/ Notice/ Term Money

7) Bill Rediscounting

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What Constitutes the Money Market in India?

The money market is a mechanism that deals with the lending and borrowing of

short term funds. Money market refers to the market for short term assets that are

close substitutes of money, usually with maturities of less than a year. A well

functioning money market provides a relatively safe and steady income-yielding

avenue, for short term investment of funds both for banks and corporates and

allows the investor institutions to optimize the yield on temporary surplus funds.

The RBI is a regular player in the money market and intervenes to regulate the

liquidity and interest rates in the conduct of monetary policy to achieve the broad

objective of price stability, efficient allocation of credit and a stable foreign

exchange market. As per definition given by RBI the money market is "the centrefor dealings, mainly short-term character, in money assets. It meets the short-term

requirements of borrower and provides liquidity or cash to the lenders. It is the

place where short-term surplus investible funds at the disposal of financial and

other institutions and individuals are bid by borrowers, again comprising

Institutions, individuals and also the Government itself" The main segments of the

money market are the call/notice money, term money, commercial bills, treasury

bills, commercial paper and certificate deposits. Mr.G. Crowther in his treatise "An

Outline of Money defines money market as If the economic relationships between

nations are not, by one means or another, brought fairly close to balance, then there

is no set of financial arrangements that can rescue the world from the

impoverishing results of chaos. "the collective name given to the various firms and

institutions that deal in the various grades of near-money". .

Call /Notice-Money Market

The call/notice money market forms an important segment of the Indian Money

Market. Under call money market, funds are transacted on overnight basis and

under notice money market, funds are transacted for the period between 2 days and14 days.The most active segment of the money market has been the call money

market, where the day to day imbalances in the funds position of scheduled

commercial banks are eased out. The call notice money market has graduated into

a broad and vibrant institution .

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Call/Notice money is the money borrowed or lent on demand for a very short

period. When money is borrowed or lent for a day, it is known as Call (Overnight)

Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus

money, borrowed on a day and repaid on the next working day, (irrespective of the

number of intervening holidays) is "Call Money". When money is borrowed or lent

for more than a day and up to 14 days, it is "Notice Money". No collateral security

is required to cover these transactions.

The entry into this field is restricted by RBI. Commercial Banks, Co-operative

Banks and Primary Dealers are allowed to borrow and lend in this market.

Specified All-India Financial Institutions, Mutual Funds, and certain specified

entities are allowed to access to Call/Notice money market only as lenders.

Reserve Bank of India has recently taken steps to make the call/notice money

market completely inter-bank market. Hence the non-bank entities will not be

allowed access to this market beyond December 31, 2000.

From May 1, 1989, the interest rates in the call and the notice money market are

market determined. Interest rates in this market are highly sensitive to the demand

- supply factors. Within one fortnight, rates are known to have moved from a low

of 1 - 2 per cent to dizzy heights of over 140 per cent per annum. Large intra-day

variations are also not uncommon. Hence there is a high degree of interest rate risk

for participants. In view of the short tenure of such transactions, both the borrowers

and the lenders are required to have current accounts with the Reserve Bank of

India. This will facilitate quick and timely debit and credit operations. The call

market enables the banks and institutions to even out their day to day deficits andsurpluses of money. Banks especially access the call market to borrow/lend money

for adjusting their cash reserve requirements (CRR). The lenders having steady

inflow of funds (e.g. LIC, UTI) look at the call market as an outlet for deploying

funds on short term basis.

Inter-Bank Term Money

A short-term money market, which allows for large financial institutions, such as

banks, mutual funds and corporations to borrow and lend money at interbank rates.The loans in the call money market are very short, usually lasting no longer than a

week and are often used to help banks meet reserve requirements.Inter-bank

market for deposits of maturity beyond 14 days is referred to as the term money

market. The entry restrictions are the same as those for Call/Notice Money except

that, as per existing regulations, the specified entities are not allowed to lend

beyond 14 days.

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The market in this segment is presently not very deep. The declining spread in

lending operations, the volatility in the call money market with accompanying

risks in running asset/liability mismatches, the growing desire for fixed interest

rate borrowing by corporates, the move towards fuller integration between forex

and money markets, etc. are all the driving forces for the development of the term

money market. These, coupled with the proposals for rationalisation of reserve

requirements and stringent guidelines by regulators/managements of institutions, in

the asset/liability and interest rate risk management, should stimulate the evolution

of term money market sooner than later. The DFHI (Discount & Finance House of

India), as a major player in the market, is putting in all efforts to activate this

market.

Treasury Bills.

Treasury Bills are money market instruments to finance the short termrequirements of the Government of India. The Treasury bills are short-term money

market instrument that mature in a year or less than that. The purchase price is less

than the face value. At maturity the government pays the Treasury Bill holder the

full face value. The Treasury Bills are marketable, affordable and risk free. The

security attached to the treasury bills comes at the cost of very low returns.

Treasury Bills are short term (up to one year) borrowing instruments of the union

government. It is an IOU of the Government. It is a promise by the Government to

pay a stated sum after expiry of the stated period from the date of issue

(14/91/182/364 days i.e. less than one year). They are issued at a discount to theface value, and on maturity the face value is paid to the holder. The rate of

discount and the corresponding issue price are determined at each auction.

Types

Treasury bills (T-bills) offer short-term investment opportunities, generally up to

one year. They are thus useful in managing short-term liquidity. At present, the

Government of India issues three types of treasury bills through auctions, namely,

91-day, 182-day and 364-day. There are no treasury bills issued by State

Governments.

Amount

Treasury bills are available for a minimum amount of Rs.25,000 and in multiples

of Rs. 25,000. Treasury bills are issued at a discount and are redeemed at par.

Treasury bills are also issued under the Market Stabilization Scheme (MSS).

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Auctions

While 91-day T-bills are auctioned every week on Wednesdays, 182-day and 364-

day T-bills are auctioned every alternate week on Wednesdays. The Reserve Bank

of India issues a quarterly calendar of T-bill auctions which is available at the

Banks website. It also announces the exact dates of auction, the amount to be

auctioned and payment dates by issuing press releases prior to every auction.

Type of Day of Day of

T-bills Auction Payment*

91-day Wednesday Following Friday

182-day Wednesday of non-reporting week Following Friday

364-day Wednesday of reporting week Following Friday

* If the day of payment falls on a holiday, the payment is made on the

day after the holiday.

The salient features of the auction system of T-Bills are :

The 14/91/182/364-days bills are issued for a minimum value of Rs.25,000

and multiples thereof.

They are issued at a discount to face value.

Any person in India including individuals, firms, companies, corporate

bodies, trusts and institutions can purchase the bills.

The bills are eligible securities for SLR purposes.

All bids above a cut-off price are accepted and bidders are permitted to place

multiple bids quoting different prices at each auction. Till November 6,

1998, all types of T-Bills auctions were conducted by means of 'MultiplePrice Auction'. However, since November 6, 1998, auction of 91-days T-

Bills are being conducted by means of 'Uniform Price Auction'. In the case

of 'Multiple Price Auction' method successful bidders pay their own bid

prices, whereas under 'Uniform Price Auction' method, all successful bidders

pay an uniform price, i.e. the cut-off price emerged in the auction.

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The bills are generally issued in the form of SGL - entries in the books of

Reserve Bank of India. The SGL holdings can be transferred by issuing a

SGL transfer form. For non-SGL account holders, RBI has been issuing the

bills in scrip form.

French Auction or Multiple Price Auction System

After receiving written bids at various levels of yield expectations, a particular

yield is decided as the cut-off rate of the security in question. Auction participants

(bidders) who bid at yield levels lower than the yield determined as cut-off get full

allotment although at a premium. The premium is equal to the yield differential

expressed in rupee terms. The yield differential is the difference between the cut-

off yield and the yield at which the bid is made. All bids made at yield levels

higher than that determined as cut-off yield get entirely rejected.

Dutch Auction or Uniform Price Auction System

This system of auction is exactly identical to that of the French Auction System as

far as the price discovery mechanism part is concerned. The difference is observed

only at the stage of payment obligation. After determination of the market related

cut-off rate, allotment is made to all the bidders at a uniform price. The concept ofpremium on account of yield differential does not exist here.

Other Instruments

New money market instruments like Certificates of Deposits (CDs) and

Commercial Paper (CPs) were introduced in 1989-90 to give greater flexibility to

investors in the deployment of their short-term surplus funds

Certificates of Deposit

Certificates of Deposit (CDs) - introduced since June 1989 - are negotiable term

deposit certificates issued by a commercial banks/Financial Institutions at discount

to face value at market rates, with maturity ranging from 15 days to one year.

Certificate of Deposit:The certificates of deposit are basically time deposits that

are issued by the commercial banks with maturity periods ranging from 3 months

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to five years. The return on the certificate of deposit is higher than the Treasury

Bills because it assumes a higher level of risk.

Advantages of Certificate of Deposit as a money market instrument

1. Since one can know the returns from before, the certificates of deposits areconsidered much safe.

2. One can earn more as compared to depositing money in savings account.

3. The Federal Insurance Corporation guarantees the investments in the certificate

of deposit.

Disadvantages of Certificate of deposit as a money market instrument:

1. As compared to other investments the returns is less.

2. The money is tied along with the long maturity period of the Certificate ofDeposit. Huge penalties are paid if one gets out of it before maturity.

Being securities in the form of promissory notes, transfer of title is easy, by

endorsement and delivery. Further, they are governed by the Negotiable

Instruments Act. As these certificates are the liabilities of commercial

banks/financial institutions, they make sound investments.

DFHI trades in these instruments in the secondary market. The market for theseinstruments, is not very deep, but quite often CDs are available in the secondary

market. DFHI is always willing to buy these instruments thereby lending liquidity

to the market.

Salient features :

CDs can be issued to individuals, corporations, companies, trusts, funds,

associates, etc.

NRIs can subscribe to CDs on non-repatriable basis.

CDs attract stamp duty as applicable to negotiable instruments.

Banks have to maintain SLR and CRR on the issue price of CDs. No ceiling

on the amount to be issued.

The minimum issue size of CDs is Rs.5 lakhs and multiples thereof.

CDs are transferable by endorsement and delivery.

The minimum lock-in-period for CDs is 15 days.

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CDs are issued by Banks, when the deposit growth is sluggish and credit demand is

high and a tightening trend in call rate is evident. CDs are generally considered

high cost liabilities and banks have recourse to them only under tight liquidity

conditions.

CPs enable highly rated corporate borrowers to diversify their sources of short-

term borrowings and raise a part of their requirement at competitive rates from the

market. The introduction of Commercial Paper (CP) in January 1990 as an

additional money market instrument was the first step towards securitisation of

commercial bank's advances into marketable instruments.

Commercial Papers are unsecured debts of corporates. They are issued in the form

of promissory notes, redeemable at par to the holder at maturity. Only corporateswho get an investment grade rating can issue CPs, as per RBI rules. Though CPs

are issued by corporates, they could be good investments, if proper caution is

exercised.

The market is generally segmented into the PSU CPs, i.e. those issued by public

sector unit and the private sector CPs. CPs issued by top rated corporates are

considered as sound investments.

DFHI trades in these certificates. It will buy these certificates, subject to its

perception of the instrument and will also be offering them for sale subject toavailability of stock.

Commercial Papers - Salient Features

CPs are issued by companies in the form of usance promissory note,

redeemable at par to the holder on maturity.

The tangible net worth of the issuing company should be not less than Rs.4

crores.

Working capital (fund based) limit of the company should not be less than

Rs.4 crores. Credit rating should be at least equivalent of P2/A2/PP2/Ind.D.2 or higher

from any approved rating agencies and should be more than 2 months old on

the date of issue of CP.

Corporates are allowed to issue CP up to 100% of their fund based working

capital limits.

It is issued at a discount to face value.

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CP attracts stamp duty.

CP can be issued for maturities between 15 days and less than one year from

the date of issue.

CP may be issued in the multiples of Rs.5 lakh.

No prior approval of RBI is needed to issue CP and underwriting the issue is

not mandatory.

All expenses (such as dealers' fees, rating agency fee and charges for

provision of stand-by facilities) for issue of CP are to be borne by the issuing

company,

The purpose of introduction of CP was to release the pressure on bank funds for

small and medium sized borrowers and at the same time allowing highly rated

companies to borrow directly from the market.

As in the case of CDs, the secondary market in CP has not developed to a largeextent.

Commercial Bills

Commercial Paper is short-term loan that is issued by a corporation use for

financing accounts receivable and inventories. Commercial Papers have higher

denominations as compared to the Treasury Bills and the Certificate of Deposit.

The maturity period of Commercial Papers are a maximum of 9 months. They are

very safe since the financial situation of the corporation can be anticipated over afew months.

The concept of raising money through commercial paper was know to the US

markets since 20th century. On our country though it was introduced in 1990, the

RBI constantly watching the growth of the CP market and it is modifying the

guidelines from time to time. For further development of CP market, the stamp

duty on CP should be abolished since there is no stamp duty in US, UK and

France and RBI has to relax the stringent Credit Rating norms from the present

Credit rating P2 of CRISIL to P3, since credit rating is not compulsory in many

countries like US, UK and France.The denominations of CP should be reduced

further for the growth of secondary market for CP.

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Commercial Paper policy changes:

Jan 1990 July

1990

July

1991

July

1992

June

1994

July

1995

Sep.

1996

Feb.

1997

Oct.

2000

Oct.

2004

Tangible Net

Worth

10 Crore 5

Crore

- - 4 Crore - - - - -

WCFBL* 25 Crore 15

Crore

10

Crore

5

Crore

4 Crore - - - - -

Minimum Size 1 Crore 50

Lakh

25

Lakh

- - - - - 5 Lakh -

Maximum Size 20% of

MPBF**

- 30%

of

MPBF

75%

of

MPBF

- 75% of

Cash

Credit

Compone

nt

100% of

Cash

Credit

Compone

nt

100% of

WCFBL

Should

not

exceed

WCFBL

-

Denominations 25 Lakh 10

Lakh

5 Lakh - - - - - 5 Lakh -

Maturity

Period

91days -

6 months

- - - 3

months 1year

- - - 15 days

1 year

7day

- OnYr.

Credit Rating P1+ by CRISIL

or Equal grade

by other

agencies

- P2 - - - - -

Other

Measures

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Bills of exchange are negotiable instruments drawn by the seller (drawer) on the

buyer (drawee) for the value of the goods delivered to him. Such bills are called

trade bills. When trade bills are accepted by commercial banks, they are called

commercial bills. If the seller wishes to give some period for payment, the bill

would be payable at a future date (usance bill). During the currency of the bill, if

the seller is in need of funds, he may approach his bank for discounting the bill.

One of the methods of providing credit to customers by bank is by discounting

commercial bills at a prescribed discount rate. The bank will receive the maturity

proceeds (face value) of discounted bill from the drawee. In the meanwhile, if the

bank is in need of funds, it can rediscount the bill already discounted by it in the

commercial bill rediscount market at the market related rediscount rate. (The RBI

introduced the Bill Market Scheme in 1952 and a new scheme called the Bill

Rediscounting Scheme in November 1970).

With a view to eliminating movement of papers and facilitating multiplerediscounting, the RBI introduced an innovative instrument known as "Derivative

Usance Promissory Notes" backed by such eligible commercial bills for required

amounts and usance period (up to 90 days). Government has exempted stamp duty

on derivative usance promissory notes. This has indeed simplified and streamlined

the bill rediscounting by Institutions and made commercial bill an active

instrument in the secondary money market. Rediscounting institutions have also

advantages in that the derivative usance promissory note, being a negotiable

instrument issued by a bank, is good security for investment. It is transferable by

endorsement and delivery and hence is liquid. Thanks to the existence of a

secondary market the rediscounting institution can further discount the bills

anytime it wishes prior to the date of maturity. In the bill rediscounting market, it is

possible to acquire bills having balance maturity period of different days upto 90

days. Bills thus provide a smooth glide from call/overnight lending to short term

lending with security, liquidity and competitive return on investment. As some

banks were using the facility of rediscounting commercial bills and derivative

usance promissory notes for as short a period as one day merely a substitute for

call money, RBI has since restricted such rediscounting for a minimum period of

15 days.

The eligibility criteria prescribed by the Reserve Bank of India for rediscounting

commercial bill inter-alia are that the bill should arise out of genuine commercial

transaction evidencing sale of goods and the maturity date of the bill should not be

more than 90 days from the date of rediscounting.

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RBI has widened the entry regulation for Bill Market by selectively allowing,

besides banks and PDs, Co-op Banks, mutual funds and financial institutions.

DFHI trades in these instruments by rediscounting Derivative Usance Promissory

Notes (DPNs) drawn by commercial banks. DPNs which are sold to investors may

also be purchased by DFHI.

Derivative Usance Promissory Notes"(DUPN)

IT is an innovative instrument issued by the RBI to eliminate movement of papers

and facilitating easy rediscounting. DUPN is backed by up to 90 days Usance

commercial bills. Government has exempted stamp duty on DUPN to simplify and

steam-line the instrument and to make it an active instrument in the secondary

market. The minimum rediscounting period is 15 days

Bill Rediscounting

The RBI introduced the Bills Market Scheme (BMS) in 1952 which was later

modified into the New Bills Market Scheme (NBMS). Under this scheme

commercial banks can rediscount the bills which were originally discounted by

them with approved institutions (viz., Commercial Banks, Dvelopment Financial

Institutions, Mutual Funds, Primary Dealers etc.)

Multiple Rediscounting

The individual bills can be substituted by Derivative Usance Promissory Notes

(DUPN) of the equal aggregate amount and maturity which are drawn by the

issuing bank to eliminate movement of papers and to facilitate multiple

rediscounting. DUPNs are exempt from stamp duty and are negotiable instruments

Ready Forward Contracts (REPOS)

Ready forward or Repos or Buyback deal is a transaction in which two parties

agree to sell and repurchase the same security. Under such an arrangement, the

seller sells specified securities with an agreement to repurchase the same at a

mutually decided future date and a price. Similarly, the buyer purchases the

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securities with an agreement to resell the same to the seller on an agreed date in

future at a prefixed price. For the purchaser of the security, it becomes a Reverse

Repo deal. In simple terms, it is recognised as a buy back arrangement. In a

standard ready forward transaction when a bank sells its securities to a buyer it

simultaneously enters into a contract with him (the buyer) to repurchase them on a

predetermined date and price in the future. Both sale and repurchase prices of

securities are determined prior to entering into the deal. In return for the securities,

the bank receives cash from the buyer of the securities. It is a combination of

securities trading (involving a purchase and sale transaction) and money market

operation (lending and borrowing). The repo-rate represents the borrowing/lending

rate for use of the money in the intervening period. As the inflow of cash from the

ready forward transaction is used to meet temporary cash requirement, such a

transaction in essence is a short term cash management technique.

The motivation for the banks and other organizations to enter into a ready forwardtransaction is that it can finance the purchase of securities or otherwise fund its

requirements at relatively competitive rates. On account of this reason the ready

forward transaction is purely a money lending operation. Under ready forward deal

the seller of the security is the borrower and the buyer is the lender of funds. Such

a transaction offers benefits both to the seller and the buyer. Seller gets the funds at

a specified interest rate and thus hedges himself against volatile rates without

parting with his security permanently (thereby avoiding any distressed sale) and

the buyer gets the security to meet his SLR requirements. In addition to pure

funding reasons, the ready forward transactions are often also resorted to manage

short term SLR mismatches.

Internationally, Repos are versatile instruments and used extensively in money

market operations. While inter-bank Repos were being allowed prior to 1992

subject to certain regulations, there were large scale violation of laid down

guidelines leading to the 'securities scam' in 1992; this led Government and RBI to

clamp down severe restrictions on the usage of this facility by the different market

participants. With the plugging of loophole in the operation, the conditions have

been relaxed gradually.

RBI has prescribed that following factors have to be considered while performing

repo:

1. purchase and sale price should be in alignment with the ongoing market

rates

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2. no sale of securities should be effected unless the securities are actually held

by the seller in his own investment portfolio.

3. Immediately on sale, the corresponding amount should be reduced from the

investment account of the seller.

4. The securities under repo should be marked to market on the balance sheet

date.

The relaxations over the years made by RBI with regard to repo transactions are:

i. In addition to Treasury Bills, all central and State Government securities are

eligible for repo.

ii. Besides banks, PDs are allowed to undertake both repo/reverse repo

transactions.

iii. RBI has further widened the scope of participation in the repo market to all

the entities having SGL and Current with RBI, Mumbai, thus increasing the

number of eligible non-bank participants to 64.

iv. It was indicated in the 'Mid-Term Review' of October 1998 that in line with

the suggestion of the Narasimham Committe II, the Reserve Bank will move

towards a pure inter-bank (including PDs) call/notice money market. In viewof this non-bank entities will be allowed to borrow and lend only through

Repo and Reverse Repo. Hence permission of such entities to participate in

call/notice money market will be withdrawn from December 2000.

v. In terms of instruments, repos have also been permitted in PSU bonds and

private corporate debt securities provided they are held in dematerialised

from in a depository and the transactions are done in a recognised stock

exchange.

Apart from inter-bank repos RBI has been using this instrument effectively for its

liquidity management, both for absorbing liquidity and also for injecting funds intothe system. Thus, Repos and Reverse Repo are resorted to by the RBI as a tool of

liquidity control in the system. With a view to absorbing surplus liquidity from the

system in a flexible way and to prevent interest rate arbitraging, RBI introduced a

system of daily fixed rate repos from November 29, 1997.

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Reserve Bank of India was earlier providing liquidity support to PDs through the

reverse repo route. This procedure was also subsequently dispensed with and

Reserve Bank of India began giving liquidity support to PDs through their holdings

in SGL A/C. The liquidity support is presently given to the Primary Dealers for a

fixed quantum and at the Bank Rate based on their bidding commitment and also

on their past performance. For any additional liquidity requirements Primary

Dealers are allowed to participate in the reverse repo auction under the Liquidity

Adjustment Facility along with Banks, introduced by RBI in June 2000.

The major players in the repo and reverse repurchase market tend to be banks who

have substantially huge portfolios of government securities. Besides these players,

primary dealers who often hold large inventories of tradable government securities

are also active players in the repo and reverse repo market.

Banker's Acceptance:

It is a short-term credit investment. It is guaranteed by a bank to make payments.

The Banker's Acceptance is traded in the Secondary market. The banker's

acceptance is mostly used to finance exports, imports and other transactions in

goods. The banker's acceptance need not be held till the maturity date but the

holder has the option to sell it off in the secondary market whenever he finds it

suitable.

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THE LIQUIDITY ADJUSTMENT FACILITY (LAF) OF RBI.

The introduction of the Liquidity Adjustment Facility (LAF) was announced in the

slack season credit policy by the RBI governor and was made effective on the 5thof

June 2000. The system is being implemented in phases and currently is a daily

exercise in which Banks and Primary Dealers (PD) participate.

Objectives of LAF

Amongst its many functions, Reserve Bank of India also acts as the banker of last

resort. In this role, the central bank has to ensure that it can inject funds into the

system to help participants tide over temporary mismatches of funds. Refinance, as

it used to happen earlier was at a fixed rate which was largely divorced from the

cost of equivalent short-term funds in the market. This gave rise to a non-

egalitarian distribution of interest rates in the short end of the curve. Further, the

amounts that could be borrowed were determined by a preset limit. To do awaywith the deficiencies, RBI moved to an auction system of repos and reverse repos

to suck-out and inject liquidity to the market. The three broad objectives of LAF

are as follows:

To give RBI greater flexibility in determining both the quantum

of adjustment as also the rates by responding to the system on a daily

basis.

To help RBI ensure that the injected funds are being used to

fund day-to-day liquidity mismatches and not to finance morepermanent assets.

To help RBI set a corridor for short-term rates, which should

ideally be governed by the reverse-repo (top band), and repo (lower

band) rates. This would impart greater stability in the markets.

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Methodology of LAF

The Financial Markets Committee, consisting of the operational Departmental

Heads, which meets every day in the morning to assess market conditions, is

responsible for decisions relating to the LAF. The Committee meets again at 12

noon to assess the bids received under LAF. The exact quantum of liquidity to be

absorbed or injected and the accompanying repo and reverse repo rates are

determined by the Committee after taking into consideration, the liquidity

conditions in the market, the interest rate situation and the stance of monetary

policy. The decisions are based on a myriad factors including net inflows and

outflows on account of forex operations, current account balances of the banks

against the CRR requirements, open market operations, redemption of loans and

coupon payments, announcement of new issues by the government, un-drawn

liquidity support on account of export refinance, collateralised lending facility to

banks and level I refinance to PDs and the overall situation of the call moneymarket. The rate of interest however is determined on the basis of the bids received

from the market.

Observations in the LAF so far

The experience gathered from witnessing the LAF, which would be three months

old soon, can be summed up through a few generalizations.

RBI has received bids both from lenders as well as borrowers in

the market Banks and PDs more aggressively do bidding for reverse repos,

both in terms of rates and amounts

The same participant often bids for both repo as well as for

reverse repo even on the same date

There exists a tendency to put in multiple bids, which is normal

in any auction process

On days there have been no bids for either repo, or reverse repo

or for both

On days, RBI has rejected all bids under repo and / or under

reverse repo

On days, RBI has been both injecting as well as taking out

liquidity from the markets

The closing call money rates on days of tighter liquidity

conditions seem to have exceeded the rate at which RBI infused

liquidity through reverse repos.

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Some criticism of the LAF and RBIs response

As is true with a new system, the LAF too has attracted a fair amount of criticism

about the way it works. It is important to note that it is through these criticisms that

the system shall evolve as an accepted and a foolproof one.

LAF discriminates between the lending banks and PDs

Reserve Bank of India, or for that matter any central bank is not there to present

unlimited liquidity through the reverse repo auctions. While setting cut-off rates

and the quantum in reverse repos, RBI keeps in mind the overall liquidity

condition of the market and not bank-wise liquidity positions. RBI can monitor the

bids submitted by the banks to identify the chronic borrowers and whether the

reverse repo is being used as a "back-door" refinance for other more permanent

assets.

The uniform price auction should be replaced with a discriminatory price auction

The main argument in favour of this being that given a uniform price auction

which eliminates the "winners curse", the tendency is to submit higher bids to

ensure success. This in turn leads to higher cut-off rates. The argument can be

countered by the proposition that the uniform price auction leads to a single

clearing rate, which sets a benchmark for the market. Also RBI feels that this form

of auction is better for the post-auction market.

Counter arguments have it that a weighted average rate can emerge from a

discriminatory price auction, which can serve as a benchmark and yet serve the

purpose of fine-tuning the bids. RBI feels that there is no settled wisdom, even

internationally, as to the ideal auction system and that it is open to a situation

review from time to time.

LAF has increased interest rates, as call rates tend to follow the reverse repo cut-

off

This would inevitably happen as the market players read from the actions of the

central bank. The ultimate objective of the LAF is to adjust short-term liquidity

situation to the overall policy stance. The LAF is still in the early protean stages of

development and further fine-tuning is bound to improve the system.

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PDs argue that they should be given assured liquidity at reasonable rates so that

they are not hit on the carry

Higher cost of carry for PDs get transmitted to the market by higher bond yields.

Also PDs face uncertainty that all bids might get rejected and they are left with

nothing. It is important to remember that Level I refinance is still available to the

PDs and that the LAF currently operates at the margin in replacement of Level II

refinance. Thus to view the impact of the LAF on PDs, the reverse repo cut-off rate

has to be seen in conjunction with the liquidity availed under Level I refinance and

a weighted average will have a far greater relevance. As has been stated earlier, the

objective of the LAF is with overall liquidity and not with the needs of individual

market players.

Moving ahead

It is without doubt that the considerations on which the concept of LAF is based

are extremely sound and that it has been able to make an impact on the market in a

very short period of time. The mechanism has also come in handy for RBI to

monitor and control short-term liquidity in the current volatility in the forex

market. During the next one year, RBI intends to move into a system of a full-

fledged LAF with multiple auctions, based on electronic dealing, and replacing

traditional assured sources of liquidity at fixed interest rates.

Scheme of Liquidity Adjustment Facility: 2001 - 2002.

The main features of the revised Scheme, known as LAF Scheme 2001-2002, are

as under:

The Scheme

Under the scheme,

(i) Repo auctions (for absorption of liquidity) and

(ii) Reverse Repo auctions (for injection of liquidity)

will be conducted on a daily basis (except Saturdays). But for the intervening

holidays and Fridays, the Repo tenor will be one day. On Fridays, the auctions will

be held for three days maturity to cover the following Saturday and Sunday. The

funds under LAF are expected to be used by the banks for their day-to-day

mismatches in liquidity.

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Fixed rate Repo auction

RBI will henceforth have an additional option to switchover to fixed rate Repos on

overnight basis; but this option is expected to be sparingly used. For the purpose of

such Repos, the rates of interest intended to be offered would be announced as part

of auction announcement on the previous evening or before 10.00 a.m. on the day

of auction, if necessary.

Long term Repo

In addition to overnight Repos, RBI will also have the

discretion to introduce longer-term Repos up to 14 day period as and

when required.

Rate of Interest

Till recently, auctions under LAF were conducted on ''uniform price'' basis. It was

decided to introduce ''multiple price'' auction, in place of existing uniform price

auction on an experimental basis and after evaluation of the experience, the RBI in

consultation with the market participants has decided to continue with the system

of multiple price method of repo and reverse repo auctions until further notice.

Interest rates in respect of both Repos and Reverse Repos will be, accordingly,based on the bids quoted by participants and subject to the cut-off rates as decided

by the Reserve Bank of India, at Mumbai. The Repo/Reverse Repo rate in per cent

per annum expected by the tenderer will be expressed up to two decimal points

rounded off to the nearest 5 basis points. As there will be no adjustment for

accrued coupon, the cash flow will depend upon the Repo rate emerging on day-to-

day basis.

Back - Stop Facility

For a smooth transition to full-fledged operation of LAF, banks and PDs are beingprovided a back-stop facility at variable rate of interest, as a cushion over the

normal liquidity facility at Bank Rate. Basically, the standing liquidity facilities

available from RBI is split into two parts, viz.,

i. normal facility and

ii. back-stop facility.

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The normal facility will be provided at the Bank Rate. The back-stop facility will

be provided at a variable daily rate. The variable rate would be linked to cut-off

rates emerging in regular LAF auctions and in the absence of such rates, to

National Stock Exchange - Mumbai - Inter-bank Offer Rate (NSE-MIBOR) as

detailed below

i. The variable rate for the back-stop facility, to be fixed on a

daily basis would be 1.0 percentage point over the reverse repo cut-off

rate at which funds were injected earlier during the day in the regular

LAF repos auctions.

ii. Where no reverse repo bid was accepted as part of LAF auction,

the rate will be 2.0 to 3.0 percentage points over the repo cut-off rate

of the day emerged in LAF auction as may be decided by RBI.

iii. In case no bids were accepted earlier during the day at either

repo or reverse repo auctions, the rate will be 2.0 to 3.0 percentagepoints over NSE-MIBOR as may be decided by RBI.

The Back-stop facility would be operated till close of banking hours. And of the

total limits of liquidity support available to PDs and banks, the normal facility

would initially constitute about two-thirds and the back-stop facility about one-

third. PD-wise and bank-wise limits will be announced separately.

Further, to facilitate better bidding by the participants, additional information on

the aggregate cash balances of scheduled commercial banks maintained with RBI,

during the fortnight, on a cumulative basis with a lag of two days as also weightedaverage cut-off yield will also be released as a part of the Press Release on money

market operations.

Mechanics of operations

i. The LAF auction timing is being advanced by 30 minutes. Bids

will be received in tender forms at IDM Cell before 10.30 a.m., as

against 11.00 a.m. at present. A separate box for the purpose will be

kept at the reception on the Ground floor of the Central Office

Building, RBI, Mumbai. Processing of the bids will be done at IDMC.

The auction results will be displayed by Mumbai Office by 12.00

noon as against 12.30 p.m. at present.

ii. The Repo will be conducted as "Hold in Custody" type,

wherein the Reserve Bank of India will act as a custodian for the

participants and hold the securities on their behalf in the

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Repo/Reverse Repo Constituents Accounts. In pursuant to this, the

participants will have to give an undertaking as given in the respective

tender forms authorizing RBI to act on behalf of them. Reserve Bank

of India shall not, however be responsible for any loss, damage or

liability on account of acting as the Custodian on behalf of the

participants. A Repo Constituents SGL Account (RC SGL Account)

and Reverse Repo Constituents SGL Account (RRC SGL Account)

will be opened and held in the Securities Department in Mumbai

Office for this purpose which will have institution-wise subsidiary

records of the securities sold under Repo and securities bought under

Reverse Repo. RBI will have Subsidiary Accounts in the case of both

of these Accounts.

iii. On success in auction in respect of Repos, the tenderers RC

SGL Account will be credited with the required quantum of securities

debiting Banks subsidiary account/Investment Account. Likewise,the tenderers Current Account will be debited for the resultant cash

flows and credited to the Banks Account. The transaction will be

reversed in the second leg.

iv. In the case of Reverse Repos, on acceptance of bid, the

tenderer's SGL account/ RRC SGL Account will be debited with the

required quantum of securities and credited to Banks Investment

Account/Subsidiary RRC SGL Account. Accordingly, the tenderers

Current Account will be credited with the Reverse Repo amount,

debiting the Bank's account. The transactions will be reversed in the

second leg.

v. Transactions between RBI and counter parties including

operation of the RC SGL Account and RRC SGL Account would not

require separate SGL forms as provision will be made in the

application form for the purpose. Likewise, transfer of securities

from/to RBIs Investment Account and Subsidiary Accounts in the

Repo and Reverse Repo SGL account will not require signing of SGL

transfer forms. However, transfer from tenderers SGL Account to the

RRC SGL Account will require completion of SGL form. In the case

of Reverse Repos, tenderers will have the option to either use theRRC SGL Account route or getting their SGL Accounts debited for

the purpose of transferring securities to RBI.

vi. Pricing of all securities including Treasury Bills will be at face

value for Repo/Reverse Repo operations by RBI. Accrued interest as

on the date of transaction will be ignored for the purpose of pricing of

securities. Coupon, if any, will be transferred to RBI in the case of

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Repos, and RBI will collect the coupon, if any, on the due date and

credit the same to the partys Current Account in the case of Reverse

Repos.

Eligibility

All Scheduled Commercial Banks (excluding Regional Rural Banks) and Primary

Dealers (PDs) having Current Account and SGL Account with RBI, Mumbai will

be eligible to participate in the Repo and Reverse Repo auctions.

Minimum bid size

To enable participation of small level operators in LAF and also to add further

operational flexibility to the scheme, the minimum bid size for LAF is being

reduced from the existing Rs.10 crore to Rs.5 crore and in multiples of Rs.5 crore

thereafter.

Margin Requirement

A margin will be uniformly applied in respect of the above collateral securities

comprising the Government of India dated securities/ Treasury bills. The amount

of securities offered or tendered on acceptance of a bid for Rs.100 will be Rs.105

in terms of face value.

Settlement of Transactions

The settlement of transactions in the auction will take place on the same day.

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SLR and Securities held in Repo SGL Account

Securities held by RBI on behalf of banks' Repo Constituents SGL account and

credit balance in the RRC SGL Account will be counted for SLR purpose and a

certificate will be issued to banks by RBI on a fortnightly basis. As far as valuation

etc. for SLR purpose is concerned, extant DBOD instructions will apply.

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BIBLIOGRAGHY:

WEBSITES:

www.rbi.org.in/weekly statisticalsupplement/various issues.co.in

www.investopedia.com . www.nseindia.com

www.economics.indiatimes.com

53727969 money market project in finance

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