RBI’s Retail Direct: No masterstroke, just breaststroke outside the water

Ever since the Reserve Bank of India (RBI) went along with Narendra Modi in demonetising large denomination currency notes in November 2016, the central bank appears to enter a reality distortion field when it comes near the prime minister. There is no other explanation for the RBI getting the PM to kick off its Retail Direct scheme, to let individuals invest in government bonds directly, and to trade in them on the Negotiated Dealing System-Online Matching (NDS-OM) platform.

Giving retail investors direct access to buying and selling government bonds, a terrain few countries have ventured into, sounds radical. Opening up the NDS-OM platform, reserved for bulk traders, to retail investors is like throwing Gymkhana Club open to the hoi polloi. But it serves no practical purpose, either for retail investors or for widening or deepening the debt market. But it does serve a purpose of the central bank, to remove one argument that markets regulator Sebi could make, to bring retail trading of government bonds under its purview and on to stock markets — retail investors do now have, in theory, a route to direct investment in government bonds, under RBI regulation.

But why would retail investors not use the new facility offered by the central bank? There is little to gain and much to lose by investing in government bonds, except as part of a portfolio of financial instruments complete with the means of hedging against interest rate risk and exchange rate risk.

Suppose someone purchases a few government bonds, offering a yield of around 6%. Suppose interest rates go up, as is quite likely over the next 12 months. The price of these bonds would fall, as a result of the yield going up, and the investor would have no protection against such interest rate risk, as the platform does not offer any scope to hedge against such risk. The alternative is to put the money in a bank fixed deposit. Of course, there is the risk of a bank going under and the depositor not getting her money back over and above the ₹5 lakh per individual covered by the deposit insurance scheme. But the probability of a bank going under is minuscule, compared to the risk of interest rates going up and the investor suffering capital erosion.

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What if the investor is interested in the coupon, the fixed amount paid per year by the issuer of the bond in return for purchasing and holding the bond, and is willing to hold the bond to maturity? Then, there is no risk of capital erosion on account of yield changes. If the investor is willing to hold on to illiquid assets, why would she not opt for the 7.15% RBI bonds? The interest earned is taxable, in any scenario. The so-called RBI bond is also totally risk-free, being issued by the Government of India. These are floating-rate bonds, with the coupon revised every six months at 0.315% above the rate of interest offered on National Saving Certificates, which, in turn, is benchmarked against the yield on government bonds. Clearly, for a saver, these floating rate bonds are preferable to ordinary government bonds, if she is willing to put up with illiquidity.

Retail investors are heavily exposed to government bonds in any case, albeit indirectly. When they invest in insurance products, when they contribute to their provident fund or subscribe to the National Pension System, they acquire hefty exposures to government bonds — by regulation. When they invest in bond mutual funds, they take on exposure to government debt by choice. Given these facilities that already exist for the ordinary investor to buy government bonds, what practical service would the RBI Retail Connect perform? Hardly any is the realistic answer.

Why then does the RBI create this retail investor shield against Sebi-regulated retail trading of government bonds? The RBI’s perception of the role of government bond trading was set out by Governor Shaktikanta Das recently in a speech: “Let me now turn to the criticality of the G-sec market for effective discharge of Reserve Bank’s functions. The Reserve Bank’s multi-faceted role as monetary policy authority, manager of systemic liquidity, government debt manager, regulator of interest rate and foreign exchange markets, regulator of payment and settlement systems and overseer of financial stability makes the G-sec market critical for the effective discharge of these responsibilities.”

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There can be no quibble about the criticality of the G-sec market for a well-functioning financial system. But the question is, is regulation by the RBI a necessary condition for the G-sec market to function well or can Sebi be trusted to enforce the rules of trading framed by the RBI and informed by the central bank’s macroprudential guidelines applicable at the moment?

The retail investor today is no longer the Dalal Street habitué of yesteryears. It is anyone with a decent job and a trading app on his or her phone. These growing cohorts of new entrants to the workforce and the investing habit are not going to invest in any product not accessible via that app.

The way to draw retail investors into government securities is to create a vibrant market for debt, private as well as government, to which investors have an incentive to gain exposure. The RBI’s conservatism on government bonds and regulations against investment in sub-prime paper has prevented the debt market from taking off.

Even when corporate debt offerings have multiplied in number and volume, these tend to be held to maturity, rather than traded. The most probable route to a vibrant debt market lies in so-called junk bonds, bonds issued by small and medium companies or lenders to such companies with less than prime credit rating but offering high enough yields to compensate for the risk. When such paper proliferates, the demand for derivative products to hedge against interest, currency and credit risk would surge, the needed products would be innovated in form and availability and the market would take off.

You cannot drown outside the water, but nor can you swim. To don swimming trunks and thrash about on the beach will preclude drowning, but will not amount to swimming. It is time the RBI understood this and took the plunge.