Introduction
In a landmark move, the Reserve Bank of India ("RBI") rolled out a new framework through its Government Securities Lending ("GSL") Directions, 2023 ("Directions")1 to foster borrowing and lending of government securities within India's financial markets.
A significant characteristic of these Directions is that eligible securities can assume two forms: as the borrowed asset and as collateral for securing a transaction. This article will critically analyse the legal implications of this distinctive feature and study its impact on market flexibility and liquidity.
Eligible Securities: Borrowed Assets and Collateral
The RBI Directions define the eligible scope of securities for GSL transactions. Central government securities, except for Treasury Bills, can be lent and borrowed. Ironically, securities obtained through repo transactions or previous GSL are also considered acceptable.
There is a broader sweep of government securities eligible as collateral for the GSL transaction. Such securities include State Governments' and Treasury Bills. Again, for this purpose, securities obtained through repo transactions or previous GSL are considered acceptable as collateral. This flexibility in the eligibility norms enables market participants to avail themselves of a larger corpus of securities, both for borrowing and as collateral. This is quite a deviation from previous regulations that had more stringent eligibility norms, which might yield better overall liquidity in the markets.
Use of Borrowed Securities and Collateral Substitution Rights
The Directions clearly allow the permitted usage of securities borrowed through GSL transactions. There are outright and repo transactions under which the borrower may sell the borrowed securities, apply them to meet short sale delivery obligations, pledge them to draw in the Liquidity Adjustment Facility offered by RBI, or lend out through another GSL transaction.
The large number of permitted uses allows borrowers substantial flexibility in managing their securities portfolio and meeting different market obligations. The facility to re-use borrowed securities, such as short-sold ones, is particularly noteworthy as it can be used more effectively in arbitrage and hedging strategies. Directions also permit substitution, as central counterparty rules permit, of the securities posted as collateral with other eligible securities. This substitution right allows a borrower to refine their collateral pool further and avoid 'locking up' particular securities for the entire tenor of the GSL transaction.
Legal Implications and Market Impact
The dual role of securities both as borrowed assets and collateral, imparts a myriad of implications on legal as well as practical grounds.
- The first justification for applying accounting treatment under the Directions is that they ensure an appropriate reflection of the economic substance of the GSL transaction: a lender should continue to reflect the lent securities in its investment portfolio, and the borrower should not recognise any borrowed securities on its balance sheet.
- The second justification is that Directions clarify the eligibility of securities under the Statutory Liquidity Ratio (SLR), thereby fostering participation in the GSL market.
- Thirdly, the possibility of reusing borrowed securities and substitutability of collateral might enhance market liquidity since the borrowers have easier control over their securities portfolio, meet delivery obligations, and access RBI liquidity.
- Lastly, the double eligibility and substitution rights that relate to the collateral affect risk management because lenders would have to carefully evaluate the credit quality and the liquidity of both the borrowed securities and the pledged collateral, and central counterparties will play a central role in determining appropriate haircuts and margin requirements.
Conclusion
GSL Directions by RBI have brought out an innovative legal structure under which government securities could be used for not only collateral but also borrowed assets purposes. Such opened up use and substitution of securities could increase liquidity in the market, greater efficiency in management of portfolios, and more comprehensive resilience of India's government securities market. As the market participants get accustomed to the new regime, the guidelines for regulation will require careful monitoring and fine-tuning to tap the full potential of government securities lending in India.
Footnote
1. Reserve Bank of India (Government Securities Lending) Directions, 2023, Reserve Bank of India, available at: https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12580&Mode=0.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
