The capital market regulator Securities & Exchange Board of India (SEBI) is considering setting up a ‘backstop’ facility for corporate bonds in case of illiquidity and crisis in the markets.

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Speaking at the 25th AGM of industry body AMFI, Sebi Chairman Ajay Tyagi emphasized on the need to increase liquidity in the corporate bond market to ensure smooth functioning of the debt mutual funds.

“Apart from mandating mutual funds to do a minimum percentage of their secondary market trades in corporate bonds on the RFQ platform of stock exchanges, SEBI is pursuing a multitude of measures to not only increase liquidity in secondary markets but also to enable greater issuances of paper rated below AAA,” Tyagi said.

One such measure the regulator is examining is the setting up of a backstop facility.

It would be an entity that can trade in relatively illiquid investment grade corporate bonds and be readily available in times of stress to buy such bonds from various market participants in the secondary market.

This may instill greater confidence of market participants in corporate bonds, especially in below AAA investment grade bonds.

“Of course, as a broad general guiding principle, for any such entity to be set up, the market participants should have ‘skin in the game’ and the ‘moral hazard’ problem ought to be satisfactorily addressed,” Tyagi added.

What is a Backstop facility?

When a company raises capital through issuance of securities, a backstop facility supports the overall offering by ensuring that the offering does not fail if all shares are not subscribed. An underwriter or a major shareholder, likely an investment bank, will act as a backstop facility and buy any of its unsubscribed shares.

A backstop guarantees that a certain amount of the offering will be purchased by particular organizations if a portion of the offering goes unsold.

Speaking to CNBC-TV18, Ananth Narayan, Professor at SPJIMR commented, “If it is the last resort buyer under extremely stressful situations, I don’t see how we can do this without either the government or the central bank getting involved. My view is that for something like this to work as last-ditch back stop, you will require either Government of India or RBI to be there. It is not enough if it is just market participant’s pool and you can do that for normal market liquidity, for secondary market liquidity under normal circumstances."

Further, Tyagi noted that the repo market on corporate bonds has unfortunately not taken off till now in India. SEBI is deliberating on having a limited purpose central clearing corporation for guaranteed settlement of tri-party repo trades in all investment grade corporate bonds, including those below AAA rated, to boost repo trading in corporate bonds.

“As major holders of corporate bonds, the mutual funds, who regularly have buying/selling needs, would be one of the biggest beneficiaries of a liquid market. Issuers will also be significant beneficiaries of a liquid and stable market in terms of lower borrowing costs,” he said.

Despite uncertain times, the overall fund raising through the capital markets during this financial year till September 18, 2020 was Rs 5.0 lakh crore (Rs 1.46 lakh crore in equity and Rs 3.54 lakh crore in debt securities).

As for a comparison with the last year, till end August, total funds raised this year were about Rs 4.5 lakh crore as compared to Rs 4 lakh crore last year, Tyagi informed.

This is particularly important since corporate India needed to build a cushion of capital to absorb the COVID shock and the markets have lent full support to help them do that, he added.