Market Makers or Market Breakers? The Regulatory Dilemma in India’s Bond Forward Trade

The authors are Anenya and Yash Sharan, students at Hidayatullah National Law University, Raipur.

Introduction

On 21 February 2025, the Reserve Bank of India (“RBI”) unveiled the RBI (Forward Contracts in Government Securities) Directions, 2025 enlisting new guidelines (“the Guidelines”) governing forward contracts in government securities. The Guidelines aim to improve the management of interest rate risks, specifically for insurance funds, strengthen banks’ governance, ease the interaction between customers and institutions, and ameliorate investors’ protection. The Guidelines, to be effective from 2 May 2025, bring about staggering and reconditioning changes. It thus becomes imperative to discuss the elephant in the room. 

Through the means of this article, the authors delve into the intricacies of the Guidelines. Firstly, the article discusses the major provisions of the Guidelines, and the changes they seek to bring. Secondly, it highlights the shortcomings and challenges of the Guidelines. The article concludes with a way forward and the authors’ suggestions to resolve the aforementioned roadblocks. 

Revolutionising Bond Forwards: Crackdown of RBI’s Provisions

The Guidelines bring major changes that are forecasted to transform how bond forward transactions are regulated and remodify the Indian banking industry.

Firstly, the Guidelines have created two separate categories for bond forward market participants through its expansion of “eligible participants” into market makers and users. Market makers include Scheduled Commercial Banks (“SCBs”) and Standalone Primary Dealers (“SPDs”) which now hold specific authorisation to provide prices to market users as well as other professional market makers. The provision aims to create better market liquidity as well as enhance price discovery processes.

Users who fall under the Rupee Interest Rate Derivatives Directions, 2019 can engage in bond forward deals exclusively to protect themselves from market risks. The classification system separates speculative activities from legitimate risk management, so that insurance firms and pension funds can utilise forward contracts properly. The RBI has established clear market participant roles to enhance governance standards which lowered the risks that could affect government securities trading. The Foreign Exchange Management (Debt Instruments) Regulations, 2019 allows both Indian residents and non-residents to partake in forward contracts when they follow its guidelines. Market makers receive well-defined roles according to the guidelines. SCBs together with SPDs now hold unlimited long and covered short positions while having specific conditions for unleveraged short positions. The wide range of participants in this framework enhances market liquidity while maintaining strong and competitive market-making activities.

Secondly, the Guidelines maintain firm position limits because they aim to protect forward contracts from being used for speculation instead of their original risk management purpose. Market makers can now take unlimited long positions while entering covered short positions when they follow prudential risk management standards. The position limits protect market makers from taking too much risk when they supply market liquidity.

Users face tighter position limitations since they can maintain unlimited long positions yet their ability to establish short positions exists only for hedging functions. The market stability is protected through these rules because institutional investors cannot use high leverage or speculative strategies. Risk mitigation principles appear as a protective measure in this provision to shield the financial system from short-selling practices that could create market volatility.

The Guidelines specify that bond forward transactions need to match users’ existing risk exposure since forward contracts function exclusively as risk management tools instead of speculative arbitrage instruments. The regulatory change signals RBI’s dedication toward protecting investors at the same time that financial innovations gain momentum.

Thirdly, the RBI has established a new settlement framework which improves the operational clarity in bond forward transactions. Through the Guidelines, counterparties can choose between physical delivery and cash settlement as settlement modes to agree upon their preferred method. Institutions now have the ability to select settlement methods that match their needs under current market conditions and liquidity situations.

All forward contracts must follow transparent valuation processes as per RBI directives to minimise pricing irregularities. Market manipulation becomes highly unlikely through independent price verification and fair-value accounting principles which increases investor confidence in the system. The standardised reporting requirements render financial institutions handling bond forward trades accountable in a transparent way which enables better regulatory oversight. These substantial measures decrease counterparty exposure to risk while advancing better market controls. The RBI establishes a transparent rule enforcement system that enhances government security forward contract credibility throughout Indian financial markets.

A Roadmap to Reform: Fixing the Flaws in RBI’s Bond Forward Guidelines

The Guidelines are set to be effective from 2 May 2025 and have been largely discussed. However, concerns persist over their implementation, participation, and regulatory oversight. The unmitigated gaps can prevent India from achieving its desired goals in the bond forward market including improved liquidity and reduced speculation and enhanced governance. Each deficit in the framework creates a chance to enhance and readjust policies which will fortify the regulatory structure.

Firstly, the distinction between market makers and users provides better system organisation yet this arrangement makes it easier for institutions with limited size and non-institutional entities to enter the market. Only SCBs and SPDs have permission to function as market makers according to the Guidelines which bars other economic institutions from conducting market-making operations. Such restrictions prevent additional institutions such as Non-Banking Financial Companies (“NBFCs”) and mutual funds and insurance firms from participating in the market which could reduce market depth. Users must limit their forward contracts to hedging purposes because the regulatory boundary between them and market makers prevents advanced risk management approaches which reduces their ability to optimise their portfolios.

To resolve this, the definition of market makers needs expansion to incorporate well-regulated financial institutions that prove their risk management expertise. The authorisation system should feature multiple tiers that allow NBFCs mutual funds and large corporate treasuries with specific prudential criteria to function as limited market makers. The Guidelines’ anti-speculation position can be preserved through implementing prudential safeguards which enable select users to establish covered short positions.

Secondly, the Guidelines attempt to stop speculative behaviour by enforcing strict position limits mostly against users. The market makers can establish endless long positions while their short positions face strict regulatory controls and user participation in uncovered short positions remains barred. The restrictions implemented by the Guidelines control systemic risks but they weaken both market liquidity and price efficiency within the bond forward market. Insufficient short-selling capabilities eliminate correct market pricing mechanisms and produce improper risk management approaches which negatively impact market liquidity in the secondary market. The regulatory limitations create the unintended consequence that some financial entities shift their derivative trades to offshore platforms where RBI has no monitoring authority.

A flexible position limit system should be developed to boost market performance and protect regulatory standards. Such a framework enables institutional investors and pension funds to conduct covered short positions within specified risk-based thresholds thus preserving short-selling as an effective risk management tool. The RBI should establish multiple leverage limits that provide more freedom to financial entities which demonstrate strong capital reserves and advanced risk management capabilities. A periodic reassessment system would also allow such entities to modify position limits based on current market conditions. Market stability would remain protected through this approach that avoids liquidity restrictions.

Thirdly, market participants now have two settlement options under the Guidelines through both physical settlement and cash settlement methods. The need for the Clearing Corporation of India Limited (“CCIL”) or RBI-approved institution clearing requirements increases operational difficulties and transaction expenses mainly affecting smaller market participants who have limited financial capabilities. The structured settlement regime of the Guidelines works against market liquidity changes which could lead to payment delays during times of financial distress. Financial institutions which must settle physically encounter liquidity problems that enhance their counterparty risk exposure while damaging the stability of the financial system. A flexible settlement method must be introduced which uses market behaviour as an adjustment mechanism to minimise challenges and keep transparency and risk prevention active during government securities trading.

The RBI should establish a settlement flexibility period which permits participants to choose between physical and cash settlement based on market liquidity levels during the pre-maturity period. The introduction of such a settlement flexibility window would stop mismatches in liquidity while decreasing counterparty risks. The RBI should allow sound counterparties to establish bilateral netting agreements under supervision to reduce clearinghouse dependence which would improve transaction efficiency. CCIL’s settlement efficiency will improve when its technological framework receives investments toward both faster and more streamlined transactions and operational clarity reduction. Such measures will improve the government securities forward market’s adaptability together with cost-effectiveness and resilience while keeping robust risk management practices in place.

Conclusion

The RBI’s Guidelines serve as a key market enhancement tool but need to address structural problems to achieve maximum effectiveness. Markets face performance limitations due to the market participant definition's restrictive conditions as well as rigid position restrictions and operational inefficiencies and complex regulatory requirements.

The RBI can strengthen India’s bond forward market by implementing strategic improvements, which include the expansion of market participants and dynamic position limits and settlement flexibility alongside standardized regulatory requirements. The development of forward contracts in government securities into reliable risk management tools, rather than speculative instruments, by achieving the right balance between risk control and market expansion would also immensely strengthen India's financial markets in the future.