Loosening the Shackles: What India Can Learn From US Bond Markets

India’s bond market remains significantly less liquid than those in developed economies. Before examining the risks associated with a shallow market, let’s look at the factors that have kept it shallow in the first place.

To begin with, market makers in India cannot freely buy or short bonds on margin.  

Conservative rules limit trading strategies, reduce market depth, and keep bid-ask spreads wide. This makes it hard for investors to enter or exit positions without distorting prices.

In contrast, margin trading plays a key role in ensuring liquidity in the US. Banks, institutional investors, hedge funds, and primary dealers use leverage to amplify their purchasing power, increasing market participation and trading volumes.

Market makers such as Jane Street and Citadel rely on borrowed funds to create liquidity, ensuring smoother price movements and tighter spreads.

Shorting and hedging are equally critical. In developed markets, institutional investors hedge exposures using derivatives such as bond futures and options or by short-selling bonds outright.

Retail investors access hedging tools via inverse bond ETFs. This makes the market more resilient, preventing disorderly moves and allowing investors to manage risk efficiently.

In contrast, India imposes significant constraints on shorting. The tenure of short trades is limited, and operational and regulatory hurdles bog the process down. This forces investors to hold positions longer than they might want, exacerbating price inefficiencies and discouraging active market participation.

Leverage is another missing piece. Stringent margin requirements prevent traders from using borrowed funds to buy bonds, limiting participation and reducing turnover.

Coming back to the point made in the beginning, a deep and liquid bond market is critical for efficient capital allocation, risk management, and price discovery. With fewer active traders, price discovery weakens, and volatility spikes become more pronounced during periods of stress.

Liquidity Boost
Another key reason for US bond market liquidity is the widespread use of repo markets. The ability to finance positions through repurchase agreements allows participants to recycle capital efficiently, ensuring steady trading activity. In India, repo markets remain restricted to a limited set of participants. Expanding access could help improve secondary market liquidity.

Capital requirements also need a rethink.

US regulations allow well-capitalised institutions to trade bonds on margin within clear risk limits. India’s rigid capital norms discourage market makers from taking positions which otherwise would have enhanced liquidity. Calibrating capital requirements to align with international standards could make bond trading more attractive.

Also in India, foreign investors remain a largely untapped. While India has eased access to government bonds for foreign portfolio investors, restrictions on derivatives trading and short-selling still exist. Enabling foreign players to participate more freely in market-making and hedging strategies could significantly deepen liquidity.

The private sector must also be incentivised to play a larger role. In the US, large trading firms and hedge funds actively participate in market-making because the regulatory framework allows them to do so profitably. Encouraging more non-bank entities to provide liquidity in Indian bonds could bring a much-needed shift in trading volumes and efficiency.

India has made strides in financial market reform, but without a deeper, more liquid bond market, the country’s ambitions of becoming a global financial powerhouse will remain unfulfilled. Easing restrictions on margin trading and shorting, expanding repo markets, and facilitating greater foreign investor participation are steps that could unlock liquidity.  

* Views expressed are personal.