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Development of Interest Rate Derivative Markets in India – Prospects, Impediments and Issues

By

Ajit Kumar

K J Somaiya Institute of Management Studies & Research

July, 2011

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Development of Interest Rate Derivative Markets in

India – Prospects, Impediments and Issues

By

Ajit Kumar

Under the guidance of

Shri H.S Mohanty Prof. Aparna Bhat Deputy General Manager Professor Reserve bank of India SIMSR

K J Somaiya Institute of Management Studies & Research

10/07/2011

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Certificate of Approval

We approve this Summer Project Report titled "Development of Interest Rate Derivative

Markets in India – Prospects, Impediments and Issues" as a certified study in management

carried out and presented in a manner satisfactory to warrant its acceptance as a prerequisite

for the award of Post Graduate Program in International Business for which it has been

submitted. It is understood that by this approval we do not necessarily endorse or approve any

statement made, opinion expressed or conclusion drawn therein but approve the Summer

Project Report only for the purpose it is submitted.

Summer Project Report Examination Committee for evaluation of Summer Project Report

Name Signature 1. Faculty Examiner 2. PG Summer Project Co-coordinator

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Certificate from Summer Project Guides

This is to certify that Mr. AJIT KUMAR, a student of the Post-Graduate Diploma in Business

Management - International Business, has worked under our guidance and supervision. This

Summer Project Report has the requisite standard and to the best of our knowledge no part of it

has been reproduced from any other summer project, monograph, report or book.

Prof. Aparna Bhat Mr H S Mohanty

Professor Deputy General Manager

K J SIMSR Reserve Bank of India

Mumbai Mumbai

Date Date

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Disclaimer

This Summer Project Report titled "Development of Interest Rate Derivative Markets in India

– Prospects, Impediments and Issues" is done in Reserve Bank of India as a part of

curriculum of Post Graduate Diploma in Management (PGDM) Program in International

Business at K J Somaiya Institute of Management Studies and Research, Mumbai. The

report is submitted to Reserve Bank of India as well as K J Somaiya Institute of Management

Studies and Research only for the academic purpose. The views expressed in the report are

only of the author and is not of any of the institutions involved.

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Abstract

Development of Interest Rate Derivative Markets in India – Prospects,

Impediments and Issues

One of the largest components of the global derivatives markets and a natural adjunct to the

fixed income markets is the interest rate derivatives. These instruments are an important

component of the overall financial sector strategy and the broad regulatory objective is to

ensure that they are used to their potential in ways that are consistent with both financial

development and the contribution of financial markets to economic growth. This report on

“Development of Interest Rate Derivative Markets in India – Prospects, Impediments and

Issues” address the following set of issues –

I. The landscape for OTC derivatives in India

II. Regulatory concerns and steps taken

III. The roadmap for OTC derivatives

IV. The development of markets in India

Key Research Objective

The objective of the project is to analyze the development of IRDs market in India , the

regulatory framework adopted as well as the issues and impediments in the their usage by

India’s institutional investors and other participants.

Methodology

This methodology adopted is a stepwise approach which can be listed as follows -

I. A Detailed analysis of the present market structure of OTC Derivatives in India. It will

mainly encompass the study of Market participation of various institutions in the

Interest Rate derivatives segment over the years. The report also aims at analyzing the

various determinants of usage, issues and impediments in the usage of IRDs by India’s

Institutional investors.

II. This would be followed by an analysis of the regulatory framework adopted for Indian

OTC Derivatives - Approach to Centralized Clearing. How central counterparties CCPs

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reduce the counterparty and credit risks and how good supervision through a well-

defined regulatory framework underpins the systemic risk.

III. Finally, as a part of recommendations, the report will deliberate on the measures that

would help ensure more stability and also contribute to the development of the OTC

Derivatives market in India.

Conclusion

After understanding the views of the market participants, a number of issues are identified.

Various studies have already been done on a number of issues and solutions have been

recommended. This report also delineates some of the major issues with the interest rate

derivative markets and products in India and recommends corresponding solutions for some of

them. However, it has to be understood that many of the current regulatory measures and the

proposed changes is to be seen in the light of trade-offs which has to be made. Indian markets

are quite different than its counterparts in the west and hence many of the standard products

and regulations can’t be applied to Indian markets. While proposing the recommendations and

making regulations to develop financial markets in India, the bigger policy objective of

Efficiency, Stability, Transparency and Inclusion has to be kept in mind.

It has been found that illiquidity in the government securities is a key issue in Interest Rate

Derivatives market. Banks are mandated to maintain 24% of their NDTL as SLR in terms for GOI

securities. Most of the banks keep entire of their securities portfolio in HTM or Held-till-

Maturity portfolio which is not available for trade.

It has been felt that role of the Central Counter Party is crucial in terms of reducing counter

party risk and market development. Multilateral Netting in OTC derivative contracts is the need

of the hour.

Development of an efficient bond market (both government and corporate bond market) is

essential for sustaining high GDP growth rate. A developed bond market can boost the growth

in infrastructure sector which is capital incentive and have longer payback period.

India is witnessing a slow but steady development in the all types of financial markets including

the derivatives markets under the calibrated regulatory approach of regulatory bodies. It will

not take long enough for the Interest Rate Derivatives to further develop in the Indian market

and soon it will dominate the financial markets.

Keywords Interest Rate Derivatives, Interest Rate Swaps, Overnight Index Swaps, Interest Rate Futures, OTC

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Acknowledgement

It was a great privilege and honor to work with Reserve Bank of India, the central bank for the

country and getting a firsthand exposure on central banking. I am extremely grateful to the

Reserve Bank of India for giving me this opportunity and I express my heartfelt thanks for the

same.

I would like to express my gratitude towards Mr. H.S Mohanty (Deputy General Manager,

Financial Markets Department) for guiding me with their valuable insights and suggestions.

I would like to express my gratitude towards Mr. G. Seshsayee (Deputy General Manager,

Financial Markets Department) for his focused guidance and constant support without which,

this project would have incomplete.

Further I express my gratitude towards Mr Sudarshan Sahu, Mr. Aloke Ghosh, Mr. Shakeel

Ahmed, Mr. Shakriq Hoda and Mr. Saurabh Ghosh for taking out time from their busy schedule

and helping me with my doubts and providing valuable inputs for this report.

Also, I’d like to express my gratitude to my faculty and guide Prof. Aparna Bhat of K J Somaiya

Institute of Management Studies and Research for her guidance and support for the completion

of this project.

Finally, I would like to thank Mrs Jaya Kosambi and Mr. A.K More of Reserve Bank of India for

all the administrative and logistical support extended to me during the internship.

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Table of Contents

CERTIFICATE OF APPROVAL ......................................................................................... 3

CERTIFICATE FROM SUMMER PROJECT GUIDES ...................................................... 4

DISCLAIMER .......................................................................................................................... 5

ABSTRACT ......................................................................................................................... 6

KEY RESEARCH OBJECTIVE .................................................................................................................. 6

METHODOLOGY ............................................................................................................................... 6

CONCLUSION ................................................................................................................................... 7

KEYWORDS ...................................................................................................................................... 7

ACKNOWLEDGEMENT ..................................................................................................... 8

LIST OF ABBREVIATIONS ...................................................................................................... 12

CHAPTER 1 ................................................................................................................... 13

INTRODUCTION TO INTEREST RATE DERIVATIVES ................................................................. 13

1.1 INTRODUCTION ............................................................................................................. 13

1.2 TYPES OF INTEREST RATE DERIVATIVES .......................................................................... 13

1.3 TYPES OF DERIVATIVE MARKETS .................................................................................... 14

1.4 THE FAMOUS OTC V/S EXCHANGE DEBATE ..................................................................... 14

1.5 HISTORY AND ORIGIN .................................................................................................... 15

1.6 INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION OR ISDA ................................ 15

INTEREST RATE DERIVATIVES IN INDIA ................................................................................. 16

2.1 THE DRIVERS FOR MARKET DEVELOPMENT .................................................................... 16

2.2 THE OTC MARKETS IN INDIA ........................................................................................... 16

2.3 CURRENT PRODUCT OFFERINGS IN INDIA ....................................................................... 17

TABLE 2.1 – DERIVATIVE PRODUCT OFFERINGS .................................................................................... 17

2.4 CURRENT DEVELOPMENTS IN INDIAN IRD MARKETS ...................................................... 17

CHAPTER 3 ................................................................................................................... 18

INTERST RATE SWAPS .......................................................................................................... 18

3.1 INTRODUCTION TO INTEREST RATE SWAPS .................................................................... 18

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ILLUSTRATION I – SIMPLE PLAIN-VANILLA SWAP ................................................................................... 19

3.2 FIMMDA GUIDELINES ON RUPEE INTEREST RATE SWAP TRADING .................................. 20

3.3 TYPES OF INTEREST RATE SWAPS IN INDIA ..................................................................... 21

3.4 DETAILS TO INCLUDE BEFORE CONFIRMING A DEAL ....................................................... 21

TABLE 3.1 – IRS SPECIFICATIONS ...................................................................................................... 21

3.5 INTEREST COMPUTATION METHODOLOGY ..................................................................... 21

TABLE 3.2 – IRS INTEREST CALCULATIONS .......................................................................................... 22

3.6 MIFOR-BASED IRS .......................................................................................................... 22

3.7 USAGE OF IRS ................................................................................................................ 23

3.8 ADVANTAGES OF IRS ...................................................................................................... 23

3.9 MARKET SHARE OF MAJOR PLAYERS IN INDIAN IRS MARKETS ........................................ 24

TABLE 3.3 - MIBOR MARKET SHARE (OVERALL) ................................................................................. 24

TABLE 3.4 – DEAL WISE MIBOR MARKET SHARE (APRIL 2011) ............................................................. 24

TABLE 3.5 - MIFOR MARKET SHARE (OVERALL) .................................................................................. 25

TABLE 3.6 – DEAL WISE MIFOR MARKET SHARE (APRIL 2011) ............................................................. 25

3.10 DATA ON MIBOR/MIFOR/ BASED IRS ........................................................................... 26

TABLE 3.7 – ANNUAL TRADE DATA .................................................................................................... 26

3.11 IRS QUOTES AND IRS SPREAD ....................................................................................... 26

TABLE 3.5 HISTORICAL RATES FOR 5-YR BENCHMARK SWAP (Q1 2009 – Q2 2011) ............................... 26

3.12 CLOSURE OF IRS CONTRACTS ........................................................................................ 27

3.13 ISSUES WITH IRS .......................................................................................................... 27

CHAPTER 4 ................................................................................................................... 30

INTERST RATE FUTURES ....................................................................................................... 30

4.1 INTRODUCTION ............................................................................................................. 30

4.2 PRODUCTS AND THE MARKET RESPONSE ....................................................................... 30

4.3 ISSUES WITH IRF AND ITS REACTIVATION ....................................................................... 31

4.4 PRODUCT SPECIFICATION ............................................................................................... 31

TABLE 4.1 – NSE IRF SPECIFICATIONS ................................................................................................ 31

4.5 ADVANTAGE OF IRF ....................................................................................................... 32

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4.6 TRADING VOLUMES IN IRF ............................................................................................. 33

TABLE 4.2 – IRF TRADING VOLUMES ON NSE ..................................................................................... 33

4.7 ISSUES WITH IRF ............................................................................................................ 33

CHAPTER 5 ................................................................................................................... 35

CURRENT REGULATORY FRAMEWORK IN INDIA ................................................................... 35

5.1 REQUIREMENT OF A REGULATORY FRAMEWORK ........................................................... 35

5.2 RBI GUIDELINES ............................................................................................................. 35

CHAPTER 6 ................................................................................................................... 38

RECOMMENDATIONS .......................................................................................................... 38

6.1 RATIONALE FOR MARKET DEVELOPMENT ...................................................................... 38

6.2 RECOMMENDATION ON OTC VERSUS EXCHANGE DEBATE .............................................. 39

6.3 RECOMMENDATION FOR IRS ......................................................................................... 39

6.3.1 ON THE ROLE OF CENTRAL CLEARING PARTY ON MULTILATERAL NETTING .......................................... 39

6.3.2 ON WIDENING THE BASE OF MARKET PARTICIPANTS .................................................................... 40

6.3.3 DEVELOPING A SHORT TERM INTEREST RATE BENCHMARK LIKE 3/6-MONTH MIBOR .......................... 41

6.3.4 IRS BASED ON CD RATES ........................................................................................................ 41

6.4 RECOMMENDATION FOR IRF .......................................................................................... 41

6.4.1 ON CASH V/S PHYSICAL SETTLEMENT OF IRF CONTRACTS .............................................................. 41

6.4.2 ON THE ILLIQUIDITY OF DELIVERABLE CONTRACTS FOR IRF .............................................................. 42

6.4.3 SHORT SELLING IN GOI SECURITIES CASH MARKET ........................................................................ 42

6.5 RECOMMENDATIONS FOR THE DEVELOPMENT EFFICIENT BOND MARKET IN INDIA ........ 42

APPENDIX ........................................................................................................................... 43

LIST OF GOVERNMENT OF INDIA SECURITIES OUTSTANDING AS OF JUNE 13, 2011 ...................................... 43

QUESTIONNAIRES ........................................................................................................................... 48

REFERENCES ....................................................................................................................... 49

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List of Abbreviations

AFS Available for Sales (Portfolio)

AFT Available for Trade (Portfolio)

BIS Bank of International Settlement

CCIL Clearing Corporation of India Limited

CCP Central Counter Party

FIMMDA Fixed Income Money Market and Derivative Association of India

FRA Forward Rate Agreement

GOI Government of India

G-Sec Government Securities

HTM Held till Maturity (Portfolio)

IRD Interest rate Derivatives

IRF Interest Rate Futures

IRS Interest Rate Swap

ISDA International Swaps and Derivatives Association

MIBOR Mumbai Inter Bank Offer Rate

MIFOR Mumbai Interbank Forward Offer Rate

NDS Negotiated Dealing System

OIS Overnight Index Swaps

OTC Over the Counter

PD Primary Dealers

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CHAPTER 1

INTRODUCTION TO INTEREST RATE DERIVATIVES

1.1 Introduction As defined in International Accounting Standard (IAS) 39, a derivative is a financial instrument:

a) Whose value changes in response to the change in a specific interest rate, security,

commodity price, foreign exchange, index if price or rates, a credit rating or credit

index, or similar variable (sometimes called the underlying);

b) That requires no initial or little initial net investment relative to other types of contracts

that have a similar response to changes in market conditions; and

c) That is settled at a future date.

An interest rate derivative is a derivative where the underlying asset is the right to pay or

receives a notional amount of money at a given interest rate. These structures are popular for

investors with customized cashflow needs or specific views on the interest rate movements

(such as volatility movements or simple directional movements) and are therefore usually

traded OTC.

The interest rate derivatives market is the largest derivatives market in the world. Globally,

interest rate derivatives account for around 70% of the total derivative transactions across

economies. The Bank for International Settlements (BIS) estimates that the notional amount

outstanding in June 2009 was US$437 trillion for OTC interest rate contracts, and US$342

trillion for OTC interest rate swaps. According to the International Swaps and Derivatives

Association, 80% of the world's top 500 companies as of April 2003 used interest rate

derivatives to control their cashflows. This compares with 75% for foreign exchange options,

25% for commodity options and 10% for stock options.

1.2 Types of Interest Rate Derivatives Interest rate derivatives are most traded derivatives instruments all over the world. They are

traded both on over-the-counter (OTC) markets as well as on exchanges. The most popular

interest rate derivatives are:

I. Forward Rate Agreement or FRA

II. Interest rate Swap or IRS

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III. Interest rate Futures or IRF

IV. Interest rate Options

V. Interest rate Swaption

1.3 Types of Derivative Markets There are two distinct groups of derivative contracts:

I. Over-the-counter derivative: Contracts that are traded directly between two eligible

parties, with or without the use of an intermediary and without going through an

exchange.

II. Exchange-traded derivatives: Derivative products that are traded on an exchange.

1.4 The famous OTC v/s Exchange Debate The over-the-counter (OTC) derivative markets are perceived as the weak link in the financial

system that increased the systemic risk of contagion and exacerbated the financial crisis

globally. The complex and non-transparent nature coupled with light-touch regulatory

approach towards OTC derivatives resulted in excessive counterparty exposures. Naturally, the

reforms in the OTC derivatives to address the issues of counterparty credit risk and non-

transparency is the focus of global debate.

Nevertheless, OTC derivatives are generally considered superior to exchange-traded derivatives

in their amenability to customization to cater the specific needs of the clients. OTC markets are

also best suited to test innovative products, let them stabilize and get refined. On the other

hand, exchange traded products are considered suitable for wider offering through

standardization.

Exchange traded derivative markets, to be efficient and complete, require a certain set of policy

framework for the underlying markets. Essentially what the exchange traded markets demand

are friction-free underlying markets with no restrictions on taking long or short positions and a

seamless integration between different segments enforced through free participation by all

agents. In simple words, efficient exchange traded derivative markets and controls in the

underlying market do not go together.

This is a fundamental challenge faced by the policy makers in economies where macroeconomic

and structural constraints as well as financial stability considerations necessitate certain

restrictions on the underlying markets. In the case of India, for instance, there are policy-

imposed limitations on participation by various economic agents. While exchange traded

derivative markets do not fit into this framework, whatever their operational benefits, OTC

market make it feasible to pursue market development in a gradual framework within the given

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constraints. This is precisely what has happened in India where OTC derivative markets have

evolved to significant volumes.

Considering the above issues and perspectives it could be seen that that the reform proposals

will need to focus more on strengthening the OTC market framework instead of being

embroiled with the binary consideration of OTC vis-à-vis exchanges.

1.5 History and origin One of the largest components of the global derivatives markets and a natural adjunct to the

fixed income markets is the interest rate swap (IRS) market. A swap is basically a contractual

agreement for exchange of cash flows between two parties. Swaps take place because

corporate and institutions with differing financing and risk requirements have specific access to

different financial markets. The origin of swaps can be traced back to the early 1970s as a tool

to circumvent the exchange regulations imposed by many countries to restrict cross border

capital flows. To overcome such hurdles corporate started a new arrangement popularly known

as ‘parallel loans’. Under such an arrangement American companies used to lend dollars to

British subsidiaries in the US while the British holding companies used to lend pound sterling to

the American subsidiaries in the UK. This practice gained momentum with the exchange rate

instability following the demise of the BrettonWoods System during 1971-73.

Following the exchange rate liberalization in the 1980s, swaps rapidly replaced existing

products like parallel and back-to-back loans because of their flexibility and lower financing and

taxation costs. The formation of the International Swap Dealers Association (ISDA) in 1985 was

a significant development that speedened up the growth of the swap market by standardizing

swap documentation.

1.6 International Swaps and Derivatives Association or ISDA ISDA was formed in 1985 and is an established international organization which works for the

development of OTC derivative markets. ISDA guidelines have made OTC market safer and

efficient. For all OTC derivatives products, the agreements are usually designed under the

framework of ISDA.

ISDA agreement focus on three key areas –

Reducing counterparty credit risk,

Increasing transparency, and

Improving the industry’s operational infrastructure

Currently, the Association has more than 820 members from 57 countries on six continents.

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CHAPTER 2

INTEREST RATE DERIVATIVES IN INDIA

2.1 The Drivers for Market Development The major driver for the development of Interest rate Derivative markets in India was the

financial reforms post liberalization of 1991. It was in March 1993 that a system of market-

determined exchange rates was adopted by India as part of a broad set of structural reform

measures. Gradually, financing the fiscal deficit transitioned from automatic monetization to

market-based borrowings resulting in a regular supply of marketable securities. With regard to

exchange rate, it was in August 1994 that the rupee was made fully convertible on current

account. These reforms allowed increased integration between domestic and international

markets and created a need to manage interest rate and currency risks.

RBI permitted banks/FIs/PDs to undertake interest rate swaps/forward rate agreements in July

1999. IRDs have been slow to emerge in India. An OTC market has sprung up primarily involving

interest rate swaps (IRS) and forward rate agreements (FRA). Interest rate futures (IRF) were

first introduced to Indian exchanges like NSE in 2003 but the product can't pick up because of

anomaly in the pricing and soon all trading activities ceases in all the IRF contracts. The product

was reintroduced in 2009 but still couldn't see substantial market participation. Currently

interest rate options are not allowed in Indian markets.

2.2 The OTC Markets in India The OTC derivatives markets all over the world have shown tremendous growth in recent years.

After financial crisis of 2008, which is believed to have been exacerbated by OTC derivatives,

increasing attention is being paid to analyzing the regulatory environment of these markets.

The Indian OTC derivatives markets, unlike many other jurisdictions, are well regulated. Only

contracts where one party to the contract is an RBI regulated entity are considered legally valid

in India. A good reporting system and a post-trade clearing and settlement system, through a

centralized counter party, has ensured good surveillance of the systemic risks in the Indian OTC

market.

From amongst the various OTC derivatives markets permitted in India, interest rate swaps and

foreign currency forwards are the two prominent markets.

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2.3 Current Product Offerings in India

Table 2.1 – Derivative Product Offerings

2.4 Current Developments in Indian IRD Markets After the lukewarm response for Interest Rate Futures product on 7 per cent, 10 year notional

bonds, the National Stock Exchange (NSE) is now launching interest rate futures on the 91-day

treasury bills from July 4, 2011. Earlier, interest rate futures were available only on 10-year

government bond. But the Reserve Bank of India has allowed interest rate futures trading on

91-day Treasury Bills (T-Bills) in March 2011, in a move to broadbase the interest rate futures

market. Also, the new interest rate futures would be cash settled. As a result, investors can

trade without the worry of being saddled with illiquid contracts, which could have been the

case if the contracts were physically settled. In case of IRF, on the 91-day Treasury bill, the final

settlement price of the futures contract is based on the weighted average price/ yield obtained

in the weekly auction of the 91-day treasury bills on the date of expiry of the contract.

Asset Class OTC Exchange-Traded

Rupee Interest Rate Derivatives

Forward Rate

Agreements, Interest

Rate Swap

Interest rate

Futures

Foreign Currency DerivativesForwards, Swaps,

OptionsCurrency Futures

Equity Derivatives

Index Future, Index

Options, Stock

Futures, Stock

Options

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CHAPTER 3

INTERST RATE SWAPS

3.1 Introduction to Interest Rate Swaps A swap is a cash-settled over the counter derivative under which two counterparties exchange

two streams of cash flows. It is called an interest rate swap if both cash flow streams are in the

same currency and are defined as cash flow streams that might be associated with some fixed

income obligations. The most popular interest rate swaps are fixed-for-floating swaps under

which cash flows of a fixed rate loan are exchanged for those of a floating rate loan. These are

called vanilla interest rate swaps. There is also a liquid market for floating-floating interest rate

swaps—what are known as basis swaps. To keep things simple (and minimize settlement risk),

concurrent cash flows are netted. The principal amount is called the notional amount of the

swap. Let’s see an example of swap using a diagram.

Consider a swap in which Party A agrees to pay Party B periodic fixed interest rate payments of

8.65%, in exchange for periodic variable interest rate payments of LIBOR + 70 bps (0.70%). Note

that there is no exchange of the principal amounts and that the interest rates are on a

"notional" (i.e. imaginary) principal amount. Also note that the interest payments are settled in

net (e.g. Party A pays (LIBOR + 1.50%) +8.65% - (LIBOR+0.70%) = 9.45% net). The fixed rate

(8.65% in this example) is referred to as the swap rate.

At the point of initiation of the swap, the swap is priced so that it has a net present value of

zero. If one party wants to pay 50 bps above the par swap rate, the other party has to pay

approximately 50 bps over LIBOR to compensate for this.

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Illustration I – Simple Plain-Vanilla Swap

Normally the parties do not swap payments directly, but rather each sets up a separate swap

with a financial intermediary such as a bank. In return for matching the two parties together,

the bank takes a spread from the swap payments (in the below example, 0.30% compared to

the above example)

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3.2 FIMMDA Guidelines on Rupee Interest Rate Swap Trading FIMMDA had laid out various guidelines for trading in fixed income and derivatives securities.

The same is published in the FIMMDA’s handbook of market practice

I. Minimum Notional Principal Amount: The minimum notional principal amount for

which market makers will stand committed to their two-way quote is Rs. 5 crores.

II. Tenor: The swap can be flexible in tenor i.e. there are no restrictions on the tenor of

the swap. Unless stated otherwise, a rupee interest rate swap shall be assumed to

have a day count basis of Actual/365.

III. Trading Hours: The trading hours will be 9.00 a.m -5.30 p.m. for all swaps wherein

the benchmark is based on the money market or the fixed income market. In respect

of swaps, wherein the benchmark is based on the foreign exchange market, the

trading hours will be in accordance with the trading hours for foreign exchange

transactions. Currently the trading hours for foreign exchange is from 9.00 a.m. to

5.00p.m.

IV. Effective Date: The Effective Date will be the first Mumbai Business Day (excluding

Saturday) after the Trade Date, except for interest rate swaps against which

payments are based upon the “INR-MIFOR” Floating Rate Option, for which the

Effective Date will be the second Mumbai Business Day (excluding Saturday) after

the Trade Date.

V. Business Day Convention: The Business Day Convention applicable to all INR interest

rate swaps shall be the Modified Following Business Day Convention, unless

otherwise specified in the confirmation.

VI. Business Day: Unless otherwise specified in the Confirmation, Saturdays shall not be

Business Days for any purpose, except in relation to INR-MIBOR-OISCOMPOUND for

which Saturday shall be deemed to be a Business Day. It is recommended that

regardless of the centre where the deal is transacted, the benchmark and the

holiday calendar for the purposes of computation of interest streams be as that in

Mumbai, except in case of interest rate swaps wherein the benchmark is based on

the foreign exchange market, for which the holiday calendar of the relevant centre

for that currency will also be applicable.

VII. Reset dates: No fixing of rates and compounding of interest will be done on a

Saturday.

VIII. Day count fraction: The Day Count Fraction applicable to all INR interest rate swap

transitions shall be Actual / 365 Fixed.

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IX. Broken or short calculation periods: The rate for any Calculation Period which is

shorter than the Designated Maturity set forth in the Confirmation will be

determined by the Calculation Agent based upon straight line interpolation between

the Floating Rate Option with a Designated Maturity that is immediately shorter

than the Calculation Period and the Floating Rate Option with a Designated Maturity

that is immediately longer than the Calculation Period.

3.3 Types of Interest Rate Swaps in India The following types of IRS are currently traded in Indian OTC markets. Among these INR-

MIBOR-OIS, INR-MIFOR and INR-BMK are most traded.

I. INR-MIBOR-OIS-COMPOUND

II. INR-MITOR-OIS-COMPOUND

III. INR-MIFOR

IV. INR-MIOIS

V. INR-BMK

3.4 Details to Include before Confirming a Deal

Table 3.1 – IRS Specifications

3.5 Interest computation methodology The table below shows the interest calculation for a 7 days swap where one fix payer receives a

overnight FIMMDA-NSE-MIBOR Rate compounded daily against its fix payment of 5% over the

notional amount Rs 10 crore or 100 million.

Floating Rate Option INR-MIBOR-OIS-COMPOUND

Designated Maturity Overnight

Spread +/- [ ]% per annum

Floating Rate Day Count Fraction Actual / 365 Fixed

Reset Dates The last day of each Calculation Period.

Compounding Inapplicable

Compounding Date Inapplicable

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Table 3.2 – IRS Interest Calculations

On 8th day, the two parties will settle the difference INR 12,374.83 i.e (100,108,265.24 -

100,095,890.41) and the fix rate payer will receive the sum as he would be the beneficiary of

the contract.

3.6 MIFOR-based IRS Foreign banks with a large NRI deposit base frequently use the US$/INR swap market to switch

their FCNR(B) based US$ funds into INR, to fund their rupee assets. INR surplus banks unable to

raise adequate INR assets of acceptable credit quality, swap their INR funds into US$ using the

forwards market and invest the US$ locally or overseas. Clearly, seen holistically, the INR

surplus banks have simply lent the INR funds in a surrogate INR term money market, using the

US$/INR swap market as a via media. There was a time when the RBI frowned upon this use of

the US$/INR swap market as a surrogate INR term money market. In January 1998, for instance,

when the RBI had to intervene to protect a rapidly depreciating rupee, they actually spoke of

clamping down on ‘arbitrage’ between the FX and money markets: presumably commenting on

the already prevalent practice of banks deploying INR in the FX markets, and thereby reducing

the forward premium to be paid by importers of US$. Arguably, by denying interest rate parity,

the RBI was at that time trying to keep a lid on actual domestic interest rates, while at the same

time protecting the rupee from excessive depreciation by keeping the US$/INR forward premia

high. The high premia would in turn deter buyers of US$, provide an incentive to sellers of US$

and keep the cost of banks and corporate entities holding speculative long US$/short INR

positions high. When the first RBI IRS/FRA circular was issued in June 1999, there was actually a

report of two banks concluding a deal between themselves using a ‘money market’ benchmark

that was the derived from the US$/INR swap market. The RBI was at that time quick to disallow

this benchmark, thereby clarifying that it did not consider the FX and money markets to be

completely integrated. However, in the credit policy statement of April 27, 2000, the RBI

Governor indicated that “with a view to providing more flexibility for pricing of rupee interest

rate derivatives and to facilitate some integration between the money and foreign exchange

markets, the use of interest rates implied in the foreign exchange forward market as a

DayFIMMDA-NSE-

MIBOR Rate (%)

Notional Principle

(NP)

(INR)

Floating

Interest

(INR)

NP+Daily Compounded

Interest @MIBOR

NP+Simple

Interest@Fixed Rate

(5%)

1 6.50 100,000,000.00 17,808.22

2 5.00 100,017,808.22 13,701.07

3 3.00 100,031,509.29 8,221.77

4 5.00 100,039,731.06 13,704.07

5 and 6 7.00 100,053,435.13 38,376.66

7 6.00 100,091,811.79 16,453.45 100,108,265.24 100,095,890.41

23

benchmark would be permitted in addition to the existing domestic money and debt rates.”

This was the genesis of the Reuters (term) MIFOR and (overnight) MITOR benchmarks, and the

market for swaps based on them.

3.7 Usage of IRS The interest rate swap is used by a wide range of commercial banks, investment banks, non-

financial operating companies, insurance companies, mortgage companies, investment vehicles

and trust, government agencies and sovereign states for one or more of the following reasons:

I. To obtain lower cost funding

II. To hedge interest rate exposure

III. To obtain high yielding investment assets

IV. To create type of investment assets not otherwise obtainable

V. To implement overall asset and liability management (ALM) strategies

VI. To take speculative positing in relation to future movement in interest rates

3.8 Advantages of IRS The advantages of interest rate swaps include the following:

I. A floating-to-fixed swap increase the certainty of an issuer’s future obligation

II. Swapping from fixed-to-floating rate may save the issuer money if interest rates

decline

III. Swapping allows issuer to revisit their debt profile to take advantage of the current

or expected future market conditions

IV. Interest rate swaps are a financial tool that potentially can help issuers lower the

amount of debt service

24

3.9 Market Share of Major players in Indian IRS markets

Table 3.3 - MIBOR Market Share (Overall)

Source: CCIL Monthly Newsletter - Rakshitra

Table 3.4 – Deal wise MIBOR Market Share (April 2011)

Source: CCIL Monthly Newsletter - Rakshitra

25

Table 3.5 - MIFOR Market Share (Overall)

Source: CCIL Monthly Newsletter - Rakshitra

Table 3.6 – Deal wise MIFOR Market Share (April 2011)

Source: CCIL Monthly Newsletter - Rakshitra

26

3.10 Data on MIBOR/MIFOR/ based IRS

Table 3.7 – Annual Trade Data

Source: CCIL Monthly Newsletter - Rakshitra

3.11 IRS Quotes and IRS Spread

Table 3.5 Historical Rates for 5-Yr Benchmark SWAP (Q1 2009 – Q2 2011)

Source: Reuter

27

3.12 Closure of IRS Contracts A swap agreement can be terminated using any of the following methods.

I. Cancellation: A swap may be terminated prior to maturity. The counterparties

make/receive a payment reflecting current market rates and are released from their

contractual obligations.

II. Novation: A new swap agreement may be created canceling one or more existing swap

agreements.

III. Netting: Two counterparties may have more than one IRS agreements with each other.

In such a case instead of going for individual settlement of each IRS contract, they may

opt for settlement through a single net value for all the outstanding transactions.

IV. Reverse Swap: A party may enter into a new swap at current market rates to offset or

reverse the terms of the existing swap agreement.

V. Selling: A party may exit a swap agreement by selling it off to another party.

3.13 Issues with IRS The following issues have been observed in the IRS OTC markets and probable reasons are

explored by talking to the market participants.

I. The absence of PSU banks in the OIS market: As we see in table 3.3, nationalized banks

account for only about 1 per cent of the overall IRS market vis-à-vis 75 per cent

accounted by the foreign banks. Prima-facie it seems that lack of expertise in PSU banks

could be a reason for no market exposure in OIS segment. But OIS being a simple plain-

vanilla product, lack of expertise can be easily ruled out as a reason. The main reason

appears to be the mandatory 24% SLR, the entire of which the bank can keep in their

HTM portfolio which they need not mark-to-market. Therefore there is no incentive for

the PSU banks to hedge their holdings in HTM portfolio.

II. Transparency: While some banks do publish rates on interest rate swaps and standard

Rupee swaps on Reuters once a day, continuous updating of these rates are not done in

the manner in which brokers, internationally, update rates on Reuters, thus enhancing

market information levels. This paucity of information impacts participants negatively. A

screen based order matching system for OIS may be considered in line with the NDS

System for government securities. RBI may consider mandatory anonymous disclosure

of deals done, in a standardized manner, on the negotiated dealing system (NDS)

platform. Publication of such figures on a consolidated basis would give the current as

well as prospective participants a better picture of market liquidity and provide the

much-needed historical data for analysis.

28

III. Pertaining to Broader Participation: With regard to participation of mutual funds (MFs),

presently, they are permitted to trade only in exchange-traded derivatives. Since there

is no active market in exchange-traded debt derivative (IRF) at present, they can’t take

trading positions in interest rate derivatives. Mutual fund participation in the OTC debt

derivative market through IRS is restricted only for hedging purpose. MFs can enter into

IRS contracts only through banks and they can’t take trading positions or can’t behave

like a market maker. Similarly, insurance companies can also take only hedging positions

in IRS markets through banks. Since there is no liquid market in exchange traded

derivatives in debt instruments, MFs and Insurance are unable to take trading positions

in interest rate market. Regulators may consider allowing more players in the interest

rate derivative markets. Allowing insurance companies can help growth in long ended

derivatives market as insurance companies, once allowed in the market, are expected to

be very active participants in long term derivative contracts given the kind of actuarial

liabilities and asset/liability mismatches that they have.

IV. Settlement, Clearing and Documentation Issue: As the OTC contracts are bilateral,

despite International Swap Dealers Association (ISDA) standard documentation being

available, a lot of negotiation occurs in clauses relating to contract enforcement and

counterparty risk management. Many counterparties insist upon outside India law and

jurisdiction.

Secondly, the lack of netting and the bilateral settlement of each contract results in a lot

of back office processing besides increasing risk of failures. As contracts are bilateral,

cancellation or reversal of contracts is very difficult and opposite positions continue to

build up the outstanding notional principal although the net position may be small.

Counterparty risk for individual participants as well as the system as a whole can be

eliminated with CCIL becoming central counterparty and implementing effective

margining mechanisms. CCIL has proposed guaranteed settlement mechanism for OTC

derivatives including IRS for all its members. Once implemented, this could remove all

the credit risk as CCIL will become the counterparty and netting will be allowed it will

facilitate portfolio compression. A company called triOptima currently provides similar

portfolio compression and portfolio reconciliation in other developed markets.

V. Netting Legislation: Whenever a bank enters into an IRS contract, it has to provide

capital for the same as per the capital adequacy ratio or capital-to-risk-asset ratio

(CRAR) mandated by BASEL II norms. When a banks gets into separate and opposite IRS

contracts with different counterparties, it has to keep capital aside for each of such

29

contracts even if the net position of the bank may be zero. Currently, bilateral netting is

facilitated by CCIL but multilateral netting is not possible. This is a major hindrance for

the banks to enter and exit from IRS contracts. TriOptima provides infrastructure for

complete end to end solution for reconciliation of portfolio exposure and portfolio

compression. CCIL is planning to provide similar services in India scenario.

VI. OIS-GSec anomaly: This has been observed that the 5-Yr benchmark OIS curve is

consistently lower than the 5-Yr g-sec yield thereby creates a clear opportunity for

arbitrage.

Participants can easily earn arbitrage gains by implementing a possible arbitrage

portfolio using GOI bonds and OIS contracts. A possible arbitrage strategy could be –

i. Invest in 1-5Y GOI securities,

ii. Fund them through daily CBLO2 platform. The borrowing in CBLO market,

however, entails interest rate risk exposure.

iii. To hedge against this risk, pay a fixed rate and receive daily compounded

floating MIBOR by buying a similar tenor OIS.

But such arbitraging is not happening in practice thus keeping the spread wide.

Existence of such clear arbitrage signifies a pricing anomaly in OIS contracts. Several

possible reasons may be suggested for the arbitrage not taking place. Illiquidity in the

GOI security markets, lack of an active term money market and limited size of the call

money market is attributed to as reasons for why such an arbitrage is not exploited by

the market participants.

30

CHAPTER 4

INTERST RATE FUTURES

4.1 Introduction On October 29, 2002, RBI set up a working group under the Chairmanship of Shri Jaspal Bindra,

Chief executive Officer, India Region, Standard Chartered Bank with appropriate

representations from banks, Primary Dealers, mutual funds and RBI to study the scope of

introduction of exchange traded interest rate derivatives. The group had several discussions

with the market participants and found the following-

I. There was a need for the exchange traded interest rate derivatives as the debt

market volumes particularly IRS have been growing rapidly.

II. Exchange traded products will reduce the risk through a clearing corporation,

multilateral netting, novation and centralized settlement.

III. Exchange will facilitate anonymous order driven screen-based trading.

IV. It will facilitate participation from all classes of investors and will thus increase

market and access.

The group submitted its report in January 2003 and recommended the following types of

exchange traded derivatives-

I. Short-term MIBOR Futures Contracts,

II. MIFOR Futures Contract,

III. Bond Futures Contract (on specific bonds) and

IV. Long term Bond Index Futures Contract.

Subsequently, in June 2003, RBI issued guidelines to banks/primary dealers/FIs for transacting

in exchange traded interest rate futures. The Securities and Exchange Board of India (SEBI)

permitted National Stock Exchange (NSE) and The Stock Exchange, Mumbai (BSE) to introduce

anonymous order driven system for trading in Interest Rate Derivatives (IRDs) in June 2003.

(SEBI Circular SEBI/SMDRP/DC/Cir- 16/2003/04/19 dated April 19, 2003).

4.2 Products and the Market response On June 23, 2003, NSE introduced three future contracts, viz.

I. Futures contract on Notional 10 year coupon bearing bond (6% coupon)

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II. Futures contract on Notional 10 year Zero coupon bond;

III. Futures contract on Notional 91 days T- Bill

However, the products fail to attract critical mass of participants and transactions, and no

trading at all happened in these products.

4.3 Issues with IRF and its Reactivation It’s really intriguing that in India interest rate derivative constitutes only 5% of the total

derivative instruments traded value wise vis-à-vis 70% of that traded worldwide. Some of the

issues with the IRF product introduced in 2003 are listed below -

I. All future contracts were required to be cash-settled and were valued on Zero

Coupon Yield Curve (ZCYC). The ZCYC as estimated by NSE produced large price

errors mainly because the Indian market is an illiquid one and only a few bonds

trade regularly.

II. There was a clear gap between what was intended by the market participants and

what was actually introduced on the exchanges.

III. With the introduction of order matching module for Govt. bonds, popularly known

as NDS-OM (Negotiated Dealing System – Order Matching Module), the trading has

shifted to the new platform and the brokered deals have come down to about 12%

of the total deals. Hence, very few deals get reported to NSE WDM (Wholesale Debt

Market) segment and if the ZCYC estimation is based on those limited number of

deals, unreliable estimates of the yield curve are bound to happen

However, after the lukewarm response of IRD after its first introduction in 2003, the product

was reintroduced in August 2009 with many modifications and a lot of hope. Initially though the

market picked up, it gradually lost steam with continuously declining volumes. The next section

summarizes the specifications of IRF product introduced in 2009.

4.4 Product Specification

Table 4.1 – NSE IRF specifications

Particulars Description

Symbol 10YGS7

Market Type N

Instrument Type FUTIRD

Underlying 10 Year Notional Coupon-bearing Government of India (GOI) security

Notional Coupon 7% with semi-annual Compounding

Tick size 0.25 paisa or INR 0.0025

32

Trading Hours 9:00 am to 5:00 pm (Monday to Friday)

Contract Size INR 2 lakhs

Quotation Similar to quoted price of GOI securities up to four decimals with 30/360 day count convention

Tenor Maximum Maturity: 12 months

Contract Cycle Four Fixed quarterly contracts for entire year ending March, June, September & December. To start with NSE has introduced two quarterly contracts

Daily Settlement Price

Volume Weighted average price of the contract during the time period specified by the Exchange. If not traded in specified timings then the theoretical price of the contract as determined by the exchange will be the daily settlement price

Settlement Mechanism

• Daily Settlement - Marked to market daily

• Final Settlement - Physical settlement on delivery day in the delivery month i.e. last working day of the month

Deliverable Grade Securities

• GOI Securities maturing at least 7.5 years but not more than 15 years from first day of the delivery month with a minimum total outstanding of Rs 10,000 crores. The list of the deliverable grade securities will be informed by the exchange from time to time.

• Further any new security which meets the eligibility criteria as mentioned above shall be added to the list of deliverable grade securities. However, additions, if any, shall be made not later than 10 business days before the first business day of the delivery month

Conversion Factor The conversion factor would equate the deliverable security (per rupee of principal), to yield 7% with semiannual compounding.

Invoice Price Futures settlement price times conversion factor plus accrued Interest

Last Trading Day Two business day preceding the last business day of the delivery month.

Delivery Day Last business day of the delivery month.

Initial Margin SPAN ® Based Margin subject to minimum 2.33% on first day and 1.6% subsequently.

Extreme loss Margin

0.3% of the value of the gross open positions of the futures contracts

4.5 Advantage of IRF Interest rate futures provide benefits typical to any Exchange-traded product, such as -

Standardization – Only contracts with standardized features are allowed to trade on the

exchange. Standardization improves liquidity in the market. The following features are

standardized:

33

Only certain expiry dates are allowed in India viz. last working day of the months of

March, June, September and December.

The size of contract can only be in multiples of a certain number called the lot size. The

lot size currently in India is Rs. 2 lakhs.

Only some specific bonds can be used for delivery

Transparency – Transparency is ensured by dissemination of orders and trades for all market

participants. Also, competitive matching of orders of buyers and sellers boosts transparency.

Transparency improves the efficiency of the market in terms of discovery of competitive price

and liquidity.

Counter-party Risk – Counterparty risk is mitigated by the exchange as explained in the

previous chapter (section 4.2). The credit guarantee of the clearing house addresses counter

party risk thereby improving the confidence of investors leading to wider participation.

4.6 Trading Volumes in IRF

Table 4.2 – IRF Trading Volumes on NSE

Note: 1 Trading in Interest Rate Futures on Currency Derivatives Segment was introduced on August 31,

2009. Hence, the figures for the month of August 2009 are not taken into account, to maintain the

comparability. Volumes ceases to almost zero since March 2011 and hence not shown in the table

4.7 Issues with IRF Despite the fact IRFs have been made accessible to a wider base of 638 participants in NSE

including 21 Banks, Primary Dealers, Mutual Funds, Insurance companies, FIIs, NRIs and

individuals etc and besides the fact that it’s expected that there shall be some significant

34

changes in the interest rate movements owing to a stricter monetary policy on the horizon, Yet

the volume in the IRF space has been waning at a faster pace in the recent past and now ceased

to near zero, is a serious question to moot upon.

The following issues have been observed in the IRF as probable reasons for an inactive IRF

markets in India. The views are arrived by talking to a number of bank treasuries and other

market participants.

I. Illiquidity of government securities markets: The total outstanding government security

is about 22.5 lakhs crore (see appendix). Out of which banks holds about 15 lakhs crores

and rest is held by insurance companies, pensions funds etc which are not very liquid.

Commercial banks have to keep 24 percent of their NDTL (Net Demand and Time

Liability) as SLR and they can keep the entire 24% of their SLR in their HTM (Held till

Maturity) portfolio which they need not mark-to-market. Hence around 12 lakhs crores

of government securities are held will all the commercial banks in their HTM portfolio

and are not available for trade. Only about 3 lakhs crores of GOI securities are kept in

the bank’s AFS (Available for Sales) and AFT (Available for trade) portfolio, which is a

very small proportion. Since the current IRF contract is physically-settled and the size of

the underlying asset is too small, investors are worried of being dumped with illiquid

securities during settlement.

II. Absence of a reliable short term interest rate benchmark index: In India, we don’t have

a short term interest rate benchmark index like a 6-month MIBOR. The published 3-

month MIBOR and 6-month MIBOR are simply polled rates and not the traded rates and

hence is not a true proxy for the market. In absence of a medium term benchmark

interest rate, the future price of a bond is difficult to determine and market participants

can’t take a view on the future interest rates.

35

CHAPTER 5

CURRENT REGULATORY FRAMEWORK IN INDIA

5.1 Requirement of a regulatory framework Currently the entire world is talking of the risk associated with credit derivatives market due to

the subprime mess while the Indian market is engrossed with inappropriate and miss-selling of

derivative products by well known banks to clients, whose business structure and exposure did

not necessarily warrant such contracts. The complicated structures of OTC derivatives make it

less understood by the users. Many Indian banks have entered into contracts with Indian clients

(mostly corporate) as a back to back transaction with a foreign bank located offshore (mostly in

Singapore and structure of the product developed there) on currencies and interest rate

structures of many countries on whom these Indian banks have little research inputs. As the

contracts start moving against the Indian corporate, many such corporate are likely to raise

their hands or go to court to prove their innocence in the deal under the pretext of banks taking

them for a ride (protection under appropriateness clause). Finally, Indian banks will be required

to foot the bill to foreign banks as these Indian banks cannot deny their obligations. The entities

which are benefitting the most are the offshore banks as they did their business with Indian

corporate without any credit exposure to them as a credit exposure to Indian corporate would

require higher bank capital vis-a-vis their exposure to a public sector banks in India. This saves

them a lot of capital and hence credit and default risk. The Reserve Bank of India (RBI) has

regularly come out with guidelines and principles to deal with the subject

5.2 RBI guidelines The major elements of the regulatory framework for OTC derivatives include a broad

specification of products to be permitted, nature of participants in the markets, distinct

responsibilities for market makers and users for all OTC derivatives, effective reporting systems

for capturing systemic information, governance and oversight and focus on developing market

infrastructure for post-trade clearing and settlement. The underlying rationale for key

stipulations is explained below.

I. There is a requirement that for an OTC derivative transaction to be legally valid, one of the

parties to the transaction has to be a RBI regulated entity. This is to ensure that the entire OTC

derivative market is within the regulatory perimeter. Prudential prescriptions for each class of

36

participants may be decided by the respective regulator within the broad policy framework but

it makes systemic monitoring possible.

II. There is a clear distinction between the roles of market makers and users for all OTC

derivatives. It is the market makers which function as risk transferors in the system. It is

extremely important that these entities function in a totally transparent and regulated manner.

Only banks and primary dealers in case of certain interest rate derivatives are permitted to act

as market makers since extending this facility to all agents can result in risks building up on the

balance sheets of such entities.

III. The users, including financial entities, are permitted to transact in derivatives essentially to

hedge an exposure to risk or a homogeneous group of assets and liabilities or transform an

existing risk exposure. This stipulation is essentially to restrict speculative trading in derivatives

by the real sector, whose primary economic interest in undertaking derivative transactions

should be to hedge their exposures.

IV. Derivative structured products (i.e. combination of cash and generic derivative instruments)

are permitted as long as they are a combination of two or more of the generic instruments

permitted by RBI and do not contain any derivative as underlying. Structured products entail

packaging of complex, exotic derivatives into structures that may lead to increased build-up of

risks in the system. Some of these structures may simply be unsuitable for a large section of

users given their complexity. Most importantly, if left unregulated, these structures may exploit

the clear regulatory arbitrage by offering hidden payoffs that are otherwise not allowed on a

standalone basis.

V. The responsibility for assessment of customer suitability and appropriateness is squarely on

the market maker. There are a detailed set of requirements that the market maker needs to

fulfill in this regard while selling any product to a user. As the recent experience in many

countries shows, inappropriate understanding of complex derivatives by the buyers of these can

have serious repercussions. The argument of caveat emptor does not really work in practice, as

many countries are realizing on account of huge derivative losses. It is ultimately a systemic

issue and it is important, in the interest of sellers of the products as well, that sufficient

suitability assessment is done before selling the product.

VI. All OTC forex and interest rate derivatives attract a much higher credit conversion factor (CCF)

than prescribed under the Basel framework and all exposures are reckoned on a gross basis for

capital adequacy purpose. The applicable CCFs were increased in 2008 since it was felt that the

conversion factors prescribed under the Basel framework did not sufficiently capture the market

volatility of underlying variables in the Indian context.

37

VII. Exposures of banks to central counterparties (CCPs) attract a zero risk weight as per Basel

norms. Additionally, collaterals kept by banks with the CCPs attract risk weights appropriate

to the nature of the CCP as reflected in the ratings under the Basel II Standardized Approach.

The latter was incorporated by RBI as CCPs cannot be considered risk free entities.

VIII. All permitted derivative transactions, including roll over, restructuring and novation are

required to be contracted only at prevailing market rates. This ensures that non-market rates

are not used to manipulate cash flows current and future.

IX. There are regulations for participation by non-residents in derivative transactions. This

basically flows from the capital account management framework which places certain

restrictions for participation by non-resident investors in the forex and interest rate markets.

38

CHAPTER 6

RECOMMENDATIONS

6.1 Rationale for Market Development The surface level understanding of the risks as well as misuse of derivative products has

brought systemic implications around the globe during the subprime crisis. India was not much

affected as it has miniscule market share in derivatives segment. But it is clear that OTC market

is essential for the development of real economy. So before deepening this market, few aspects

regarding transparency, regulation and liquidity needs to be addressed in order to prevent the

financial system from shocks.

Before making any recommendations for the market developments, it’s imperative to

understand the basis objectives of derivative markets. According to Dr. Subir Gokarn, Dy.

Governor, RBI, financial sector development can broadly be viewed as pursuing four objectives.

Efficiency: We can look at the notion of efficiency from two perspectives. For the provider of

products and services, it means the ability to do this at the lowest possible cost, with the full

benefit of technology and market infrastructure. For the user, efficiency relates to the

availability of products and services which address his/her requirements at the lowest possible

price.

Stability: From the viewpoint of the financial system, stability requires that aggregate risk is

bounded in some way. This requires, in turn, that individual participants be required to mitigate

and manage their own risks. However, in situations in which systemic risk goes beyond the

aggregate individual risk, additional measures may be warranted.

Transparency: The basic premise is: "what cannot be measured cannot be managed". The more

market participants know about overall activities and outcomes, the better able they are to

make their cost‐benefit calculations and act on them, contributing to the overall effectiveness

of the market.

Inclusion: Financial development is not an end in itself. It serves the broader purpose of

facilitating economic activity, through resource mobilization and risk management. The more

accessible the financial system is to individuals in pursuit of these two objectives, the better.

39

On the basis of the above mentioned overall framework, the following recommendations could

be considered.

6.2 Recommendation on OTC versus Exchange Debate After the 2008 sub-prime crisis, it has been argued that OTC contracts should be moved to

exchanges has OTC posses serious systemic risk which could be contagion and can jeopardize

the entire financial system. But as Christopher L. Culp has said, “Blaming OTC market or

derivatives for financial losses is akin to blaming cars for drunken driving fatalities.” It has

been understood that both OTC and exchange traded derivatives are required to cater the

needs of the market participants. While OTC is known for its amenability to customization, and

innovations, exchanges are required for standardization and to facilitate participation from the

retail segment. Therefore as a recommendation, this report concludes that, it could be said

that rather than embroiling in the binary consideration of OTS vis-à-vis exchanges, the focus

should be on strengthening the OTC market framework.

6.3 Recommendation for IRS IRS market is already quite developed in India with a daily average volume of about 8,000 crore

vis-à-vis a daily average volume of 10,000 crore in government securities. However concerning

to the skewness in the market participants and the inefficiencies in the settlement procedures,

the following is recommended.

6.3.1 On the Role of Central Clearing Party on multilateral netting

CCIL Clearing Corporation of India LTD, which started functioning in 2002, is the only centralized

clearing party for trade processing and settlement services in India. It currently provides a

guaranteed settlement facility for government securities trading, clearing of collateralized

borrowing and lending obligations (CBLO), guaranteed settlement of foreign exchange trading,

and settlement of all IRS.

CCIL has proposed a guaranteed settlement mechanism for IRS for all its members. The

guaranteed settlement of funds is proposed through the members’ current account with RBI,

where initial margin and subsequently mark-to-market margins will be blocked.

This report doesn’t recommend such provisions for guaranteed settlement for three reasons

viz.

I. Firstly, such margins will make the IRS contracts quite expensive to enter and

thereby defeats the whole purpose of OTC markets where flexibility and

customization is the key.

40

II. Secondly, since one of the parties in IRS OTC markets are has to a RBI regulated

entity like banks, the case of default is minimum as banks are instructed to check

the suitability and appropriateness of the client for such contracts before entering

into an IRS contract.

III. And thirdly, since the cash flow happens only on a specified date only on the netted

interest rates and not on notional amount. Since the actual cash flows happens on

the spread between the floating leg and the fixed leg, the participants may not like

to block margins for the entire life time of the contract for the spread, which could

be quite narrow.

However it is recommended that CCIL should implement mechanism for multilateral netting as

soon as possible by building up an efficient technology infrastructure for deal reporting and

matching. Currently, since the multilateral netting is not possible, even the cancelled or closed

contracts are to be settled separately which generates a lot of back office operations. Also,

banks have to allocate capitals for maintaining their CRAR (Capital-to-Risk-Asset Ratio) even

though they may not have any open positions in the contracts.

At present, close out netting is not possible and banks calculate the counterparty exposure on

trade-by-trade basis despite the fact that there may be off-setting transactions. This leads to

high utilization of counterparty limits and restricts the liquidity in the market. Multilateral

netting will increase efficiency in the market and will ensure banks have exposures on sound

counterparties. To manage the risk out of multilateral netting, CCIL may also consider

maintaining a settlement guarantee fund by imposing margins on the transactions where

participants are using multilateral netting facility.

6.3.2 On Widening the Base of Market Participants Currently, only RBI regulated entity like schedule commercial banks can act as a market maker for IRS

contracts. Other bodies including mutual funds, Insurance companies and corporate can enter into IRS

through banks only for the purpose of hedging.

This report doesn’t recommended that to open the markets for all players to take trading position or act

as market maker (mandated to quote two way price) for the following reasons –

I. Indian IRS market is mostly dominated by OIS, which is based on overnight MIBOR which is a

close proxy for call money markets. Since call money markets in India is restricted only for

Banks and PDs, allowing other participants in IRS contracts will give them a de-facto entry to call

money market which is not warranted given the mostly uncollateralized nature of the call

money market.

41

6.3.3 Developing a short term interest rate benchmark like 3/6-Month MIBOR

Unlike in developed markets where 6-month LIBOR is popular and widely traded, 6-month

MIBOR in India is a polled rate and is not a true proxy for the actual market rates. Moreover

there are no developed term money markets in India. Most of the IRS trades are done on OIS

which is based on the overnight call rates. Since only banks and some restricted participants are

the only players in the call money markets, the OIS based IRS product is only restricted too such

players. For the involvement of broader market participants in IRS, development of reliable

benchmark index like 3/6-Month MIBOR and a term money market is recommended.

6.3.4 IRS based on CD Rates

In absence of term money markets and lack of benchmarks like 3/6-Month MIBOR, it is

recommended that for participation from broader set of market players, new IRS products

should be designed based on DC rates. Since CDs are money market instruments and is widely

developed in India with a tenor ranging from 1 month to 12 month, this rate could be used as a

reliable index for IRS. Since a broader number of market participants trade in CDs, an IRS based

on CDs will attract broader market participants.

6.4 Recommendation for IRF IRFs can be considered as one of the first few steps the Government of India has taken towards

the fulfillment of multiple objectives. Some of them would be –

I. Development of corporate debt market;

II. Full capital account convertibility;

III. Complete deregulation of interest rates;

IV. Strengthening of risk management;

V. Development of term money market and

VI. Better risk management device to hedge interest rate exposure owing to volatility in

Interest rates.

The major issues with the IRF are with the pricing procedure, settlement norms and restricted

participant base. The following recommendations could be considered.

6.4.1 On Cash v/s Physical Settlement of IRF Contracts

Many experts believe that physical settlement for the IRF contracts is a hindrance for the

development if markets for the IRF products. This is because it brings the notional bond and

Cheapest-to-Deliver (CTD) bonds using conversion factor from a basket of deliverable bonds

chosen by the exchange, making IRF a difficult to understand product. However, market

participants are indifferent towards a cash-settled and physically-settled contract as long as the

market is liquid. It is said that “in a liquid market, it doesn’t matter if you get the underlying or

42

you get price of the underlying”. Even is most of the developed markets, IRF contracts are

physically-settled and hence this report doesn’t recommend any change in the settlement

process from physically-settled to cash-settled for IRF contracts.

6.4.2 On the illiquidity of deliverable contracts for IRF

In India, since the long term dated government securities are less liquid than short term T-bills,

this report recommends that new IRF contracts has to be introduces with short term T-bills as

underlying instead of using a notional 10-year bond with 7 per cent coupon as a underlying

asset.

As a step forward in this regard, National Stock Exchange (NSE) is launching new Interest Rate

Futures contracts on 91-day treasury bills. This move is expected to broaden the base for the

IRF markets as the invested will not be worried about being saddled with illiquid contacts

during settlements.

6.4.3 Short selling in GOI Securities cash market

At present, while it is possible to take two-way positions (i.e both long and short) in FX markets,

the same is not true for GOI securities. It could be argued that one reason for non-development

of G-Sec markets is lack of hedging ability in case of certain structures since short selling in

these securities is prohibited. This report recommends that to resolve illiquidity problem, the

short selling of the G-Secs should be considered with adequate checks and balances in place.

6.5 Need for the Development Efficient Bond Market in India Finally, it’s imperative to answer the question; Why India requires an efficient and developed

bond market? A bond market is not just a platform for the traders and speculators to make

money, but instead it should be seen in context of development of Indian infrastructure and

sustaining it’s about 9% growth rate for a longer period. Bond markets are essential for

developing infrastructure. Infrastructure projects are long term and are capital incentive in

nature. These projects can’t be financed solely by banks loans and government securities,

because it increases the risk for banks. A developed bond market will encourage private

corporate to raise money from public using the bond markets.

RBI has already taken significant steps to promote bond markets by making policy frameworks

for the introduction of products like Credit Default Swaps or CDS. However, the details

implication of CDS is not within the scope of this report.

43

APPENDIX

List of Government of India Securities outstanding as of June 13, 2011 List of Government of India Securities outstanding as June 13, 2011

Sl. No. ISIN Nomenclature

Date of issue

Date of maturity

Outstanding Stock (Rs. Crore)

1 IN0020020080 6.72% 2007/12 18-Jul-2002 18-Jul-2012 546.81

2011-12

2 IN0020010057 9.39% 2011 2-Jul-2001 2-Jul-2011 37,000.00

3 IN0019910044 11.50 % 2011 5-Aug-1991 5-Aug-2011 2,861.36

4 IN0020032028 FRB, 2011 8-Aug-2003 8-Aug-2011 6,000.00

5 IN0019910127 12.00 % 2011 21-Oct-

1991 21-Oct-

2011 3,246.91

6 IN0020000116 11.50 % 2011(II) 24-Nov-

2000 24-Nov-

2011 11,000.00

2012-13

7 IN0020020023 6.85% 2012 5-Apr-2002 5-Apr-2012 26,000.00

8 IN0020020056 7.40% 2012 3-May-

2002 3-May-2012 33,000.00

9 IN0019840035 10.25 % 2012 1-Jun-1984 1-Jun-2012 1,574.13

10 IN0020000066 11.03%2012 18-Jul-2000 18-Jul-2012 13,500.00

11 IN0020010073 9.40%2012 11-Sep-

2001 11-Sep-

2012 11,000.00

12 IN0020032036 FRB, 2012 10-Nov-

2003 10-Nov-

2012 5,000.00

2013-14

13 IN0019820037 9.00 % 2013 24-May-

1982 24-May-

2013 1,751.33

14 IN0020010032 9.81% 2013 30-May-

2001 30-May-

2013 11,000.00

15 IN0019980187 12.40 % 2013 20-Aug-

1998 20-Aug-

2013 11,983.91

16 IN0020020122 7.27% 2013 (conv) 3-Sep-2002 3-Sep-2013 46,000.00

17 IN0020042043 FRB, 2013 10-Sep-

2004 10-Sep-

2013 4,000.00

18 IN0020020221 6.72% 2014 24-Feb-

2003 24-Feb-

2014 15,273.60

19 IN0020030105 5.32% 2014 16-Feb-

2004 16-Feb-

2014 5,000.00

2014-15

20 IN0020020049 7.37 % 2014 16-Apr-

2002 16-Apr-

2014 42,000.00

21 IN0020090018 6.07% 2014 15-May-

2009 15-May-

2014 40,000.00

44

22 IN0020032010 FRB, 2014 20-May-

2003 20-May-

2014 5,000.00

23 IN0019830010 10.00 % 2014 30-May-

1983 30-May-

2014 2,333.26

24 IN0020090067 7.32% 2014 20-Oct-

2009 20-Oct-

2014 18,000.00

25 IN0019840084 10.50 % 2014 29-Oct-

1984 29-Oct-

2014 1,755.10

26 IN0020080043 7.56% 2014 3-Nov-2008 3-Nov-2014 41,000.00

27 IN0019990137 11.83 % 2014 12-Nov-

1999 12-Nov-

2014 11,500.00

28 IN0020000132 10.47%2015 12-Feb-

2001 12-Feb-

2015 6,430.00

2015-16

29 IN0020000033 10.79%2015 19-May-

2000 19-May-

2015 2,683.45

30 IN0019850034 11.50% 2015 21-May-

1985 21-May-

2015 3,560.50

31 IN0020090026 6.49% 2015 8-Jun-2009 8-Jun-2015 40,000.00

32 IN0020100023 7.17% 2015 14-Jun-

2010 14-Jun-

2015 56,000.00

33 IN0020042027 FRB, 2015 2-Jul-2004 2-Jul-2015 6,000.00

34 IN0020000090 11.43%2015 7-Aug-2000 7-Aug-2015 12,000.00

35 IN0020042035 FRB, 2015(II) 10-Aug-

2004 10-Aug-

2015 6,000.00

36 IN0020020130 7.38% 2015 (conv) 3-Sep-2002 3-Sep-2015 61,000.00

37 IN0020010099 9.85%2015 16-Oct-

2001 16-Oct-

2015 10,000.00

2016-17

38 IN0020060219 7.59% 2016 12-Apr-

2006 12-Apr-

2016 65,000.00

39 IN0020010016 10.71% 2016 19-Apr-

2001 19-Apr-

2016 9,000.00

40 IN0020042019 FRB, 2016 7-May-

2004 7-May-2016 6,000.00

41 IN0020040013 5.59% 2016 4-Jun-2004 4-Jun-2016 6,000.00

42 IN0019990129 12.30 % 2016 2-Jul-1999 2-Jul-2016 13,129.85

43 IN0020090059 7.02% 2016 17-Aug-

2009 17-Aug-

2016 60,000.00

44 IN0020010107 8.07% 2017 15-Jan-

2002 15-Jan-

2017 49,000.00

2017-18

45 IN0020020031 7.49% 2017 (con) 16-Apr-

2002 16-Apr-

2017 58,000.00

46 IN0020022011 FRB-2017 2-Jul-2002 2-Jul-2017 3,000.00

47 IN0020070010 7.99% 2017 9-Jul-2007 9-Jul-2017 59,000.00

48 IN0020020098 7.46% 2017 28-Aug-

2002 28-Aug-

2017 57,886.80

49 IN0020020163 6.25% 2018 (conv) 2-Jan-2003 2-Jan-2018 16,886.80

45

2018-19

50 IN0020110014 7.83% % 2018 11-Apr-

2011 11-Apr-

2018 18,000.00

51 IN0020080019 8.24% 2018 22-Apr-

2008 22-Apr-

2018 50,000.00

52 IN0020010024 10.45%2018 30-Apr-

2001 30-Apr-

2018 3,716.00

53 IN0020030063 5.69 % 2018(Conv)] 25-Sep-

2003 25-Sep-

2018 16,130.00

54 IN0019980286 12.60 % 2018 23-Nov-

1998 23-Nov-

2018 12,631.88

55 IN0020030097 5.64 % 2019 2-Jan-2004 2-Jan-2019 10,000.00

56 IN0020080068 6.05% GS 2019 (FEB) 2-Feb-2009 2-Feb-2019 53,000.00

2019-20

57 IN0020030048 6.05% 2019 (con) 12-Jun-

2003 12-Jun-

2019 11,000.00

58 IN0020090042 6.90% 2019 13-Jul-2009 13-Jul-2019 45,000.00

59 IN0020010065 10.03 % 2019 9-Aug-2001 9-Aug-2019 6,000.00

60 IN0020020171 6.35% 2020 (con) 2-Jan-2003 2-Jan-2020 61,000.00

2020-21

61 IN0020000025 10.70 % 2020 22-Apr-

2000 22-Apr-

2020 6,000.00

62 IN0020100015 7.80% 2020 3-May-

2010 3-May-2020 60,000.00

63 IN0020092071 FRB, 2020 21-Dec-

2009 21-Dec-

2020 8,000.00

64 IN0020000124 11.60 % 2020 27-Dec-

2000 27-Dec-

2020 5,000.00

2021-22

65 IN0020110022 7.80% 2021 11-Apr-

2011 11-Apr-

2021 27,000.00

66 IN0020060318 7.94%2021 24-May-

2006 24-May-

2021 49,000.00

67 IN0020010040 10.25% 2021 30-May-

2001 30-May-

2021 26,213.32

68 IN0020060037 8.20 % 2022 15-Feb-

2007 15-Feb-

2022 57,632.33

2022-23

69 IN0020020072 8.35% 2022 14-May-

2002 14-May-

2022 44,000.00

70 IN0020070028 8.08% 2022 2-Aug-2007 2-Aug-2022 40,969.41

71 IN0020039031 5.87%2022 (conv) 28-Aug-

2003 28-Aug-

2022 11,000.00

72 IN0020070051 8.13% 2022 21-Sep-

2007 21-Sep-

2022 48,495.28

46

2023-24

73 IN0020030014 6.30% 2023 9-Apr-2003 9-Apr-2023 13,000.00

74 IN0020030055 6.17% 2023 (conv) 12-Jun-

2003 12-Jun-

2023 14,000.00

2024-25

75 IN0020090034 7.35% 2024 22-Jun-

2009 22-Jun-

2024 10,000.00

2025-26

76 IN0020030071 5.97 % 2025 (Conv) 25-Sep-

2003 25-Sep-

2025 16,687.95

2026-27

77 IN0020010081 10.18% 2026 11-Sep-

2001 11-Sep-

2026 15,000.00

78 IN0020060078 8.24 % 2027 15-Feb-

2007 15-Feb-

2027 57,388.55

2027-28

79 IN0020070036 8.26 % 2027 2-Aug-2007 2-Aug-2027 64,427.33

80 IN0020070069 8.28 % 2027 21-Sep-

2007 21-Sep-

2027 1,252.24

81 IN0020020247 6.01% GS 2028 (C

Align) 8-Aug-2003 25-Mar-

2028 15,000.00

2028-29

82 IN0020030022 6.13% 2028 4-Jun-2003 4-Jun-2028 11,000.00

2029-30

2030-31

2031-32

83 IN0020060086 8.28 % 2032 15-Feb-

2007 15-Feb-

2032 55,687.11

2032-33

84 IN0020070044 8.32 % 2032 2-Aug-2007 2-Aug-2032 15,434.05

85 IN0020020106 7.95% 2032 28-Aug-

2002 28-Aug-

2032 59,000.00

86 IN0020070077 8.33% 2032 21-Sep-

2007 21-Sep-

2032 1,522.48

2033-34

2034-35

87 IN0020040039 7.50%2034 10-Aug-

2004 10-Aug-

2034 60,000.00

88 IN0020042050 FRB, 2035 25-Jan-

2005 25-Jan-

2035 350.00

47

2035-36

89 IN0020050012 7.40% 2035 9-Sep-2005 9-Sep-2035 42,000.00

2036-37

90 IN0020060045 8.33%2036 7-Jun-2006 7-Jun-2036 59,000.00

2037-38

2038-39

91 IN0020080050 6.83% GS 2039 19-Jan-

2009 19-Jan-

2039 13,000.00

2040-41

92 IN0020100031 8.30% GS 2040 2-Jul-2010 2-Jul-2040 44,000.00

Total

2,251,441.74

48

Questionnaires Questionnaire prepared to obtain market data and the perception in general amongst the

market participants, of the interest rate OTC derivatives transactions followed in India

1. The OIS/GSEC spreads have consistently stayed negative i.e. the OIS rates have generally been lower than the GSEC yields. What is your opinion on the reasons behind this market anomaly?

2. Why is there an absence of market participants taking advantage of the arbitrage opportunities?

3. What percentage of the total IRS volume is used for hedging and trading (each separately)?

4. OIS as a class of products are not very popular overseas: for example, the volumes in the US$ OIS would typically be a small fraction of volume of swaps using 3-month US$ LIBOR as the floating benchmark. Why is there popularity for the MIBOR OIS in the Indian market?

5. In India, MIBOR based swaps dominate the market while other benchmarks like MIFOR and INBMK have limited liquidity. Why?

6. What are the barriers to entry in this market?

7. What are the current issues and impediments in the market? What are deficiencies in the market structure restricting growth?

8. What are the significant accounting policies followed for derivative transactions?

9. Whether effective hedge criterion (80-125%) is being followed for IRS transactions?

10. What percentage of total income of your bank comes from the IRS market?

11. Any present regulatory policies imposed by the RBI hindering growth in the market?

12. Does the enforcement of a regulatory mechanism over the derivative transactions bring in rigidity into OTC market and transform them into non-OTC character?

49

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Frank Fabozzi and Moorad Choudhry, The Handbook of European Fixed Income Securities, (John

Wiley, 2004)

Report of the RBI – SEBI Standing Technical Committee on Interest Rate Futures (June 2009):

http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/IRFF_170609.pdf

Working Paper on ‘OTC Derivatives Market in India: Recent Regulatory Initiatives and Open

Issues for Market Stability and Development’ - INDIAN COUNCIL FOR RESEARCH ON

INTERNATIONAL ECONOMIC RELATIONS

RBI press releases of the Report of the Working Group on Reporting of OTC Interest Rate and

Forex Derivatives, May 25, 2011, Chairman: Shri P Krishnamurthy

FIMMDA Handbook of Market Practices

RBI deputy governor, Shyamala Gopinath speech on Over-the-counter derivative markets in

India - Issues and perspectives, (July 2010), http://www.bis.org/review/r100803d.pdf

CCIL Fact book 2010

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presented at INDIAN COUNCIL FOR RESEARCH ON INTERNATIONAL ECONOMIC RELATIONS.

50

Report On Interest Rate Futures, by Technical Advisory Committee on Money, Foreign Exchange

and Government Securities Markets RESERVE BANK OF INDIA (August 2008)

Increasing Participation in OTC Derivatives Market (IRS & FRA)

Recommendations of Jaspal Bindra Committee

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