Some regulators and central banks have voiced concerns about the use of ever more complex derivative tools. But there are others, such as Reserve Bank of India, that welcome the potential that derivatives have to mitigate and manage risk. Natasha de Teran reports.

Earlier this year, the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI) approved the introduction of the country’s first exchange-traded interest rate derivatives products. In late June, the National Stock Exchange (NSE) followed by launching futures contracts on 10-year government bonds and 91-day treasury bills.

India’s underlying government bond markets are liquid, trading in excess of $1.4bn-$1.5bn per day, and as a result many believe the new contracts will take off quickly and develop fast. Equally, local players and the RBI now hope the new interest rate contracts will replicate the success of the first exchange-traded equity derivatives that were introduced in early 2002. Already the notional daily volume of these instruments averages close to $500m, compared with the $700m turned over in the underlying cash markets.

When the futures contracts were launched earlier this summer, a number of players made early moves to establish their presence in the market. Local mutual fund firm Birla was among the first to use them, while JP Morgan traded contracts within the first week and wants to be a pioneer in the market. Mr A Balasubramanian, the head of fixed income at Birla Mutual Fund in Mumbai, who oversees a $1.3bn fixed income portfolio, says he plans to continue using the contracts for hedging and portfolio rebalancing purposes.

Limitation worries

Despite the excitement over the contracts, there is still some scepticism about the regulations surrounding them and how these will affect the market’s development. One of the principal objections that bankers have is the limitation on speculating: only the 18 primary dealers are able to take new positions through the contracts, all other firms are limited to using the products for hedging.

Avijit Agarwal: ‘In the long term, the instruments will find wide-scale acceptance in the corporate and money management worlds’

Avijit Agarwal, head of treasury at Barclays Capital in Mumbai, says: “We would prefer to adopt a wait and watch approach before getting into this market. And until we have the full flexibility of being able to actively trade with these, it doesn’t make much sense to us.”

Derivatives professionals tend not to be the first to applaud the caution of central bankers but the RBI appears to have a firm fan-base among those leading the local derivatives market. Even though the regulations are hindering the market’s rapid development, many agree that the RBI is right to limit usage in the initial stages.

Siddharth Mathur, market strategist for rates at JP Morgan in Mumbai, says the regulator is “quite legitimately being cautious with its initial rules”, reflecting the market’s positive response to the regulator’s stance.

Vijayan Subramani, treasurer at Citicorp in Mumbai, is even more optimistic. He describes the RBI as being “very forward looking, open and receptive”, and anticipates that once the market is seen to be running smoothly, the rules will soon be adjusted.

Ajay Mahajan, country treasurer for India at Bank of America in Mumbai, agrees. “I think once the RBI gains confidence in the market’s ability to understand the risks involved and manage them effectively, the banking system at large will be able to participate more fully in the market.”

Stages of development

Such optimism looks as though it will be rewarded. Usha Thorat, executive director of the RBI in charge of interest rate products, envisages two further stages of development for the market. “In the first stage, the RBI will consider allowing banks to do whole balance sheet interest rate risk hedging, although of course it will also depend on the capability of each bank to create mark-to-market positions of interest rate risk on their balance sheets,” she says. At a later stage, banks with adequate cushions will also be able to take trading positions through the futures market, while options on the futures will also be allowed, Ms Thorat says. Although she has no definite timeframe for the two amendments, she says she “would prefer them to come sooner rather than later”.

However, bankers have another more recently introduced set of instruments to keep them busy. Since early July the RBI has allowed certain banks to trade foreign exchange options – a decision that has been strongly welcomed by market players, and one that is likely to have been triggered by the fact that the bank now has $80bn in reserves.

Louis Cucciniello: ‘We are able to offer corporates plain vanilla options, as well as being able to build them tailored structures’

Most market participants describe the introduction of over-the-counter foreign exchange options as an exciting development. Louis Cucciniello, head of FX options trading and sales for non-Japan Asia at JP Morgan, believes it is a great leap forward. Previously, he says, if corporate clients wanted to hedge their FX exposure, he would have had to offer them plain vanilla forwards that would have locked them into trading at the agreed rate on the trade’s maturity, regardless of whether that rate then proved optimal.

“This was a very uneconomical and inflexible way of hedging. Now we are able to offer corporates plain vanilla options, as well as being able to build them tailored structures. That has made a huge difference,” says Mr Cucciniello.

Again, the products’ introduction is being staged. In the initial phase only a few authorised banks are able to be market makers, while corporates and foreign institutional investors are limited to using the products for hedging purposes. However, as with the new futures contracts, market participants believe the RBI will watch the market closely and move forward from there.

Smoothing the way

Next on the horizon will be credit derivatives. Mr Mahajan, says there are still a number of key issues to address. Over the coming months, the RBI will resolve some residual capital charge issues, while the laws and legal documentation surrounding the instruments also need to be put into place. Once these are resolved, bankers foresee strong interest because corporate issuance in India has picked up on the back of falling interest rates.

Although liquidity is limited to those rated triple A by Credit Rating and Information Services India Limited (Crisil), investor confidence in lower-rated names is likely to improve once the laws have been tightened and Mr Mahajan expects non-triple A issuance will also rise. “The addition of a credit derivatives market would boost confidence in this sector,” he says.

Curve concerns

As for the new interest rate futures, market players still have some reservations. The futures are notional contracts based on a zero coupon curve priced by the NSE. To construct the curve, the NSE obtains data from the cash market and feeds that into its model, which throws up a zero coupon curve. However, because the data used contains off-market transactions, traders say the model’s accuracy is distorted.

“This necessarily introduces basis risk between the cash market and the futures settlement price,” says Mr Mathur. “This basis risk is pretty significant – which will probably keep several cash market participants away, as at present there is no way to hedge out that risk.”

Mr Balasubramanian agrees. “The coupon curve demands some familiarity, and it’s not as perfect as it could be.”

Positive response

Contract specifications aside, bankers remain largely upbeat about the products. Mr Subramani expects the contracts to appeal to institutional, banking and corporate counterparts. Although the contract size has been limited to 200,000 rupees, and therefore encourages retail participation, he does not expect to see a large amount of retail interest. Mr Mahajan says that because there are a lot of tax incentives under collectivised savings schemes, the response from the retail segment may be even further subdued.

While some critics say that the initial weeks’ trading in the futures has been marked by a lack of liquidity, Ms Thorat is not put off. Although she acknowledges the market will take a while to develop, she is pleased that trading has so far been running smoothly. But as time goes on, she admits, she would like to see more players with diverse risk appetites and different trading views enter the market.

Mr Balasubramanian likens the new futures market to the equity derivatives market which, when it started in India, was slow to take off. “However, as retail investors and mutual fund managers got used to the mechanics of the instruments, the market began to grow very fast. I imagine the same thing will occur with interest rate derivatives,” he says.

Either way, the future for derivatives in India looks more than rosy. Mr Agarwal says that in the past five years there has been considerable growth in knowledge among local banks, corporates, institutional investors and the regulators, which all now recognise that the Indian markets are poised to take the next step. “Overall we see a great future for all these products,” he says. “India is no different from other markets. We expect that, in the long term, the instruments will find wide-scale acceptance in the corporate and money management worlds.”


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