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

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

By

Ajit Kumar

Under the guidance of

Shri H.S Mohanty Deputy General Manager Reserve bank of India

Prof. Aparna Bhat Professor SIMSR

K J Somaiya Institute of Management Studies & Research

10/07/2011

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

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 Professor K J SIMSR Mumbai Date

Mr H S Mohanty Deputy General Manager Reserve Bank of India Mumbai Date

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.

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. II. III. IV.

The landscape for OTC derivatives in India Regulatory concerns and steps taken The roadmap for OTC derivatives 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 Indias 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 Indias Institutional investors. This would be followed by an analysis of the regulatory framework adopted for Indian OTC Derivatives - Approach to Centralized Clearing. How central counterparties CCPs

II.

III.

reduce the counterparty and credit risks and how good supervision through a welldefined regulatory framework underpins the systemic risk. 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 cant 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-tillMaturity 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

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, Id 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.

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 AFT BIS CCIL CCP FIMMDA FRA GOI G-Sec HTM IRD IRF IRS ISDA MIBOR MIFOR NDS OIS OTC PD

Available for Sales (Portfolio) Available for Trade (Portfolio) Bank of International Settlement Clearing Corporation of India Limited Central Counter Party Fixed Income Money Market and Derivative Association of India Forward Rate Agreement Government of India Government Securities Held till Maturity (Portfolio) Interest rate Derivatives Interest Rate Futures Interest Rate Swap International Swaps and Derivatives Association Mumbai Inter Bank Offer Rate Mumbai Interbank Forward Offer Rate Negotiated Dealing System Overnight Index Swaps Over the Counter 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. II. Forward Rate Agreement or FRA Interest rate Swap or IRS

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III. IV. V.

Interest rate Futures or IRF Interest rate Options 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. Exchange-traded derivatives: Derivative products that are traded on an exchange.

II.

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 nontransparency 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 policyimposed 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--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 industrys 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 marketdetermined 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

Asset Class Rupee Interest Rate Derivatives Foreign Currency Derivatives

OTC Forward Rate Agreements, Interest Rate Swap Forwards, Swaps, Options

Exchange-Traded Interest rate Futures Currency Futures Index Future, Index Options, Stock Futures, Stock Options

Equity Derivatives

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.

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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 swapswhat 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. Lets 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 FIMMDAs handbook of market practice I. II. 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. 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. 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. 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. 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. 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. Reset dates: No fixing of rates and compounding of interest will be done on a Saturday. Day count fraction: The Day Count Fraction applicable to all INR interest rate swap transitions shall be Actual / 365 Fixed.

III.

IV.

V.

VI.

VII. VIII.

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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 INRMIBOR-OIS, INR-MIFOR and INR-BMK are most traded. I. II. III. IV. V. INR-MIBOR-OIS-COMPOUND INR-MITOR-OIS-COMPOUND INR-MIFOR INR-MIOIS INR-BMK

3.4 Details to Include before Confirming a Deal

Table 3.1 IRS Specifications

Floating Rate Option Designated Maturity Spread Floating Rate Day Count Fraction Reset Dates Compounding Compounding Date

INR-MIBOR-OIS-COMPOUND Overnight +/- [ ]% per annum Actual / 365 Fixed The last day of each Calculation Period. Inapplicable Inapplicable

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.

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Table 3.2 IRS Interest Calculations

Day 1 2 3 4 5 and 6 7 FIMMDA-NSEMIBOR Rate (%) 6.50 5.00 3.00 5.00 7.00 6.00 Notional Principle (NP) (INR) 100,000,000.00 100,017,808.22 100,031,509.29 100,039,731.06 100,053,435.13 100,091,811.79 Floating Interest (INR) 17,808.22 13,701.07 8,221.77 13,704.07 38,376.66 16,453.45 NP+Simple NP+Daily Compounded Interest@Fixed Rate Interest @MIBOR (5%)

100,108,265.24

100,095,890.41

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

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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, nonfinancial operating companies, insurance companies, mortgage companies, investment vehicles and trust, government agencies and sovereign states for one or more of the following reasons: I. II. III. IV. V. VI. To obtain lower cost funding To hedge interest rate exposure To obtain high yielding investment assets To create type of investment assets not otherwise obtainable To implement overall asset and liability management (ALM) strategies 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. II. III. IV. A floating-to-fixed swap increase the certainty of an issuers future obligation Swapping from fixed-to-floating rate may save the issuer money if interest rates decline Swapping allows issuer to revisit their debt profile to take advantage of the current or expected future market conditions Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service

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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

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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

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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

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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. Novation: A new swap agreement may be created canceling one or more existing swap agreements. 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. 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. Selling: A party may exit a swap agreement by selling it off to another party.

II. III.

IV. V.

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--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 plainvanilla 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. 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.

II.

27

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 cant 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 cant take trading positions or cant 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. 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.

IV.

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
28

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 Invest in 1-5Y GOI securities, 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. i. ii.

29

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 followingI. II. III. IV. There was a need for the exchange traded interest rate derivatives as the debt market volumes particularly IRS have been growing rapidly. Exchange traded products will reduce the risk through a clearing corporation, multilateral netting, novation and centralized settlement. Exchange will facilitate anonymous order driven screen-based trading. 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 derivativesI. II. III. IV. Short-term MIBOR Futures Contracts, MIFOR Futures Contract, Bond Futures Contract (on specific bonds) and 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)
30

II. III.

Futures contract on Notional 10 year Zero coupon bond; 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

Its really intriguing that in India interest rate derivative constitutes only 5% of the total derivative instruments traded value wise vis--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. There was a clear gap between what was intended by the market participants and what was actually introduced on the exchanges. 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

II. III.

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 Symbol Market Type Instrument Type Underlying Notional Coupon Tick size Description 10YGS7 N FUTIRD 10 Year Notional Coupon-bearing Government of India (GOI) security 7% with semi-annual Compounding 0.25 paisa or INR 0.0025
31

Trading Hours Contract Size Quotation Tenor Contract Cycle

Daily Settlement Price

Settlement Mechanism Deliverable Grade Securities

Conversion Factor Invoice Price Last Trading Day Delivery Day Initial Margin Extreme loss Margin

9:00 am to 5:00 pm (Monday to Friday) INR 2 lakhs Similar to quoted price of GOI securities up to four decimals with 30/360 day count convention Maximum Maturity: 12 months Four Fixed quarterly contracts for entire year ending March, June, September & December. To start with NSE has introduced two quarterly contracts 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 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 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 The conversion factor would equate the deliverable security (per rupee of principal), to yield 7% with semiannual compounding. Futures settlement price times conversion factor plus accrued Interest Two business day preceding the last business day of the delivery month. Last business day of the delivery month. SPAN Based Margin subject to minimum 2.33% on first day and 1.6% subsequently. 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:

32

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 its expected that there shall be some significant

33

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 banks 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. Absence of a reliable short term interest rate benchmark index: In India, we dont have a short term interest rate benchmark index like a 6-month MIBOR. The published 3month 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 cant take a view on the future interest rates.

II.

34

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 35

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. 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.

IV.

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. 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.

VI.

36

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. 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.

VIII.

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.

37

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, its 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 costbenefit 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.

38

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--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--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 doesnt 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.

39

II.

III.

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. 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 doesnt 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.

40

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. II. III. IV. V. VI. Development of corporate debt market; Full capital account convertibility; Complete deregulation of interest rates; Strengthening of risk management; Development of term money market and 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 doesnt matter if you get the underlying or
41

you get price of the underlying. Even is most of the developed markets, IRF contracts are physically-settled and hence this report doesnt 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, its 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 its 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 cant 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.

42

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)

IN0020020080

6.72% 2007/12 2011-12 9.39% 2011 11.50 % 2011 FRB, 2011 12.00 % 2011 11.50 % 2011(II) 2012-13 6.85% 2012 7.40% 2012 10.25 % 2012 11.03%2012 9.40%2012 FRB, 2012 2013-14

18-Jul-2002

18-Jul-2012

546.81

2 3 4 5 6

IN0020010057 IN0019910044 IN0020032028 IN0019910127 IN0020000116

2-Jul-2001 5-Aug-1991 8-Aug-2003 21-Oct1991 24-Nov2000

2-Jul-2011 5-Aug-2011 8-Aug-2011 21-Oct2011 24-Nov2011

37,000.00 2,861.36 6,000.00 3,246.91 11,000.00

7 8 9 10 11 12

IN0020020023 IN0020020056 IN0019840035 IN0020000066 IN0020010073 IN0020032036

5-Apr-2002 3-May2002 1-Jun-1984 18-Jul-2000 11-Sep2001 10-Nov2003

5-Apr-2012 3-May-2012 1-Jun-2012 18-Jul-2012 11-Sep2012 10-Nov2012

26,000.00 33,000.00 1,574.13 13,500.00 11,000.00 5,000.00

13 14 15 16 17 18 19

IN0019820037 IN0020010032 IN0019980187 IN0020020122 IN0020042043 IN0020020221 IN0020030105

9.00 % 2013 9.81% 2013 12.40 % 2013 7.27% 2013 (conv) FRB, 2013 6.72% 2014 5.32% 2014 2014-15

24-May1982 30-May2001 20-Aug1998 3-Sep-2002 10-Sep2004 24-Feb2003 16-Feb2004

24-May2013 30-May2013 20-Aug2013 3-Sep-2013 10-Sep2013 24-Feb2014 16-Feb2014

1,751.33 11,000.00 11,983.91 46,000.00 4,000.00 15,273.60 5,000.00

20 21

IN0020020049 IN0020090018

7.37 % 2014 6.07% 2014

16-Apr2002 15-May2009

16-Apr2014 15-May2014

42,000.00 40,000.00

43

22 23 24 25 26 27 28

IN0020032010 IN0019830010 IN0020090067 IN0019840084 IN0020080043 IN0019990137 IN0020000132

FRB, 2014 10.00 % 2014 7.32% 2014 10.50 % 2014 7.56% 2014 11.83 % 2014 10.47%2015 2015-16

20-May2003 30-May1983 20-Oct2009 29-Oct1984 3-Nov-2008 12-Nov1999 12-Feb2001

20-May2014 30-May2014 20-Oct2014 29-Oct2014 3-Nov-2014 12-Nov2014 12-Feb2015

5,000.00 2,333.26 18,000.00 1,755.10 41,000.00 11,500.00 6,430.00

29 30 31 32 33 34 35 36 37

IN0020000033 IN0019850034 IN0020090026 IN0020100023 IN0020042027 IN0020000090 IN0020042035 IN0020020130 IN0020010099

10.79%2015 11.50% 2015 6.49% 2015 7.17% 2015 FRB, 2015 11.43%2015 FRB, 2015(II) 7.38% 2015 (conv) 9.85%2015 2016-17

19-May2000 21-May1985 8-Jun-2009 14-Jun2010 2-Jul-2004 7-Aug-2000 10-Aug2004 3-Sep-2002 16-Oct2001

19-May2015 21-May2015 8-Jun-2015 14-Jun2015 2-Jul-2015 7-Aug-2015 10-Aug2015 3-Sep-2015 16-Oct2015

2,683.45 3,560.50 40,000.00 56,000.00 6,000.00 12,000.00 6,000.00 61,000.00 10,000.00

38 39 40 41 42 43 44

IN0020060219 IN0020010016 IN0020042019 IN0020040013 IN0019990129 IN0020090059 IN0020010107

7.59% 2016 10.71% 2016 FRB, 2016 5.59% 2016 12.30 % 2016 7.02% 2016 8.07% 2017 2017-18

12-Apr2006 19-Apr2001 7-May2004 4-Jun-2004 2-Jul-1999 17-Aug2009 15-Jan2002

12-Apr2016 19-Apr2016 7-May-2016 4-Jun-2016 2-Jul-2016 17-Aug2016 15-Jan2017

65,000.00 9,000.00 6,000.00 6,000.00 13,129.85 60,000.00 49,000.00

45 46 47 48 49

IN0020020031 IN0020022011 IN0020070010 IN0020020098 IN0020020163

7.49% 2017 (con) FRB-2017 7.99% 2017 7.46% 2017 6.25% 2018 (conv)

16-Apr2002 2-Jul-2002 9-Jul-2007 28-Aug2002 2-Jan-2003

16-Apr2017 2-Jul-2017 9-Jul-2017 28-Aug2017 2-Jan-2018

58,000.00 3,000.00 59,000.00 57,886.80 16,886.80

44

2018-19 50 51 52 53 54 55 56 IN0020110014 IN0020080019 IN0020010024 IN0020030063 IN0019980286 IN0020030097 IN0020080068 7.83% % 2018 8.24% 2018 10.45%2018 5.69 % 2018(Conv)] 12.60 % 2018 5.64 % 2019 6.05% GS 2019 (FEB) 2019-20 57 58 59 60 IN0020030048 IN0020090042 IN0020010065 IN0020020171 6.05% 2019 (con) 6.90% 2019 10.03 % 2019 6.35% 2020 (con) 2020-21 61 62 63 64 IN0020000025 IN0020100015 IN0020092071 IN0020000124 10.70 % 2020 7.80% 2020 FRB, 2020 11.60 % 2020 2021-22 65 66 67 68 IN0020110022 IN0020060318 IN0020010040 IN0020060037 7.80% 2021 7.94%2021 10.25% 2021 8.20 % 2022 11-Apr2011 24-May2006 30-May2001 15-Feb2007 11-Apr2021 24-May2021 30-May2021 15-Feb2022 27,000.00 49,000.00 26,213.32 57,632.33 22-Apr2000 3-May2010 21-Dec2009 27-Dec2000 22-Apr2020 3-May-2020 21-Dec2020 27-Dec2020 6,000.00 60,000.00 8,000.00 5,000.00 12-Jun2003 13-Jul-2009 9-Aug-2001 2-Jan-2003 12-Jun2019 13-Jul-2019 9-Aug-2019 2-Jan-2020 11,000.00 45,000.00 6,000.00 61,000.00 11-Apr2011 22-Apr2008 30-Apr2001 25-Sep2003 23-Nov1998 2-Jan-2004 2-Feb-2009 11-Apr2018 22-Apr2018 30-Apr2018 25-Sep2018 23-Nov2018 2-Jan-2019 2-Feb-2019 18,000.00 50,000.00 3,716.00 16,130.00 12,631.88 10,000.00 53,000.00

2022-23 69 70 71 72 IN0020020072 IN0020070028 IN0020039031 IN0020070051 8.35% 2022 8.08% 2022 5.87%2022 (conv) 8.13% 2022 14-May2002 2-Aug-2007 28-Aug2003 21-Sep2007 14-May2022 2-Aug-2022 28-Aug2022 21-Sep2022 44,000.00 40,969.41 11,000.00 48,495.28

45

73 74

IN0020030014 IN0020030055

2023-24 6.30% 2023 6.17% 2023 (conv) 2024-25

9-Apr-2003 12-Jun2003

9-Apr-2023 12-Jun2023

13,000.00 14,000.00

75

IN0020090034

7.35% 2024 2025-26

22-Jun2009

22-Jun2024

10,000.00

76

IN0020030071

5.97 % 2025 (Conv) 2026-27

25-Sep2003

25-Sep2025

16,687.95

77 78

IN0020010081 IN0020060078

10.18% 2026 8.24 % 2027 2027-28 8.26 % 2027 8.28 % 2027 6.01% GS 2028 (C Align) 2028-29 6.13% 2028 2029-30 2030-31 2031-32

11-Sep2001 15-Feb2007

11-Sep2026 15-Feb2027

15,000.00 57,388.55

79 80 81

IN0020070036 IN0020070069 IN0020020247

2-Aug-2007 21-Sep2007 8-Aug-2003

2-Aug-2027 21-Sep2027 25-Mar2028

64,427.33 1,252.24 15,000.00

82

IN0020030022

4-Jun-2003

4-Jun-2028

11,000.00

83

IN0020060086

8.28 % 2032 2032-33 8.32 % 2032 7.95% 2032 8.33% 2032 2033-34 2034-35

15-Feb2007

15-Feb2032

55,687.11

84 85 86

IN0020070044 IN0020020106 IN0020070077

2-Aug-2007 28-Aug2002 21-Sep2007

2-Aug-2032 28-Aug2032 21-Sep2032

15,434.05 59,000.00 1,522.48

87 88

IN0020040039 IN0020042050

7.50%2034 FRB, 2035

10-Aug2004 25-Jan2005

10-Aug2034 25-Jan2035

60,000.00 350.00

46

89

IN0020050012

2035-36 7.40% 2035 2036-37 8.33%2036 2037-38 2038-39

9-Sep-2005

9-Sep-2035

42,000.00

90

IN0020060045

7-Jun-2006

7-Jun-2036

59,000.00

91

IN0020080050

6.83% GS 2039 2040-41 8.30% GS 2040

19-Jan2009

19-Jan2039

13,000.00

92 Total

IN0020100031

2-Jul-2010

2-Jul-2040

44,000.00

2,251,441.74

47

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 oating 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?

48

REFERENCES
John C. Hull, Options, Futures and Other Derivatives (7th ed.), (Prentice -Hall, 2009) 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 CCIL Monthly Publications, Rakshitra (May 2011) Thomas, Susan and Aggarwal, Nidhi (Oct 19, 2010), Implementing an arbitrage trade using GOI Bond Interest Rate Swaps, paper presented at the Indira Gandhi Institute of Development Research Regulatory Perspectives on Derivatives Markets in India - Keynote address by Dr. Subir Gokarn, Deputy Governor, Reserve Bank of India at the International Options Market Association, World Federation of Exchanges Annual Conference organized by the National Stock Exchange at Mumbai on May 4, 2011 Note on CCILs settlement of rupee derivative products (IRS & FRA), Letter to all members and other interested persons, Dec 20, 2004 Arora, Dayanand (April 2010), OTC Derivatives Market in India: Recent Regulatory Initiatives and Open Issues for Market Stability and Development, Working Paper No. 248, paper presented at INDIAN COUNCIL FOR RESEARCH ON INTERNATIONAL ECONOMIC RELATIONS.

49

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 Recommendations of Jaspal Bindra Committee Market (IRS & FRA)

NSEs Interest Rate Futures Brochure for Banks/PDs, Corporate, Mutual Funds and Retail Participants. Patnai, Ila and Shah, Ajay, (February 7, 2003), Interest-rate risk in the Indian banking system

50