Second chance for interest rate futures

By Ameya Khandge and Vardaan Ahluwalia, Trilegal
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The end of August saw the long-awaited re-launch of exchange-traded interest rate futures (IRFs), as part of ongoing financial sector reforms. This is the first major initiative in the derivatives market since the launch of currency futures around the same time last year. The introduction of IRFs is a positive effort to add further depth to India’s financial markets; if successful, it will offer a liquid product to meet the hedging and arbitrage needs of market participants.

Ameya Khandge Partner Trilegal
Ameya Khandge
Partner
Trilegal

IRFs were first launched unsuccessfully six years ago. Their failure to find a market at that time was attributed to the restriction on participation by banks, which are the most significant holders of government debt, and to IRFs being linked to the zero yield curve, a benchmark that was then not well developed in India.

The new IRF regime is the latest attempt to introduce greater transparency, standardization and efficiency to the debt market. Learning from past experience, the Securities and Exchange Board of India and the Reserve Bank of India (RBI) established a technical committee to advise on how the product should be redesigned.

The new regime seeks to introduce exchange-traded 10-year notional coupon-bearing government security futures. The size of each contract is Rs200,000 (US$4,500), with a maximum tenor of 12 months.

The rules governing the new IRFs emphasize risk management and aim to keep reckless trading in check. Participating clearing members need to have a minimum liquid net worth of Rs5 million, and clients must also meet certain margin and security requirements. Further, to stem malpractices, clearing corporations are required to separate the margins deposited by the clearing members on behalf of their clients from margins deposited for trades on its own account. Clients’ margins are to be held in trust for client purposes only.

The IRF framework places checks and balances in the trading system. For instance, a risk evaluation report must be carried out at least once every six months. Position limits, supported by alert systems, have been placed at both the client level (6% of the total open interest or Rs3 billion, whichever is higher) and trading member level (15% of the total open interest or Rs10 billion, whichever is higher).

The guidelines have opened up the market by permitting foreign institutional investors (FIIs) to participate. However, the regulator has placed a check on the FIIs by stipulating that their gross position (in cash and IRF market participation taken together) should not exceed the individual permissible limit for investment in government securities.

Will IRFs achieve greater success this time around, given the regulator’s careful approach and efforts to learn from the outcome in 2003? The product saw a cautiously enthusiastic welcome, with 15,000 contracts with a value of Rs2.67 billion being traded on the opening day. But the euphoria did not last long; within a fortnight of the launch, the volume of trade declined sharply, falling about 76.33% to Rs632 million.

While the efforts of the technical committee to improve the product are evident, certain concerns still exist. For instance, market participants insist that the IRF segment will encounter illiquid cycles due to the inherent nature of the underlying securities involved.

Although the client position limits have been increased compared to the 2003-edition IRF, many market analysts believe the amended limits are still too low. For banks, which have significant exposure to government securities and seek to hedge their risk using IRFs, the Rs3 billion limit will probably be insufficient to provide any substantial hedge.

There is also a lack of divergent views on interest rate trajectory contributing towards the liquidity crunch in the segment. There may need to be greater participation by a more diverse participant base, including insurance companies, retail investors and mutual funds. Within three weeks of the launch of the new IRF, the RBI had released a follow-on notification permitting non-banking finance companies to use the product for hedging their underlying exposures.

Most participants are keen to see the first cycle of settlements completed in December, with any associated issues in relation to the mechanism being resolved. Currently, settlement is by physical delivery instead of cash payment.

The potential for the IRF market is not in question, and the availability of an exchange-traded platform in addition to the existing over-the-counter framework is certainly welcome. While initial teething problems can be expected, it is important that regulators are swift in identifying and tackling such issues to ensure that the market for IRFs does not fail again. To this end, the regulators may also want to consider reducing the level of micro-management of the product design. At the time of writing it is too early to reliably predict the success of this initiative, but one hopes that the coming months will witness the establishment of a stable market for IRFs.

Ameya Khandge is a partner at Trilegal in Mumbai where Vardaan Ahluwalia is an associate. Trilegal is a full service law firm that advises on corporate and commercial law in India and provides commercially oriented legal advice in relation to all sectors of the economy. The firm has offices in Delhi, Mumbai, Bangalore and Hyderabad and has over 100 lawyers, some with experience at law firms in the US, the UK and Japan.

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