Interest rate futures market in India

Abstract

Due to the global financial crisis, more and more regulators and markets are biasing their policies away from the Over-The-Counter (OTC) forward market in favour of exchange-traded market. In an exchange traded derivative, the systemic risk is limited to the open position of the contracts. India has also moved in this direction by introducing currency futures which was launched on August 26, 2008, followed one year later by the launch of interest rate futures (IRFs) market on August 31, 2009. The launch of IRFs is however not new. In 2003 IRFs were introduced in India but failed miserably. The reasons that were given for the re-launch of IRFs in India are: 1) Expand the scope of financial markets in India and integrate it with the global economy, 2) Fuller Capital Account Convertibility 3) Boost the Indian bond market, 4) Empower corporations to hedge interest rate risk, 5) Efficient asset-liability management avenues for banks and financial institutions and 6) Empower household sector to manage loans and investments The 2003 failure has been attributed to a variety of reasons like: a) Zero Coupon Yield Curve (ZCYC) pricing (which is difficult to understand compared to YTM pricing) b) Cash settlement (which makes the market easy for manipulation) and c) Restricted participation of banks (banks could only hedge and not take speculative positions which hampered liquidity). The working group formed for the launch of IRFs in 2009 took care of all these problems. However, after starting with a bang the trading of IRFs soon fizzled out leading to very less liquidity. The problems faced by the IRF market in 2009 as we see it are: a) In a not very mature market like India there is very limited retail participation, b)A OTC market was enough to allow the big participants to hedge their risks and that a futures market was really not needed, c) Timing of the launch was not appropriate as the increasing volatility due to recent financial crisis has kept out many investors and d) We feel that in a new and less developed market, it is actually better to have only cash settlement rather than physical settlement. There are also some other factors like Lack of market makers, Lack of sophisticated arbitrageurs, Position Limits and Lack of flexibility of Exchanges. Based on our study of the Working Group report and our analysis of the 2003 and 2009 IRFs markets in India we have come up with the following set of recommendations: * Encourage wider retail participation: A concerted effort has to be made by all the participating exchanges and regulators to educate the public about the need for hedging interest rate risk and ways and means to do so. * Market Making: As a last resort, RBI may also use its muscle and force institutions like LIC to take more part in IRF market making, as it recently did several times during the recent financial crisis to save equity markets from crashing. * Holistic View of the Market: One big problem with the current market structure is that RBI failed to take more holistic view of the financial markets and looked at Interest Rate Futures in isolation. It did not consider the interconnectedness of many of the branches of financial markets. * Greater Flexibility to Exchanges: A greater amount of flexibility must be provided to decide some of the rules and structures in order to ensure greater success of IRF market The critical issue right now is the successful settlement of transactions on December 18, 2009. All eyes are set on this date as it is going to be the first maturity date of a contract in this episode of IRF market. As has been explained before, a lot of the market participants are not sure how the delivery mechanism will work out and are skeptical about the illiquid nature of many delivery grade bonds. There a number of things that RBI can do to ensure things work out smoothly on December 18 like: a) RBI can open up a temporary repo window to ensure that participants do not end up with highly illiquid bonds, b) The wide range of deliverable grade bonds must be narrowed down by increasing the minimum outstanding required for it to be acceptable, and c) The regulators will have to come down heavily on any kind of market manipulation to infuse some confidence in the potential participants Although the above mentioned recommendations might be tried we are not confident of them yielding positive results. There is a fundamental flaw in the introduction of IRFs at this time. RBI would be better off disbanding the IRF market and introducing it at a later time when Indian markets are more developed and ready for complex product like interest rate futures. We are of this view because we feel that it is a step too soon towards introducing a product which is really meant for a more developed market with better infrastructure like a vibrant repo market, presence of sophisticated arbitrageurs like hedge funds, etc. Also, the timing for the introduction could not have been worse for a risk averse market like India. The recent insulation of India and China from the global credit crisis was to a great extent due limited currency convertibility compared to other countries which prematurely opened their economies to the developed markets. This is sufficient proof that it is not always a good idea to try to appear more developed than you actually are.