One of the key reasons why the Indian financial system was not affected by the 2008 global meltdown was the banking regulator’s conservatism. The central bank ring-fenced the Indian banking system by imposing stringent criteria on various instruments, including trades in permitted derivative products, and deferring the introduction of others, one of which was blamed for sinking large global financial institutions.
The Reserve Bank of India (RBI) had proposed the introduction of credit default swaps (CDS) a number of times since 2003, but drew up final guidelines for them only this year.
Developments in the currency and interest rate derivatives markets show RBI has only recently opened up the space. In 2010, it introduced currency options though currency futures were launched just before the credit crisis in 2008. Both have garnered reasonable volume, but are nowhere close to their volumes overseas.
Derivatives allow companies to hedge their currency risks and play a key role in asset-liability management. It is a must-have for firms with most of their inflows in dollars and costs in rupees.
“We live in a world where there is mismatch and we need certainty that the mismatch can be bridged. That’s why we need various kinds of derivatives,” said Rostow Ravanan, chief financial officer of software firm MindTree Ltd. “Availability and access to a robust derivatives market is what brings stability in the operation of a corporate.”
As Indian firms gets connected to the world for their operations, the need for derivatives is on the rise, say bankers. “Derivatives are here to stay,” said Ananth Narayan G., head of fixed income, currencies and commodities at Standard Chartered Bank. “Risk remains extremely high to stay un-hedged. Clients’ risk-management needs will always be there, so will derivatives.”
One critical derivative product introduced after the downturn is the cross-currency option, launched on the exchanges in October 2010. RBI allowed options on four currency pairs: rupee-dollar, rupee-yen, rupee-pound sterling and rupee-euro. Volume in this segment has crossed $500 million on the National Stock Exchange, but is far below volumes in the currency forwards market.
Volume in futures and options combined crossed Rs1 trillion in July, in a sign the currency derivatives market is picking up pace. Average volume in exchange-traded currency derivatives is Rs60,000-80,000 crore.
Banks and retail investors dabble in the segment as speculators. Small and medium enterprises enter the market for their simple needs, but big firms largely stay away as their needs are complex and they need custom contracts that exchanges cannot provide.
RBI governor D. Subbarao has indicated he believes in the dictum Festina lente —make haste slowly—when it comes to reforms. This, say bond market dealers, indicates RBI will be cautious and ensure regulations are well entrenched before introducing more derivative products.
The central bank has been cautious regarding the introduction of new products. It issued four draft discussion papers and guidelines before coming up with final guidelines on CDS in India.
There are two kinds of derivatives—traded bilaterally over the counter (OTC) and exchange-traded. Until a few years ago, most of the derivatives in India were of the OTC kind. Even now, the size of the OTC currency market is larger than that of its exchange-traded counterpart.
The currency derivatives segment includes foreign currency forwards, currency swaps and currency options. The interest rate derivatives segment includes interest rate swaps, forward-rate agreements and interest rate futures (IRF). Then, there are products linked to the overnight money markets, such as collateralized borrowing, lending obligations and overnight index swaps.
Overnight money market-linked products are overwhelmingly successful, but products that involve a longer-term view have failed.
In most developed nations, fixed-income markets compete with equity markets to attract investors. In contrast, in India, the daily equity market volume is at least double that of the debt market, including government and corporate bonds.
A few large investors, mostly banks, control the bond market. Other investors include insurance companies, a few mutual funds, and pension and provident funds. They are also the medium through which RBI intervenes in the bond and currency markets.
Several committees have been formed to deliberate on measures to deepen the bond market and introduce new products. The most influential was headed by R.H. Patil, chairman of National Securities Depository Ltd and Clearing Corp. of India Ltd. The key recommendations of the committee, submitted in 2005, are yet to be implemented despite the finance ministry’s acceptance of them.
The cautious attitude of the regulator—that derivatives are used for hedging and not speculation—is helping to safeguard the financial system, but may be impeding the market’s growth. As the derivatives market will be dominated by hedging needs rather than speculation purposes, currency derivatives will continue to outshine interest rate derivatives, say experts.
In global markets, interest rate derivatives are the most popular products, followed by currency derivatives. The volume in equity derivatives is small in comparison. But in India, equity derivatives have notched up large volumes compared with currency and interest rate derivatives. In fact, currency derivatives are picking up well, but interest rate derivatives, particularly interest rate futures, have not been accepted.
Experts say India has all the derivatives products that make a market vibrant. New products, they say, may not be needed at all.
“You don’t need any fancy derivatives to make the market more vibrant. You just need to have more participation of India forex and simplification of rules,” said Abhishek Goenka, chief executive officer of India Forex Advisors Pvt. Ltd.
The main problem with the available derivatives is they are not traded in their current form and RBI may have to eventually tweak them to make them more market-friendly. RBI may have to introduce some amount of speculation and change the structure of the products.
This is a contentious issue.
Many banks have significantly downsized or completely wound down their derivatives teams, especially after RBI clamped down on exotic deals.
In a way, this indicates that the future of derivatives may be constrained by RBI if it continues with its tough supervisory stance. There will not be many entities to make two-way quotes available or extend liquidity in the market.
Indian public sector banks that assume the responsibility of being market-makers for any new instrument behave in a similar manner. It has often been seen that after the launch of a derivative product, volumes go up sharply as banks trade aggressively among each other. The volume thins out every passing day as they lose interest and other players don’t fill in.
To invite serious entities into the market, RBI needs to change the structure of the products, say market experts.
As per the present set of rules, all derivatives must be physically settled. That means, at the end of the contract, the buyer should buy the underlying assets. This hurts fixed-income derivatives in particular.
For any fixed-income derivative product with a long-term view, there are not enough bonds that are liquid in the market. Since they cannot be traded, it becomes uneconomical for the purchaser to get these papers as they need to be held till the bonds mature. Products such as IRF are not picking up despite the regulators’ best efforts.
However, RBI has introduced cash-settlement in 91-day treasury bills IRF, which experts say is a first step to introduce cash settlement in a range of other derivatives products. The Indian market could see progress on this front in the coming days.
In currency markets, liquidity is expected to improve in other maturity markets. Now it is limited to contracts maturing in two-three months, but Goenka of India Forex expects liquidity to improve in the 6-12 month maturity basket as well in the coming days.
Corporate clients will need to have a bigger play in the exchange-traded currency market. They currently do not get longer-tenure contracts of their liking because of the absence of banks—the market makers in the longer tenure of the exchange-traded currency derivatives market.
There is a serious lack of jobbers and arbitrageurs in the currency market too. These professionals quote two-way prices and act as intermediaries in the currency derivative markets. Currency market participants say going forward, India will see more such intermediaries as they are in equity market sub-brokerages as currency derivatives become fashionable with retail traders. Retail traders have only recently started participating in the currency derivative segment and their participation will increase.
The biggest problem of India’s financial markets is the absence of a term-money market, needed to integrate all the money market rates with the final lending rate of banks.
This is how developed markets perform. Lending rates are linked to the term-money rates prevailing in the market and banks have to add a risk premium to it.
Lending rates of Indian banks have become more transparent with the introduction of a base rate system. However, the reference rate taken to arrive at the base rate differs from one bank to other. Once the term-money market comes into play, banks’ base rate, certificates of deposit, fixed-income rates and even CDS, besides a plethora of other instruments, can be standardized. This will bring in a lot more transparency and with it a different set of players in the market.
In fact, banks don’t need to have different rates among themselves once there is an active term-money market. They may just check rates and make their decisions on a daily basis, as with a standardized CDS. This, according to some, could become a reality one day in the Indian banking system. There could be Libor-equivalent lending as in overseas markets. Libor stands for London inter-bank offered rate.
If markets become deeper, rates will converge and capital convertibility will open up. But there are economic implications of opening up. The market may turn into one for speculators from being one for hedgers.
As India’s links with the global markets strengthen, OTC derivatives are getting standardized and the documents signed between banks and the clients are adhering to the standardized international format laid down by the International Swaps and Derivatives Association. This shows that firms are getting aligned with international standards when it comes to derivatives.
Interest rate derivatives may include instruments such as caplets, floorlets and swaptions, while credit-risk derivatives may include credit-linked corporate notes, credit-linked swaps, asset-backed securities, etc.
For such instruments to succeed, Indian companies will need to acquire the relevant market expertise.
“These derivatives are needed to manage balance sheets with multi-currency exposure. If Indian companies become big and mature enough to dabble in multi-currencies, then these instruments will be needed. But Indian companies’ balance sheets are fairly simple, so these instruments are a bit far away for the Indian market,” said J. Moses Harding, head of markets at IndusInd Bank Ltd.
The interest rate market is currently more or less limited to overnight index swaps.
An interest rate swaps market has also developed in the OTC space. Banks are the key participants here and while the volume is low, it is steadily gaining popularity. The popular benchmark here is the Mumbai inter-bank offer rate (Mibor) and the Mumbai inter-bank forward offered rate (Mifor).
As India needs to have its own lending benchmark along the lines of the Libor, Mifor and Mibor-related derivatives will gain in popularity, experts say.
Having said that, derivatives are instruments created when there is a need felt for them.
“Derivatives innovation is limited by imagination. You can create as many derivatives as you want, but there should be proper regulations around to control them,” said Ravanan of MindTree.
According to bank and corporate treasurers, the greatest lesson learnt after the 2008 crisis was that derivatives should be used strictly for hedging and not for speculation. Companies that dabbled in speculation and bought derivatives for making quick money learnt their lesson the hard way.