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Guarantees set to boost derivatives trading volume

Guarantees set to boost derivatives trading volume
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First Published: Tue, Jul 07 2009. 09 11 PM IST
Updated: Tue, Jul 07 2009. 09 11 PM IST
Mumbai: The company that settles all bond and foreign exchange transactions in the country, Clearing Corp. of India Ltd (CCIL), will soon offer guarantees on two of the most traded over-the-counter (OTC) derivatives in the country—interest rate swaps and currency forwards—in a move that will likely boost trading volumes.
Between them, interest rate swaps and currency forwards account for about 85% of OTC derivatives trading in India. The outstanding trading volume of the swap market is Rs35 trillion and that of currency forwards is about $500 billion (Rs24.25 trillion). The markets are expanding at about 35% annually, according to CCIL.
An interest rate swap is a transaction in which a floating rate loan is exchanged against a fixed rate loan. An entity uses swaps to hedge or manage its exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than it would have been able to get without the swap.
A currency forward is a contract between two entities to exchange currencies at a future date and at a specific price and quantity.
CCIL will start guaranteeing the products from the point of a deal till its settlement, assuring that the transaction would be honoured, said two senior CCIL officials involved in developing the products. This would help banks save on capital requirements and reduce settlement and operational risks associated with such transactions.
CCIL chairman R.H. Patil spoke about plans to introduce the guarantees at a seminar in Mumbai, the Business Standard had reported on 17 May.
In the absence of a guarantor, these derivative deals can be risky and banks are required to set aside capital to take care of any possible defaults. According to Indrani Rao, chief forex officer of CCIL, banks can save at least 80% of their capital when CCIL starts guaranteeing the deals.
“Banks can also get rid of a lot of operational issues. For instance, they can do away with the department that looks after swaps and forwards markets. Counterparty limits and capital layout will no longer be the constraint,” said Rao.
The CCIL initiative to guarantee OTC derivatives trading assumes significance in the context of growing defaults and shrinkage in trade volume last year after an unprecedented credit crunch hit global markets.
The outstanding trade volume in the interest rate swaps market was Rs70 trillion in August. After the collapse of Wall Street investment bank Lehman Brothers Holdings Inc. in September, the volume dropped to less than half. Daily trading volume also fell sharply from an average Rs30,000 crore to Rs5,000 crore. Having a cen tral counterparty will help restoring confidence, said CCIL officials.
OTC market operators are enthusiastic about the development. “With CCIL guarantees, the volume should go up in these markets. It may become as popular as trading government bonds on NDS-OM (a platform where dealers strike deals anonymously) as there is no counter-party risk involved,” said Arvind Sampath, director of rates trading at Standard Chartered Bank.
Currently, CCIL settles and clears currency forward deals by extending the guarantee only for two days before the actual settlement. Interest rate swap deals are settled without extending any guarantee.
While guarantees for currency exchange forwards will come into force in about a month, guarantees for interest rate swaps will take some more time, said CCIL officials.
OTC deals are largely bilateral in nature, signed between two parties, and can be of any size. Banks and corporations use the OTC market as the sizes of these contracts can be customized in accordance with their needs. In contrast, the contracts for exchange traded products have a standard size and specific maturity dates.
The OTC deals are done mainly over the phone or through trading terminals. CCIL may launch a trading platform for these products, said CCIL’s chief risk officer Siddhartha Roy.
According to CCIL officials, even though the monthly volume of trade in the forwards market is around $90 billion, the cash required to be exchanged at the end of the month, after taking into consideration firms’ payment obligations and receivables from other firms, also known as netting, is only $1-1.5 billion.
Although CCIL did not disclose the exact margin requirement for offering such guarantees, a back of the envelope calculation puts the requirement at around 0.40% of the size of each deal. The margin will also depend on the size and nature of the contract. “The risk profile of the counterparties will be considered for the margin,” said Roy.
“If the margin is high, people will not go for the guarantee,” said Sampath.
For margin requirements, CCIL will accept liquid government bonds and cash. Typically, for interest rate swaps, the most popular benchmark used is the Mumbai interbank offered rate, an overnight rate at which banks borrow money from each other. The duration of such swaps can be up to 10 years.
The interest rate swaps market is largely controlled by 20 major entities. Collectively, they account for about 75% of the trading volume. There are many players in the currency forwards market, with banks dominating the scene.
Overseas, “dark pools” or exclusive clubs of large banks, control interest rate swaps. They trade between themselves in an informal OTC market and the transactions are cleared by a central counterparty.
The concept is yet to pick up in India because of the relative low trading volume, but once CCIL starts guaranteeing these products, the volume will rise and such exclusive clubs of large financial institutions may also emerge, according to foreign exchange dealers.
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First Published: Tue, Jul 07 2009. 09 11 PM IST