Mumbai: Trading in interest rate futures (IRFs) has slowed to a trickle as initial enthusiasm has been replaced by worries about the limited variety of players in the market and fears that the dice are loaded in favour of sellers.
IRFs made their debut on the National Stock Exchange (NSE) on 31 August, six years after an earlier edition failed, as part of new efforts to allow participants to buy protection against and bet on interest rates changes. Currently, NSE is the only exchange offering trading in IRFs.
The average daily trading turnover on NSE fell from Rs77.5 crore in September to Rs6 crore in January.
IRFs are an agreement to buy or sell an underlying debt security at a fixed price on a fixed day in the future, and the prices of these derivatives mirror the rise and fall in the yield of the underlying government bonds. Unlike overnight interest rate swaps, IRFs have to be traded on exchanges rather than over the counter.
Graphic: Paras Jain / Mint
The Securities and Exchange Board of India (Sebi) and the Reserve Bank of India have limited the maturity of IRF contracts between a minimum of three months and a maximum of 12 months. This time around banks have been allowed to hedge interest rate risks as well as take bets on the rate trajectory. Also, foreign institutional investors have been given access to the market.
To begin with, NSE launched two contracts, one of which matured in December and the other will mature in March.
Bankers say one problem is that the underlying bonds are illiquid. “As the underlying securities are mostly illiquid, when they come up for maturity, delivery is virtually impossible,” said an official of a primary dealer that buys and sells government bonds.
In a bid to ease concerns over delivery obligations, in December, Sebi allowed exchanges to set any period of time during the delivery month as the delivery period for the securities.
The chief investment officer of fixed income funds at a Mumbai-based foreign fund house said the uncertainty over the deliverable securities is worrying players. “I am not sure what stock of securities I will get as the system is delivery-based. Given that volumes are low, if we get a stock of illiquid securities, it could land us in trouble. Though we have enrolled for IRFs, we have still not undertaken any trade.”
“The product itself is defective. Only the seller gains as he has the discretion of delivering either liquid or illiquid securities,” an official of State Bank of India (SBI), the country’s largest lender, said on condition of anonymity.
Another critical issue is the absence of participants with contrarian views on interest rate movements. At least three bankers whom Mint spoke to said currently all banks are going short on bond trades, assuming that the interest rates will rise in the future. There are not many “long only” players, or those who buy bonds.
“If insurance companies start participating, there will be players on the long side, which may improve the liquidity. At present, there is no insurer trading on the platform,” said the SBI official.
Insurance firms are not yet allowed to trade in IRFs.
Developed markets where IRFs have already taken off allow short-selling and provide a good repo market. In India, short-selling is not allowed beyond five days, and the repo market is not adequately developed. “If we have good shorting in the spot market, then people will come to repo market for borrowing. In the absence of these two, you only have people who want to sell the futures and buy bonds on spot. This has created a situation where everybody is sitting on one side of the market,” said a bond dealer with a foreign bank.
To alleviate some of these concerns, Life Insurance Corp. of India, India’s largest insurer, and Central Bank of India in December decided to purchase government bonds from members who desire to liquidate the securities received against their interest rate derivative obligations.