With the green signal coming from the joint technical committee of the Reserve Bank of India (RBI) and the Securities and Exchange Board of India, interest rate futures trading on stock exchanges would soon be a reality in India.
It’s now exactly six years since India’s first attempt at introducing interest rate futures on a stock exchange platform bombed.
In 2003, the National Stock Exchange (NSE) had introduced interest rate futures contracts that were priced off a zero coupon yield curve, a design market participants weren’t comfortable with.
Besides, RBI didn’t allow banks to take trading positions in interest rate futures, although they could in the over-the-trade interest rate swap market. They could only use the futures market to hedge interest rate risk in the “held for trading” and “available for sale” categories of their investment portfolios.
Since banks are the largest players in debt securities, their inability to trade naturally hurt the liquidity of the futures market.
The new product design approved by the joint committee is based on the recommendations of an RBI-appointed working group, submitted in February 2008.
Many experts and market participants feel that this product would fare much better than the one introduced in 2003, as the main concern regarding the product design has been dealt with and the earlier restrictions on banks’ participation have been removed.
The underlying will be a 10-year notional coupon-bearing government security, with the notional coupon being 7% with semi-annual compounding.
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The working group that proposed the new product design had taken on board the difficulties related to pricing based on the zero coupon yield curve and has hence suggested a contract that’s almost exactly in line with bond futures traded the world over. With this, the primary concern market participants had about the earlier product has been removed.
Still, some of the specifications related to the product have raised concerns.
According to the head of treasury at a foreign bank, the primary concern is related to physical settlement and the fact that the deliverable grade of securities include any government security with a maturity between 7.5 years and 15 years and with an outstanding stock of Rs10,000 crore.
Within this classification, there are a number of extremely illiquid securities that no buyer in the interest rate futures market would like to end up with.
According to a stock exchange official, this problem would always occur with bonds since few bonds are liquid at any given point of time. The solution, according to him, is to have a more active repo market, where these illiquid bonds can be financed.
In fact, even the working group set up by RBI had said that the vibrancy of the interest rate futures market would depend on the vibrancy of the repo market.
The sad thing is that the repo market currently is far from vibrant and there doesn’t seem to be anything policymakers are doing to bring change.
Some experts feel that the client-level position limit of Rs300 crore or 6% of open interest, whichever is higher, could hamper growth in the initial stages. This is because for most banks, a Rs300 crore position would hardly provide any meaningful hedge.
Among other things, the technical committee has also set the trading hours for the contract, apart from minute specifications regarding product design.
This goes against the working group’s view that “of the market micro-structure issues such as notional coupon, basket of deliverable securities, dissemination of conversion factors, and hours of trading (should be) best left to respective exchanges”.
Indian policymakers have traditionally been control freaks, but it’s time they gave some freedom to exchanges. With everything about the product and even the hours of trading decided, exchanges have nothing else to compete on but price.
In the currency futures market, the price charged to customers has been zero for some time. In such a situation, it won’t be surprising if unethical practices creep into the exchange space in order to gain volumes.
Another problem with the regulator being involved in product design is when, for any reason, changes would be required in the proposed contract.
With two regulators involved in the case of interest rate futures, it could take months for some corrective action to be taken. If exchanges are allowed to take these decisions, the time to market will be much shorter.
A case in point is the securities lending and borrowing (SLB) mechanism, which was introduced in the equities market more than a year ago. It soon became evident that the product specifications didn’t suit the markets’ requirement. But it wasn’t before many months had passed that some corrective action was taken.
Ironically, even with the changes, trading in the SLB segment hasn’t taken off. If decisions were left to the stock exchanges, the product design would have been aligned with the markets’ requirement long ago.
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