Interest rate derivatives are the largest traded contracts on organized exchanges as well as in the over-the-counter markets globally. According to data released by the Bank for International Settlements late last week, interest rate derivatives accounted for over 85% of the total notional derivatives turnover on organized exchanges. This excludes trading in equity single stock derivatives as well as commodity derivatives, but it’s safe to say that even if one were to include these segments, interest rate derivatives would be the largest traded segment.
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In India, however, the experience with exchange-traded derivatives is quite different. Equity derivatives have been successful and have grown to a significant size about 11 years after their launch. Barring single stock options, all segments have done well. The currency derivatives segment is also liquid. And there is a fair amount of trading in commodity derivatives as well. But despite repeated attempts, trading in interest rate derivatives has failed to take off.
In 2003, the National Stock Exchange introduced interest rate futures contracts that were priced off a zero coupon yield curve, a design market participants weren’t comfortable with. Besides, the Reserve Bank of India (RBI) didn’t allow banks to take trading positions in interest rate futures. Since banks are the largest operators of debt securities, their inability to trade naturally hurt liquidity of the futures market. Later, in 2009, there was another attempt at introducing interest rate futures, based on recommendations by a joint technical committee of RBI and the Securities Exchange Board of India (Sebi). The new proposals dealt with the product design concerns of the 2003 contract and also removed the restrictions on the participation of banks in the market. Still, trading didn’t take off.
Market participants say the main concern with the product introduced in 2009 was that buyers of these contracts could end up with illiquid government bonds. The contracts are physically settled and sellers have the option of settling with securities that were cheapest to deliver. Of course, the number of securities that qualify for the settlement process are limited. But given the nature of the underlying bond market where liquidity keeps shifting, it’s very likely that buyers of interest rate futures contracts would end up with illiquid bonds. As a result, there is hardly any trading in this segment. This year there were no trades on one-third of the trading days while volumes in the rest of the trading sessions averaged one contract. There’s little doubt in anyone’s mind that even the second attempt to introduce interest rate derivatives has been a failure.
RBI and Sebi, too, have sensed this and as part of their plans to remedy this, they have announced a new contract that will be priced off 91-day treasury bills. As with all short-term interest rate futures contracts across the world, they will be cash-settled. Therefore, it will at least not face the problem faced by the earlier contract. Besides, the settlement price will be derived from auctions conducted by RBI and hence would not be manipulable. Banks and primary dealers have exposures to short-term interest and should have trading interest in the product. Even so, as one exchange official points out, one will know if there is market interest only after the product is launched. After all, it was felt by some experts that the earlier product may do reasonably well since it had addressed some of the problems with the 2003 contract.
As pointed out in this column earlier, this is a wrong way to design a product. Exchanges globally work alongside market participants and introduce new products based on feedback. Similarly, if any changes need to be made to product design, exchanges need to have the flexibility to move quickly and make those changes.
But rather than being nimble-footed, Indian exchanges have to wait endlessly until joint committees comprising RBI and Sebi officials approve new products and changes to existing products. This has huge disadvantages.
New products need to be nurtured by exchanges, by spending resources on marketing and building awareness. In the case of interest rate futures, exchanges would attempt at building awareness among brokers and large traders that have traditionally confined themselves to the equities segment. They would have done this during the launch of the new product in August 2009. Now they need to do it all over again with the 91-day treasury bill contract. Needless to say, this would have been much easier if the time gap between the launch of the two products wasn’t so long.
Hopefully, the cash-settled short-term product would draw people to trade in interest rate derivatives on exchanges. While that may be a good outcome in itself, it will unfortunately further prolong the process of giving exchanges more freedom with designing new products.
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