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New life for interest rate futures?

After two failed attempts, the IRF market is seeing fairly steady interest

It appears to be a case of third time lucky for interest rate futures (IRFs) in India. After two failed attempts, the IRF market is seeing fairly steady interest, though it remains to be seen whether the attraction will sustain once the interest rate cycle flattens out.

IRFs were launched, or perhaps we should say relaunched in the new avatar, by the big exchanges in late January 2014. On the first day of trade, the National Stock Exchange (NSE) had clocked a turnover of above 3,000 crore and the Bombay Stock Exchange (BSE), on its first day of trade, managed a turnover of 467 crore. But a lot of that was because most banks chipped in to support a market that the Reserve Bank of India (RBI) has been eager to develop.

In subsequent months, turnover had dwindled. In February 2014, Reuters had reported that RBI was pushing public sector banks to participate in the market to ensure that the third attempt at launching rate futures doesn’t succumb to the same fate as the previous two attempts. RBI, of course, denied any such pressure.

By August 2014, the average daily turnover on the NSE, which accounts for a bulk of the trading in IRFs, had dwindled to about 450 crore. On the BSE, the average daily turnover, fell to a low of 71 crore in September 2014.

Since then, however, there has been a sharp reversal in the market. In December, the NSE saw average daily turnover go back to levels seen on the first day of trade and the figure has remained above 2,000 crore consistently for the past five months. Interest on the BSE has also picked up, with an average turnover of 479 crore being reported last month.

In a speech in January 2015, RBI deputy governor H.R. Khan noted that volumes have picked up and added that, more importantly, open interest has also grown steadily.

So, has this market finally picked up in India and will the interest sustain?

There are a couple of factors that have led to a revival of interest in IRFs, one of them being the turn in the rate cycle in India. Remember that consumer price inflation started falling from July 2014, which had led to an expectation of interest rate cuts. This expectation had led to a steady decline in bond yields starting August 2014. The 10-year benchmark yield, which was at 8.64% in early August 2014, fell to 7.83% by the end of December.

The turn in the rate cycle along with the fall in yields gave market participants a reason to get active in the IRF market. The uncertainty encouraged hedging activity, while the possibility of a fall in bond yields and a consequent rise in bond prices may have also attracted some to take long positions in the IRF market.

A second factor behind the pick up in IRF volumes may be linked to the strong interest from foreign investors in the Indian debt markets. Foreign institutional investors (FIIs) bought a net of $26 billion in the Indian debt markets in 2014 and another $6.4 billion this year. This has meant that foreign banks have been active in the IRF market on behalf of their clients.

While these two macro factors may be the underlying reasons for the pick up in IRFs, those in the market say that interest will sustain even if the rate cycle flattens out, as it probably will later this year.

According to Nikhil Johri, chief executive officer and chief investment strategist, Trivantage Capital Management India Pvt. Ltd, while a bulk of the volumes are currently coming from a handful of private and foreign banks, along with primary dealers, high net worth individuals and family offices have also shown interest in the market and portfolio products linked to IRFs.

Johri expects the attractiveness of IRFs to increase over the next 12-18 months, particularly if RBI chooses to widen the market by introducing IRFs based on bonds other than the 10-year benchmark bond.

Lakshmi Iyer, chief investment officer (debt) and head, products, at Kotak Mahindra Asset Management Co. Ltd, agrees that volumes have picked up compared with the initial months but says that there is a long way to go before we can call IRFs a success in India. She points out that volumes are still about one-tenth of the volumes in the cash market and that the activity is largely driven by foreign and private banks. Mutual funds have shown some interest in the market purely for hedging purposes, she adds.

While it has to be said that the third attempt to launch IRFs appears to have been more successful that the first two attempts in 2003 and 2009, even RBI acknowledges that more needs to be done. Khan, in his January speech, said that the structure of the debt market will continue to be a reason for the lukewarm response to IRFs.

Since government bond holding is concentrated among banks, insurance companies, provident or pension funds, and RBI and most of these investors hold a large chunk of these securities till maturity, the need for a hedging product is relatively limited, said Khan. The lack of diversity of view among market participants is another reason behind the relatively tepid response, Khan said, though he was quick to add that the central bank will continue to make attempts to deepen the markets by widening the range of products and removing barriers to participation.

Ira Dugal is assistant managing editor, Mint.

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