Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

The case for more freedom in interest rate futures market

While new contracts are welcome, participants need to be given more freedom to trade, if policy makers are serious about growing the market

Average daily turnover has risen from around 500 crore at the time of launch in early 2014 to around 2,500 crore now. Open interest has risen by over six times during the same period. The fact that this comes after at least three false starts—the first as early as 2003—is heartening.

Thankfully, the Securities and Exchange Board of India (Sebi) and the Reserve Bank of India (RBI), joint regulators for the market, are taking steps to further strengthen it. They’ve allowed exchanges to launch new products and have given them flexibility to launch more contracts around the existing 10-year product. While this will go a long way in growing the market, there are some other fixes needed too. As far as possible, policy makers should address these in a holistic manner, rather than making piecemeal improvements.

For perspective, after taking considerable feedback from the market, RBI and Sebi permitted cash-settled contracts on 10-year government bonds. Exchanges were free to launch new products on the so-called ‘on-the-run’ 10-year bonds, i.e., the bond that is the most sought after and traded in the cash market. The steady growth in volumes and open interest suggests that the regulators have got the product design right finally. Market participants no longer talk of any flaws as far as product design goes. Besides, the central bank governor has made it clear, both publicly and to market participants, that he is interested in the development of the market.

But average daily volumes of roughly $400 million on the NSE—vis-a-vis equity derivatives volumes of around $40 billion—suggest that the market is nowhere near its potential. Note here that interest rate derivatives are the largest traded contracts globally. According to Bank for International Settlements data, the interest rate segment accounts for more than four-fifth of total notional derivatives turnover on organized exchanges.

Of course, one of the reasons the size of the market in India is a fraction of the equity derivatives market is the fact that it’s just a year old. At its stage of development, both the equity derivatives as well as the currency derivatives markets weren’t much bigger in size. But another reason is that regulators have either not been clear about the extent to which some institutions such as non-banking financial companies can use the market, or have restricted use by some institutions such as mutual funds. According to a head of interest rate and currency derivatives at a leading trading firm, prospective institutional clients have been shying away because of a lack of clarity on what trading strategies are permitted, and the resulting fear that certain transactions may later be frowned upon by the central bank. While RBI has issued circulars in this regard, some of the terminology is too broad and is open to interpretation, practitioners say. Some participants such as co-operative banks can easily trade bonds, but have to go through an elaborate approval process before being allowed to trade bond futures. This column had said last year that for the development of a healthy market, institutions must be allowed to engage in various trading strategies.

On the positive side, regulators recently allowed new products, namely cash-settled interest rate futures with 6-year and 13-year government bonds as the underlying securities. Bonds that can be selected as the underlying can have a residual maturity of between four and eight years in the case of the 6-year product and between 11 and 15 years in the case of the 13-year product. The scope of the existing 10-year product has been broadened to include bonds with a residual maturity of between eight and 11 years. In effect, exchanges can soon have products pretty much across the yield curve.

Since a large part of trading globally occurs on expected changes in the yield curve, the new product suite will come in handy in the attempt to build the market. Having a broader range will also help hedgers and make the interest rate futures market serve more effectively as an asset-liability management tool.

So far, NSE has taken the clear lead in building the market. BSE Ltd and Metropolitan Stock Exchange of India Ltd have managed to garner average daily turnover of less than 100 crore this month. Perhaps, with the expansion in the number of contracts that can be launched, these exchanges, too, might increase their focus on the segment.

But again, while the new contracts are welcome, market participants need to be given more freedom to trade, if policy makers are serious about growing the market. As things stand, the restrictions some market participants face clashes with the central bank governor’s intent of building the exchange-traded market. While no one’s asking for unbridled access and speculation in the market—after all, there are already position limits—there is clearly a case for more freedom with trading strategies that can be employed.

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