Hemant Mishra/Mint
Hemant Mishra/Mint

RBI and its interest in the bond futures market

Market participants must welcome the central bank's interest in the IRF product

According to a Reuters story last week, the Reserve Bank of India (RBI) is pressuring state-owned banks to trade on the newly launched interest rate futures market. The story quoted a treasury official at a bank saying his bank was threatened to trade. Another official said his bank had to commit to trading in the new market because “who is going to say no to RBI?"

The story might have made some sense if state-owned banks had been trading heavily, eager to pacify a seemingly belligerent central bank. But traded volumes don’t suggest such activity. At best, state-owned banks account for about half of the traded volumes (a few hundred crore on average daily) on the largest exchange. Besides, when a Mint reporter checked with treasury officials at three state-owned banks about the report of RBI’s threats, each of them replied in the negative.

Their response matched an RBI clarification: “It is normal practice for the Reserve Bank (of India) to talk to market participants and traders about market dynamics. Because IRF (interest rate futures) is a new product, RBI officials might have had discussions with the market regarding trading volumes. But this would be to gauge investor interest; at no point were traders pressurized to trade." Of course, it is true, as was pointed in this column last month, that the new central bank governor is taking a particular interest in the success of the interest rate futures product. It must also be noted that the latest IRF product has been designed keeping in mind market feedback, since three attempts in the past in this segment had failed. So it is likely that RBI officials asked some banks why they weren’t trading the product, especially since the new product was designed based on their feedback. It appears that the central bank’s attempts to get such feedback from market participants might have been misconstrued as pressure to trade.

But RBI’s interest in this market is healthy: the market needs tools to manage risks. And one of the main lessons from the financial crisis is that exchange-traded and centrally cleared products are far better in terms of transparency and risk management.

Besides, it’s not like the central bank is obsessed with the IRF product. Recently, it allowed more tenors in the repo market, and many months ago it introduced credit default swaps (CDS) to enable market participants to hedge credit risk. (The CDS market hasn’t yet taken off, and it’s time to incorporate some market feedback to make that product work.)

A moot question here is if the interest rate futures market will grow into a liquid market. Turnover on the three exchanges that trade the product averaged 550 crore a day last week. Sure, it’s a big drop compared with the first few days of trading, but then initial volumes can hardly ever be trusted. It’s important to note here that even with the currency futures segment, volumes stood at only a few hundred crore on National Stock Exchange (NSE) and MCX Stock Exchange (MCX-SX) in the first month of trading (see graph). Now, this a very liquid market, with NSE, MCX-SX and BSE Ltd trading contracts worth close to 15,000 crore daily.

Typically, it takes time for volumes to grow because many market participants take time to get systems and approvals in place to trade a new product. Some participants such as foreign institutional investors may take longer to participate—waiting for liquidity and depth to reach healthy levels. There are compelling reasons for foreign institutional investors to use the market. For instance, currently a long position in the cash market will involve currency risk as well; with futures, this risk is mitigated.

But for the development of a healthy market, institutions must be allowed to engage in various trading strategies. As things stand, mutual funds are only allowed to take hedging positions, although there is no clarity on what technically constitutes a hedge. While it goes without saying that mutual fund companies will welcome clarity on this, the mutual fund regulator, Securities and Exchange Board of India, must consider allowing them more flexibility while trading in the market. The insurance regulator hasn’t yet given its formal clearance for this product. Given the large cash market positions insurance companies have, they will have natural use for this product and must be encouraged to use it.

Of course, banks have an important role to play and should be allowed to operate as market makers. If they take only hedging positions, the market will be lop-sided. And while it’s nice to know that the central bank is taking interest in the product, it will also do well to issue guidelines on participation by non-banking finance institutions.

All told, market participants must welcome the central bank’s interest in the IRF product. After all, they will be the biggest beneficiaries of a liquid and vibrant interest rate derivatives market which allows them to hedge risks associated with their bond holdings.

Anup Roy contributed to this column. Your comments are welcome at inthemoney@livemint.com

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