Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

Interest rate futures finally look set to take off

It is demand from banks and primary dealers that is expected to give the initial boost

MCX Stock Exchange was the first off the blocks with the new interest rate futures product allowed by regulators. It reported a turnover of 928 crore on Monday, which seems healthy, although it’s best to ignore the first day’s volumes for new products. National Stock Exchange will launch the new products on Tuesday, followed by BSE Ltd the next week.

Considering that the interest rate futures segment has had at least three false starts, the pertinent question is if interest in the latest product will be sustained. To start with, policy makers seem to have got the product design right finally, having acceded to the markets’ request of having cash-settled contracts on 10-year government bonds. Exchanges are 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. Banks, which are expected to be the main participants, are sounding excited about the prospects of the new product.

This is nothing short of a miracle—after so many false starts, one would have expected banks to wait and see how the new product performs before going through the process of internal approvals and putting systems in place to trade the new product.

According to the head of markets of a multinational bank, apart from the product design, recent measures by the central bank in the repo market will ensure better connectivity between the cash and the futures markets.

To be sure, with Raghuram Rajan at the helm of the central bank, market participants are sanguine about the prospects of new products such as interest rate futures. Two market participants said that their conversations with the Reserve Bank of India (RBI) governor suggest a particular interest in the success of the interest rate futures product. This is hardly surprising—a committee he had chaired on financial sector reforms wrote in its report titled ‘A Hundred Small Steps’, “Banks need access to more instruments to manage the interest rate risk for infrastructure lending induced asset-liability mismatches. The committee’s recommendation of a more enabling regulatory environment towards instruments such as credit default swaps and interest rate futures is key to helping this process along." It also said, “The absence of interest rate futures can hurt the treasury market."

Yet, some market experts have apprehensions about wide participation in the market. Gangadhar Darbha, an executive at an investment bank and a member of a central bank committee to strengthen its monetary policy framework, says that since banks have huge long bond positions in the cash market, they can hedge by taking short positions in the futures market. However, he adds, the pertinent question is who will take long positions in the futures market. The head of markets at a private sector bank says that banks can be expected to be on both sides of the market, conducting various strategies including duration management of their portfolio. Besides, there may be cases where a long cash position is preceded by a long futures position, or what is called a long hedge.

Another worry is regarding the participation of other institutions such as mutual funds and insurance companies. Based on current rules, they may be allowed to only hedge their existing positions. If they are given greater flexibility by the respective regulators, they can add considerable depth to the markets. In addition, in order to generate interest from companies that need to hedge their interest rate risk, there needs to be a mechanism by which treasury rates are transmitted to the base rate or the prime lending rate at which banks lend to companies. As things stand, it makes no sense for companies to hedge using treasury futures.

Having said this, it is demand from banks and primary dealers that is expected to give the initial boost to the new product. If initial interest is encouraging, trading firms may soon join as well.

As pointed out earlier, interest rate derivatives are the largest traded contracts world over, and have the potential to grow into a large market here as well. Exchange-traded markets bring with them the benefits of transparency and a central counterparty, among other things, and their development is clearly beneficial for the market. Policy makers should ensure that unnecessary hurdles against institutional participation are removed, so that the market depth and liquidity increases. Unlike earlier, corrective measures on market structure and/or product design should be taken quickly, so that the momentum of the new launch can be sustained.

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