Sucheta Dalal :More A Case Of Irrational Fear Than Necessary Caution (28 April 2003)
Sucheta Dalal

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More A Case Of Irrational Fear Than Necessary Caution (28 April 2003)  

Instead of facilitating the launch of interest rate derivatives, the Reserve Bank of India’s (RBI’s) draft guidelines released last Thursday seem set to delay the launch of India’s newest derivative trading instrument. The RBI has imposed such tight restrictions on banks’ ability to trade in interest derivatives that the market will be stunted even before it takes off. In fact, both players and policy makers are so disappointed with the guidelines that the proposed launch of three interest derivative products on April 28 may be temporarily postponed.

The RBI has said that entities regulated by it can initially trade in interest futures only for hedging interest risk of their underlying government securities (G-secs) portfolio. And, that it will consider access to a wider range of products, trading and market making activities at a later stage.

One the face of it, the RBI seems to be correctly cautious. It wants to help open a window for trading interest products because it is conscious that “interest derivatives present immense opportunity for mitigating market risks inherent in the balance sheets” of banks. On the other hand, it worries that improper product understanding, inadequate risk containment measures, and poor monitoring could lead to substantial losses.

The problem with this argument is that the RBI should then be equally perturbed at the enormous risk associated with the Interest Rate Swap market. This is entirely a telephone market, with no restrictions on banks or suggestion that swaps should only be a hedging mechanism. On the other hand, interest derivatives are exchange-traded products that will operate within a proper regulatory framework with clear audit trails, risk mitigation measures and market-wide limits.

The difference is that the inter-bank interest rate swap market is entirely under RBI control and supervision, while the exchange-traded, order-driven interest derivatives market will be regulated by the Securities and Exchange Board of India (Sebi). And that is probably the crux of the problem.

Because of the finance ministry’s backing, the process of launching interest derivatives has managed to make steady progress, but it hasn’t been without its share of attempted roadblocks. For instance, an argument that continues to be trotted out to the media by unnamed bankers is whether the zero coupon yield curve (ZCYC) is inferior to the yield to maturity (YTM) curve as the basis for cash settlement of 10-year bond futures. My sources say that bankers who argued in favour of the YTM at a Sebi committee meeting chaired by Dr J R Varma were unable to establish why and how the YTM curve was superior to ZCYC. On the other hand, the ZCYC was chosen based on rigorous data testing that was not contested by its opponents.

The RBI guidelines issued last week seem to have settled the debate over ZCYC v/s YTM, and ended the threats by anonymous bankers to “take up the issue” with the central bank. But there is still the issue of RBI’s own restrictions on banks’ participation in the market. For starters, Sebi plans to launch the trading segment with three interest derivative products: Ten-year long bond futures, futures on notional treasury bills (T-Bills) with a maturity of 91 days, and options on notional long bond and notional T-Bills.

The RBI has stipulated that in the first phase, its regulated entities can transact only in interest rate futures on notional bonds and T-Bills for the limited purpose of hedging the risk in their underlying investment portfolio. Interest derivative transactions will be deemed as hedges only if it is clearly identified with underlying G-secs in the AFS/HFT categories, if the effectiveness of the hedge can be “reliably measured” and is assessed as “highly effective” throughout the period.

This stringent limitation of role of banks to hedging their G-sec portfolio will drastically restrict bank participation and skew the market. Most banks have identical risk profiles on their G-sec holdings, which means they would stand to gain from an interest rate decline and are hence all likely to be sellers in the interest futures market.

Sources involved in structuring the interest derivative products say that the market has immense potential but in the initial phase, it was expected to be driven by banks and primary dealers. Unless the market gets off the ground and generates good volumes, it will discourage newer non-bank players from entering this segment. For instance, a leading debt market broker points out corporate houses borrowing at fixed rates are ideal candidates for hedging their interest risk; insurance companies and pension funds are likely to be natural users of these products, as also housing finance companies, mutual funds and large retail borrowers. But persuading these categories to use interest derivatives as hedges would require a persistent marketing effort and the existence of a vibrant market.

Another sticky issue is the RBI saying that it is “concurrently permitting banks, primary dealers and financial institutions to seek membership of the Futures and Options (F&O) segment of the stock exchanges for the limited purpose of undertaking proprietary transactions for hedging interest rate risk”. The Securities Contracts Regulation Act does not permit lending and fund-based activity by broker-members of stock exchanges. This means that unless the Act is amended to create an exception for bank-members undertaking proprietary trades, such membership cannot happen anytime soon.

All of a sudden, it would seem that the interest derivatives ball has landed in the finance ministry’s court. Although the RBI has only released draft guidelines and invited public comment, it may have to make significant changes in its rules before trading takes off. According to a banker, “it is almost as if the RBI has decided that we will not launch the product and will not allow Sebi to do it either”.

Competition and distrust among regulators and statutory investigative agencies is not unknown in developed nations. But it is up to the finance ministry to use its powers of persuasion to ensure that such irrational fears and distrust are not allowed to kill an important addition to the portfolio of trading instruments; especially one which could free banks to focus on profitability without worrying unduly about interest rate risk.

-- Sucheta Dalal