Harun R Khan: Derivatives dynamics - looking back and looking ahead
Keynote address by Mr Harun R Khan, Deputy Governor of the Reserve Bank of India, at the
Finance Conclave 2015 on "Indian Derivatives Markets - Striking a Balance between Risk
Protection and Liquidity", organised by the SP Jain Institute of Management & Research,
Mumbai, 17 January 2015.
* * *
The speaker acknowledges the contributions of Shri Himansu Mohanty of the Reserve Bank of India. The speaker
also acknowledges the inputs from Shri. Sudarsana Sahoo of the Reserve Bank of India.
1. Prof. Sesha R. Iyer, Prof. Suresh G Lalwani, Prof. Ranjit Pattanaik and learned
panellists & invitees. I am happy to be here today on the occasion of the Finance Conclave
2015 on "Indian Derivatives Markets - Striking a Balance between Risk Protection and
Liquidity" organized by the SP Jain Institute of Management & Research and share some of
my thoughts on the dynamics of derivatives in the Indian context.
2. "Derivatives" have for quite some time been a totem of expertise for anyone
connected with finance, be it a market practitioner or a financial economist or a financial
sector regulator. Part of the interest no doubt stems from the usefulness of the derivatives,
but a large part of interest is actually a form of pure wonder of incomprehension owing to the
complexity of its valuation, design and risk implication. Be that as it may, derivatives at
various times have evoked quite extreme reactions from thought leaders in the field. Warren
Buffet is reported to have described derivatives as, "financial weapons of mass destruction,
carrying dangers that, while now latent, are potentially lethal." Similar sentiment has been
echoed by George Soros, while advising people to avoid derivatives, "....because we don't
really understand how they work." At the other end of the spectrum, former Federal Reserve
Chairman Alan Greenspan, a steadfast defender of derivatives, said in a Senate Committee
hearing "What we have found over the years in the marketplace is that derivatives have been
an extraordinarily useful vehicle to transfer risk from those who shouldn't be taking it to those
who are willing to and are capable of doing so". The Global Financial Crisis (GFC) had
spurned a large volume of literature laying much of the blame for the crisis at the door of
indiscriminate use of derivatives, pointing out the dangers inherent in derivatives and
underscoring the need for further regulating the market. Immediate aftermath of a crisis was
not a good time to take a balanced view, and now that much of the dust has, somewhat
settled down, we can perhaps look at the problem dispassionately.
Financial sector & the derivatives
3. Before we go to the theme of derivatives, it is necessary to briefly discuss the
financial sector as such so as to provide a backdrop, as it were. It has been generally
accepted that a financial sector is a necessary precondition for economic growth and
progress. Economists like John Hicks, Walter Bagehot and Joseph Schumpeter have held
that the development of financial sector helped mobilize the resources necessary for "the
immense work" that constituted the industrial revolution. Of course, like everything else in
economics, this also has a contrary view point. Economists Joan Robinson and Robert Lucas
have expressed scepticism about the emphasis given to the financial sector. Extensive
research in recent years goes to show that a well developed financial sector may be neither
a necessary nor a sufficient condition for economic growth but the absence of an efficient
financial sector can surely retard growth.
4. The financial sector essentially enables inter-temporal transfer of income and
smoothens the consumption over the life time of an individual. On the other side, it also pools
the surplus and allocates it to various socially productive projects which require an upfront
outlay with the potential of generating a surplus at the end of the production cycle. It involves
parting of money from the one who has the surplus to the one who needs it. But it could be a
dangerous proposition. It is for nothing that Polonius counsels his son Laertes in
Shakespeare's Hamlet, "Neither a borrower nor a lender be". The legal-financial system that
has evolved over the centuries has developed an elaborate architecture to ensure that the
trust of the people is maintained in the financial system and they lend and borrow their
requirement freely and safely. The financial sector has basically two kinds of problems. The
first relates to information asymmetry inasmuch as one party to the transaction, the borrower
or the investee, always knows more than the other party, the lender or the investor. This is a
large topic in itself which I do not intend to deal with here, except that it also lays the ground
for the second problem in financial transactions, that is, the risk of default or more generally
the risk of erosion in the value of the asset. A smooth functioning of the financial system
requires that this problem is adequately addressed.
5. Derivatives play an important role in addressing the risk inherent in financial
transactions. A derivative has traditionally been defined as a contract whose value derives
from and is dependent on the value of an underlying asset, such as, a commodity, currency,
or security. The concepts of various derivatives have been known since antiquity - the
oftcited anecdote of the sixth century BC philosopher Thales buying options on olive pressing
mills is too well known to recount here. Various forms of derivatives - mostly forwards and
futures - have traded off and on in the seventeenth and eighteenth centuries, for example,
forwards on tulips and futures in the Yodoya rice market in Japan. The major milestones in
the history of derivatives are the establishment of the Chicago Board of Trade (CBOT)
(1848), establishment of the Chicago Produce Exchange (1874), which was converted to
Chicago Mercantile Exchange (CME) (1919) and the formation of futures clearing houses
(1925). I may mention in passing that notwithstanding the increasing activity in the
commodities derivatives markets, there were always apprehensions about the impact of
derivatives trading on the cash market which led to frequent bans on commodity derivatives.
6. The history of derivatives on financial securities is rather short. Following the
breakdown of the Bretton-Woods, which led to floating exchange rates, the CME introduced
the first currency futures in 1972. In 1975 CBOT created the first interest rate futures contract
to which CME responded with Treasury bill futures contract in 1975. In 1977, CBOT created
the first treasury bond futures contract. In 1982, Kansas City Board of Trade launched the
first Stock Index futures followed by the CGOT's futures contract on S&P 500 index in the
same year. In 1983, the Chicago Board of Exchange (CBOE) introduced an option on an
index of stocks.
7. During the 1990's, there was huge outcries over a series of debacles over derivative
trading with market participants reporting large losses. The cases of Proctor & Gamble
(swaps), Showa Shell (forwards) Metallgeselschaft (futures), Allied Irish Bank, Barrings Bank
(options)& Orange Country(swaps) have become standard case studies in the academic
curriculum. The discourse that followed sometimes blamed the products and often the
entities trading these products. The markets continued more or less in the same vein but the
trading and risk management protocols amongst the market participants were tightened.
8. The GFC brought the focus back to the derivatives and their trading. What
happened is essentially as follows. Innovative design of derivative instruments facilitated flow
of large quantum of funds to the housing sector through sub-prime loans, fuelling a housing
sector boom and when the housing prices started correcting, the derivative instruments too
started losing value. Both forces interacted with and reinforced each other, and the
snowballing effect brought the markets down. It has been argued that laying the blame for
the crisis entirely on the derivative products is akin to a bad workman blaming his tools. The
problem perhaps lied not so much on the instruments themselves, but on the inadequacy of
the market infrastructure to deal with the opacity and complexity of these products and on the
lack of appropriate risk management protocol amongst the financial institutions that traded
and took position in these products. Let me quote Kenneth Arrow, who in an article in the
Guardian, sums up the predicament rather succinctly when he says "There have been two
developments in the economic theory of uncertainty in the last 60 years, which have had
opposite implications for the radical changes in the financial system. One has made explicit
and understandable a long tradition that spreading risks among many bearers improves the
functioning of the economy. The second is that there are large differences of information
among market participants and that these differences are not well handled by market forces.
The first point of view tends to argue for the expansion of markets, the second for
recognising that they may fail to exist and, if they do come into being, may fail to work for the
benefit of the general economic situation." And again, "There is obviously much more to the
full understanding of the current financial crisis, but the root is this conflict between the
genuine social value of increased variety and spread of risk-bearing securities and the limits
imposed by the growing difficulty of understanding the underlying risks imposed by growing
complexity."
Dynamics of derivatives market
9. Before I deal with the Indian derivative markets, let me discuss some salient issues
about the derivatives market in general. The market for financial derivatives, as indeed the
market for any financial assets, is populated by three generic classes of participants: the
hedgers, the arbitrageurs and the speculators. The hedgers are the final consumers, as it
were. The arbitrageurs help establish the law of one price across market segments so that
similar products with similar risk profiles cost the same in various markets at any given point
of time. The speculators, a word with much negative connotations, essentially do
intertemporal arbitraging and serve a very useful economic function of price discovery,
particularly in the financial markets. Inasmuch as the value of all financial assets is based on
a view of the future, the act of speculation tends to correct the value of under-valued or
overvalued assets. Caution, however, is invited by the fact that the future is uncertain, and
leveraged speculation based on irrational exuberance is fraught with dangerous
consequences as has been witnessed during many a crisis.
10. For the market participants, liquidity has talisman like significance. What is the
meaning of liquidity? Trading volumes? Bid-ask spread? These are only indicators of
liquidity. In an economic sense, liquidity means the ease with which a security or an asset
can be converted to "money" (bank and ultimately central bank liability) at the going price. It
is a basic requirement of a market because an investor will hold an asset only if she is
convinced that she will be able to sell that asset at the going price without the price tumbling
by the act of her sale. Similarly one will be able to issue liabilities, assured that investors will
buy it without a discount. Thus smooth functioning of the financial market requires liquidity.
But at the same time, it must be understood that liquidity is not an end in itself that the
market efficiency increases with increase in liquidity without any bound. Here I will like to
quote Bob Solow on this. He says, "Much more significant is the fact that the bulk of
incremental financial activity is trading, and trading, while it may provide a little useful public
information about market opinion, is largely a way to transfer wealth from those with inferior
information and calculation ability to those with more. There is no enhancement of economic
efficiency to speak of." Hence it is necessary to keep the context of economic efficiency in
view while talking about market efficiency.
Indian equity market & the derivatives
11. Financial markets in India in the modern sense of the term have had a short history
and are in a way in their nascent stage. You will recall that post-independence, in the
planeconomy era, we had what has been called a regime of financial repression where the key
economic variables were determined by fiat rather than through a market process. The
financial markets evolved into their present form following the liberalization that started in the
early nineties. The introduction of the floating exchange rate and deregulation of interest
rates facilitated development of an active foreign exchange and fixed income securities
market. It is true that India had perhaps the oldest stock market in Asia, with the Bombay
Stock Exchange dating back to 1855. The stock market, however, saw quantum change
following the scam of 1991. Securities & Exchange Board of India (SEBI) was formed in
1992, and NSE in 1992(it started operations in 1994). I will just mention two other landmarks:
the introduction of the NIFTY futures on the National Stock Exchange (NSE) in 1998 and the
SENSEX futures on the Bombay Stock Exchange (BSE) in 2000.
12. Equity markets are the quintessential representation of functioning of a market
economy. They are the ultimate crucible for ideas such as corporate governance, investor
protection, market discipline, etc., and the existence and success of a buoyant, robust
corporate sector is critically dependent on the functioning of equity market. One can say with
pride that notwithstanding the low ranking of India in the World Bank's list of countries in
regard to "ease of doing business", we rank 7th in the attribute "protecting minority investors".
The equity markets in India today are among the best in the world, with state-of-the-art
technology, institutional mechanism, and products. Apart from large daily volumes, we have
other products such as equity derivatives, security lending and borrowing, algorithm trading,
etc.
13. The main focus of concern in equity market is investor protection and integrity of
trading. Equity derivatives, like all derivatives, can be used either to hedge an existing
position or express a view on the equity prices or indices. Derivatives being leveraged
structures have the potential to amplify the loss or gain in an asset. For the same reason, it
can also contribute to the volatility.
14. From a systemic financial stability perspective, the concern about the equity market
stems from the source of financing equity positions. It is matter of great concern if bank
lending funds an equity market boom, or for that matter, any asset price boom. This is an
unforgettable lesson from the crash of 1929, further underscored by the GFC. Recognising
this, the banking regulations cap banks' exposure to the equity markets.
15. When we come to foreign exchange and interest rate derivative markets, the
perspective changes significantly. It is to be appreciated that interest rate and exchange
rates are important macro-economic variables with economy-wide implications. The Reserve
Bank of India has responsibility in regard to both the rates and is statutorily mandated to
ensure sound functioning of these markets. Therefore, its approach to development the cash
as well as derivative segments of these markets has been characterised by what one can
call as cautious gradualism. I shall elaborate on the issues involved in these markets.
Foreign exchange derivatives
16. The backdrop for the foreign exchange market is provided by several factors
following the Balance of Payment crisis we faced in 1991. Full current account convertibility
since 1994, increasing openness on the capital accounts, a persistent and sometimes rapidly
increasing current account deficit, the instability in autonomous capital flows, the investment
needs of an expanding economy and globalization aspirations of Indian corporates are some
of them. Our stated objective is to maintain orderliness in the foreign exchange market even
as the exchange rate is market determined without any target level or band. The other factor
one has to reckon with is the so-called impossible trinity where an independent monetary
policy, a fixed exchange rate and an open capital account are impossible to simultaneously
attain. Since no economy of India's size and complexity can sacrifice its independence in
monetary policy, the inevitable consequence is an eclectic combination of some capital
account openness and some flexibility in the exchange rate.
17. How does all this influence the development of the foreign exchange derivatives
market? Our approach to development of the foreign exchange derivatives market has been
largely biased by the use of these products as instruments of hedging for individuals and real
sector firms with a pre-existing foreign exchange exposure. Take for example an exporter
who has a foreign exchange receivable at a future date and any adverse movement is likely
to adversely affect her expected Rupee revenue and therefore her balance sheet. A
derivative product like a forward sale or a put option is designed to remove all or some
uncertainty of the exporter's expected revenue and thereby impart stability to its balance
sheet.
18. But a derivative product also is an instrument for expressing a view on the future
path of the price of the underlying. Thus if you expect the Rupee to fall in value at a future
date, you can sell it in the forward or futures market or buy a put option. This has the effect of
depreciation in the spot exchange rate of the Rupee. Can this be called a justified correction
in the spot exchange rate? It depends upon how justified the expectation was in the first
place. Expectations are often mechanical extrapolation of the immediate past. If Rupee starts
depreciating for some reason, an expectation of further depreciation is engendered,
derivatives provide the means to express this expectation, and expectations are often
selffulfilling. Any sharp depreciation of Rupee could lead to further panic reactions: exporters
cancelling the forward sale contracts they had already booked and importers rushing to buy
forwards to protect their future commitments.
19. As I have mentioned, exchange rate is an important macro variable and given the
various factors affecting our external sector, our tolerance for large volatility or sharp
movements is rather limited. In this background one can understand the regulatory
framework for foreign exchange derivatives in India. Firstly, it has so far been mostly
dominated by the OTC segment and derivatives have been meant as instruments of hedging.
That is, an entity can enter into a derivative contract only if it has a foreign currency
exposure. One party to the contract has necessarily to be an Authorised Dealer who is
supposed to be the market maker. So as to ease the derivative transactions, we have been
making operational relaxations, such as, buying or selling forwards or options on the basis of
past performance as indicator of current and future exposure rather than having to produce
evidence of underlying each time. But still, underlying exposure is the basic driver.
20. In 2008, currency futures started trading on the exchanges with a view to expanding
the derivatives products, improving transparency and price discovery and affording an easy
access to the foreign exchange derivative market. This brought in a kind of dichotomy in the
foreign exchange derivative market. A futures market does not usually work on the basis of
an underlying exposure. Moreover, there is free entry and exit and is cash settled. This is a
perfect setting for anyone to express a view on the currency and it is quite contrary to the
regime for the OTC market. It has been a usual response to sharp movements in the
exchange rate to modulate the regulatory regime in the OTC market by disincentivising free
booking and cancellation of contracts aimed at making gain out of the Rupee movement. But
is such a thing possible in the futures market? That is why during the volatility episode in July
2013, restrictions were imposed in the futures market. These have been mostly undone and
some extent of symmetry has been brought about between the OTC and the exchange
traded segments of the foreign exchange derivative markets. An important step in this
connection has been to grant access to the futures market to the foreign portfolio investors in
an attempt to offer them a viable alternative to the overseas NDF market. To provide boost to
the currency futures, some more relaxations like enhancing the limit upto which exposure will
not require the proof of the underlying exposure & procedural simplification relating to
documentation are being examined.
21. The Currency Futures volume that plunged post administrative measures taken by
the Reserve Bank in July 2013 recovered after removal of the restrictions. The trading
volume though remains lower than the pre-July 2013 levels (US$ 3.2 billion in January 2015
so far vs. US$ 7 billion in June 2013), the daily open interest position has improved to near
pre-July 2013 level of about US$ 4 billion. The trading in the Currency Futures, however,
continues to be dominated by non-bank trading members (proprietary) and the brokerage
firms (as clients). There are only a few corporates holding insignificant open interest in the
currency futures. Though the effectiveness of currency futures as a hedging instrument
remains low for several reasons, the product enjoys complementarity with the OTC products
in developed markets as counter-parties to OTC transactions aggregate their exposures and
cover them though exchange traded products (hub-and-spoke approach) which are quoted at
narrow bid-offer spread. It is expected that with active participation of banks in currency
futures, this complementarity will provide useful linkage between the OTC and exchange
traded currency derivatives.
22. We are committed to the idea that the range of derivative products should be wide
enough so that market participants are free to choose them according to their risk
management strategy in a cost effective manner. Though options, mostly plain vanilla, have
been allowed, their use has not been widespread. The average daily trading volume of forex
options is just about US$ 300 million. We are contemplating expanding the products
available and considering allowing option trading strategies. In this context, it will be useful to
note the use of various option structures by market participants during the period prior to the
GFC. The currency market volatility and sharp movements in the aftermath of the GFC
caused many of these entities to book heavy losses, which lead to a spate of complaints and
litigations. For that matter, the Rupee which has been mostly on an appreciating mode during
2007-08, suddenly reversed the trend post-Lehman and many exporters suffered large MTM
losses even on simple forward contracts. This brings home the point I made earlier that the
blame lies with unwise use of the derivative products linked to forex or otherwise for that
matter other underlyings rather than the products themselves. While the firms using
derivative products must have an adequate risk management framework comprising an
understanding of the risk and the derivatives used to mitigate that risk, the banks also have a
responsibility to offer products that are suitable &appropriate for their client's risk profile and
risk management framework. This concern is sought to be addressed through mandating
banks to ensure suitability and appropriateness of the derivatives products they are selling to
their clients.
23. It is pertinent to mention briefly a theme current in contemporary discourse-
BondCurrency-Derivatives (BCD) nexus. This is an ideal objective in an open economy financial
system. What it means is this: any foreign investor, using any international currency, can buy
an Indian Government or corporate liability denominated in Rupees or otherwise and hedge
all risks, either onshore or offshore, the attendant credit, interest rate & currency risks. This is
a natural prerequisite for free international capital movements, and from an Indian
perspective, for mobilisation of the much needed resources. The problem, however, is
inherent in the proposition itself. This presupposes complete capital amount openness,
particularly for financial institutions& transactions. The pros & cons of full capital account
openness is a contentious issue and in any case, we are not ready for it at this point of time.
Thus the full BCD nexus has to wait on progress in capital account liberalisation. In the
meanwhile, I must point out that BCD nexus is neither absolutely necessary nor a sufficient
condition for mobilising resources for investment to support economic growth. I will just have
to point out the growth story of post-war Japan, that of China of last two decades and even of
India before the crisis to support this point.
Interest rate derivatives
24. In an economy with expanding financial sector, interest rate is a key variable that
affects firms and individuals across the board. In the pre-liberalisation era, the interest rate
was largely "administered" and there was little need for hedging interest rate risk. It must be
appreciated that interest rate derivatives market is not a retail market. But the individuals and
small firms do benefit out of an interest rate derivative market in so far as the financial
institutions and market makers can hedge their interest rate risk and consequently offer
better rates to their customers. Globally, the interest rate derivatives constitute the largest
segment of the derivatives market.
25. Need for interest rate derivatives was recognised early and in 1999, guidelines were
issued for two core products in the OTC segment: the Forward Rate Agreements (FRA) and
the Interest Rate Swaps (IRS). The absence of a term money market has hampered the any
meaningful growth of the interest rate derivative markets, except one product viz., the
Overnight Index Swaps (OIS), which has gathered large volumes. We have always been
concerned about lack of a term money market and have taken some steps ( e.g. introduction
of term repos under Liquidity Adjustment Facility of the Reserve Bank of India, increasing the
frequency of Bank's term repos to four times during a reporting fortnight, recent
announcement for permitting re-repoing of government securities, etc.) to nudge the market
participants in that direction. Hopefully, term money market and an active interest rate swap
market will develop in tandem.
26. The need for an exchange traded interest rate derivative market was also felt pretty
early. An exchange traded market, apart from transparency, price discovery, cost
effectiveness, and better risk management, also provides a market where market makers
can hedge their risk. The development of an active interest rate futures market has so far
eluded us and the process can provide an interesting case study. The products were first
introduced in 2003 which were cash settled and based on zero coupon yield curve. After
some initial interest, the market liquidity completely dried up. In 2008, after the currency
futures were introduced, interest in Interest Rate Futures (IRF) were revived and after wide
consultations, physically settled futures contracts were introduced on 10-year Government
bonds. This is a classic product and it was expected that it will attract market interest. This
product too did not survive beyond its infancy. After a lull, a cash settled single bond futures
contract was introduced in January 2014 and has been trading with reasonable liquidity. It is
proposed to expand such contracts to other tenors. The volumes and open interest in such
contracts is limited by the total outstanding of the respective bonds. In the recent times, the
volumes have picked up significantly. The average daily volume rose from Rs.13.97 billion
post-launch of single bond futures in January 2014 to about Rs.25.50 billion in January 2015
so far. More importantly, the open interest have registered steady growth in the recent period
with average daily figure of Rs.63.60 billion during the current month so far. It is expected
that this product will develop market's familiarity with the terrain and prepare it for more
generic products in future.
27. The reason for lukewarm response in interest rate product partially lies in the
structure of our debt markets. The government bond holding is concentrated amongst banks,
insurance companies, provident/pension funds and the Reserve Bank of India. The same
goes for corporate bonds as well. Most of these investors are hold-to-maturity types who do
not face volatility in the value of their holdings and consequently have no need for a hedging
product. Secondly, there is perhaps a lack of diversity of view among the market participants.
The market structure does not change quickly and it may not be optimal to impose
accounting hegemony on banks and financial institutions to force them towards hedging in
the interest of developing the market. The strategy for development of the market, therefore,
has to comprise widening the range of products, granting flexibility in product design to the
exchanges, removing barriers for participation, etc. The Reserve Bank is now considering
introduction of bond futures in other maturities in consultation with the SEBI.
Credit derivatives
28. The Indian financial system has traditionally been bank based system where the
external financial requirements of firms have been mostly met by banks. In the
preliberalisation era, there were specialised term lending institutions which used cater to the
long term capital requirement. This is no longer the case now. The need for a vibrant and
liquid corporate bond market is based on several considerations. First, it will cater to the long
term funds requirement of the corporate sector and help the banks manage their asset
liability mismatch more effectively. Second, in a growing economy and with complex financial
needs of existing and new firms, the corporate debt market provides a better, more cost
effective access to funds. Among the steps taken to bring liquidity into the market is
introduction of credit derivatives which help bond holders to insure themselves against risk of
default. Having been introduced in the aftermath of the GFC, the product has been launched
perhaps with a high dose of safety measures as some analysts suggest and this could
perhaps accounts for its limited liquidity. There is a need to re-visit the issues hindering
development of the CDS market, such as, non-availability of netting benefit of marked to
market (MTM) leading to higher capital charges for the market players, dominance of high
rated bonds not warranting any need for credit risk protection, procedural issues for some of
the foreign banks being reluctant to execute Credit Support Annexes (CSA), large players
like insurance companies not being able to sell protection, etc. The Reserve Bank is
examining some of the prudential conditions that can be relaxed without compromising
systemic stability.
Financial market infrastructure
29. As I mentioned earlier, the considered view of the GFC is that it is not so much the
derivative products that are to be blamed but the infrastructure for trading and the risk
management and regulations of the institutions. The corrective steps to prevent the
recurrence of such a crisis have focussed a great deal on improving the transparency and
risk management in the market infrastructure. Let me quote from the Pittsburgh Declaration
of G-20 leaders summit. It stated, "All standardized OTC derivative contracts should be
traded on exchanges or electronic trading platforms, where appropriate, and cleared through
central counterparties by end-2012 at the latest. OTC derivative contracts should be reported
to trade repositories. Non-centrally cleared contracts should be subject to higher capital
requirements. We ask the FSB and its relevant members to assess regularly implementation
and whether it is sufficient to improve transparency in the derivatives markets, mitigate
systemic risk, and protect against market abuse." Keeping in view the thrust of the G20 on
reforms in the OTC derivatives market, Reserve Bank has drawn up and is implementing a
roadmap focussed on standardisation (e.g., OIS has been standardised) reporting to the
Trade Re