V K Sharma: The financial innovations that never were
Keynote address by Mr V K Sharma, Executive Director of the Reserve Bank of India, at the
Finnoviti 2012, organised by Banking Frontiers, Mumbai, 8 November 2012.
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The views expressed are those of the author and not of the Reserve Bank of India.
I deem it an honour and privilege to be addressing this very distinguished and august
audience. Right at the outset, I would like to impress upon this very learned and discerning
audience that responsible Financial Innovation is not an end in itself, but instead, a means to
an end of sub-serving the real sector and in that sense it is consistent with, and a natural fit
to, public policy purpose of "financial sector-real sector balance". As this distinguished
audience is aware, there is broad consensus and unanimity now among all key stakeholders
that it was the unsustainable "financial sector-real sector imbalance" due to certain financial
innovations that was the real cause of the last global financial crisis.
Generic financial innovation has typically evolved in the form of both on-balance sheet and
off-balance sheet derivative instruments. While Collateralized Debt Obligations (CDOs),
CDO-squared, CDO-cubed, Credit Linked Notes (CLNs) etc., are the typical examples of
onbalance sheet financial innovations, Currency Swaps, Interest Rate Swaps (IRS), Futures,
Options, Credit Default Swaps (CDS), etc., are those of off-balance sheet financial
innovations. In both the types, the underlying theory and practice has been the so-called law
of one price or, what is the same thing as the no-arbitrage argument, involving replication of
derivatives cash flows in the cash markets. In other words, a derivative of an underlying cash
market asset will be so priced/valued that it is not possible to arbitrage between the cash
market and the derivative market, provided the derivative in question is fairly priced/valued.
For, if a derivative were priced expensive relative to the underlying asset, an arbitrageur will
engage in riskless arbitrage by selling the expensively priced derivative and buying the asset
in the cash market by financing it at the going repo rate. In the opposite case, an arbitrageur
will engage in riskless arbitrage by shorting the asset in the cash market, investing the
proceeds of short sale at the higher going repo rate and buying the relatively cheap
derivative until, in equilibrium, the derivative was fairly priced/valued relative to the asset in
the cash market. Another way to posit the above is to say that a derivative's cash flows/pay
offs can be exactly replicated in the cash market provided, of course, seamless, and
frictionless, arbitrage is allowed. Significantly, and interestingly, such seamless and
frictionless arbitrage also applies, just as much, to derivatives themselves! Illustratively, a
long position in forward can be replicated by buying a call option and selling a put option with
the strike prices for both at the current forward price. If the actual forward price is expensive
relative to the "synthetic" forward (call + put options), an arbitrageur will engage in risk-less
arbitrage by selling the expensively priced forward and buying the relatively cheap "synthetic"
forward (call + put options) and vice versa! The reason why I am laboring this point is
because this is very central to the key message of my address today.
Specifically, I propose to cover in my address today three financial innovations proxied by
three derivative instruments, viz., Interest Rate Swap (IRS), Credit Default Swap (CDS) and
Interest Rate Futures (IRF) as they evolved, or did not evolve, in India.
Interest Rate Swap (IRS) market
The Report of the Committee on Financial Sector Assessment (Chairman: Dr. Rakesh
Mohan) noted that the notional principal amount of outstanding Interest Rate Swaps (IRS) of
all commercial banks increased from Rs. 10 trillion+ as on 31st March 2005 to Rs. 80 trillion+
as of 31st March 2008. However, due to trade compression, involving multilateral early
termination, by the Clearing Corporation of India Ltd. (CCIL), the notional principal amount of
outstanding IRS of commercial banks declined to Rs. 50 trillion+ as of 30th June 2012. A
granular analysis reveals that of all the commercial banks engaging in IRS, public sector
banks with about 74% of total bank assets accounted for less than 2% of notional principal
amount of outstanding IRS and private sector and foreign banks, with about 19%, and 7%, of
total bank assets, accounted for 18%, and 80%, of total notional principal amount of
outstanding IRS, respectively. In other words, with combined assets of just Rs. 6 trillion or so,
foreign banks accounted for notional principal amount of outstanding IRS of Rs.40 trillion.
Significantly, it is disturbing to note that, day in, and day out, the IRS yields trade way below
yields of comparable maturity Government securities. Specifically, currently the 5 year IRS
yield is trading at a negative spread of 120 basis points to 5 year G-Sec! Besides, while the
G-Sec yield curve is almost flat, the IRS yield is steeply inverted to the extent of 120 basis
points defying term, credit risk and liquidity risk premia which typically characterize a normal
yield curve of risk assets! A typical, but fallacious, and vacuous, rationalization offered of this
counter-intuitive, warped, weird and preposterous feature is that while IRS yields are
influenced by expected path of future interest rates, those of G-Secs are influenced by their
supply!! Nothing could be farther from the truth for this rationalization turns the very logic and
reason on their head. For, as I said, being pure time value of money, G-Secs are influenced
by, and immediately price in, inflationary expectations arising from higher fiscal deficit which,
in turn, is the cause of additional supply of G-Secs and not the other way round. Thus, here
we have an IRS market completely up side down and running on its head. This is completely
anti-thetical to the law of one price, or the no-arbitrage argument. For, if this law held, given
hugely negative spreads to Govts., fixed rate receivers, who far exceed, and overwhelmingly
outnumber, fixed rate payers, would have engaged in a very simple arbitrage, involving
buying corresponding maturity G-Sec in the cash market by financing it in the overnight repo
market, and paying fixed, and receiving overnight, in the IRS market! This very normal, and
logical, arbitrage would have had the effect of benefiting all the three stake-holders, viz.,
(a) fixed rate receivers receiving much higher yield than they are currently, (b) Government
of India borrowing at much lower cost, and (c) business and industry in general, and
infrastructure sector, in particular, getting long-term-fixed-rate-low-cost financing solutions. In
other words, this would have been a win-win for all key stake- holders but, the fact of the
matter is that, if anything, this is just not happening. As to the explanation of this almost a
permanent, structural, though quirky and weird, counter-intuitive, perverse, and preposterous
feature of the Indian IRS market, the stock, but specious, refrain is that arbitrage, involving
receiving fixed on G-Secs and paying fixed in IRS, is not possible because of the so-called
"basis risk"! But this is totally untenable for the simple reason that "basis risk" applies just as
much to "hedging" as indeed it does to "arbitrage"! In other words, "basis risk" is
"arbitragehedging" agnostic and, therefore, it inevitably, and incontrovertibly, follows that the IRS
market is also not being used even for "hedging". If that be so, as indeed it is, the question,
especially, but significantly, when one also considers the fact that only 2% of the notional
principal amount of the outstanding IRS is accounted for by the real sector i.e. business
customers, it begs is what then is 98% of this Rs. 50 trillion+ IRS market being used for. In
other words, in the case of the Indian IRS market, what holds instead is the
"law-of-twoprices-AND-no-arbitrage-argument"! In this background, it would be no exaggeration to say
that these hugely negative spreads of IRS to G-Secs are as counter-intuitive, quirky,
anomalous, warped and preposterous as a father's negative age spread to his son's is!
Indeed, in the analytical framework of my Singapore Speech for identifying systemic financial
risks, this situation can be reasonably interpreted, in a disturbing and sit-up-and-take-notice
manner of speaking, as a veritable IRS "Super-Bubble", signifying "huge huge" under-pricing
of interest rate/credit risks. This I say with analytical conviction because a "bubble", signifying
"huge" under-pricing of risks, is typically diagnosed with spreads of riskier assets to risk-free
G-Secs being unusually low, but still positive, whereas, here in the IRS segment, spreads to
G-Secs have persistently, and consistently, been negative to the extent of 100 to 150 basis
points for 5 year maturity! It thus follows that the situation here in IRS segment is almost
getting to the point where the IRS market, instead of being a means to an end of sub serving
the real sector is, to all intents and purposes, existing, almost entirely for its own sake to
almost complete exclusion of the needs of the real sector, creating a massive "financial
sector-real sector imbalance". On this touch-stone, and hallmark, the IRS market in India is
then a non-derivative, nay, a financial innovation that never was.
Credit Default Swap (CDS)
Like Interest Rate Swap, or for that matter any other derivative, Credit Default Swap is no
exception to cash market replication principle of derivatives pricing. Without going into
mathematical gymnastic proper, price of a CDS, in spread terms, is reasonably approximated
by the difference between the spread of a reference bond to corresponding maturity G-Sec
yield and the spread of IRS to the same maturity G-Sec yield. Thus, if Sc be corporate bond
spread and Ss be IRS spread to risk-free G-Sec yield of corresponding maturity, then the
fair/theoretical/model value/price of a CDS is approximately equal to Sc minus Ss.
Tautologically, since G-Sec yield is common to both spreads, another way to approximate
CDS price is simply to take the difference between the yield of the reference bond and the
same maturity IRS yield. As this learned audience is aware, finally when the product was
launched on 7th December, 2011, it was a stillborn. In fact, its epitaph was written in the
warped, anomalous, quirky and preposterous feature of hugely negative IRS yield spreads to
corresponding maturity G-Sec yields itself! For, as this discerning audience will readily see
from the above formula, because of hugely negative IRS spread, fair price of a CDS would
be so high as to make it both pointless, and useless, to buy a reference bond and also hedge
it with a CDS! In other words, one is much better off straightaway buying a corresponding
maturity risk-free G-Sec itself!! Significantly, if actual CDS premium/price/spread is higher
than the above theoretical/model price, then an arbitrageur will sell a CDS (which is
equivalent to going long the reference corporate bond) and receive this actual spread and
short the reference bond and invest the proceeds of short sale at the going corporate bond
repo rate and receive fixed, and pay overnight, in an IRS, and do the opposite arbitrage if the
actual CDS spread is lower than the theoretical/model spread/price until the arbitrage
opportunity disappears and theoretical/model and actual market prices align again. But sadly,
like in a classical catch-22, this arbitrage is just not possible simply because of its complete
absence, as I said before, in the IRS market and, therefore, alas, much as we would all wish,
a happening corporate bond market cannot happen, inter alia, to supplement huge
infrastructure funding needs of the Indian economy.
Interest Rate Futures (IRFs)
If the CDS was a stillborn, IRF too suffered mortality in its infancy the second time round
after its 2003 version which itself was almost a stillborn. For, after their second launch in
August 2009, Interest Rate Futures on 10-year notional government bond had seen two
settlements, viz. the December 2009 contract and March 2010 contract. Significantly, both
traded volumes and Open Interest (OI), witnessed decline over the two settlements,
eventually decaying very quickly to zero permanently. In particular, the December 2009
contract, which had a peak Open Interest of Rs. 980 million declined to a pre-settlement
Open Interest of Rs. 610 million and settled "entirely" by physical delivery, representing
physical settlement of 62% of the peak Open Interest. In contrast, the March 2010 contract,
which witnessed a peak Open Interest of Rs. 570 million declined to a pre-settlement Open
Interest of Rs. 420 million and also settled entirely by physical delivery, representing physical
settlement of 72%! Both these settlements were a far cry from the hall-mark and touch-stone
of an efficient, frictionless, seamlessly coupled, and organically connected, physically-settled
futures market even where physical delivery typically does not exceed 1% to 3% of the peak
Open Interest! This happened because of the inefficient "disconnect" and "friction" in the IRF
market due to only one way arbitrage viz. buying the cheapest-to-deliver (CTD), with the
highest implied repo rate (IRR), by financing the same at the actual repo rate and
simultaneously selling futures. In fact, as ascertained from one market participant, who
accounted for almost the entire Rs. 600 million worth of physical delivery into the December
2009 contract, the implied repo rate of the CTD was 6.75% as against the actual repo rate of
3.4%, representing a risk-free arbitrage profit of 3.35%!! Unlike this, on the other side, for the
so-called benchmark, and most expensive-to-deliver, Government security, the IRR was
almost zero to negative, suggesting an arbitrage opportunity of short-selling this bond and
investing the proceeds of short sale at much higher actual repo rate and buying the futures
contract! But this arbitrage could not be engaged in for want of short selling for a period
coterminus with that of the futures contract. It is the possibility of this two-way arbitrage,
working in the opposite directions, that, like a "good conductor" of "heat" and "electricity" in
physics, will seamlessly conduct/transmit liquidity from the relatively more liquid (the
mostexpensive-to-deliver) benchmark government bonds to the so-called illiquid (the
cheapest-todeliver) bonds in the deliverable basket! Here, I hasten to caution that the totally misplaced
temptation, and impatience, to introduce/launch "cash-settled" IRF, any how, some how, and
at any cost, must be firmly, and decisively, resisted for such medicine will be worse than the
disease! The reason is that unlike assets such as equity, foreign currencies, commodities
which are "homogeneous", government bonds, except , of course, for their same credit risk,
are, given their differing coupons and maturities, "heterogeneous" and, therefore, for the
cogent arguments adduced above, "physically-settled" contracts will make for seamless
transmission/conduction of liquidity from the most liquid benchmark bonds to the relatively
less liquid bonds in the deliverable basked and thus impart, and permeate, "much-needed"
homogeneity in the entire deliverable basket of government bonds! But I again hasten to add
that I am not even remotely suggesting that it is perfectly legitimate to have "cash-settled"
derivatives contracts in the case of "homogeneous" assets like equity, currencies and
commodities!! For any "cash-settled" derivative, where physical settlement is possible, tends
to become a "non-derivative", violating the cardinal principle of arbitrage-free
pricing/valuation and, therefore, as I said before, comes to exist almost entirely for its own
sake and to almost complete exclusion of the larger public policy purpose of sub-serving the
hedging needs of the real sector, creating a massive "financial sector-real sector imbalance"
and, thus, in turn, become the very antithesis of responsible financial innovation.
Market segmentation
Continuing market segmentation in India is the biggest undoing of an efficient, deep, liquid,
organically connected, and seamlessly integrated financial market which is also a "sine qua
non" for effective, efficient and instantaneous monetary transmission. Market
fragmentation/segmentation contributes to price distortion and inefficiency. The most tangible
and manifest evidence of market segmentation in India is the "dis-connect" between IRS, IRF
and government securities markets as reflected in the IRS (bank credit risk) yields being
100 to 125 basis points below G-Sec yields and IRF yields (when last traded) being about
70 basis points higher than their fair value, signifying almost complete absence of arbitrage
and thus a pernicious violation of the "no-arbitrage", or what is the something as, the
"law-ofone-price, argument" which, as the discerning audience is by now well aware, is the most
fundamental basis of "fair value derivatives pricing". Such manifest "dis-connect" militates
against the development of a seamlessly integrated financial market with coupling and
organic connect between all the three! However, this market segmentation can be credibly,
effectively and decisively addressed if the nuts-and-bolts reforms propositioned below, which
are, if you will, equally also the necessary, and sufficient, conditions, are synchronously
orchestrated in all-at-the-same-time-no-piecemeal- and-no-half-way-house manner:
(i) For the cogent reasons elucidated in the paragraph 7 above, the totally misplaced
temptation, and impatience, to introduce/launch cash settled IRF must be firmly, and
decisively, resisted. For else, this will, to quote Jamie Dimon, Chairman of JP
Morgan Chase, tantamount to "doing the "easy' and not the 'right' thing" and, in the
process, replicating an IRS genie in the IRF/CDS markets which then grows so fast
so much that it becomes difficult to put it back into the regulatory bottle.
(ii) What must certainly not be done is even to contemplate, much less permit, the
most-liquid-single-bond IRF for the very simple reason that this benchmark security
represents less than 10% of the current 10-year IRF deliverable basket and would,
therefore, at a time, when we are talking about "inclusion", this will amount to
veritable "exclusion" of 90% of the 10-year Government securities from the benefit of
hedging which arguably runs counter to the public policy purpose of IRF providing
hedging to as wide a universe of government securities as possible.
(iii) What also must certainly not be done is even to contemplate, much less allow,
selling/repoing of securities acquired under market repo, another name for
"rehypothecation", if the IMF finding in the wake of the 2007-Global Financial Crisis
is anything to go by! The IMF noted that pre-2007, thanks to re-hypothecation, the
shadow-banking system in the USA generated funding/liquidity of US $ 4 trillion with
the underlying "original collateral" of just US $ 1 trillion, implying astronomical and
whopping margins/haircuts of "minus" US $ 3 trillion!
(iv) What also must certainly not be done is allocate specific government securities to
different Primary Dealers for market making as this will be a "triple whammy" in that
this will straight away fragment/segment market, lead to concentration of risk and
militate against portfolio diversification.
(v) Symmetrical and uniform accounting treatment of both cash and derivatives
(IRF/IRS/CDS) markets.
(vi) Removal of the "hedge effectiveness" criterion of 80% to 125% which militates
against use of derivatives for hedging purposes for it is better to have "ineffective"
hedge than to have no hedge at all!
(vii) Roll-back of the Held to Maturity (HTM) protection i.e. substituting the current
"accounting hedge" with "derivative hedge". This is because with HTM, there is no
incentive/compulsion whatsoever for use of market-based solutions like IRS/IRF
which also require constant monitoring, infrastructure, transaction costs like
brokerage and margins etc. Indeed, fears that such roll-back may be disruptive, and
disorderly, are totally unfounded if one considers the fact that there is "overwhelming
net fixed rate receiving" appetite/ interest in the Rs. 50 trillion+ IRS market which will
be even more so with the introduction of IRF, what with the total outstanding amount
of dated Government securities at Rs. 30 trillion being much less than the
outstanding amount of IRS of Rs. 50 trillion!!
(viii) Delivery-based short-selling in the cash market for a term co-terminus with that of
the futures contract and introduction of term repo, and reverse repo, markets,
coterminus again with the tenure of futures contract for borrowing and lending of cash
and G-Secs.
(ix) Both for IRS and IRF, actual notional/nominal amount of IRS/IRF must be allowed
on duration-weighted basis unlike the current regulation which restricts the
maximum notional/nominal amount of hedging instrument to no more than the
notional/principal amount of the exposure being hedged resulting in under-hedging
of risk.
While lavishing praise on a speech, of course, in his characteristically inimitable style, the
illustrious and very distinguished Governor of the Reserve Bank of India, Dr. D. Subbarao,
famously remarked and I quote "The Speech is significant not because of the answers it
provides but because of the questions it raises"! With the very fond hope that my today's
speech measures upto, and passes muster on, Governor's touch-stone and hall-mark, I wish
all stakeholders God speed so that at the next edition of this event, some Keynote Speaker
delivers a speech titled "The Financial Innovations That Are Since There"!
Finally, I wish Finnoviti 2012 all the success that it so very much deserves!
Thank you all so very much indeed!