Subir Gokarn: Regulatory perspectives on derivatives markets in India
Keynote address by Dr Subir Gokarn, Deputy Governor of the Reserve Bank of India, at the
International Options Market Association, World Federation of Exchanges Annual
Conference, organised by the National Stock Exchange, Mumbai, 4 May 2011.
* * *
Inputs from Sudarsana Sahoo, Edwin Prabhu, Rajib Das, H.S. Mohanty, Nishita Raje and G. Mahalingam are
gratefully acknowledged.
Introduction
It is a pleasure for me to be speaking at this conference organized by the International
Options Market Association. The presence and role of derivatives in India, both OTC and
Exchange traded, has been increasing steadily over the years. These instruments are an
important component of the overall financial sector strategy and the broad regulatory
objective is to ensure that they are used to their potential in ways that are consistent with
both financial development and the contribution of financial markets to economic growth.
I would like to begin by laying out a simple framework, which helps us think about financial
sector development in terms of multiple objectives. This will provide a useful backdrop to the
various issues relating to derivatives in India, which I will then go on to talk about.
Financial sector development can broadly be viewed as pursuing four objectives.
Efficiency: We can look at the notion of efficiency from two perspectives. For the provider of
products and services, it means the ability to do this at the lowest possible cost, with the full
benefit of technology and market infrastructure. For the user, efficiency relates to the
availability of products and services which address his/her requirements at the lowest
possible price.
Stability: From the viewpoint of the financial system, stability requires that aggregate risk is
bounded in some way. This requires, in turn, that individual participants be required to
mitigate and manage their own risks. However, in situations in which systemic risk goes
beyond the aggregate individual risk, additional measures may be warranted.
Transparency: The basic premise is: "what cannot be measured cannot be managed". The
more market participants know about overall activities and outcomes, the better able they are
to make their cost-benefit calculations and act on them, contributing to the overall
effectiveness of the market.
Inclusion: Financial development is not an end in itself. It serves the broader purpose of
facilitating economic activity, through resource mobilization and risk management. The more
accessible the financial system is to individuals in pursuit of these two objectives, the better.
Against this backdrop, I will address four sets of issues :
1. The landscape for OTC derivatives in India
2. Regulatory concerns and steps taken
3. The roadmap for OTC derivatives
4. The development of markets in India.
The landscape for OTC derivatives in India
The primary OTC derivatives in India: Interest rate derivatives - Interest rate swaps (IRS)
and forward rate agreements (FRA); FX derivatives- FX forward, options and swaps.
The IRS and FRA were introduced in July 1999 to help banks and PDs to better manage
their interest rate risk in the wake of deregulated interest rate regime. Swaps having
explicit/implicit option features such as caps/ floors/ collars are not permitted.
Currently, there are four benchmarks used in Rupee IRS, viz. MIBOR, MIFOR, INBMK,
MIOIS. The trading is mainly confined to MIBOR benchmark. The average daily traded
volume in the MIBOR swap over the last three years is placed at Rs.8,873 crore, quite
comparable with that of the G-Secs at Rs. 10,937 crore. Often the daily traded volume in
MIBOR swaps remained above that of the G-Secs.
Of the MIBOR swaps, the swaps on overnight MIBOR, i.e. OIS, is the most actively traded
instrument. The OIS trades are mainly confined to 1-year tenor, followed by 2-year and
5-year tenors.
The relatively high volumes suggest that the product is providing a useful way of hedging
against interest rate risk. However, it needs to be pointed out that the market is mainly driven
by inter-bank transactions. Customer-related transactions comprise only about around 1 per
cent of the volume. Also, the participation profile remained skewed. The share of foreign
banks is at above 80%, whereas the share of public sector banks is at around 1%. The OIS
curve has been below the G-Sec curve for most of the time.
In the OTC FX derivatives, forwards have been the most widely used instrument followed by
swaps and options. USD-INR futures had picked up substantial volume since their
introduction in August 2008, but the forwards still possess the dominant market share.
It is evident that hedgers generally still prefer OTC forwards to futures, as these provide the
benefit of customization, does not involve cash flows related to daily MTM margining and are
linked to final remittances of foreign currency funds. Increased trading volume in the futures
market is mainly attributed to the speculative interest in the backdrop of non-requirement of
underlying exposure, absence of any restriction on cancellation and re-booking and above all
the cash settlement which obviates the need for payment of principal amount. Significantly,
easy arbitraging between the forward and futures had kept the spread between the futures
and forward quite tight.
Regulatory concerns and steps
The recent global financial crisis has brought to light the weaknesses of the OTC derivatives
market. Firstly, the complexity and opacity of the OTC market facilitated excessive risk taking
by the market participants. Secondly, the lack of information about the counterparties
coupled with non-availability of the transaction information with the regulators led to seizure
of the market. Thirdly, the bilateral counterparty risks have become complex given the variety
of structures and asset classes used by the market participant. Further, with increase in
volumes and complexities of the OTC derivatives, the infrastructure for clearing and
settlement became a major impediment.
We believe that the OTC derivative markets in India are well regulated. Some of the key
regulatory safeguards available in the OTC derivative transactions are:
1. One of the counter parties to the OTC derivative transactions has to be a RBI
regulated entity.
2. Users are permitted to transact in derivatives essentially to hedge an underlying
exposure.
3. There are clear prescriptions about the roles and responsibilities of market makers;
mostly banks and primary dealers (for interest rate derivatives) are permitted to act
as market makers.
4. The market maker has the responsibility for assessing customer suitability and
appropriateness and they are required to fulfill the prescribed set of requirements
while selling any product to a user.
5. The overall framework within which derivative transactions are to be undertaken has
to be guided by the Board approved policy. The risk management framework should
lay down the procedures to deal with any violation of risk limits.
6. All derivative products are required to be marked to market if a liquid market in the
product exists or otherwise marked to model, provided all the model inputs are
observable market variables and full particulars of the model, including the
quantitative algorithm are documented.
In the aftermath of the global financial crisis, the principal theme of discourse internationally
is to improve the efficiency and reliability of the OTC derivative markets. Two broad steps in
this direction are (a) clearing and settlement of OTC derivative transactions through Central
Counterparties (CCP) and (b) mandating reporting of OTC derivatives trades to designated
trade repositories. Against this backdrop, it must be pointed out that, over the years, the
Bank had taken several measures to improve the transparency and efficiency of OTC
derivatives market. Some of the major ones are:
1. The Bank had instituted mandatory reporting system for the OTC derivative
transactions. The banks have been mandated to report the inter-bank IRS trade
data on-line to CCIL since August 2007. The client level trade data are also now
collected from the banks. In case of FX derivatives, the AD category-1 banks report
the aggregate details of transactions in forward contracts, currency swaps and
currency options to the Bank at fixed periodicity. The Bank uses the trade level and
aggregate level data to monitor the overall market wide exposure as well as the
exposure level of the individual market makers along with their exposures to specific
derivative instruments.
2. The Bank has facilitated greater use of central clearing counterparty (CCP) based
clearing and settlement system for OTC derivative transactions which helps in
reducing the risk of financial loss through counterparty default and provides capital
relief. Currently, the transactions relating to FX forward are settled on guaranteed
basis through CCIL. The process for introduction of guaranteed settlement of IRS
transactions is underway.
3. Thirdly, the level of transparency has been improved by way of increased
dissemination of price and volume information. The price and volume data improves
the risk management efficiency of the market participants and enhances the
pricediscovery function. Moreover, it offers greater degree of protection to the
unsophisticated class of end-users.
The roadmap for OTC derivatives in India
A number of initiatives for the further development of OTC derivatives in India have been
initiated. Some of the major ones are:
New Products: The product on anvil is the Credit Default Swap (CDS). The draft guidelines
on CDS were placed on RBI's website in February 2011 for public comments. CDS on
corporate bonds issued by single legal residential entities have been proposed, with the
underlying bonds to be listed ones, but with two exceptions: unlisted but rated bonds of
infrastructure companies and unlisted/unrated bonds issued by the SPVs set up by
infrastructure companies. The final guidelines are expected soon.
CCIL has been acting as the trade repository for IRS transactions since
Trade Repository:
August 2007. There is no such trade repository structure for the FX derivatives at present.
There are proposals to introduce repository structure for USD-INR forwards (including
swaps) and options.
Central counterparty clearing: CCIL has put in place guaranteed settlement for FX forward
transaction effective from the date of contract since December 2009. In case of IRS, CCIL
has been providing non-guaranteed settlement since November 2008. It is expected to
transit to guaranteed settlement for IRS transactions shortly.
Portfolio Compression: An important innovation in OTC derivative markets introduced
during the last few years relates to portfolio compression services. Since the only way to exit
a position in an OTC derivative is to enter into another with opposite pay off, the gross
notional outstanding multiplies manifold as a result. Huge build-up in gross notional
outstanding demands higher capital charges and reduces the available counter-party limits
for undertaking other business transactions. Moreover, it does not capture the economic
essence of the portfolios. CCIL is the process of developing trade compression services.
Generally speaking, our approach to financial markets development has been calibrated,
keeping in mind the overall objectives of financial sector development. Particularly at this
juncture, while we intend to expand set of products and instruments available, we also wish
to emphasize the improvement in the pre and post-trading infrastructure as well as
consolidation of the regulatory regime so that financial stability is not threatened.
Development of markets in India
Exchange traded products provide the benefits of transparent pricing and robust risk
management. The Reserve Bank introduced currency futures and interest rate futures on the
exchanges with a view to increasing the depth and breadth of the derivatives market, in turn
helping to provide an effective risk management framework to users.
Currency futures were launched on the National Stock Exchange (NSE) in August 2008 and
subsequently on other exchanges. European style option on USD-INR pairs was launched
on NSE and USE in October 2010. The biggest challenge in designing a framework for
exchange traded currency derivatives in India was the prevailing regulatory system for the
OTC products. In the OTC environment, there is an elaborate framework for regulating
transactions, including derivatives, and the presence of an underlying exposure is an
essential requirement. It was not possible to carry over this requirement onto the exchange
traded market. To deal with this, even if partially, position limits have been imposed on
exposures to exchange traded products.
Interest Rate Futures (IRF) contracts on 10-year notional coupon bonds were launched on
NSE in August 2009. Persons resident in India and FIIs have been permitted to participate in
the market. The product witnessed significant activity during the initial period, but liquidity
tapered off subsequently. The muted market response to IRF is generally attributed to the
illiquidity nature of the underlying G-sec market and lack of hedging interest in the wake of
present HTM regime.
Notwithstanding this experience, RBI has already issued guidelines for futures contracts on
91-day T-Bills, which are expected to be introduced shortly. We are also considering
introduction of IRF contracts on 2 year and 5 year G-Secs to provide the products at the
shorter end which would offer flexible hedging options to the market participants.
Concluding remarks
I would like to go back to the four-objective framework with which I began my presentation.
The roadmap for the development of derivatives, or for that matter, any new financial product
or service, will strive to maintain a balance between these four objectives. From this
perspective, the approach should be neutral to the form and nature of the product or service;
it should be concerned only with whether it is helping to meet the objectives, or at least not
detracting from any of them. I would particularly like to emphasize the objective of inclusion,
which, in this context, looks at the desirability of a product in terms of how effectively it might
meet the requirements of a very heterogeneous group of producers of various goods and
services.
Taking the specific example of OTC forex products, it is apparent that they remain attractive
to a majority of people with forex exposures because they can be customized to the specific
characteristics of each transaction. However, the parallel development of the futures market
suggests that there may be some complementarities between the two. A hub-and-spoke
analogy comes to mind, with OTC products serving as the spokes and the counter-parties to
these transactions then aggregating their exposures and managing them with exchange
traded products. Although this phenomenon is not quite prevalent in India at present, for me,
this provides a useful way to think about the overall roadmap, with each component playing a
legitimate role.
I would like to thank the organizers for inviting me to deliver the keynote address at this
IOMA Conference and trust that it has been a useful input.