Traders bank on derivatives in volatile market

An interesting article in ET, worth taking note of. For bond markets it could be second time lucky. Reserve Bank of India’s guidelines for interest rate futures have been received with much optimism from traders who are excited about the opportunity to take a leveraged view on interest rates. This excitement is despite the fact that an initial attempt to launch the instrument in 2003 turned out to be a damp squib. One reason for the optimism is that RBI introduced the new norms after an intensive dialogue with market participants and industry bodies identifying factors, which prevented the instrument from taking off earlier. The report, which was released a week ago, proposes to introduce derivatives which will be helpful in a market where interest rate volatility is the norm. The central bank had launched over-the-counter interest rate derivatives such as interest rate swaps and forward rate agreements in 1999. However, even as IRFs were launched in 2003 by the National Stock Exchange, the product failed to attract participants and volumes never picked up in this segment. What’s on the cards? An interest rate future is a futures contract with an interest-bearing instrument as the underlying asset. For starters, apart from bond houses, the central bank now proposes to allow banks to trade in interest rate futures. This would help banks hedge against interest rate risks by entering into futures contracts aligned to the spot market. The panel has recommended introducing IRFs, where long-bond futures contracts are physically settled, as is the case in developed markets. To begin with, the panel has proposed a futures contract, based on a notional coupon bearing ten-year bond. Moving away from the earlier practice of cash-based settlements, the RBI panel has recommended that bond futures would need to be physically settled, in line with international practices. For the time being, the panel has suggested that only banks and bond houses be allowed to undertake delivery-based short-selling practices in the cash market. The evolution of a deeper repo market could allow for this to be extended to other market participants as well. For the FIIs, who are a significant community in bond trading these days, the working group has advised that FIIs could be allowed to take long positions in the futures market, keeping in mind that their gross long positions in the cash market does not exceed the maximum-permissible cash market limit of $ 4.7 billion. Why would it work now? Bond traders are quite positive that the market for interest rate futures will take off, after the new set of guidelines were released. According to IDBI Gilts’ head of fixed income securities S Raghavan, “Interest rates are currently headed northwards and there has been a lot of interest shown in IRFs, especially by multinational banks. In the past, there were fewer participants in the market and even derivatives contracts were not used widely. Now, even public sector banks trade actively in overnight interest swaps.” The Fixed Income, Money Markets and Derivatives Association too is working on ways to make interest rate futures a more viable proposition. Mr Raghavan added that the settlement of the futures contract was earlier linked to the yield on treasury bills and was based on a zero coupon yield curve. Given that the central bank now proposes to link it to either the government securities yield or the Mibor curve, there are greater chances of the product taking off this time around. STCI Primary Dealer’s managing director Pradeep Madhav said, “To begin with, the product design itself has been altered and a delivery-based modelling is being proposed. The panel proposes to link the product to the ten-year government bond segment, which is most actively traded in the market.” Traders felt that allowing banks to trade in IRFs too, apart from using the instrument for hedging purposes, would be a welcome move. That apart, forex traders in multinational banks state that liquidity is still an issue in the Indian market. The three prime benchmarks are the overnight indexed swap, the Mifor and the yield on the benchmark bond in the g-sec market, (currently the 7.99% bond maturing in 2017). StandardChartered Bank MD and head, corporate sales, global markets, Hemant Mishr said, “While the Mifor is largely used only in the debt market, use of the benchmark g-sec yield faces the issue of illiquidity. This leaves behind the overnight indexed swap and traders having cash positions in the gilt market would benefit using IRFs. This would be specifically the case if they want to have short positions in the g-sec market as they can monetise their views on future movements in interest rates.” How could it be made better? Bond traders are of the opinion that if the RBI would introduce a model based on the cheapest-to-deliver mechanism, it would help the market further. This is a system followed in the US, where if a trader finds himself short on one security, he can deliver through another security closer to the former. This would definitely help boost volumes. Mr Mishr added, “We still do not have a term structure of interest rates in India as yet. It would help to begin operations by focusing on few securities and select tenors. It may not be possible to traverse across the yield curve as it would give rise to the problem of illiquidity.” Going further, RBI may look at introducing contracts with more maturities. Liquidity and greater market participation are key to the success of this market. This would give players an opportunity to take advantage of rising yields, given that players need not always be on the receiving end,” said a senior forex trader.