RBI unveils roadmap for interest rate futures

After introducing currency futures trading, the Reserve Bank of India is getting ready to usher in interest rate futures in the country.

After introducing currency futures trading, the Reserve Bank of India (RBI) is getting ready to usher in interest rate futures in the country. The RBI’s Technical Advisory Committee has proposed to introduce interest rate futures contract based on a notional coupon bearing 10-year bond initially and settled by physical delivery.

Depending upon market response and appetite, exchanges concerned may consider introducing contracts based on 2-year, 5-year and 30-year government securities, or those of any other maturities, or coupons, it said in the final report on interest rate futures (IRF). In the group’s view, some of the market micro-structure issues such as notional coupon, basket of deliverable securities, dissemination of conversion factors, and hours of trading were best left to the respective exchanges.

It also proposed that foreign institutional investors (FIIs) should be allowed to take only long positions. The overall limit for foreign investors would be capped at $4.7 billion, the RBI said. FIIs may also be allowed to take short positions in IRF, but only to hedge actual exposure in the cash market up to the maximum limit permitted.

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The committee suggested that since banks constitute the single most dominant segment of the financial sector in the country, they should also be allowed to contract IRF not only to hedge interest rate risk in their financial statements, but also take trading positions subject to regulations. It also suggested that to ensure symmetry between cash market in government securities and interest rate futures, the latter might be exempted from securities transactions tax.

To begin with, delivery-based, longer term/ tenor/ maturity short selling in the cash market may be allowed only to banks and primary dealers, subject to the development of an effective securities lending and borrowing mechanism/ a deep, liquid and efficient repo market.

The RBI group reasoned that considering the RBI’s role in ensuring efficiency and stability in the financial system, the broader policy (including those relating to product and participants) be the responsibility of the RBI and the micro-structure details (which evolve thorough interaction between exchanges and participants) be best left to respective exchanges.

In the wake of deregulation of interest rates as part of financial sector reforms and the resultant volatility in interest rates, bankers were arguing for hedging instruments to manage interest rate risk. Accordingly, in 1999, the RBI took the initiative to introduce Over-the-Counter (OTC) interest rate derivatives, such as Interest Rate Swaps (IRS) and Forward Rate Agreements (FRA). With their success, particularly with the IRS, the National Stock Exchange (NSE) introduced exchange-traded IRF contracts in 2003. However, for a variety of reasons, discussed in detail in the report, the IRF failed to attract a critical mass of participants and transactions, with no trading at all thereafter.

What are they all about?

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• An interest rate future is a futures contract with an interest-bearing instrument as the underlying asset like 10-yr government bond or 30-yr government securities. Currency is excluded, even though interest rates are a factor in currency values

• Interest rate futures were pioneered by the Chicago Board of Trade in 1975 in response to a growing market need for tools that could protect against sharp and frequent swings in the cost of money

• Most global markets trade futures on two underlyings, one at the long end (maturity of 10 yrs or more) and another at the short end (maturity up to one year) of the yield curve

• Interest rate future trading is a favourite tool of developed western markets and account for nearly one-third of total derivative transactions