In the 2005 budget speech India’s Finance Minister P Chidambaram mentioned the crucial role that over-the counter (OTC) derivatives play in mitigating the risks of corporates and financial entities. A strong signal of support from the government for the OTC market was welcomed by the industry, and it was hoped that this would provide development impetus to a sector lacking in legal and regularity clarity. But this may take some time, reports Nick Herbert.
Derivative trading is not new to India. There is a well-functioning derivatives market that resides on recognised exchanges and is regulated by the Securities and Exchange Board of India (SEBI), which also regulates the capital markets industry. SEBI's remit, however, does not cover OTC transactions, which leaves these deals somewhat in limbo. Because they do not conform to the recognised definition of a derivative as being exchange traded, the instrument is at the mercy of laws and regulations dating back to the 19th century that characterise them as wagering or gambling contracts.
Once the legal status of these deals has been clarified it becomes a question of regulation and which entity is best placed to fulfil that role. It is fairly certain that the honour will fall to the Reserve Bank of India (RBI), which already regulates the pro-OTC derivatives banking sector, interest rates and currency markets. The RBI is naturally placed for the job as it already allows trading in certain instruments.
Interest-rate products are actively traded and the market has witnessed stunning growth. The interest-rate market is dominated by Overnight Index Swaps (OIS) and swaps referenced to one of the major Indian domestic floating interest rates, the Mumbai Interbank Forward Offered Rate (Mifor). "As a best estimate, we reckon that daily trading volumes in Mifor and OIS reach up to as much as US$1bn-equivalent," said Sanjeev Bejaj, country treasurer at Bank of America's India operation. "That has grown from volumes of around US$200m just a year ago."
Such turnover suggests tight bid/offer spreads. According to Bejaj, trades out to 10 years are possible in both Mifor and OIS, with a bid/offer of 2bp–3bp in OIS to five years and one of 7bp or so thereafter. Bid/offer spreads in Mifor range from 2bp–5bp to the five-year maturity, and 4bp–7bp further out. Average tickets sizes are for Rs250m (US$5.8m).
Taking the market to the next level in terms of product development is hindered by a conservative policy adhered to by the RBI. Interest-rate options are expressly disallowed although foreign exchange options were given the go-ahead earlier in the year.
The specific case of interest-rate options serves to highlight some of the ambiguity seen in the Indian derivatives market. Whereas there is no OTC interbank market, notes with embedded options have been a feature of the capital markets (regulated by SEBI) for a number of years. Current restrictions mean that risk inherent in callable notes cannot be parcelled out and redistributed into the market. "Essentially, you can't usually be short volatility. You can buy options [cap and floors] but you can't sell them," said Vinod Aachi of Deutsche Bank.
The RBI has also intervened in some nascent markets. In April it put the brakes on the use of quanto structures. This sector, which represented only a tiny part of the overall market, had developed to take advantage of the relatively steep yield curve in the US. "The RBI is responsible for the health of the financial sector and it obviously thought that players' understanding of the US interest-rate market was not sophisticated enough," said one banker.
For many, the pace of reform is too slow – especially in comparison to the speed of development in China's derivatives market. But there is precedent to the decision making process.
While the Asian financial crisis of 1997/1998 was an epiphany to many of the region's central banks, India escaped the worst of the fallout and, for some, stands vindicated in its role as guardian of the domestic financial market. So whereas the rest of Asia's central banks have looked to the west and each other in their attempts to construct a robust integrated financial model, India has ploughed own path and followed its own timetable. "Some countries like to wait for demand to surface before constructing a regulatory framework, others like to establish an infrastructure in advance," said BofA's Bejaj. "Who's to say who's right?"
The time for India to develop an appropriate regulatory infrastructure will come, though. "Demand for the full range of OTC derivatives is growing, but it's not yet reached the tipping point," said Aachi.