The Indian fixed income markets have charted impressive growth in the last few years. The current markets are vastly different from the 'administered interest rate regime' used until the early-nineties. Until 1999 market participants had to reduce duration or switch to cash if they wanted to hedge interest rate exposures or had a view that interest rates were set to rise because short-selling was not allowed. Now an investor can use interest rate derivatives to hedge against a rise in interest rates or even to profit from such moves. Market Size
The Indian interest rate derivatives market is now over three years old and growing fast. The Reserve Bank of India announced the introduction of over-the-counter rupee derivatives in the form of forward rate agreements and interest rate swaps in July 1999. These have helped manage and control interest rate risks and also deepen the money markets. Only banks, primary dealers and financial institutions are allowed to trade FRAs and swaps to hedge interest rate risk for their own balance sheet management and for market-making purposes. Corporates are allowed to use these products to hedge their interest rate risk. Swaps having explicit or implicit option features such as caps, floors and collars are not permitted. RBI started by allowing market participants to use debt market rates as benchmarks, but this was later extended to include implied foreign currency rates.
The size of the market has also grown exponentially. In terms of the number of contracts and outstanding notional principal, interest rate derivative transactions have jumped from about 200 contracts amounting to INR40 billion (USD855 million) in March 2000 to 6,500 contracts for INR1,500 billion in December. Daily volumes are now in excess of INR5 billion (notional) from INR500 million-INR1 billion in the early years. The market is now more liquid than the corporate bond market. Bid-offer spreads are currently 5-10 basis points while they were as wide as 20-25bps in the initial period. However, the market remains highly concentrated with a few market participants. Data shows that 13 major participants account for over 90% of the outstanding notional.
The product palette has also been changing. Initially, the swaps were indexed to overnight interest rates and the overnight indexed swaps (OIS) were the most active. Later, the reserve bank permitted foreign currency benchmarks, such as forward premium, and the market grew deeper. The OIS and the implied rupee rates derived from foreign exchange forwards are the most actively used benchmarks. Other benchmarks over which swaps have been dealt are commercial paper rates, benchmark gilts and also constant maturity Treasury swaps. The MIBOR swap curve has now extended to 10 years while the OIS curve extends into seven years. However, up to five-year tenors are the most liquid. New structures also permit having cash flows in rupees with the floating rate leg linked to dollar LIBOR rates, for example rupee quantos.
Concentration
Though most debt market participants are permitted access to the rupee derivatives market, only a handful of players contribute significantly to the activity. Foreign banks are the most dominant players followed by a few new private sector banks. A few corporate houses are also very active in these markets. Public sector banks have a marginal presence followed by mutual funds. Insurance companies have not participated in the rupee derivatives market as yet. Public sector banks have a large presence in the interest rate markets but their share in the rupee derivatives market is much lower. Their slow entry into this segment could likely be on account of the time taken to develop adequate skills and systems. The entry of public sector banks could benefit the market in a big way as they would be able to set larger counterparty limits on account of their size.
End Users
Bank participants have used the rupee derivative markets for trading as well as hedging their trading or investment portfolios. Also, since short-selling of gilt securities is not permitted in India, banks can use rupee derivatives to effectively short interest rates. Corporates, on the other hand, have also benefited by the introduction of rupee derivatives. Traditionally there has only been liquidity in the Indian corporate bond market during a boom. Corporates can now tap the bond markets when demand is strong and use swaps to convert their liability to a floating rate to benefit from a further fall in interest rates if they are bullish. If they are bearish on rates they can swap their floating rate loans to fixed or extend the maturity of their loans using swaps. These are just a few simple uses of swaps but the exact applications are varied and serve a number of objectives.
The past year has witnessed a strong surge in activity in the derivatives segment in India. Volumes have multiplied, aided by the increase in number of market participants and emergence of new products. The bullishness in the fixed income markets and developments in the foreign exchange markets also added to the trend.
The Future
Markets participants and regulators have already started to chart the path in the coming years. The central bank's committee on rupee derivatives has submitted its recommendations and laid out a roadmap for expanding the rupee derivatives market. It has suggested the introduction of less complex interest rate options and the introduction of exchange-traded interest rate derivatives for better hedging of risk to encourage wider participation in derivatives. Other related issues, such as legality, netting, documentation, accounting and valuation procedures, board policies, risk management systems and regulatory requirements, are also being addressed.
We expect the markets to maintain their pace in the coming year powered by the entry of more participants, public sector banks and insurance companies, and the introduction of more products, such as options and futures. As issues plaguing the markets are addressed and players get more comfortable we could see this market filling the gap between the Indian fixed income markets and fixed income markets in other developed countries.
This week's Learning Curve was written by Ashish Agrawal, v.p. in fixed income research at DSP Merrill Lynch in Mumbai.
