The opening up of the Indian markets has been accompanied by the liberalization of regulations relating to the Indian foreign exchange and money markets. The last few years have seen the development of derivative markets in the Indian rupee and the deepening of the cash markets. This growth has been through testing times, with the Indian rupee's sharp depreciation in line with other South-East Asian currencies, along with geo-political issues destabilizing the environment. Yet, the growth of these markets has been rapid. This article seeks to take stock of the current derivative markets in India and look at various issues that would need to be addressed to take the market forward.
THE CURRENCY SWAP MARKET
It has been almost three years since the Reserve Bank of India spurred the development of a derivative market by allowing onshore banks--called authorized dealers in regulatory parlance--to offer currency swaps in the Indian rupee. The use of this product was facilitated by allowing Indian entities that had no foreign exchange exposures to actually take on an exposure, thus providing for a two-way market.
Currency swaps have provided several multinationals and large public-sector companies with a tool to swap their foreign currency borrowings into fixed rate Indian rupees. Companies today can access overseas money markets on a fully hedged basis as an alternative to the local bond markets. The premiums of the swap markets over the local bond markets have reduced and the two curves are almost at par. Liquidity has picked up and there exists an interbank market, albeit only among a handful of foreign banks.
While the currency swap market has grown significantly, there are some issues that need to be addressed.
* Limited players: The market for currency swaps is restricted to onshore foreign banks and a few private banks and institutions. Public sector banks, which account for over 80% of the Indian banking system, are noticeable by their absence. Unfamiliarity with the product and its pricing, lack of systems and processes, and inadequate knowledge of legal, accounting and documentation issues have kept this important sector away from currency swaps.
The market also is restricted to onshore banks, and offshore entities have almost no access to this market. Only foreign institutional investors can hedge a part of their equity and debt exposures in the foreign exchange forward or the currency swap market.
* Lack of cash hedging mechanisms: Controls on accessing offshore foreign currency money or bond markets, coupled with illiquid local currency term markets, prevent participants from hedging currency swaps through the cash markets. Swaps are normally hedged through reverse swaps or through forward contracts (normally liquid only up to one year).
* Regulations imposed by the RBI: Local regulations imposed by the central bank in 1998 in the light of a sharply falling Indian rupee do not allow companies to rebook their foreign currency trade or capital exposures once cancelled. This regulation, also applicable to currency swaps, prevents cancellation of an existing forward contract with one bank and rebooking with another. This reduces the volumes of swaps by preventing companies that have short-term forwards booked with a bank, from rebooking the same exposure with any of the handful of banks that offer currency swaps.
* Familiarity with accounting/documentation: Most Indian public sector banks have stayed away from using currency swaps due to inadequate knowledge of the International Swaps and Derivatives Association master agreement, a standard among most of the foreign banks. However, in the recent past, several organizations, such as the Foreign Exchange Dealers Association of India, the Fixed Income Money Market and Derivatives Association and ISDA, have conducted various seminars to educate local banks on the features and benefits of using these documents.
* Credit limits: The growth of an interbank market depends upon the availability of credit limits and the ability to net transactions between banks. Local regulations at present prohibit netting. Steps to evolve a legal framework to facilitate netting would help in freeing up credit limits between counterparties.
THE INTEREST-RATE SWAP MARKET
The RBI sought to deepen the interest-rate markets with a two-fold objective. One was to make the markets more efficient so as to help in funding the government's burgeoning borrowing program as well as in improving credit delivery to the Indian industry recovering from an economic slowdown. The other reason was to provide Indian banks with additional tools to reduce the interest-rate risks on their balance sheets and help them comply with the asset-liability management guidelines issued in 1999 and effective April 1, 2000.
With these goals in mind, the RBI allowed interest-rate swaps in July 1999. The RBI gave markets the freedom to use any debt-related benchmarks and tenors, while prohibiting interest-rate option products. The first few days saw banks vying with each other to be the first to transact with a range of counterparties across several benchmarks. But, after the initial euphoria, there was a slackening in the number of transactions and the market now is waiting for further impetus to propel this forward.
The slow growth in the market has often been blamed on the reliance on a single overnight benchmark, the overnight Mumbai Interbank Offer Rate (MIBOR). With a very small proportion of corporate bond issuances linked to this benchmark, not many end-user corporates derive benefit from swaps linked to this. Of course, the overnight MIBOR has developed as a popular benchmark among banks since most interbank cash borrowing/lending is through the overnight markets. Most banks have restricted themselves to one-year tenors against the overnight benchmark though some foreign banks quote out to three to five years.
Again, Indian public sector banks have stayed away from this market due to their unfamiliarity with derivative products in general. Given the dominance of the local banks of the Indian banking system, the popularity of interest-rate swaps is heavily dependent on these banks increasing their familiarity with interest-rate swaps and using them to manage the risks on their balance sheets. As mentioned before, FIMMDA has recognized the participation of local banks as an important condition for the successful development of these markets and is working on various steps toward educating local banks.
Corporate demand has been for other benchmarks better suited to managing the interest-rate risk inherent on their liabilities side. Some benchmarks that have been attempted by a few banks are shown in table 1.
Steps taken by regulators toward developing an active repo market could remove some of the above limitations. However, FIMMDA, as a representative of market interests, is working on various steps at arriving at solutions to deepen this fledging market.
This week's Learning Curve was written by Mukund Santhanam, senior manager, head of derivative sales at Standard Chartered Bankin Mumbai.
