This is a guest article by Saswata Das. He graduated from IIM Calcutta earlier this year and works in the Financial sector. We thank him for his article and look forward to his future articles!

With trade volumes of IRFs in NSE barely touching the 1000 mark these days, it seems that all the initial excitement has fizzled out. This apparently dismal performance doesn’t bode well for the second edition of Interest Rate Futures introduced after a long hiatus of six years.

It’s really intriguing that in India interest rate derivative constitutes only 5% of the total derivative instruments traded value wise vis-à-vis 70% of that traded worldwide.

So what could be the possible reasons for such a state of the Indian financial market especially in the interest rate futures segment? Despite the fact IRFs have been made accessible to a wider base of 638 participants in NSE including 21 Banks, Primary Dealers, Mutual Funds, Insurance companies, FIIs, NRIs and individuals etc. Besides it’s expected that there shall be some significant changes in the interest rate movements owing to a stricter monetary policy on the horizon. Yet the volume in the IRF space has been waning at a faster pace in the recent past.

IRFs can be considered as one of the first few steps the Government of India has taken towards the fulfillment of multiple objectives. Some of them would be the development of corporate debt market; fuller capital account convertibility; complete deregulation of interest rates; strengthening of risk management; development of term money market and lastly a better risk management device to hedge interest rate exposure owing to volatility in Interest rates.

Improvements over the previous edition of IRFs would be the pricing procedure, settlement norms and restricted participant base, which have been changed for better. Previously banks, who are high volume players in the fixed income markets, weren’t allowed to trade in IRFs other than doing ‘effective’ hedging. This time banks are being encouraged to participate in big way as all the rules previously applicable have been done away with.

In any financial market a market maker is required to absorb and infuse liquidity to foster depth in that market. Who is willing to own up the responsibility of market making in this case?

Yet players who are supposed to pour in significant volume are still dormant although for resurrection of IRF their participation is of prime importance. Mutual funds, financial institutions including Insurance companies who claim to be the users of IRFs, have been loath to provide the much coveted liquidity. Mutual funds still waiting for volumes to pick up and they are waiting for the first round of settlement of contracts to be over. In a way this could be a self fulfilling prophecy since a substantial amount of volume was initially expected of them and now they themselves are testing waters.

As far as Insurance companies are concerned, Insurance Regulatory Development Authority has just given a go ahead to insurance companies only on the IRF front. IRDA should allow all the players to use all derivative instruments and facilitate a wider participation from this set of investors. Insurance companies quite predictably are reluctant to act as liquidity providers and have become mere users of the instruments. Insurance giant LIC is still shy to dabble into the IRF space because of reasons like poor volume and liquidity. Most importantly the fact that IRFs first quarterly settlement is due this December and thus it is still in its nascency, nothing much can be expected of the investors who are still not sure as to how effective IRFs would be in serving their purpose.

Here kicks in the importance of the regulator, SEBI in our case has improvised a lot over the previous avatar of IRF contract terms but has missed out on some crucial issues like working in tandem with regulatory authorities like IRDA governing the participating capacities of the insurance companies.

Another facet of the problem would be the underlying of the IRF which is nothing but a notional 10 year bond bearing a coupon of 7% paid semi annually. The current underlying might create basis risk and cause inconvenience to smaller participants. Individuals who are not educated enough to neutralize the basis risk would incur losses. Effective usage of derivative instrument calls for sufficient amount of knowledge on the various facets of the product and the underlying security. Knowledge on pricing of the instrument, dynamics of both short and long term interest bearing instruments help players act with utmost maturity while trading IRFs and this is also one of several factors hindering IRFs from taking off in a big way. Lack of sufficient Benchmarks in the IRF space could be another reason as in India are available only on long term instruments as underlying and this complete absence of short term instruments as underlying in partially responsible for illiquidity in the segment.

Thus it’s high time the regulators act a little proactively and effect certain changes especially in terms of availability of IRFs on a broader spectrum of securities. For instance International Monetary Market, a part of CME has contracts on discount instruments like US Government T-Bills, Eurodollar futures in its short term interest rate future space apart from US Treasury Bond contract popularly traded as long term financial futures contract.

In economies with financially developed financial markets, Interest rate future prices reflect the reactions of the investors to the anticipated movement in the interest rates just the way government signals on expected interest rate by repo and call money rates to the economy.

It is anticipated that a quicker economic recovery, accelerating inflation rate, implying a higher interest regime will come into existence with a quarterly policy review by RBI due on this Oct 27th, investors will soon feel a greater need to hedge fomenting a surge in the volumes of this most successful financial innovation of 1970’s vintage.

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