The Group is grateful for the guidance provided by the members of the Technical Advisory Committee (TAC) on Money, Foreign Exchange and Government Securities Markets.

The Group also places on record its appreciation of the contribution by Dr. K V Rajan, Shri Himadri Bhattacharya, Shri Salim Gangadharan, Shri G Padmanabhan, Ms Meena Hemchandra, Shri Chandan Sinha, Shri G Mahalingam, Smt Supriya Pattnaik, Shri R N Kar, Dr. M K Saggar, Shri S Chatterjee, Shri T Rabisankar, Shri K Babuji and Shri Indranil Chakraborty.

The Group would like to place on record its appreciation of the research and secretarial assistance provided by Shri H S Mohanty, Shri Navin Nambiar and Shri Puneet Pancholy of the Financial Markets Department.

In the wake of deregulation of interest rates as part of financial sector reforms and the resultant volatility in interest rates, a need was felt to introduce hedging instruments to manage interest rate risk. Accordingly, in 1999, the Reserve Bank of India took the initiative to introduce Over-the-Counter (OTC) interest rate derivatives, such as Interest Rate Swaps (IRS) and Forward Rate Agreements (FRA). With the successful experience, particularly with the IRS, NSE introduced, in 2003, exchange-traded interest rate futures (IRF) contracts. However, for a variety of reasons, discussed in detail in the report, the IRF, ab initio, failed to attract a critical mass of participants and transactions, with no trading at all thereafter.

2. The Working Group was asked to review the experience so far and make recommendations for activating the IRF, with particular reference to product design issues, regulatory and accounting frameworks for banks and the scope of participation of non-residents, including FIIs.

3. The first draft of the Report was placed before the Technical Advisory Committee whose views/ suggestions were duly addressed in the second revised draft which was endorsed by the TAC in their subsequent meeting. Comments received from one Member, who could not be present for the meetings, are annexed to the Report.

4. The Group noted that banks, insurance companies, primary dealers and provident funds, who between them carry almost 88 per cent of interest rate risk on account of exposure to GoI securities, need a credible institutional hedging mechanism to serve as a 'true hedge' for their colossal pure-time-value-of-money / credit-risk-free interest rate-risk exposure. Although the IRS (OIS) is one such instrument for trading and managing interest rate risk exposure, it does not at all answer the description of a ‘true hedge’ for the exposure represented by the holding of GoI securities of banks because, much less price itself, even remotely, off the underlying GoI securities yield curve, it directly represents, on a stand-alone basis, an unspecified private sector credit risk and not at all the pure, credit risk-free time-value-of-money exposure of GoI securities. Government securities yield curve is the ultimate risk-free sovereign proxy for pure time value of money, and delivers all over the world, without exception, the most crucial and fundamental public good function in the sense that all riskier financial assets are priced off it at a certain spread over it.

5. One of the reasons for the IRF not taking off is ascribable to deficiency in the product design of the bond futures contract, which was required to be cash-settled and valued off a Zero Coupon Yield Curve (ZCYC). As the ZCYC is not directly observable in the market, and is not representative in an illiquid market, participants were not willing to accept a product which was priced off a theoretical ZCYC. In response to this ‘felt-need’, the SEBI proposed in January 2004, a contract based on weighted average YTM of a basket of securities.

6. However, as regards cash settlement of IRF contracts proposed earlier, the Group was of the opinion that while the money market futures may continue to be cash-settled with the 91 day T-Bills/MIBOR/ or the actual call rates serving as benchmarks, the bond futures contract/s would have to be physically-settled, as is the case in all the developed, and mature, financial markets, worldwide. Although, very few contracts are actually carried to expiration and settled by physical delivery, it is the possibility of final delivery that ties the spot price to the futures price. In any futures contract, the key driver of both price discovery, and pricing, is the so called 'cash-futures-arbitrage', which guarantees that the futures price nearly always remained aligned, and firmly coupled, with the price of the ‘underlying’ so that the futures deliver on their main role viz., that of a ‘true hedge’. Cash-futures arbitrage cannot occur always if contracts are cash-settled due to a very real possibility of settlement price being discrepant / at variance with the underlying cash market price – whether because of manipulation, or otherwise - at which the long will ultimately offload / sell. Last, but not the least, any suggestion of artificial/manipulated prices can severely undermine Government’s ability to borrow at fair and reasonable cost.

7. As regards the specific product, the Group was of the view that to begin with it would be desirable to introduce a futures contract based on a notional coupon bearing 10-year bond, 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 GoI securities, or those of any other maturities, or coupons. 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 respective exchanges.

8. The Group was of the view that delivery-based, longer term / tenor / maturity short-selling of the underlying GoI Securities, co-terminus with that of the futures contract is a necessary condition to ensure that cash-futures arbitrage, deriving from the ‘law of one price’ / ‘no arbitrage argument’, aligned prices in the two markets. Hence, to begin with, delivery-based, longer term / tenor / maturity short selling in the cash market may be allowed only to banks and PDs, subject to the development of an effective securities lending and borrowing mechanism / a deep, liquid and efficient Repo market.

9. The Group further felt that with the introduction of delivery-based, longer term short-selling in GoI securities and IRF, as recommended, the depth, liquidity and efficiency of GoI securities will considerably improve on account of seamless coupling through arbitrage between IRS, IRF and the underlying GoI securities, which, in turn, would be seamlessly transmitted to the corporate debt market.

10. The RBI (Amendment) Act 2006 vests comprehensive powers in the RBI to regulate interest rate derivatives except issues relating to trade execution and settlement which are required to be left to respective exchanges. The Group was of the view that considering the RBI’s role in, and responsibility for, 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.

11. Under the existing regulatory regime, while banks are allowed to take hedging as well as trading positions in IRS / FRAs, they are permitted to use IRFs only for hedging. However, Primary Dealers (PDs) are allowed to take both trading and hedging positions in IRFs. As banks constitute the single most dominant segment of the Indian financial sector, in order to re-activate the IRF market, and reduce uni-directionality, it is imperative that banks be also allowed to contract IRF not only to hedge interest rate risk inherent in their balance sheets (both on and off), but also to take trading positions, subject, of course, to appropriate prudential/ regulatory guidelines.

12. In the present dispensation, as banks can classify their entire SLR portfolio as 'held-to-maturity' and, which, therefore, does not have to be marked to market, they have no incentive to hedge risk in the market. Since a deep and liquid IRF market will provide banks with a veritable institutional mechanism for hedging interest rate risk inherent in the statutorily-mandated SLR portfolio, the Group was of the considered view that the present dispensation be reviewed synchronously with the introduction of IRF, as given the maturity, and considerable experience of banks with the IRS, the same policy purpose will be achieved transparently through a market-based hedging solution.

13. Besides, it will only be appropriate that the accounting regime be aligned across participants and markets with similar profile. Currently, there exists divergent / differential accounting treatment for IRS and IRF. While the Accounting Standards (AS) 30 recently issued by the ICAI - which prescribes convergence of accounting treatment of all financial instruments in line with the international best practice - is expected to remedy the situation, the standard shall not become mandatory until 2011. Therefore, in the interregnum, the RBI may consider exercising its overarching powers over interest rate derivatives and GoI securities markets under the RBI (Amendment) Act, 2006, and mandate uniform accounting treatment for IRS and IRF.

14. At present, FIIs have been permitted to take position in IRF up to their respective cash market exposure (plus an additional USD 100 million) for the purpose of managing their interest rate risk. Considering the number of FIIs and sub-accounts, the additional USD 100 million allowed per FII would imply a total permissible futures position of USD 128.3 billion, which would be far in excess of the currently permitted limit of USD 4.7 billion. Since long position in cash market is similar to long position in futures market, FIIs may be allowed to take long position in the IRF market subject to the condition that the gross long position in the cash market as well as the futures market does not exceed the maximum-permissible cash market limit which is currently USD 4.7 billion. FIIs may also be allowed to take short positions in IRF, but only to hedge actual exposure in the cash market upto the maximum limit permitted. The same may, mutatis mutandis, also apply to NRIs’ participation in the IRF.

Interest Rate Futures (IRF) were introduced in India in June 2003 on the National Stock Exchange (NSE) through launch of three contracts - a contract based on a notional 10-year coupon bearing bond, a contract based on a notional 10-year zero coupon bond and a contract based on 91-day Treasury bill. All the contracts were valued using the Zero Coupon Yield Curve (ZCYC). The contracts design did not provide for physical delivery. The IRF, ab initio, failed to attract a critical mass of participants and transactions, with no trading at all thereafter. A proposal for change in the product design - introducing pricing based on the YTM of a basket of securities in lieu of ZCYC - was made in January 2004 but has not been implemented.

1.2 In the background of this experience with the IRF product, amidst an otherwise rapidly evolving financial market, the Reserve Bank’s Technical Advisory Committee (TAC) on Money, Foreign Exchange and Government Securities Markets in its meeting in December 2006 and July 2007, discussed the need for making available a credible choice of risk management instruments to market participants to actively manage interest rate risk. On the suggestion of the TAC, the Reserve Bank of India (RBI) on August 09, 2007, set up a Working Group on IRF under the Chairmanship of Shri V K Sharma, Executive Director, RBI with the following terms of reference:

(i) To review the experience with the IRF so far, with particular reference to product design issue and make recommendations for activating the IRF.

(ii) To examine whether regulatory guidelines for banks for IRF need to be aligned with those for their participation in Interest Rate Swaps (IRS).

(iii) To examine the scope and extent of the participation of non-residents, including Foreign Institutional Investors (FIIs), in IRF, consistent with the policy applicable to the underlying cash bond market.

(iv) To consider any other issues germane to the subject matter.

1.3 The constitution of the Working Group was as follows: 

1.4 The Group met on August 16, September 25 and November 30, 2007. The Group benefited from the contributions of Shri Anand Sinha, Executive Director, RBI, Shri Pavan Sukhdev³, MD & Head of Global Markets, India, Deutsche Bank AG and Shri S Balakrishnan, Management Consultant, who participated in the Group’s meetings as invitees.

1.5 The rest of this Report is organized as follows. Chapter 2 reviews the experience with IRF in the Indian markets and provides a backdrop to the subsequent Chapters. Chapter 3 discusses imperatives of symmetry across cash and futures markets, participants including banks, regulatory and accounting issues. Chapter 4 deals with the specific issue of participation of non-residents, particularly FIIs, in the IRF markets. Chapter 5 nuances product design issues such as imperatives of physical settlement of the bond futures contract. Chapter 6 summarizes the key observations and recommendations of the Group.

1.6 One of the Members of the Group, Dr. Susan Thomas, submitted a note on her reservations on some of the recommendations of the Group which is appended.

1.7 The Report has three Annexes: Memorandum setting up Working Group, a study on cross-country practices in IRF and an illustrative design for a contract based on settlement by physical delivery.

2.1 In the wake of deregulation of interest rates as part of financial sector reforms and the resultant volatility in interest rates, a need was felt to introduce hedging instruments to manage interest rate risk. Accordingly, in 1999, the Reserve Bank of India took the initiative to introduce Over-the-Counter (OTC) interest rate derivatives, such as Interest Rate Swaps (IRS) and Forward Rate Agreements (FRA). In November 2002, a Working Group under the Chairmanship of Shri Jaspal Bindra⁴ was constituted by RBI to review the progress and map further developments in regard to Interest Rate Derivatives (IRD) in India. On the recommendation of the High Level Committee on Capital Markets (HLCC), the Bindra Group also examined the issues relating to Exchange Traded Interest Rate Derivatives (ETIRD).

2.2 In its report (January 2003), the Bindra Group discussed the need for ETIRD to create hedging avenues for the entities that provide OTC derivative products and listed anonymous trading, lower intermediation costs, full transparency and better risk management as the other positive features of ETIRD. It also discussed limitations of the OTC derivative markets viz., information asymmetries and lack of transparency, concentration of OTC derivative activities in major institutions, etc. The Bindra Group favored a phased introduction of products but suggested three bond futures contracts that were based on indices of liquid GoI securities at the short, the middle and the long end of the term structure. The Bindra Group also considered various contracts for the money market segment of the interest rates and came to a conclusion that a futures contract based on the overnight MIBOR would be a good option.

2.3 The Security and Exchange Board of India’s (SEBI) Group on Secondary Market Risk Management also considered introduction of ETIRD in its consultative document prepared in March 2003. Concurring with the recommendations of the Bindra Group, the SEBI Group considered various options in regard to launching IRF and recommended a cash-settled futures contract, with maturities not exceeding one year, on a 10-year notional zero-coupon bond. It is pertinent to mention that the Group recognized the advantages of physical settlement over cash settlement. However, it recommended that ‘the ten year bond futures should initially be launched with cash settlement’ because of possibility of squeeze caused by low outstanding stock of GoI securities, lack of easy access to GoI security markets for some participants (particularly households) and absence of short selling.

2.4 Accordingly, in June 2003 IRF was launched with the following three types of contracts for maturities up to 1 year on the NSE.

• Futures on 10-year notional GoI security with 6% coupon rate
• Futures on 10-year notional zero-coupon GoI security
• Futures on 91-day Treasury bill

2.5 While the product design issues were primarily handled by the exchanges and their regulators, RBI permitted the Scheduled Commercial Banks (SCBs) excluding RRBs & LABs, Primary Dealers (PDs) and specified All India Financial Institutions (AIFIs) to participate in IRF only for managing interest rate risk in the Held for Trading (HFT) & Available for Sale (AFS) categories of their investment portfolio. Recognizing the need for liquidity in the IRF market, RBI allowed PDs to hold trading positions in IRF subject, of course, to prudential regulations. However, banks continued to be barred from holding trading positions in IRF. It may be mentioned that there were no regulatory restrictions on banks’ taking trading positions in IRS. Thus SCBs, PDs and AIFIs could undertake IRS both for the purpose of hedging underlying exposure as well as for market making with the caveat that they should place appropriate prudential caps on their swap positions as part of overall risk management.

2.6 In terms of RBI’s circular, SCBs, PDs and AIFIs could either seek direct membership of the Futures and Options (F&O) segment of the stock exchanges for the limited purpose of undertaking proprietary transactions, or could transact through approved F & O members of the exchanges.

2.7 As far as the accounting norms were concerned, pending finalization of specific accounting standards by the Institute of Chartered Accountants of India (ICAI), it was decided to apply the provisions of the Institute’s Guidance Note on Accounting for Equity Index Futures, mutatis-mutandis, to IRF as an interim measure. The salient features of the recommended accounting norms were as under:

2.7.1 Since transactions by banks were essentially for the purpose of hedging, the accounting was anchored on the effectiveness of the hedge.

2.7.2 Where the hedge was appropriately defined and was ‘highly effective’⁵, offsetting was permitted between the hedging instruments and hedged portfolio. Thereafter, while net residual loss had to be provided for, net residual gains if any, were to be ignored for the purpose of Profit & Loss Account.

2.7.3 If the hedge was not found to be ‘highly effective’, the position was to be treated as a trading position, till the hedge effectiveness was restored and accounted for with daily MTM discipline, but with asymmetric reckoning of losses and gains; while the losses were to be reckoned, gains were to be ignored.

2.7.4 In the case of trading positions of PDs, they were required to follow MTM discipline with symmetric reckoning of losses and gains in the P&L Account.

2.8 On the other hand, the accounting norms for the IRS were simply predicated on fair value accounting without any explicit dichotomy between recognition of loss and gain. The general principles followed were as follows:

2.8.1 Transactions for hedging and market making purposes were to be recorded separately.

2.8.2 Transactions for market making purposes should be MTM, at least at fortnightly intervals, with changes recorded in the income statement.

2.8.3 Transactions for hedging purposes were required to be accounted for on accrual basis.

2.9 While Rupee IRS, introduced in India in July 1999, have come a long way in terms of volumes and depth, the IRF, ab initio, failed to attract a critical mass of participants and transactions, with no trading at all thereafter. Since both the products belong to the same class of derivatives and offer similar hedging benefits, the reason for success of one and failure of the other can perhaps be traced to product design and market microstructure. Two reasons widely attributed for the tepid response to IRF are:

2.9.1 The use of a ZCYC for determining the settlement and daily MTM price, as anecdotal feedback from market participants seemed to indicate, resulted in large errors between zero coupon yields and underlying bond yields leading to large basis risk between the IRF and the underlying. Put another way, it meant that the linear regression for the best fit resulted in statistically significant number of outliers.

2.9.2 The prohibition on banks taking trading positions in the IRF contracts deprived the market of an active set of participants who could have provided the much needed liquidity in its early stages.

2.10 In late 2003, an attempt to improve the product design was made by SEBI in consultation with RBI and the Fixed Income Money Market and Derivative Association of India (FIMMDA). Accordingly, in January 2004, SEBI dispensed with the ZCYC and permitted introduction of IRF contracts based on a basket of GoI securities incorporating the following important features:

• The IRF contract was to continue to be cash-settled.
• The IRF contract on a 10-year coupon bearing notional bond was to be priced on the basis of the average ‘Yield to Maturity’ (YTM) of a basket comprising at least three most liquid bonds with maturity between 9 and 11 years.
• The price of the futures contract was to be quoted and traded as 100 minus the YTM of the basket.
• In the event that bonds comprising the basket become illiquid during the life of the contract, reconstitution of the basket shall be attempted, failing which the YTM of the basket shall be determined from the YTMs of the remaining bonds. In case 2 out of the 3 bonds comprising the basket become illiquid, polled yields shall be used.

However, the exchanges are yet to introduce the revised product.

2.11 In December 2003, an internal working group of the RBI headed by Shri. G Padmanabhan, then CGM, Internal Debt Management Department (IDMD), evaluated the regulatory regime for IRD, both OTC as well as exchange-traded, with a view to recommending steps for rationalization of the existing regulations. Starting with the premise that the regulatory regime in respect of both products which belong to the same family of derivatives should be symmetrical, the working group recommended removing anomalies in the regulatory, accounting and reporting frameworks for the OTC derivatives (IRS / FRA) and IRF. Among the principal recommendations were allowing banks to act as market makers by taking trading positions in IRF and convergence of accounting treatment in respect of both the products.

3.1 One of the basic principles governing regulation of financial markets is that there should be symmetry across markets as well as across products which are similar. Any asymmetry in this regard is likely to create opportunities for regulatory arbitrage and other inequities. As mentioned in the previous chapter, an earlier Working Group had brought out several areas of divergence in this regard between the OTC and exchange-traded segments of Interest Rate Derivatives, identifying limited participation of banks in IRF as a major hindrance to its development.

3.2 The existing regulatory regime is asymmetrical / anomalous in that (i) a Primary Dealer (PD) is allowed to hold trading positions in IRF whereas a bank is not, and (ii) a bank is allowed to hold trading positions in IRS but not in IRF. The first asymmetry / anomaly is further reinforced by the fact that many PDs have since folded back into their parent banks and as on date out of 19 PDs, 10 are bank PDs.

3.3 The success of any financial product, at least in the early stages, critically depends not only upon the presence of market makers but also on their credibility and ability to provide liquidity. It is true that the order-driven, exchange traded products do not need market makers in the same manner as the quote-driven OTC ones do; they nevertheless need liquidity which is imparted by active traders. At the time of initial launch of IRF, only PDs were allowed to take trading positions. Considering that subsequently many PDs have reverse-merged with their parent banks, it has become so much more imperative that banks be also allowed to take trading positions which will be symmetrical with what they are currently allowed to do in the IRS market.

3.4 The large volumes traded in IRS market owe themselves to a number of factors. First, banks were allowed, right from day one, to play a market making role by taking trading positions. This incentivised the market-savvy banks to play an active role and provide liquidity to the product. Second, notwithstanding the fact that IRS may not provide the most appropriate hedge for fixed income portfolios (which predominantly comprise GoI securities) because of the ‘disconnect’ between the IRS rates and yields on GoI securities, it may have been used for hedging due to lack of any other alternative competing product. Thirdly, anecdotal evidence in conjunction with large volumes traded in the IRS seem to suggest that it is used more widely as an instrument of speculation because of its inherent characteristics of cash settlement and high leverage due to absence of any margins.

3.5 The Group, therefore, unequivocally feels that the current restriction limiting banks’ participation in IRF to only hedging their interest rate risks should be done away with and that banks be freely allowed to take trading positions in IRF, depending on their risk appetite, symmetrically with the underlying cash market and IRS market. Needless to mention, banks shall have to put in place appropriate structures for identification and management of risks inherent in the trading book. Besides, they should be subject to prudential regulations of RBI as well as risk management requirements of the exchange(s). Integrated risk management framework should apply symmetrically to cash as well as interest rate derivatives viz., IRS and IRF.

3.6 International accounting practices are currently seeing a move towards standardization and convergence in respect of all financial instruments including derivatives. While Financial Accounting Standards Board (FASB) of the US has its own standards codified in FASB 133, International Accounting Standards Board (IASB) has formulated IAS 39 which has been adopted in many countries including the Euro-zone. The Institute of Chartered Accountants of India has also issued Accounting Standard (AS) 30, which incorporates the norms for recognition and measurement of all financial instruments in line with IAS 39 and other international best practice. These norms would ensure consistency not only across all financial instruments, cash and derivatives, but also across all participants, be it banks or corporates. However, AS 30 issued by the ICAI will come into effect from April 1, 2009 and will be only recommendatory in nature until 2011. Moreover, it will also require appropriate endorsement by the regulatory authorities for full implementation of the new accounting standards.

3.7 As has been mentioned earlier, there is no asymmetry in the accounting treatment across IRF and IRS insofar as these instruments are held for trading purposes - IRF by PDs and IRS by banks, PDs and AIFIs. Both the instruments are required to be MTM at periodic intervals with transfer of gains / losses to the P&L account. It is presumed that when banks are allowed to take up trading positions in IRF, identical accounting treatment would be extended to them as well. The Group notes that this accounting practice is in conformity with the international best practice.

3.8 There is, however, a dichotomy in the treatment of IRF and IRS held by entities for the purpose of hedging. While in case of IRF, a detailed procedure based on hedge effectiveness has been laid out, in case of IRS, accrual accounting has been prescribed without any amplification / clarification. This, as documented in the report of the Working Group headed by Shri Padmanabhan, has led to divergent accounting practices among the banks insofar as use of IRS as a hedge is concerned. Some banks take the entire portfolio of IRS in their trading books. Some others, whose parent entities conform to IAS / FASB, adopt the principle of effective hedge akin to the method prescribed for IRF. Yet others adopt a more conservative approach as presently prescribed by RBI for fixed income securities i.e. ignoring the notional gains and recognizing the notional loss and transferring it to the P&L Account⁶.

3.9 In this context, the Group felt that in case it is decided to bring into effect the recommended course of action for revitalizing the IRF markets, it would be necessary to spell out the accounting treatment for IRF as also to ensure that there is symmetry not just between the accounting treatment for IRF and IRS, but also between the derivatives and the underlying.

3.10 The Group recognizes the imperative of permitting short selling in the cash market symmetric to futures market. At present, short selling in the cash market is restricted to five days. A short position in futures contract is equivalent, in effect, to short selling the corresponding ‘underlying’ GoI security.

3.11 There is a very cogent rationale of 'cash futures arbitrage' which alone ensures the 'connect' between the two markets throughout the contract period and also forces convergence between the cash and futures markets, at settlement. In case of discrepancy in prices between the cash market and derivatives market like futures, cash-futures arbitrage, deriving from the ‘law of one price’ / ‘no-arbitrage argument’, will quickly align the prices in the two markets. Specifically, if futures are expensive / rich relative to the cash market, i.e. if the actual Repo rate is less than the implied Repo rate, arbitrageurs will go long the GoI security in the cash market by financing it in the Repo market at the actual Repo rate and short the futures contract, thus realizing the arbitrage gain, being the difference between the implied Repo rate and actual Repo rate. On the other hand, if the futures are cheap relative to the cash market, i.e. if the actual Repo rate is more than the implied Repo rate, arbitrageurs will short the cash market by borrowing the GoI security, for a period exactly matching the tenor / maturity of the futures contract, in the Repo market for delivery into short sale, investing the sale proceeds at the actual Repo rate and go long the bond futures, thereby realizing the arbitrage gain, being the difference between actual Repo rate and implied Repo rate! In either case, such arbitrage-driven trades will inevitably settle at expiration of the contracts by physical delivery with risk-free arbitrage profits being realized.

3.12 In view of the above, the present restriction of five days on short selling in the cash market needs to be revisited. This will depend on the development of effective securities lending and borrowing mechanism / a deep, liquid and efficient Repo market. Subject to these, and other safeguards currently applicable, the short selling period will have to be extended to be co-terminus with the maturity of futures contract. The risk concerns with delivery-based, longer term / tenor / maturity short selling, co-terminus with futures term / tenor /maturity can be equally effectively addressed by the same set of symmetrical prudential regulations as are applicable to futures contracts. Accordingly, the Group recommends that delivery-based, longer term / tenor / maturity short selling co-terminus with futures term / tenor / maturity, be allowed to banks and PDs, subject to the development of an effective securities lending and borrowing mechanism / a deep, liquid and efficient Repo market. It is pertinent also to appreciate that permitting short selling in GoI securities alone will not work in the absence of a liquid and an efficient Repo market. By extension, it can be said that success of IRF would depend upon the vibrancy of the Repo market. In this context the Group noted that the collateralized market is dominated by Collateralized Borrowing and Lending Obligation (CBLO) which is akin to a tri-partite Repo. Notwithstanding the efficiency of the CBLO as a money market instrument as well as for financing the securities portfolio, the fact remains that it cannot serve the purpose of a ‘short’ that needs to borrow a specific security for fulfilling its delivery obligation. While removal of restriction on short selling and introduction of IRF shall provide an impetus to the demand for borrowing securities in the Repo Market, the supply is likely to be fragmented between the Repo and the CBLO market. The Group felt that for the success of IRF, it would be necessary to improve the depth, liquidity and efficiency of the Repo market, for which, the Group felt, it was necessary to replace the existing regulatory penalty for SGL bouncing with transparent and rule-based pecuniary penalties for instances of SGL bouncing.

3.13 Introduction of IRF along with delivery-based, longer tenor short selling (co-terminus with the tenor / maturity of the IRF) will not only impart liquidity and depth to the GoI securities market but will also, as a logical, and natural, concomitant, deliver liquidity and depth to the corporate debt market. The comfort of being able to hedge their interest rate risks through short selling of GoI securities or shorting the IRF will enable the market-makers in corporate debt securities to make two way prices in the corporate debt with very tight bid-offer spreads. In other words, the resultant liquidity and depth in the GoI securities will be seamlessly transmitted to / replicated in the corporate debt market, which will, in turn, facilitate mobilizing much needed financial resources for the infrastructure sector.

3.14 In the USA, the Commodities Futures Trading Commission (CFTC) regulates all exchange traded futures contracts, including those on commodities, foreign exchange, interest rates and equities. In Germany, it is BaFIN (the Federal Financial Supervisory Authority), in the UK, it is the Financial Services Authority (FSA) and in Japan it is the Financial Services Agency which have omnibus regulatory jurisdiction over all exchange-traded futures contracts.

3.15 In India, in terms of the section 45W read with 45 U (a) of chapter III D⁷ of RBI Act, 1934, the RBI is vested with authority ‘to determine the policy relating to interest rate products and give directions in that behalf to all agencies…’ The Act also provides that the directions issued under the above provision shall not relate to the procedure of execution or settlement of trades in respect of the transactions on the stock exchanges recognized under section IV of the Securities Contract (Regulation) Act (SCRA), 1956.

3.16 The RBI has a critical role inasmuch as it regulates the market for the underlying viz., Government Securities, as also a significant part of the participants’ viz., banks and PDs. The overall responsibility of ensuring smooth functioning of the financial markets as well as ensuring financial stability rests with the RBI. This position has been comprehensively recognized, and provided for, in the legislation mentioned in the earlier paragraph.

3.17 The RBI (Amendment) Act 2006 vests comprehensive powers in the RBI to regulate interest rate derivatives except issues relating to trade execution and settlement which are required to be left to respective exchanges. The Group was of the view that considering the RBI’s role in, and responsibility for, 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.

4.1 Non-residents including FIIs are prohibited, under the provisions of Foreign Exchange Management Act (FEMA), 2000, to undertake any capital account transaction unless generally or specifically permitted by RBI. In this context, it is pertinent to mention that since 1996, the FIIs have been allowed to invest in GoI securities and corporate bonds within a limit which has been progressively revised upwards and presently stands at USD 4.7 billion with a sub-limit of USD 3.2 billion for GoI securities and USD 1.5 billion for corporate bonds.

4.2 FIIs have been permitted by RBI⁸ to take position in IRFs up to their respective cash market exposure in the GoI securities (book value) plus an additional USD 100 million each. If each of the registered FIIs were to take position within the permitted limits, the total exposure of FIIs will come to USD 128.3 billion, far in excess of the currently permitted limit for investment / long position in the cash market, which is USD 4.7 billion!

4.3 Public policy symmetry demands that what an entity is not allowed to do in the cash market, it should not be allowed to do in the derivatives market. As a corollary, it follows that an entity should be allowed to take position in the derivatives market only to the extent it is permitted to do so in the cash market. In view of the above overriding limitation, the Group makes the following observations:

4.3.1 The basic purpose that IRF serve is to provide a means for hedging interest rate exposures of economic agents. Since FIIs are permitted to hold long position in GoI securities (and also corporate bonds), they have an interest rate risk and therefore, it would be in order if they are allowed to take short position in IRF, only to hedge exposure in the cash market up to the maximum permitted limit, which is currently USD 4.7 billion.

4.3.2 A long position in the IRF is equivalent to a long position in the underlying. It follows, therefore, that FIIs be allowed to take long position in IRF market as an alternative strategy to investing in GoI securities, subject, of course, to the caveat that the total gross⁹ long position in both cash and futures market taken together should not exceed the limit of investment in GoI securities (and corporate bonds) in force – currently USD 4.7 billion.

4.3.3 At present, the limit of total FII investment in GoI securities and corporate bonds is fixed at an aggregate level, but it is allocated amongst individual FIIs and monitored / enforced as such. For reasons of symmetry, it is only appropriate that the various limits on FIIs exposures in the IRF (and also in the underlying) be fixed, monitored and enforced at an individual level. Since all the positions uniquely flow from the permitted limit of cash market investment, the proposed regime shall be but an extension of the existing structure for fixing, monitoring and enforcing the latter limit and shall not place any additional burden on the regulatory framework.

4.4 Accordingly, the Group recommends that participation of FIIs in the IRF be subject to the following:

a) Its total gross long position in cash market and IRF together does not exceed the permitted limit on its cash market investment,
b) Its short position in IRF does not exceed its actual long position in cash market.

The same may, mutatis mutandis, also apply to NRIs participation in IRF.

4.5 It is evident that the regime discussed above does not admit a FII taking short position in IRF without any long position in the cash market. There can be valid arguments in favour of allowing FIIs such positions as these entities carry considerable market experience with them and can, therefore, play a significant role if permitted wide access to the IRF market. However, considering the nascent stage of development of the IRF and bearing the spirit behind the restrictions on their cash market exposures in mind, the Group felt that the regime proposed in the paragraph 4.4 above would be appropriate at the current stage of Capital Account Liberalization.

CHAPTER 5

PRODUCT DESIGN & SOME ISSUES RELATING TO MARKET MICROSTRUCTURE

1. Working Group on Over-the-Counter Rupee Derivatives (Jan 2003), RBI, (Chairman: Jaspal Bindra)

2. Exchange Traded Interest Rate Derivatives in India, Consultative Document, Group on Secondary Market Risk Management, Securities and Exchange Board of India, (March 2003)

3. Group on Rupee Interest Rate Derivatives (Dec 2003), RBI, (Chairman: G Padmanabhan)

4. Arrow, Kenneth J (1953): 'The Role of Securities in the Optimal Allocation of Risk-Bearing', Econometrie

5. Boberski, David (2007): ' Valuing Fixed Income Futures', Mcgraw-Hill Library

6. Cornell, B. (1997): 'Cash settlement when the underlying securities are thinly traded: A case Study', The Journal of Futures Markets

7. Das, Satyajit (Sep 2005): 'Derivative Products & Pricing: The Swaps & Financial Derivatives', John Wiley & Sons Inc

8. Hull, John C. (2006): 'Options Futures and other derivatives'

9. Kumar, Praveen and Seppi, Duane J. (Sep, 1992): 'Futures Manipulation with Cash Settlement', The Journal of Finance, Vol. 47, No. 4.

10. Lien, Donald and Tse, Yiu Kuen (Nov, 2003): 'A Survey on Physical Delivery versus Cash Settlement in Futures Contracts' , SMU Economics and Statistics working paper series, Paper No. 19-2003

11. Pirrong, Craig (Apr, 2001): 'Manipulation of Cash-Settled Futures Contracts', The Journal of Business, Vol. 74, No. 2.

12. The Treasury Futures Delivery Process (Feb, 2007), 4^th Edition, Chicago Board of Trade.

13. 'An Investigation of Cheapest to Deliver on Treasury Bond Futures Contracts,' (with Zvi Wiener). Journal of Computational Finance, vol. 2, number 3, Spring 1999, pp. 35-55

¹Shri Gambhir was replaced by Shri V Srikanth, who succeeded him as the Chairman of FIMMDA.

²Shri Lateef retired from service before completion of the Group's task.

³In the absence of Shri Sukhdev, Shri Ananth Narayanan, Deutsche Bank participated in one of the meetings.

⁴Then CEO, Standard Chartered Bank, India

⁵The definition of effectiveness broadly followed the principles mentioned in IAS-39

⁶This, however, is at variance with international best practice which treats all financial instruments -
derivatives as well as the underlying - symmetrically, with MTM and recognition of gains/losses.

⁷Introduced vide The Reserve Bank of India (Amendment) Act, 2006 (Act No 26 of 2006)

⁸Cf. circular dated EC.CO.FII/347/11.01.01 (22)/2003-04 dated July 11, 2003.

⁹The rationale for not allowing netting of exposures in cash and spot markets is that the FIIs could otherwise take infinitely large positions in the two markets that offset each other and comply with the letter but contravene the spirit of the current public policy governing the cash market exposure, which is currently capped at USD 4.7 billion (USD 3.2 billion for GoI securities and USD 1.5 billion for corporate bonds).

¹⁰Arrow (1953)

¹¹Manipulation of physically settled futures markets is relatively common in case of commodities such as crude,
metals etc. A classic example of strategic and manipulative squeeze is the one in the silver futures market
engineered by the Hunt brothers in 1980.

¹²Hull (2006)

¹³Cornell, Bradford (1997), Jones (1982), Garbade and Silber (1983)

¹⁴See, eg. Lien, D and Tse, Y K (2006)

¹⁵Quoted in Lien, D and Tse, Y K (2006)

¹⁶It may be mentioned that the Treasury bills based futures contracts on the CME settle to the weekly U.S.
Treasury bill auction rate. (cf. http://www.cme.com/trading/prd/ir/13weektbills.html)

¹⁷The rate of return that can be obtained from selling a debt instrument futures contract and simultaneously
buying a security deliverable against that futures contract with borrowed funds. Therefore, the bond or note with
the highest implied repo rate is cheapest to deliver.

¹⁸When the market yield is greater (lower) than the notional coupon, the CTD will be the security with highest (lowest) duration. This proposition may not carry analytical rigor but is used as a convenient thumb rule for economically relevant cases. See Benninga and Wiener (1999)

¹⁹See http://www.cbt.com/cbot/pub/cont_detail/0,3206,1413+701,00.html

²⁰DBOD No FSC BC 60/24.76.002/2002-03 dated January 16, 2003 and IDMC PDRS No 2896/03.05.00/2002-03 dated January 14, 2003.

²¹The statistic for Government Securities includes the outstanding amount of Central Government dated
securities & Treasury Bills and State Development Loans

²²The statistic for Corporate Bonds also includes Bonds/ Debenture issued by PSUs, FIs and Local Bodies
(Source: NSDL News letter - January 2008)

²³One of the Members of the Group, Dr Susan Thomas, was of the view that existence of a deep, liquid
and efficient Repo market was not a necessary pre-condition for success of IRF.

²⁴ One of the members of the Group, Dr Susan Thomas, was of the view that bond futures do not have to
be physically settled.