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R. Viswanathan

Gambling by any other name, be it “price discovery”, “improving liquidity”, “widening and deepening the market”, or “conforming to global practices” cannot shed its basic characteristics.

The recently (re)introduced interest rate futures (IRF) in the market would be largely indulged in for speculative, a.k.a gambling, purposes. In this market, banks have been given unlimited access from the end of August 2009. This policy needs to be reviewed by the authorities, as discussed in this article.

IRF is really a contract for buying/selling debt instruments. The price of a fixed interest bearing bond is related to the current market interest vis-À-vis the coupon rate. If the market interest rate goes up, the value of the bond will go down and vice versa. Therefore, the contract is called IRF. Universally, IRF is based on Government securities, whether short- or long-term. In India also, IRF is related to the price of Government securities and Treasury Bills. IRF was introduced in 2003 in India. The product did not evoke response from market participants and was withdrawn. One major constraint voiced then was that the banks were restricted to only hedging their portfolio of G-securities. IRF was repackaged and made its debut in the new avatar on August 31, 2009. The major changes were: 1. Banks are now allowed to trade to any extent irrespective of the value of their G-securities portfolio. 2. In 2003, the settlement was cash based, that is, buyer and seller paid/received cash for the amount due, but now, it will be physically settled, viz., they have to give/receive G-securities for the amount due.

IRF deals dominate the derivative markets world over. Derivatives, which derive their value from an underlying financial instrument, commodity or future cash receipts, are traded either in the “over the counter” (OTC) market or in the exchanges. Forward contracts fall in the first category and futures are traded in the exchanges. The main advantage of the latter is that there is no credit risk, viz., default by any party to perform, whereas in the OTC markets, this risk is real. It is because in futures, the exchanges guarantee performance, by taking suitable margins from the dealers/participants. Another advantage is that deals in OTC market are opaque, that is, are not publicly disclosed, whereas in exchange deals, information is widely available. These two benefits were rightly emphasised by the top management of RBI, SEBI and NSE, when the product was launched on the August 31, 2009.

The conceptual logic supporting IRF is that it can be used as a hedge against future uncertainties in bond price. For example, if a bank has invested Rs 100 crore in a GoI bond with a yield to maturity of 7.2 per cent and it is traded at par, because the ruling market rate for such a bond is also 7.2 per cent. It desires to sell the bond after 12 months, but is apprehensive that the interest rate could go up by then and the value of the bond will go down. It can then enter into an IRF maturing after 12 months at the yield rate of 7.2 per cent. In case the interest rate does go up and the bond value comes down, the bank will still get a price of Rs 100 crore for the bonds. Similarly, if the bank decides to purchase GoI bonds at a future date, say after 6 or 12 months, it can lock its price at current ruling rate by purchasing IRF.

Reality is, however, different in the markets. When the RBI stipulated in 2003 that banks could only hedge their portfolio, the market did not pick up at all. Thus, market is made only when banks and other participants use IRF for speculative purposes. Perhaps endorsing this view, The Economist magazine has mentioned in its October 17-23 issue that “many non-financial firms hold derivative positions far in excess of their hedging needs”. Non financial companies in India would also trade in IRF largely for speculative purposes because very few, if any, such companies invest in G-securities. Even if some of them invest in corporate debt securities, the price of these need not move in alignment with G-securities. This was proved a decade ago when a leading hedge fund in US, Long Term Capital Management took huge bets on the premise that prices of corporate bonds and G-securities would move in tandem and lost heavily, as the two prices moved in opposite directions. Banks and financial firms are also expected to take positions in the IRF market, much above what their portfolio of G-securities warrants. Thus, both parties to the IRF transactions would only be speculating (gambling) on the future prices of G-securities without any need to hedge their portfolio.

At present, Indian banks operate conservatively as they should, being custodians of the nation’s savings. If banks take to speculative activities, then their very fabric could be shaken over time. Granted, some legitimate activities of banks call for taking a view on the future course of events, but these risks are within reasonable limits and are for investments in the real sector of the economy. Since there seems to be a general euphoria about IRF among many knowledgeable people, RBI should at least stipulate certain overall quantitative restrictions on banks on the total amount invested in this business. For example, it could be stipulated that the total exposure of banks in IRF should not exceed 10 per cent of their net worth. This itself is a fairly substantial amount, the aggregate capital and reserves of scheduled commercial banks being around Rs 3,68,255 crore as on March 31, 2009, according to the RBI report on trend and banking in India. 10 per ent would be about Rs 36,825 crore. As against this amount, the daily traded volume in IRF was reportedly around Rs 6,000 crore in September 2009 in NSE.

Suggestion of a ceiling on banks’ exposure to IRF is more to protect the smaller banks. The bigger banks would, hopefully, install sophisticated systems to measure, monitor and manage risks in IRF. Even if they take undue risks, the Government will always come to their rescue on the principle of “too big to fail”, which operates even in the US and UK. It is the smaller banks that could be exposed to unmanageable risks by indulging in IRF and other derivatives. Public memory is short, but one 100-year-old private bank collapsed about 10 years ago in India by actively trading and losing big in the secondary stock market, due to the alleged goading of some of its directors who were stock brokers. Will the RBI impose some quantitative ceiling on IRF trades of banks before the business pulls down a small private bank?

(The author is former Deputy Managing Director of SBI)

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