Interesting calibration

The RBI’s new rules relating to rupee interest rate derivatives are an attempt to promote more activity in this segment, while ensuring that vulnerable retail users are protected. Interest rate derivatives are among the most popular derivative instruments globally, and the central bank is right in ensuring that its users are not unnecessarily restrained. According to the Bank of International Settlements, notional amounts outstanding in OTC interest rate derivatives towards the end of June 2018 was $193 trillion; this was also the fastest growing derivative segment. With the ongoing trade war and geo-political tensions leading to a global slowdown, prompting central banks including the Federal Reserve to halt interest rate hikes, uncertainty global interest rates has increased. This makes it imperative for retail as well as non-retail investors to hedge their interest rate risks. The RBI is attempting to streamline rules governing the trading of these instruments in the stock exchanges and the inter-bank over the counter market, in order to meet the higher demand for IRD.

Given the complexity of these instruments and the difficulty in judging the direction of interest rate movements, the RBI is right in specifying that instruments traded in the OTC market such as the forward rate agreements, interest rate options and European Interest Rate Options can be offered to retail users only for hedging interest rate risk. Non-retail users, who have more financial resources and understand these products better, can use these products for trading or speculation. It is also a good idea to restrict complex products such as swaptions and structured derivative products to non-retail users. The central bank is also trying to usher in greater transparency by laying down that floating interest rates or indices used in the OTC contracts have to be benchmarked to indices published by the financial benchmark administrator (FBA) or approved by FIMMDA. The central bank has also devoted a lot of attention to transactions of NRIs in the inter-bank interest rate derivative market, since they have been active here. NRIs are also being given a much higher trading limit of $3.5 billion in overnight indexed swap (OIS), and the cap for foreign portfolio investors is set at $7 billion.

While most of the trading activity in interest rate futures takes place in the interbank market, there isn’t much interest in exchange traded instruments. Trading turnover in NSE bond futures, that have Government Bond or T-Bill as the underlying basis, has been declining over the last couple of years. The RBI has allowed exchanges to offer standardised interest rate products, but these cannot become popular unless awareness is created at the retail level.