Over-the-counter (OTC) derivatives have come to play an important role in the financial systems the world over. These instruments allow users to unbundle risks and allocate them to investors most willing and able to assume them. This has brought substantial benefits to the commercial community in facilitating hedging and, hence, business planning more generally, and have enabled the financial institutions to offer a progressively wider range of services and greater efficiency in the intermediation process as well as to exploit market imperfections and other trading opportunities for their own gain. However, conditions need to be created to encourage more of them to participate in this market using a wider array of instruments, with appropriate policies to promote stability and development of the financial infrastructure.

The factors generally attributed as the major driving force behind growth of financial derivatives are-

1. increased volatility in asset prices in financial markets,

2. increased integration of national financial markets with the international markets

3. marked improvement in communication facilities and sharp decline in their costs,

4. development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies and

5. innovations in derivatives markets which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets.

Globally, OTC market for interest rate derivatives has grown significantly over the last decade. About 70 per cent of the total notional outstanding amount for interest rate options comes from the OTC market. In a BIS survey published in November 2002, the notional amount outstanding in OTC interest rate derivatives market in June 2002 stood at US $ 90 trillion as compared to US $ 48.1 trillion in June 1998. Again, of US $ 90 trillion, 76 per cent was contributed by Swaps, 14 per cent by Options and 10 per cent by Forward Rate Agreements (FRAs).

In order to manage and control interest rate risks as also to further deepen the money market, OTC rupee derivatives in the form of Forward Rate Agreements (FRAs)/Interest Rate Swaps (IRS) were introduced in India in July 1999. These derivatives enable banks, primary dealers (PDs) and all-India financial institutions (FIs) to hedge interest rate risk for their own balance sheet management and for market-making purposes. Banks/PDs/FIs can undertake different types of plain vanilla FRAs/IRS. Swaps having explicit/implicit option features such as caps/floors/collars are not permitted now.

Available data show that FRAs/IRS transactions have recorded substantial increase during the recent period. In terms of number of contracts and outstanding notional principal amount, such transactions have jumped from about 200 contracts amounting to Rs.4,000 crore in March 2000 to 6,500 contracts for Rs.1,50,000 crore in December 2002. However, the market is highly concentrated as the share of 13 major participants in the aggregate outstanding notional principal amount accounted for over 90 per cent in December 2002 (Annex I.1). Though in majority of these contracts, the market players have used NSE-MIBOR as the benchmark rate, they have also been using such other benchmarks as Mumbai Inter-Bank Forward Offered Rate (MIFOR), Mumbai Inter-Bank Offered Currency Swaps (MIOCS), Mumbai Inter-Bank Overnight Index Swaps (MIOIS), Treasury Bill rates, etc.

Meanwhile, mutual funds were allowed by SEBI to participate in derivative trading in February 2000. Exchange-traded derivatives were introduced by way of futures in Stock Exchange, Mumbai (BSE) and National Stock Exchange (NSE) from June 2000. SEBI has also allowed use of options on indices and individual stocks with effect from July 2001. With regard to OTC products, Foreign Exchange Management Act, 2000 permits banks to provide risk management tools like swaps, options, caps, collars and FRAs to clients to hedge interest rate risk arising out of foreign currency liabilities. Recently, a RBI Technical Committee has recommended introduction of "Foreign Currency - Rupee Options".

Against this background, it was felt that the hedging mechanism should be uniform between rupee liabilities and foreign currency liabilities. Also, since considerable time has elapsed after the introduction of guidelines on FRAs/IRS in 1999 and market has attained a certain level of maturity in using these products coupled with the fact that participants would be increasingly exposed to interest rate risk in future, there is a need to consider more complex features of swaps and options.

In order to examine all these issues, the Working Group on OTC Rupee Derivatives was constituted by RBI on November 7, 2002 under the Chairmanship of Shri Jaspal Bindra, Chief Executive Officer, India Region, Standard Chartered Bank with appropriate representations from banks, PDs, mutual funds and RBI, following its announcement in the mid-term Review for the year 2002-03 on October 29, 2002. The Group was required to suggest the modalities for introducing dealing in derivatives having explicit option features such as caps/floors/collars in the rupee derivatives segment and also the norms for capital adequacy, exposure limits, swap position, asset-liability management, internal control and other risk management methods for these derivatives.

Further, the High Level Committee on Capital Market (HLCC) in its meeting on November 8, 2002 recommended that issues relating to exchange-traded interest rate derivatives should also be referred to this Group for examination.

The Group while deliberating on the issues had identified, in its second meeting, five broad areas where it felt that more structured work was required. Accordingly, five Sub-Groups were constituted to study in detail and recommend on the following areas:

• Increasing Participation in OTC Derivative Market.

• Exchange-traded Derivatives.

• Accounting, Valuation, Legality of OTC Derivatives and Master Agreement.

• Board Policies, Regulatory Requirement and Risk Management Policies.

• Products that can be allowed without short selling.

The group submitted its report in January 2003.

The report was published on the website of RBI to elicit views of interested parties. Inter-institutional group meetings between RBI and SEBI resulted in the finalisation of issuing guidelines by respective bodies, i.e. SEBI and RBI on Exchange Traded Rupee Derivatives. These are discussed in separate article.