While OTC derivatives market in India has recorded significant growth in recent period, the market is highly concentrated among selected foreign banks, private sector banks and a PD. The Group felt that the market needs to be broad-based in terms of different classes of participants in it; otherwise, eventually counter-party exposures limit of these selected entities would act as an impediment to growth of this market. In this context, it would be logical to seek greater participation from target segments such as public sector banks, mutual funds (MFs), insurance companies (ICs) and primary dealers (PDs). Accordingly, the following difficulties faced by these segments need to be addressed.

• Ambiguity over legality of OTC derivatives (discussed in Section V)

• Lack of legality of netting of obligations to save on credit lines (discussed in Section V)

• Lack of transparency in terms of disclosures of quotes and valuation curves,

• Need to demystify the apprehensions on derivatives instruments through imparting proper training both at the senior management level and the middle level

• Implicit ban on use of brokers

• Narrow participants base. The market is particularly characterised by the absence of MFs, insurance companies and public sector banks.

While some banks do publish rates on interest rate swaps and standard FC-Rupee swaps on Reuters once a day, continuous updation of these rates are not done in the manner in which brokers, internationally, update rates on Reuters, thus enhancing market information levels. This paucity of information impacts participants negatively. It was felt by the Group that any enhancement in the levels of transparency would go a long way in encouraging active participation in the derivatives market. Hence, the Group recommends that, in order to improve transparency, RBI may consider mandatory anonymous disclosure of deals done, in a standardised manner, on the negotiated dealing system (NDS) platform. Publication of such figures on a consolidated basis would give the current as well as prospective participants a better picture of market liquidity and provide the much-needed historical data for analysis.

Further, the Group felt that FIMMDA should as soon as possible, start publishing valuation curves on the currently two most liquid benchmarks - MIBOR and MIFOR and standardise market practices in terms of accrediting brokers, documentation, etc

Dispelling the apprehension on derivatives could be a major step in popularising the use of derivative instruments, particularly among public sector banks and PDs. The Group recommends that FIMMDA may arrange to impart training in derivative products covering various aspects such as pricing, valuation, risk management, documentation and back office functions. The approach could be two-pronged: one directed towards the senior management and the other at the level of dealers. The training programs for the dealers should be more intensive

Currently, since brokers are not permitted to deal in derivatives segment, market participants tend to confirm brokered deals as direct deals. In the existing Guidelines on FRAs/IRS, there is no explicit ban on the use of brokers by the participants. However, use of brokers in call/notice money markets and deposit mobilisation by banks stands prohibited from 1978. As such, there are practically no 'money market brokers' in India. However, brokers operate in the government securities market. In the foreign exchange market, brokers accredited by the Foreign Exchange Dealers Association of India (FEDAI) have been permitted. Banks and FIs have, however, been permitted the use of brokers, subject to safeguards, for specific purposes.

The Group felt that the need for broker participation in the market should be examined afresh to bring about the required depth and liquidity in these markets. The Group recommends moving forward with due caution and allowing only the brokers accredited by FIMMDA to act as authorised intermediaries in derivatives market. It was felt that brokers should function only as intermediaries with no proprietary involvement to limit the probability of fraud. In the "Hand-book of Market Practices" brought out by FIMMDA, a broad framework for accrediting/approving intermediaries in money market has been contemplated but it is yet to take shape. The Group recommends stringent regulation of the FIMMDA-accredited derivative market brokers with proper institution of systems of accountability and responsibility for these intermediaries as per international best practice

With regard to virtual absence of public sector banks in this area, it is found that the principal impediment to their participation lies in the lack of clarity on legality of OTC derivatives. A general apprehension about the market arising from lack of skill and exposure and lack of transparency also contribute to their low inclination to enter the market. With regard to PDs, only one PD is actively participating in the market. The other PDs are hesitant to enter the derivatives market mainly due to the unclear legal status of the OTC derivatives and lack of transparency in the market.

With regard to participation of mutual funds (MFs), presently, they are permitted to trade only in exchange-traded derivatives. Since there is no exchange-traded debt derivative at present, no guidelines are available in this regard. Mutual fund participation in the OTC debt derivative market needs further examination from the point of view of its legality. Hence, in the interest of abundant clarity, the Group recommends that SEBI may consider issuing guidelines in regard to products that MFs can trade in, the purpose for which MFs can enter into these transactions and any other related regulatory aspects.

Similarly, in respect of insurance companies, the regulatory authority, i.e., Insurance Regulatory Development Authority (IRDA) should consider permitting insurance companies to operate in derivatives market for the purpose of hedging. The Group recommends that IRDA should come out with guidelines for participation of insurance companies in derivatives market. This can help growth in long ended derivatives market as insurance companies, once allowed in the market, are expected to be very active participants given the asset/liability mismatches that they have.

While the introduction of Section 18A of Securities Contract (Regulation) Act, 1956 has resolved the legality problem as far as exchange-traded derivatives are concerned, the issue is still open for OTC derivatives. The provisions of law which affect the legality of OTC derivatives are:

• Section 30 of Contracts Act, 1872 which renders all wagering contracts as unenforceable and void.

• Section 2(aa) of Securities Contract (Regulation) Act, 1956, defining “derivatives” and

• Section 18A of Securities Contract (Regulation) Act, 1956 which makes only the exchange-traded derivatives legal.

The definition of derivative as contained in Section 2 (aa) of SCRA, 1956 is not wide enough to cover OTC derivatives like Interest Rate Swaps and Forward Rate Agreements, and it would render all OTC contracts void ab initio under Section 18A, which states:

18A. Contracts in derivatives

Notwithstanding anything contained in any other law for the time being in force, contracts in derivatives shall be legal and valid if such contracts are –

1. traded on a recognised exchange;

2. Settled on the clearing house of the recognised stock exchange in accordance with the rules and bye-laws of such stock exchange

In view of this legal constraint, RBI, based on an opinion obtained from the Solicitor General of India, had directed FIMMDA to frame a draft legislation governing OTC derivatives which is given below:

“Notwithstanding anything contained in any other law for the time being in force or the provisions of section 28 of this Act, the following contracts shall be legal and valid:

(i) if such contracts in derivatives are:

1. traded on a recognised stock exchange;

2. settled on the clearing house of the recognised stock exchange in accordance with the rules and bye-laws of such stock exchange.

(ii) if such contracts are of the class and nature as notified by the Reserve Bank of India or the Securities and Exchange Board of India or the Central Government from time to time and entered into by persons or entities as may be authorised as ‘eligible persons/entities’ by the Reserve Bank of India or the Securities and Exchange Board of India or the Central Government from time to time.”

The Group felt that an ordinance/change in the SCRA, as suggested by FIMMDA, would provide abundant clarity on the matter, along with ensuring a degree of comfort to such market players who had been hesitant so far to undertake OTC derivative transactions. Accordingly, the Group recommends that the matter may be now followed up vigorously with the Ministry of Finance by RBI for appropriate amendment to Section 18A of SCRA, 1956.

Also, derivative trading is implicitly allowed by banks under Banking Regulation Act, 1949 (Annex V.1). Hence, the Group recommends that, in the meantime, to clarify the status of derivatives contracts in India, the Banking Regulation Act, 1949 may be amended stating that notwithstanding anything contained under Section 30 of Contracts Act, 1872, if any such derivative contracts are of the class and nature as notified by the Reserve Bank of India from time to time and entered into by persons or entities as may be authorised as ‘eligible persons/entities’ by the Reserve Bank of India, they will be legally valid.

The Group discussed the issues in documentation, clearing, settlement and counterparty risk management that have been hampering the development of the OTC derivatives market in India:

• As the OTC contracts are bilateral, despite International Swap Dealers Association (ISDA) standard documentation being available, a lot of negotiation occurs in clauses relating to contract enforcement and counterparty risk management. Many counterparties insist upon outside India law and jurisdiction.

• The lack of netting and the bilateral settlement of each contract results in a lot of back office processing besides increasing risk of failures

• As contracts are bilateral, cancellation or reversal of contracts is very difficult and opposite positions continue to build up the outstanding notional principal although the net position may be small.

• Each party has to manage counterparty risk on its own leading to a variety of exposure limits and credit support or collateral arrangements. No mark-to-market settlement is made usually considering the processing burden.

Several matching, collateral management and clearing services operated in G-10 countries have been detailed in the Bank for International Settlements (BIS) Report on OTC derivatives (BIS, 1998) (Annex V.2). Of these, London Clearing House’s SwapClear which was introduced in 1999 and OM Stockholm which operates a centralised clearing system for both exchange-traded and OTC derivatives, including customised financial instruments, offer workable models for clearing and settlement of OTC swap contracts through a clearing house. The Group recommends that a similar facility may be introduced through Clearing Corporation of India Limited (CCIL) for clearing of OTC derivatives in India. Key aspects of this model are given in Annex V.3. The system proposed would have the following advantages:

• Counterparty risk for individual participants as well as the system as a whole is eliminated with CCIL becoming central counterparty and implementing effective margining mechanisms.

• With no counterparty risk, credit exposure limits will be freed for market participants leading to expansion in market volumes.

• Simplification of documentation and settlement operations can be achieved which would reduce operational risk and settlement costs resulting in broader participation.

• Large participants such as nationalised banks would feel comfortable with CCIL as central counterparty and the elimination of the need for bilateral documentation.

• Elimination of counterparty risk would lower swap costs as this risk premium would not need to be built into price.

• Fewer payments would result from multilateral netting.

• Operational risks can be reduced and efficiencies achieved with straight-through- processing.

On the whole, the market would benefit from reduced risks and costs associated with derivatives settled through the clearing house.

As the volume and value of the derivative transactions increase in the market, the counterparty limits will get exhausted and will reduce the banks’ ability to act as a market maker in various financial products. It will also lead to increased amounts of capital being required to be maintained by banks. Even currently, some of the banks are unable to undertake interest rate swap transactions due to counterparty limits being exhausted. Netting would, therefore, be necessary given the lack of limits that counterparties would have for one another as volumes expand.

In this connection, the Group noted that RBI has forwarded a draft 'Payment and Settlement Legislation Bill' to the Government of India. The Group recommends that a suitable clause which will permit netting of derivative contracts may be incorporated in the draft.

Netting can also be done by novation and it aims to reduce liquidity risk on both the counterparty and its correspondent bank, and to reduce counterparty credit risk from a gross to a net basis in respect of each separate forward date. The Group recommends that till such time as the netting legislation is passed, bilateral netting by novation, on similar lines as done by FEDAI, may be operationalised by FIMMDA for the derivatives market.

Although netting by novation is, in essence, a bilateral mechanism, it can be operated on a multilateral basis within a larger group of banks, but in that case a third party may be employed to undertake the novated net obligation as counterparty to each participating bank. This process is described as "novation and substitution". The Group recommends that multilateral netting by novation for derivatives market may be operationalised by CCIL. CCIL should have a clear understanding of the risks involved in netting and there should be well-defined procedures of management of credit and liquidity risks that specify the responsibilities of each of the participants with the CCIL. The introduction of centralised trading and settlement mechanisms for purely bilaterally negotiated and settled transactions would give rise to a need for additional regulation. Electronic trading systems need to be regulated in a limited sense if these come to serve a price discovery function. The Group was of the opinion that detailed guidelines would have to be issued in regard to netting by novation through CCIL.