Banks are authorised to trade in OTC derivatives of certain types (recognised exclusively as banking products) as per Banking Companies Regulation Act. Section 6(1) of the Banking Regulation Act, 1949 (BR Act), inter alia, states as under:

"In addition to the business of banking, a banking company may engage in any one or more of the following forms of business, namely:-

(a) the acquiring, holding, issuing on commission, underwriting and dealing in stock, funds, shares, debentures, debenture stock, bonds, obligations, securities and investments of all kinds; the purchasing and selling of bonds, scrips or other forms of securities on behalf of constituents or others; ……"

From the above it is clear that a banking company can deal in obligations. Derivatives, being in the nature of obligations, will be covered within the ambit of "obligations" and hence a banking company will be able to deal in derivatives.

Traditionally Banks and authorised Foreign Exchange Dealers under membership of Foreign Exchange Dealers Association (FEDA) were dealing in Forward Contracts in Foreign Currencies to cover risks inherent in Exchange fluctuations. 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.Consequently India has a strong dollar-rupee forward market with contracts being traded for one, two … six-month, one-year expiration. Indian users of hedging services are also allowed to buy derivatives involving other currencies on foreign markets

In order to manage and control interest rate risks as also to further deepen the money market, introduction of OTC rupee derivatives in the form of Forward Rate Agreements (FRAs)/Interest Rate Swaps (IRS) was felt necessary. 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 could undertake different types of plain vanilla FRAs/IRSIt was however considered that introduction of Swaps having explicit/implicit option features such as caps/floors/collars are not to be permitted now.

With this objective in view RBI constituted a working group under the Chairmanship of Shri Jaspal Bindra, CEO, Standard Chartered Bank to look into, inter alia, the possible ways of developing a market for over-the-counter (OTC) rupee derivatives. The Group will also review the existing guidelines for OTC rupee derivatives in India. The Terms of Reference of the Working Group are as under:

1. To suggest the modalities for introducing dealing in derivatives having explicit/implicit option features such as caps/floors/collars in the rupee derivatives segment.

2. To suggest norms for capital adequacy, exposure limits, swap position, asset-liability management, internal control and other risk management methods for these derivatives.

3. Any other related issue.

The group has submitted its report in December 2002. In order to further deepen the money market and enable market participants to manage and control interest rate risk, the Working Group explored the possibilities of expanding the over-the-counter (OTC) rupee derivatives market in India. The Group also considered introduction of exchange-traded interest rate derivatives in India for better hedging of risk as also to encourage wider participation in derivatives market. The Group focussed on such related issues as legality, netting, documentation, accounting and valuation procedures for interest rate options. It has also laid down various considerations governing Board policies, risk management system and regulatory requirement. RBI is to finalise is decision on the recommendations.

While introduction OTC derivatives is to be Effected after carrying out legislative amendments suggested in the report, exchange traded derivatves came to be approved by RBI/SEBI in June 2003 consequent on the recommendations of Jaspal Bindra Committee Report]

Policy guidelines for forward rate agreement (FRAs)/interest rate swaps (IRS) were issued to SCBs (excluding RRBs), PDs and all-India FIs, allowing them to undertake FRAs/IRS as a product. To provide more flexibility for pricing of rupee interest rate derivatives and facilitate some integration between money and foreign exchange markets, use of "interest rates implied in the foreign exchange forward market" were permitted as benchmarks, in addition to existing domestic money and debt market rates. In turn SEBI approved Exchange-Traded Interest Rate Derivatives and issued a press release for information of the public on April 19, 2003. Guidelines were also issued by SEBI to the Stock exchanges (NSE/BSE) approving trading of Exchange traded Interest Derivatives.

There was sharp increase in the volume of FRAs /IRS market during 2001-02. Available data show that FRAs /IRS transactions, both in terms of number of contracts and outstanding notional principal amount, rose from 1,615 contracts amounting to Rs.22,865 crore as on April 6, 2001 to 4,379 contracts for Rs. 86,749 crore as at end-March 2002. During 2002-03, till September 20, 2002, transaction in this segment recorded 5,675 contracts for Rs. 1,31,898 crore. Although there has been a significant increase in the number and amount of contracts, participation continues to be restricted mainly to select foreign and new private sector banks and PDs. In a majority of these contracts, NSE-MIBOR was used as the benchmark rate. The other benchmark rates used include 3-month benchmark rate on Reuters, MIFOR, government securities yield for 1 year, primary cutoff yield on 364-day treasury bills, etc.
[Source: RBI Report Trends & Progress of Banking in India 2002]

Credit derivatives are a new market segment in the area of financial derivatives. They are financial products which transfer either specific or all the inherent risks of a credit position from one partner in the transaction viz., the risk seller, to another viz., the risk buyer, against payment of a premium. They are a new management tool, which facilitates evaluation and transfer of credit risk. Credit derivatives thus serve to evaluate and separate risks and to make them fungible. The areas of application are the traditional credit and bond business as well as risk and portfolio management. Credit derivatives deal with credit risk or risk of debtor default as pure debtor risk and not general market risk. The hedge refers directly to a particular debtor. The credit risk is typically debtor specific. The focus is placed on individual solutions designed to fulfil customer-specific wishes with an eye on their balance sheets. The products are hardly standardised, and there is practically no secondary market trade, even in the USA. Internationally, capital treatment has yet to be clarified and standardised documentation is not available for most of the products

Reserve Bank of India has now decided that banks would be allowed to use credit derivatives to manage risks relating to lending, including buying protection on loans and investments, to reduce risk. Banks would be barred from using these derivatives for trading and only domestic entities would be allowed to enter in credit risk contracts, RBI has also issued draft guidelines while seeking comments from the banks. However final guidelines are not issued by RBI and the products "credit derivatives" has not been introduced as yet. This may be possible only after legislative amendments are carried out.

Both SEBI and RBI are taking keen interest in the development of new products in derivatives and extension of the trade therein. SEBI as the market regulator with responsibility for market development has constituted an internal committee designated as "Technical Group on New Derivative Products". The groups meets regularly and the minutes of its proceedings can be viewed at the website of SEBI. On its part RBI is under obligation to implement Basel Committee Revised Norms (2nd Consultative package) by the year 2004-05. The second accord is basically based on higher perception of risk sensitivity. RBI is therefore keen to devise a package of risk management tools for SCBs in India and working on this criterion. In fact both SEBI and RBI also have inter-institutional consultative meetings on the topic of Derivatives Product Development.