Bonds & Derivatives - The Road Ahead (Part: 2)
[Extracted from Valedictory Address by Shri Mohammad Tahir, Executive Director, Reserve Bank of India,
at the Fourth Annual Conference on "Bonds & Derivatives - The Road Ahead" organized jointly by
FIMMDA and PDAI at Goa on February 1, 2003]

"Bond derivatives

Bonds carry several risks. They carry interest rate and price risks, currency risk(for a foreign buyer) and credit risk(company risk and country risk). These risks can be separated and hedged through separate derivative instruments.

"In view of increasing rates of defaults and credit downgradings, the global market for credit derivatives has been growing very fast, during last few years. The market has grown from $25 billion in 1996 to $ 1,500 billion in 2000. However, the credit derivatives market is still in its infancy, when compared with the global market for all derivatives at $48,000 billion in 2000.

"Derivatives market is in an evolving stage in India. We have, therefore, to proceed cautiously to avoid pitfalls. We have to proceed step by step, mastering the intricacies and then proceeding ahead. We have to be humble students of the subject.

"It has been known that a wide investor base enables the system to absorb shocks effectively and prevent volatility particularly as the retail investors are largely buy and hold investors. In the Indian context, one of the challenges has been to enable investors in far flung places to participate in the government securities market easily and transparently. Allowing retail participation on a non-competitive basis in the primary auctions was a step in this direction. Now with trading of government securities on the Stock Exchanges becoming a reality, the enabling infrastructure is finally in place for those far removed from the wholesale market at Mumbai. The benefits for the investors will be competitive and transparent prices, minimal settlement risks and ease of entry and exit from the market as retail trading of Government securities through Stock Exchanges develops. The Primary Dealers are expected to play an important role, serving as the critical link between the wholesale and retail segments of the market.

"For the regulated entities, settlement will be through clearing member /custodians so that the integrity of the system is not compromised. Also, to begin with, the institutional trades on the stock exchanges will not be marginable and will be settled on the basis of giving and taking deliveries. This practice is identical to what is currently being followed in respect of institutional trades in the equity segment. However, the objective is to move to the internationally accepted practice of margining all trades. This issue is under the consideration of RBI-SEBI Technical committee.

"Also, the trading of government securities in the stock exchanges represents a change in the process of price discovery from the existing telephone market. RBI has also taken steps for data dissemination of trades by putting the NDS trades/ quotes on our website on a real time basis.

"A complete financial market in an academic sense means that every financial claim in the market can be replicated. Although, the attainment of the "completeness" status remains an utopia even in the most advanced of the markets, it has to be acknowledged that every market should offer a reasonable bouquet of products to satisfy the savings and investment needs in a cost effective manner. I would here like to emphasize the role of STRIPS and Floating rate bonds and the crucial role of derivatives can play towards risk mitigation in financial markets.

"STRIPS (Separate trading in registered interest and principal securities):

"The working group on STRIPS has given an effective road map for the implementation of STRIPS in the Indian market. It is our belief that introduction of STRIPS will enable the market participants, particularly banks to manage their assets and liabilities in a more effective way than they are currently able to. Also an active STRIPS market means the evolution of a zero curve and hence more efficient pricing of bonds. However, introduction of STRIPS mean that the market makers in STRIPS should be able to manage the risks arising out of holding of stripped coupons effectively. RBI is aware of this and will take suitable steps as and when necessary.

"Floating rate bonds / bonds with option features:
"Recent experience suggests that floating rate bonds represent an effective way of managing balance sheet risks arising out of interest rate movements has not been sufficiently appreciated. Management of such risks is particularly crucial in a period when interest rate outlook is uncertain. I anticipate a lot of experimentation both in terms of choice of indices like treasury bills yields, WPI/ CPI as well as product design. I also expect bonds with optional features (call/put) to pick up as participants develop skills & instruments, particularly in the derivatives market, to lay off the risks associated with such optional features."