While OTC derivatives market has traditionally played a dominant role in debt markets globally and would continue to do so in future, it is desirable to supplement the OTC market by an active exchange-traded derivative market. In fact, those who provide OTC derivative products can hedge their risks through the use of exchange-traded derivatives. In India, in the absence of exchange-traded derivatives, the risk of the OTC derivatives market cannot be hedged effectively. Exchange-traded derivative market has the following features:

• an electronic exchange mechanism and emphasises anonymous trading,

• full transparency,

• use of computers for order matching,

• centralisation of order flow,

• price-time priority for order matching,

• large investor base,

• wide geographical access,

• lower costs of intermediation,

• settlement guarantee,

• better risk management,

• enhanced regulatory discipline, etc.

At present, in India, there exists a reasonable OTC market for interest rate products which raises the need for exchange-traded interest rate derivatives products.

Also, some of the features of OTC derivatives markets embody risks to financial market stability, viz.,

1. the dynamic nature of gross credit exposures,

2. information asymmetries and lack of transparency,

3. the high concentration of OTC derivative activities in major institutions, and

4. the dominance of OTC derivatives markets in the global financial system.

Instability arises when shocks, such as counterparty credit events and sharp movements in asset prices that underlie derivative contracts, occur which significantly alter the perceptions of current and potential future credit exposures. When underlying asset prices change rapidly, the size and configuration of counterparty exposures can become unsustainably large and provoke a rapid unwinding of positions.

The Group felt that there is a need for exchange-traded interest rate derivatives (IRDs) as debt market volumes, particularly in IRS, have been growing rapidly and exchange-traded products would reduce the risk substantially through a clearing corporation, novation, multilateral netting, centralised settlement and risk management. The Group considered that India has already set up mature institutional infrastructure for trading, clearing and settlement in the equity markets which could be harnessed for the debt market. It, therefore, proposes to allow trading in IRDs through the anonymous order- driven screen-based trading system of the stock exchanges which will facilitate participation by all classes of investors and increase market access across the country.

In this context, the Group examined the suitability of products that could be introduced immediately on the exchange. Accordingly, the products considered included contract on a basket of bonds or contract on a synthetic derived out of some of the bonds, contract on swap rate index or contract on a bond index or contract on overnight rates (MIBOR Futures) or contract on T-Bills. The Group felt that a phase-wise introduction of products would provide more stability to the market. Hence, it would be more relevant if an index is selected which will comprise a basket of liquid bonds from the underlying market. The same can be from different maturity buckets like for short-term up to 5 years, in the mid-segment ranging from 8 to 12 years and longer-end bonds. Since there is more liquidity in the 8-12 year bucket, an ideal index should capture the bonds to arrive at an index that would reduce the basis risk. It was also felt that while creating the index, some back-testing and stress-testing is required. It was also observed in this context that selecting a few specific bonds for derivative products would not be very difficult as there is relatively higher level of liquidity in some of the bonds of longer horizons. Hence, products on specific bonds can also be considered at a later stage. The Group also felt that Future contracts on Overnight MIBOR could also be welcomed by market participants as NSE-MIBOR is used extensively by market participants and it is a widely-used rate for overnight reference rate. The Group discussed about contract on CP rates but it was felt that CP issue sizes are very small and since the market for a particular CP is not well spread out, it could lead to a credit call on a company rather than a hedge instrument. The Group also discussed the possibility of having a contract related to AAA corporate category bonds but it was felt that since the market in this category is illiquid and also due to heterogeneous credit-worthiness of individual companies even within the AAA-category, it would be difficult to establish a derivative market at present. The Group also felt that as there would be less interest in contracts on T-bills since available 91-day T-bill stock is limited, all 364-day T-bills with residual maturity of 91 days may be made deliverable for such contracts. The Group maintained that to start with, the contracts should range from 1 month, 2 months and up to 12 months.

It is proposed that interest rate futures, interest rate options, interest rate swaps – both plain vanilla swaps as well as swaps with embedded options like caps/floors/collars, as well as standardised repos may be allowed to be traded on the stock exchanges. The introduction could be in a phased manner starting with Futures contract and followed by Option contracts.

The Group considered that the success of a product would depend upon its utility and economic purpose. After prolonged deliberations and assessing the present state of underlying debt market and OTC derivative market, the Group narrowed down its focus on four contracts viz.,

1. Short-term MIBOR Futures Contracts,

2. MIFOR Futures Contract,

3. Bond Futures Contract and

4. Long-term Bond Index Futures Contract.

The derivative contracts short-listed by the Group for trading on the stock exchanges at the initial stage are described briefly as under :

Short-term MIBOR Futures Contract
This would be a futures contract based on the FIMMDA-NSE Overnight Daily MIBOR. There would be 12 variants of this futures contract depending on contract tenor, viz., a 1-month contract, a 2-month contract, and so on up to a 12-month contract. Contract price would be quoted on a 100 minus MIBOR basis. A contract would expire on the last business day of the expiration month. Daily settlement will take place at the closing price of the Futures contract where closing price would be the last 30 minutes' weighted average prices of the deals reported on the system. If it is not traded during last half an hour, then the last traded price should be considered as closing price. The final settlement will take place in cash on the expiration day based on the simple average MIBOR fixations for the tenor of the contract. The fixation for the day prior to a holiday would be considered as the MIBOR fixation for the holiday for a contract.

MIFOR Futures Contract
This would be futures contract based on the 6-month LIBOR and Rupee-Dollar 6-month forward rate provided by FEDAI for the expiration date. These contracts would be quarterly contracts and will follow the March-June-September-December expiration cycle. Contract price would be quoted on a 100 minus MIFOR basis. A contract would expire on the last business day of the expiration month. Daily settlement will take place at the closing price of the Futures contract where closing price would be the last 30 minutes' weighted average prices of the deals reported on the system. If it is not traded during last half an hour, then the last traded price should be considered as closing price. The final settlement will take place in cash on the contract expiration day based on the MIFOR computed for the day by the stock exchange after the close of market hours taking into account the relevant LIBOR rate as well as the Rupee-US$ Forward premia computed by FEDAI (currently 6-month).

Bond Futures Contract
This would be a futures contract based on specific underlying Central Government bonds. There would be four variants of this futures contract depending on contract tenor, viz., a 3-month contract, a 6-month contract, a 9-month contract, and a 12-month contract. The specific bond(s) will be as identified by the stock exchange from time to time based on broad parameters like liquidity, outstanding issue size, etc. These futures would be valued on quoted clean price. On expiration day, the final cash settlement would be on the basis of closing price of the day.

Long-term Bond Index Futures Contract
This futures contract would be based on an index derived from liquid securities in the long term maturity bucket, such as 8-12 years. The market capitalisation for the purpose of this index will be based on actual weighted average trade prices. There would be four variants of this futures contract depending on contract tenor, viz., a 3-month contract, a 6-month contract, a 9-month contract and a 12-month contract. The price quote shall be clean composite price. Daily settlement would be done at the closing price of the day.

The market regulator should lay down only broad eligibility criteria and the Exchanges should be free to decide on the underlying stocks and indices on which futures and options could be permitted depending upon the preferences of market participants. The broad eligibility criteria should focus on the issues of risk containment and manipulability. Manipulability is in turn a function of liquidity (daily average volumes) of trades in the underlying instruments as well as its market capitalisation. The choice of the underlying would have to be achieved from a fine balance between the goal of improving broad-based liquidity of the underlying debt market, and the risk of a possibility of a market misconduct arising from having derivatives on a highly illiquid underlying.

The Group recommends that the present market structure for trading of equity derivatives on stock exchanges could be used for the proposed exchange-traded market for interest rate derivatives. The broad details of the market structure are as follows:

Equity derivatives trading is permitted at present only in NSE and BSE. It is proposed that interest rate derivatives contracts should be allowed to be traded on the automated, order-driven system of these exchanges only.

In view of the familiarity of the market and its participants with the systems, processes and procedures followed for exchange-traded equity derivatives should be applied for interest rate derivatives on the permitted exchanges. No additional infrastructure or connectivity issues need to be resolved to use the equity derivatives trading model for trading in interest rate derivatives. There would also be no requirement for a fresh membership on the exchanges or on the clearing corporation/clearing houses to trade on interest rate derivatives provided RBI is satisfied with the present eligibility criteria for membership. NSE have indicated that they are in a position to commence trading in interest rate derivatives within a short period.

Like equity derivatives market, the proposed interest rate derivatives market may have four entities in the system as detailed below :

• Trading Members (TM)Thay have more than one user.

• Clearing Members (CM) – These are members of the clearing corporation and carry out risk management activities and perform actual settlement. CMs are also trading members and clear trades for themselves and/or others. Those CMs that are allowed to clear their own trades as well as on behalf of other TMs are called Trading-cum-Clearing members(TCM). Those CMs that are allowed to clear only their own trades (including on behalf of their clients) are called Self-Clearing Members (SCM).

• Professional Clearing Members (PCM) – A PCM is a CM who is not a TM. Typically, banks and custodians become PCMs and clear and settle for their TMs.

• Participants – A participant such as a FI, is a client of TMs. These clients may trade through multiple TMs but settle through a single CM.

The Group feels that the existing two-tier membership structure, viz., Clearing Members and Non-Clearing Members, of the equity derivatives segment may be retained for the debt derivative segment as well. Also, members of the existing equity derivative segment of an exchange will not automatically become members of the interest rate derivatives market segment. Only those who satisfy the stricter eligibility conditions of the IRD market will be admitted to debt derivatives trading.

Risk Management

The clearing corporation/house becomes counterparty to each trade or provide unconditional guarantee to settle the trade. Risk management measures adopted by exchanges and clearing corporation/clearinghouse include:

• Liquid net worth requirements, i.e., liquid assets as prescribed must be pledged in favour of clearing corporation

• Portfolio based margining approach, which takes an integrated view of the risk involved in the portfolio of each client comprising his positions in all derivative contracts.

• Initial margin requirements, based on worst scenario loss of a portfolio of an individual client to cover 99% VaR over one day horizon across various scenarios of price changes and volatility shifts.

• Mark-to-market margin in respect of daily settlement.

• Margin on calendar spreads, short option minimum margin, margin on premiums.

• Exposure limits on the notional value of gross open positions of a clearing member.

• Position limits for Trading Members, clients, market, etc.

• Unique client code.

• Settlement Guarantee Fund with contribution from the market participants

Clearing and settlement activities in the segment should be undertaken by the Clearing Corporation/house with the help of Self-Clearing Members (SCM), Trading Member–Cum–Clearing Member (TCM) and Professional Clearing Members (PCM). The clearing mechanism essentially involves working out open positions and obligations of clearing (SCM/TCM/PCM) members through multilateral netting at client level.

Funds settlement should take place through clearing banks. For the purpose of settlement, all clearing members are required to open a separate bank account with the designated clearing bank for segment. The Group felt that the Primary Dealers as well as banks should be allowed to settle the deals as Professional Clearing Members of NSCCL as existing in the futures and options (F&O) segment of the exchange. Also, the RTGS system could be used for effecting inter-bank settlement in future.

Futures contracts have two types of settlements - the marked-to-market (MTM) settlement which happens on a continuous basis at the end of each day and the final settlement which happens on the last trading day of the futures contract. All futures contracts for each member need to be MTM to the daily settlement price of relevant futures contract at the end of each day. The CMs who have a loss are required to pay MTM loss amount in cash which is in turn passed on to the CMs who have made a MTM profit. CMs are responsible to collect and settle the daily MTM profits/losses incurred by the TMs and their clients clearing and settling through them. Similarly, TMs are responsible to collect/pay losses/ profits from/to their clients.

The Group also deliberated upon the following issues relating to trading of IRD on stock exchanges. Its views on these issues are summarised below:

The Group recommends that settlement should be done on cash basis other than that for bond futures contract where settlement should be done on delivery basis. This would ensure better integration between spot market and futures market. Futures and options on individual securities can, therefore, be delivered as in the spot market.

The Group recommends that the netting should be allowed on intra-day basis at client level positions. However, the case of cross margining with underlying market would be considered at a later stage.

The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on accounting of derivatives transactions in the equity derivatives market. The ICAI could be requested to develop similar guidelines for accounting of exchange-based transactions in interest rate derivatives. The tax issues incidental to derivative transactions in the equity market could be similarly applicable to interest rate derivative transactions.