Risk management has become an integral part of financial activities of banks and other market participants. These risks cannot be ignored and have to be managed by market participants as part of ALM or hedged. In this context, creating an environment that promotes risk management assumes critical importance. This requires addressing certain policy and institutional issues in developing a market for risk-taking, risk sharing and risk-diversification in India.

First and foremost, a well-developed repo market constitutes an important pre-requisite for promotion of risk-management practices among market participants. Regulatory gaps and overlaps in debt markets need to be sorted out quickly to facilitate the repeal of the 1969 Notification which bans forward trading in securities. Market players can then be permitted to short sell securities, which will go a long way in aiding the process of ALM for banks and other market players. There is a case for encouraging RUF in Indian market. Regulatory issues regarding the RUF need to be reviewed in this context.

Indian conditions are suitable for introduction of asset-liability based derivatives such as Strips and Asset Backed Securities, specifically from two viewpoints. First, they provide an ALM tool and secondly, strips facilitate a risk-free zero-coupon yield curve which can be used for pricing other instruments. Introduction of a market for strips requires meticulous planning on aspects such as issue of benchmark securities, fungibility, auction system, settlement procedures and general infrastructure. There is a vast scope for asset based securitisation in India, despite its constraints. A few deals have already been concluded with respect to residential mortgages and auto loans. However, inhibitive stamp duties, inadequate foreclosure laws and lukewarm investor response come in the way of development of this market.

There is also scope for introduction of credit-default swaps in India. Credit swap offers advantages of hedging credit risk without impairing the relationship with the borrower. Under Indian conditions, this instrument provides a mechanism for an institution like IDFC to take on the credit risks of banks. As a prelude to permitting credit derivatives, there seems to be a case for permitting banks to extend guarantee or lend on the guarantee of another bank within prudential limits.

FRAs/IRS enable users to lock into spreads. The Reserve Bank of India has already announced its intention to introduce interest rate swaps. In addition, the market for forward rate agreement can also be developed. A prerequisite for the development of rupee derivatives in India is the existence of a term yield curve which would enable efficient pricing of derivatives. A benchmark rate should be a good proxy for the actual borrowing costs in the market. The rate should be transparent and non-manipulative. The overnight call money market is the only liquid market in the Indian financial system. An overnight reference rate has already emerged through National Stock Exchange and Reuters. Therefore, to begin with, the Mumbai Inter-bank Overnight Average (MIONA) swap, settled against a call benchmark, can be considered as a starting point. Once, the term money market develops, other benchmarks will emerge.

Active use of derivatives require the existence of a term money market for six-months to one year tenure. It is widely accepted that there is no clearly defined inter-bank term money structure in India beyond the overnight rates. Statutory pre-emptions on inter-bank liabilities, somewhat regulated interest rate structure, cash credit system of financing, high degree of volatility in the call money rates, availability of sector specific refinance, and absence of money market instruments of varying maturities have been some of the factors that affect the development of a term money market.

The Reserve Bank of India has gradually removed many of the constraints in the term money market. Freeing of interest rates in the call money market, replacement of the system of cash credit by the loan system, deregulation of term deposit rates and lending rates, bringing down the minimum period of term deposits to 15 days, freedom to banks to determine their own penalty structure for premature withdrawal of deposits and exemption of inter-bank liabilities from the maintenance of CRR and SLR, subject to the statutory minimum of 3 percent and 25 per cent, respectively, for all categories of bank liabilities are some of the important steps in this direction.

A major reason for the lack of term money market is the absence of the practice of ALM system among banks for identifying mismatches in various time periods. The recent RBI guidelines on ALM are expected to contribute to the evolvement of an ALM system, which would help banks to take decisions to lend on a term basis and also offer two-way quotes in the market. This would act as a catalyst for development of a term money market. Banks should also be given freedom to announce PLR across the term curve so as to give them an additional tool to match their duration gaps. Risk management will be further enhanced when banks are permitted to extend fixed rate loans to borrowers.

A deep cash market is imperative before derivative products can be introduced in order to prevent derivatives market from transmitting volatility to the cash market. This requires orderly movement of the inter-bank call money market and also raises the need for a liquidity adjustment facility from RBI to facilitate the development of a corridor of interest rate through repo and reverse repo mechanisms. This would obviate the need for having various refinance facilities and impart necessary stability to inter-bank reference rate.

FRAs are particularly useful from a risk management perspective to hedge short term interest rate risk. FRAs are good indicators of forward money market curves and as such are the best indicators of market participants' expectations of future deposit rates which can be an useful input in monetary management. These products enable issuers to access those markets (whether fixed or floating) where they possess a comparative advantage, and swapping the interest payments in the market of their choice. However, given the current structure of the Indian Rupee money market and its characteristics, introduction of derivatives should be undertaken in a gradual manner. A suggested sequencing pattern could be to develop market for FRA and IRS first before moving on to options.