Indian Derivative

Markets
Future Prospects

CAPAM 2003
August 7, 2003
Agenda
 Progress of derivative markets in India
 Market structure and regulation
 Future prospects
Agenda
 Progress of derivative markets in India
 Market structure and regulation
 Future prospects
 Derivatives – A journey well
begun
OTC Exchange traded
 1980s – Currency  June 2000 – Equity Index
Forwards futures
 1997 – Long term FC –
 June 2001 – Equity Index
options
Rupee swaps  July 2001 – Stock Options
 July 1999 – Interest  November 2001 – Stock
rate swaps and FRAs futures
 July 2003 – FC-Rupee  June 2003 – Interest rate
options futures

November 2002 - RBI Working group on Rupee derivatives

March 2003 - RBI Working group on credit derivatives
 Derivatives –acquiring size
Introduction of new products have resulted in increased volumes

Market Type Cash Derivatives Derivatives as

Turnover Turnover % of cash

Foreign Exchange(1) $ 276 Bn $ 662 Bn 239%

Interest rates (2)

Rs 28 Trn Rs 1.5 Trn 5.4%

Equity (3)
Rs 9.32 Trn Rs 4.4 Trn 47.2%

Notes:
1. Gross turnover in interbank Spot and forward markets for FY’02
2. Estimated annual turnover for FY’03 for GOISec, Corporate bonds and Swaps
3. Gross turnover on BSE and NSE during FY’03

Rs 1 Trn = Rs 100,000 Cr
Agenda
 Progress of derivative markets in India
 Example – Rupee Swap Market
 Market structure and regulation
 Future prospects
Rupee Interest rate swaps
 Swap market is now four years old
 FY ‘03 has seen tremendous growth in volumes
and outstanding contracts
 Increasing volumes have led to lower bid-offer
spreads for some of the price points
 No of market players have increased
 More banks and PDs have joined the market
 Corporate activity has also increased
 Emerging consensus about benchmark rates
 OIS and MIFOR have emerged as two key swap curves
Rupee Swaps – Growing
volumes
Outstanding notional value has grown 50 times over
last 3 years
150 7000
6000
125
5000
100
4000
75
3000
50
2000
25 1000
0 0
M a r-00 M a r-0 1 M ar-02 D ec-02 M ar-00 M ar-01 M ar-0 2 D ec-02

'Outsta nding principa l (Rs '0 00 cr) Outstanding C ontracts

 Daily market volume in excess of Rs 500 Cr and is higher

than trading in corporate bonds market
 Significant volume on account of inter-bank trading
 Rupee Swaps – Transaction
costs
25.00

20.00 Swap type Bid Offer on

J une 3, Feb 14,
15.00 2002 2003
1-yr OIS 4 bps 4 bps
10.00 3-yr OIS 15 bps 8 bps
5-yr OIS 20 bps 7 bps
5.00 3-yr M IFOR 20 bps 10 bps
5-yr M IFOR 20 bps 8 bps
-
M ay-02 Jul-02 Aug-02 O ct-02 Nov -02 Jan-03 M ar-03

5- Year Mifor 5- Year OIS

Increasing volumes have led to lower bid-offer

spreads
Rupee Swaps
 6 Month MIFOR and overnight MIBOR as popular
floating rate benchmarks
 MIFOR swaps more liquid
 Lack of liquid term money market based benchmark
 Interest in long tenure swaps has also grown
 MIFOR curve has lengthened upto 10 yrs OIS curve is
active upto 7 yrs
 However, bid –offer spreads are still relatively high (15-
20 bps) for more than 5 year swaps
 Bid-offer on 15 year GOI Sec is less than 1 bps
Agenda
 Progress of derivative markets in India
 Market structure and regulation
 Future prospects
Market structure and
regulation
 Interest rate swaps
 Lack of credible term money benchmark
 Lack of participation large players with interest rate risk - PSU
Banks, MFs and Insurance companies
 Absence of cash market for floating rate products
 Legality of OTC derivatives
 Transparency – availability of price and volume data
 MTM and valuation framework
 Equity Derivatives
 Banks not allowed to participate in equity derivative markets
Market structure and
regulation
 Interest rate Futures
 Current contract design leads to large basis
risk between futures and cash market
 Need for wider set of benchmarks
 Regulatory restriction on Banks
 IRF can be used only for hedging and not trading
 Strict hedge definition applicable only to IRFs
 Restriction on short selling in cash market
Market structure and
regulation
 Derivatives usage by corporates
 Can OTC derivatives for hedging purpose only
 No such restriction in case of exchange traded
derivatives
 Accounting and tax treatment
 Lack of comprehensive guidelines for accounting
and tax treatment
 Balance sheet disclosures
 Fair value and purpose
Agenda
 Progress of derivative markets in India
 Market structure and regulation
 Future prospects
Completion of product range
 OTC Interest rate options
 Caps, Floors and Swaptions
 Vanilla products could be introduced initially
 RBI’s working group on Rupee derivatives has
already made its recommendations

 OTC Credit derivatives

 Implementation of recommendations of RBI’s working
group on Credit derivatives
 Credit default swaps and Credit linked notes
Completion of product range
 Exchange traded interest rate options
 Options on underlying instruments
 Options on Futures
 Success will depend upon liquidity in the IRF contracts

 Currency Futures
 Willlargely depend upon the progress towards full
capital account convertibility

 Exchange traded Interest rate swap contracts

 Example – LIFFE / CBOT Swap note contracts
 Best of both worlds !!!
Widening the participation
 Improving OTC market liquidity
 Market risk awareness among institutional players
 Capital for Market risk in case of Banks and PDs
 Emphasis on soft skills – training
 Importance of risk management systems cannot be
over-emphasised

 Importance of Exchange traded markets

 Bring more players to the market, more safely
 Efficient price-discovery and transparency
 Liquid Futures contracts make hedging of OTC
derivatives more efficient
Driving innovation
 Liquidity in vanilla derivative markets is likely to drive
product innovation

 Example - Principal protected index notes

 Synthesized by Banks/ FIs to generate liquidity
 In the nature of bonds where principal is protected
 Offer yield enhancement through participation in
Equity/Currency/Credit markets
 Issuers hedge the underlying risk either through exchange
traded or OTC derivatives
 Investors find these attractive in low interest rate regimes
Key concerns
 Counterparty credit risk
 Credit risk in derivative transactions changes
dynamically and works both ways
 Need for sophisticated risk management systems to
correctly capture and manage the risk

 Concentration risk
 Internationally,
OTC derivative markets have been
concentrated amongst few large players
 Concerns about systemic risk
Concentration in derivative
markets

Source: Office of Comptroller of Currency

Bank derivatives report
Ensuring systemic integrity
 Measurement and management of credit risk in OTC
derivative transactions

 Robust mark-to-market and valuation framework

 Accounting and disclosure guidelines (IAS 39)

 Minimisation of taxation and regulatory arbitrage across

products and institutions
Ensuring systemic integrity
 Netting and Collaterlisation
 Need for a comprehensive Netting law
 Central counterparty for OTC derivatives to
achieve multilateral netting
 Adequacy of margins is the key issue
 Collateralisation and Netting
 Global trend towards collateralisation
 ISDA estimates international gross amount of
collateral to be $ 719 Bn in 2003
 Increase of 67% over 2002
Bilateral Netting

Source: Office of Comptroller of Currency

Bank derivatives report
Summing up
Risks and Rewards of Derivative markets
• Market efficiency
• Risk sharing and transfer
• Low transaction costs
• Capital intermediation
Liquidity enhancement
•
• Price discovery
• Cash market development
• Hedging tools
• Regulatory savings
• More leverage
• Less transparency
• Regulatory arbitrage
• Rising CP exposure
• Hidden systemic risk
• Tail-risk future exposure
• Weak capital
requirements
• Zero-sum transfer tools
" Although the benefits and costs of
derivatives remain the subject of spirited
debate, the performance of the economy and
the financial system in recent years suggests
that those benefits have materially exceeded
the costs."

Alan Greenspan

“We view them as time bombs both for the

parties that deal in them and the economic
system. In our view derivatives are financial
weapons of mass destruction(WMD), carrying
dangers that, while now latent, are potentially
lethal.”

Warren Buffet
Thank You