Interest rate swap spooks RBI

The central bank fears the Asian market may impact interest rate derivatives.

The Reserve Bank of India (RBI) is concerned over the overnight interest rate swap (IRS), based on Indian interest rates, that is picking up in Singapore and a few other south-east Asian countries. The banking regulator is worried that the IRS may have an impact on the domestic interest rate derivatives market.

The central bank's concern over the IRS comes on the back of fears over the rupee non-deliverable forwards (NDF) market.

The overseas rupee IRS market has had a quiet evolution, beginning about six months ago. The over-the-counter market provides investors, interested in betting on the Indian interest rates, an opportunity to participate.

Hedge funds and private equity funds are active participants in the overseas IRS market, which is outside the regulatory ambit of the RBI. These investors cannot trade in interest rate derivatives in India.

In interest rate swaps, the underlying is the interest rate. IRS is a derivative product wherein market players can take a view on the underlying Indian interest rate reflected through the yields on government securities.

The overnight IRS is generally a short-term contract involving exchange of the overnight rate for some fixed interest rate. The overnight interest portion is compounded and paid at the maturity of the contract. It is normally used to check any losses due to fluctuations in interest rates or to lower interest costs on borrowings.

The NDF market has been in existence since 1993-94. But volumes started rising only in 2002-03, when movements in the NDF market began impacting the rupee's exchange rate in the domestic market.

The IRS market witnesses a daily volume of around Rs 1,000-2,000 crore (around $350-450 million). The development of the IRS market coincided with large volumes in the domestic interest rate derivatives markets in March-April, when the interest rate scenario in India was volatile. During February-April, the daily IRS volumes had touched Rs 10,000 crore. During this period, most of the banks had entered into interest rate swaps to cover their investment portfolio from extreme fluctuations in interest rates, money market dealers said.

The dealers said the IRS market was usually very active during the monetary policy announcements or during times of extreme tightness in the liquidity in the Indian banking system.