If interest futures are to work in the manner planned, several changes will be needed in different areas.
Interest rate futures contracts were introduced six years ago. However, in sharp contrast to the currency futures market, trading in interest futures never took off. To my mind, the principal reason was the restriction that banks, who are obviously the largest players in the bond market, could use the futures market only to hedge the price risk on their ‘available for sale’ and ‘trading’ portfolios. Since all banks are long in terms of their holdings, they could only be sellers of the contracts. With nobody on the other side, interest rate futures had a still birth.
More than five years later (in October 2008), RBI also allowed banks to take trading positions in the futures market. However, in the June 2009 ‘Report of The RBI-SEBI Standing Technical Committee on Interest Rate Futures’, one was intrigued to see a reference (paragraph 5.1) only to hedging interest rate risk (to be sure, extended to the banks’ entire balance sheets). One hopes that this does not imply any second thoughts on the October 2008 permission to trade, when interest futures are re-introduced, which many are expecting to happen in the near future.
There are a couple of other issues as well in the RBI-Sebi report, which makes one wonder whether some other impediments may come in the way of a successful launch of the interest futures contract. For one thing, one of the needs for interest rate futures, as articulated in the report, is for providing “the household sector greater access to interest rate risk-management tools through Exchange-Traded interest rate derivatives”. Surely this purpose is defeated by the recommendation in the report that futures contract would be settled only by physical delivery. The household sector does have interest rate risks, particularly on housing loans, a point I will revert to, but hardly holds any government securities: In effect, a delivery-based futures market is of practically no use to this sector.
Given the experience of 2003, one would like the re-launch to be in as user-friendly and hassle-free as possible — in other words, cash settlements (as in the currency futures market). If delivery-based settlements are considered essential at all from the start, it would be more practical to have a specific security (say the benchmark 10-year bond, which is the most traded) as the underlying. The report has recommended that, for the 10-year G-Sec contract, securities maturing between 7.5 and 15 years could be delivered: There are currently 18 securities within the maturity band, leading to the use of the ‘cheapest to deliver’ concept in choosing the security to be delivered. The concept has obviously been borrowed from the practices in the US market and it may take time for less sophisticated banks to be comfortable with it. There is, however, a loophole to the settlement mechanism, namely unwinding contracts before the first day of the delivery month, to avoid physical deliveries. (There are other points in the Sebi-RBI report, particularly on the risk-management side, of too technical a nature for this column.)
Apart from these issues, there are other, long-overdue reforms of the securities and derivatives market, which need to be addressed: The day-count convention followed in the G-sec market is 30/360. There is a strong case for moving the G-Sec market to the actual/actual (interest period) convention. The present market practice is artificial and a relic of an era when computing power was neither cheap nor readily available, and compromised on calculation accuracy. The practice has long been abandoned in the US and the UK government bond markets, in favour of the actual/actual day count. The reason is simple: The latter correctly reflects the actual payment of interest as the half-yearly coupons are due on dates six calendar months apart (say April 24 and October 24).
An added benefit of the actual/actual day count would be that it would bring the pricing in the derivatives and G-Sec markets, and also in the money market, much closer to each other.
As argued earlier, the principal interest rate risk for the household sector is on home loans. Clearly, there is a case, as the RBI has emphasised more than once, for greater transparency of the benchmark for floating interest rates. Could, for example, floating rates on home loans be linked to, say, the T-bill rate, and a 5/10 year interest rate swap with the home loan floating rate benchmark as the underlying, be introduced?
Even otherwise, there is a need for a 3/6 months floating rate benchmark, which would be extremely useful for the banking system to manage the interest rate risk on long-term bonds and otherwise also better manage the asset-liability maturity mismatches. Ideally, the benchmark should be the term inter-bank rate — but the market is still not very liquid. In the meantime, we probably need to look at T-bill yields. The benchmark could be say the average of the last three auctions.
Given the volumes of outstanding contracts, we also need guaranteed settlements in the interest rate swap market.
