Indian Derivative Markets Future Prospects

CAPAM 2003August 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

June 2000 – Equity Index futures

June 2001 – Equity Index options

July 2001 – Stock Options

November 2001 – Stock futures

June 2003 – Interest rate futures

1980s – Currency Forwards

1997 – Long term FC –Rupee swaps

July 1999 – Interest rate swaps and FRAs

July 2003 – FC-Rupee options

Exchange tradedOTC

November 2002 - RBI Working group on Rupee derivativesMarch 2003 - RBI Working group on credit derivatives

Derivatives –acquiring size

Market Type Cash Turnover

Derivatives Turnover

Derivatives as % 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’022. Estimated annual turnover for FY’03 for GOISec, Corporate bonds and Swaps3. Gross turnover on BSE and NSE during FY’03

Rs 1 Trn = Rs 100,000 Cr

Introduction of new products have resulted in increased volumes

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

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

Outstanding notional value has grown 50 times over last 3 years

0

1000

2000

3000

4000

5000

6000

7000

Mar-00 Mar-01 Mar-02 Dec-02

Outstanding Contracts

0

25

50

75

100

125

150

Mar-00 Mar-01 Mar-02 Dec-02

'Outstanding principal (Rs '000 cr)

Rupee Swaps – Transaction costs

Increasing volumes have led to lower bid-offer spreads

-

5.00

10.00

15.00

20.00

25.00

May-02 Jul-02 Aug-02 Oct-02 Nov-02 Jan-03 Mar-03

5- Year Mifor 5- Year OIS

Bid Offer on Swap type J une 3,

2002 Feb 14,

2003 1-yr OIS 4 bps 4 bps 3-yr OIS 15 bps 8 bps 5-yr OIS 20 bps 7 bps

3-yr MIFOR 20 bps 10 bps 5-yr MIFOR 20 bps 8 bps

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 Will largely 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 CurrencyBank 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 nettingAdequacy of margins is the key issue

Collateralisation and NettingGlobal trend towards collateralisationISDA estimates international gross amount

of collateral to be $ 719 Bn in 2003Increase of 67% over 2002

Bilateral Netting

Source: Office of Comptroller of CurrencyBank derivatives report

Summing up

• More leverage• Less transparency• Regulatory arbitrage• Rising CP exposure• Hidden systemic risk• Tail-risk future

exposure• Weak capital

requirements• Zero-sum transfer tools

• Market efficiency• Risk sharing and

transfer• Low transaction costs• Capital intermediation• Liquidity enhancement• Price discovery• Cash market

development• Hedging tools• Regulatory savings

Risks and Rewards of Derivative markets

" 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."

“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.”

Alan Greenspan

Warren Buffet

Thank You