Finance & RevenueInclusionPast IssuesWhither Financial Inclusion

Financial Innovations That Never Were

The Report of the Committee on Financial Sector Assessment, headed by Rakesh Mohan, noted that the notional principal amount of outstanding interest rate swap (IRS) of all commercial banks increased from over Rs 10 trillion (as on 31st March 2005 ) to over Rs 80 trillion ( as of 31st March 2008). However, the notional principal amount of outstanding IRS of commercial banks declined to Rs 50 trillion as of 30th June 2012. A granular analysis reveals that of all the commercial banks engaging in IRS, public sector banks accounted for less than 2 per cent of the notional principal amount of outstanding IRS while private sector and foreign banks accounted for 18 per cent and 80 per cent, respectively. In other words, with combined assets of Rs 6 trillion or thereabouts foreign banks accounted for notional principal amount of outstanding IRS of Rs 40 trillion.

Significantly, it is disturbing to note that the IRS yields trade way below yields of comparable maturity government securities. Further, while the government securities yield curve is almost flat, the IRS yield is steeply inverted defying term, credit risk and liquidity risk premia, which typically characterise a normal yield curve of risk assets. A typical, but fallacious, rationalisation offered of this counter-intuitive feature is that while IRS yields are influenced by expected path of future interest rates, those of government securities are influenced by their supply! Nothing could be farther from the truth. Government securities are influenced by, and immediately price in, inflationary expectations arising from higher fiscal deficit, which in turn is the cause of additional supply of government securities, not the other way round. Thus, here we have an IRS market completely upside down. This is completely anti-thetical to the law of one price, or the no-arbitrage argument. For, if this law held, given hugely negative spreads to government securities, fixed rate receivers, who far exceed fixed rate payers, would have engaged in a very simple arbitrage involving buying corresponding maturity government securities in the cash market by financing it in the overnight repo market. This very normal, and logical, arbitrage would have had the effect of benefiting all the three stakeholders – fixed rate receivers receiving much higher yield than they are currently, the Government of India borrowing at much lower cost, and business and industry in general and the infrastructure sector in particular getting long-term fixed-rate low-cost financing solutions. In other words, this would have been a win-win for all key stakeholders. The fact of the matter though is that this is just not happening. The stock but specious explanation of this almost permanent, though quirky, feature of the Indian IRS market is that arbitrage involving receiving fixed returns on government securities and paying fixed returns in IRS is not possible because of the so-called ‘basis risk’. But this is totally untenable for the simple reason that ‘basis risk’ applies just as much to ‘hedging’ as it does to ‘arbitrage’.

The totally misplaced temptation and impatience to introduce ‘cash-settled’ IRF must be firmly and decisively resisted, for such medicine will be worse than the disease

In other words, ‘basis risk’ is ‘arbitrage-hedging’ agnostic and, therefore, it inevitably, and incontrovertibly, follows that the IRS market is not being used even for ‘hedging’. If that be so, then what is 98 per cent of the Rs 50 trillion IRS market being used for?

Indeed, in the analytical framework for identifying systemic financial risks, this situation can be reasonably interpreted as a veritable IRS ‘super-bubble’, signifying huge under-pricing of interest rate/credit risks. It thus follows that the situation in the IRS segment is almost getting to the point where instead of being a means to an end of subserving the real sector, it is, for all intents and purposes, existing almost entirely for its own sake, creating a massive financial sector–real sector imbalance. The IRS market in India is then a financial innovation that never was.

Like IRS, or for that matter any other derivative, credit default swap (CDS) is no exception to the cash market replication principle of derivatives pricing. The price of a CDS, in spread terms, is reasonably approximated by the difference between the spread of a reference bond to corresponding maturity government securities yield and the spread of IRS to the same maturity government securities yield. However, when such a product was launched in December 2011, it was stillborn. In fact, its epitaph was written in the quirky and preposterous feature of hugely negative IRS yield spreads to corresponding maturity government securities yields itself. As a result, a happening corporate bond market could not happen, inter alia, to supplement the huge infrastructure funding needs of the Indian economy.

If the CDS was stillborn, Interest Rate Futures (IRF) too suffered mortality in its infancy the second time round after its 2003 version. After its re-launch in August 2009, interest rate futures on 10-year notional government bonds have seen two settlements, viz., the December 2009 contract and March 2010 contract. Significantly, traded volumes and open interest both witnessed decline over the two settlements, eventually decaying very quickly to zero. Both these settlements were a far cry from the hallmark of an efficient, frictionless and organically connected, physically-settled futures market even where physical delivery typically does not exceed 1-3 per cent of the peak open interest. This happened because of the inefficient ‘disconnect’ and ‘friction’ in the IRF market due to one-way arbitrage, viz., buying the cheapest-to-deliver with the highest implied repo rate (IRR) by financing the same at the actual repo rate and simultaneously selling futures. But this arbitrage could not be engaged in for want of short-selling for a period co-terminus with that of the futures contract. It is the possibility of this two-way arbitrage, working in opposite directions, which like a ‘good conductor’ will seamlessly transmit liquidity from the relatively more liquid (most-expensive-to-deliver) benchmark government bonds to the so-called illiquid (cheapest-to-deliver) bonds in the deliverable basket. Here, I hasten to caution, that the totally misplaced temptation and impatience to introduce ‘cash-settled’ IRF must be firmly and decisively resisted, for such medicine will be worse than the disease. Neither am I even remotely suggesting that it is perfectly legitimate to have ‘cash-settled’ derivatives contracts in the case of ‘homogeneous’ assets like equity, currencies and commodities. Any ‘cash-settled’ derivative, where physical settlement is possible, tends to become a non-derivative, violating the cardinal principle of arbitrage-free pricing.

Continuing market segmentation in India is the biggest undoing of an efficient, deep, liquid, organically connected and seamlessly integrated financial market

Continuing market segmentation in India is the biggest undoing of an efficient, deep, liquid, organically connected and seamlessly integrated financial market. Market segmentation contributes to price distortion and inefficiency. The most tangible and manifest evidence of market segmentation in India is the ‘disconnect’ between the IRS, IRF and government securities markets. However, this market segmentation can be credibly, effectively and decisively addressed if the reforms propositioned below are synchronously orchestrated:

  1. The totally misplaced temptation, and impatience, to introduce cash settled IRF must be firmly and decisively resisted, as this will, to quote Jamie Dimon, Chairman of JP Morgan Chase, be tantamount to “doing the ‘easy’ and not the ‘right’ thing”.
  2. What must certainly not be done is to even contemplate, much less permit, the most-liquid, single-bond IRF, for the very simple reason that this benchmark security represents less than 10 per cent of the current 10-year IRF deliverable basket and would, at a time when we are talking about ‘inclusion’, amount to veritable ‘exclusion’ of 90 per cent of the 10-year government securities from the benefit of hedging.
  3. What also must certainly not be done is to contemplate, much less allow, selling of securities acquired under market repo, if the IMF finding in the wake of the 2008 global financial crisis is anything to go by.
  4. What also must certainly not be done is allocate specific government securities to different primary dealers for market making as this will be a ‘triple whammy’, in that it will segment the market straightaway, lead to concentration of risk and militate against portfolio diversification.
  5. Symmetrical and uniform accounting treatment of both cash and derivatives markets.
  6. Removal of the ‘hedge effectiveness’ criterion of 80 per cent to 125 per cent which militates against use of derivatives for hedging purposes.
  7. Roll-back of the held-to-maturity protection, i.e., substituting the current accounting hedge with derivative hedge.
  8. Both for IRS and IRF, actual notional/nominal amount must be allowed on duration-weighted basis unlike the current regulation, which restricts the maximum notional/nominal amount of hedging instruments to no more than the notional/principal amount of exposure being hedged.

V K Sharma

V K Sharma is Executive Director, Reserve Bank of India
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