The Reserve Bank of India has over time introduced guidelines on Interest rates derivatives products - both over-the-counter (OTC) and Exchange traded. Since the permissible underlying and purpose, capital requirement and accounting guidelines of OTC interest rate swaps differed substantially from those for interest rate futures, the need was felt to do a detailed study on the prevailing regulations with a view to harmonising these regulatory prescriptions. Accordingly, a Group was constituted to study issues related to interest rate derivatives on an on-going basis, under order of DG (RM) on August 7, 2003. The current Group was chaired by Shri G. Padmanabhan, Chief General Manager – Internal Debt Management Department, Reserve Bank of India (currently Regional Director for Andhra Pradesh) with the following objectives.

1. Evaluating the present regulatory framework for Interest Rate Derivatives and recommend steps to rationalise the prevailing regulations
2. Highlight major issues which are acting as roadblocks in the development of interest rate derivatives market and suggest a roadmap for the future.

The other members of the Committee are as follows:

Reserve Bank of India Shri Shyam Sunder

Reserve Bank of India Shri Amitava Sardar

Reserve Bank of India Shri K Damodaran

Reserve Bank of India Shri T Rabi Sankar

Reserve Bank of India Shri Indranil Chakraborty

ICICI Bank Ltd Shri Neeraj Gambhir

J P Morgan Shri V Srinivasan

J P Morgan Shri Harish Aggrawal

The Committee had a series of meetings over the period from Sep 2003 to Nov 2003. The report is structured in the following manner. Chapter I discusses the prevailing regulations on OTC / Exchange Traded derivatives, highlighting the need for rationalisation. Chapter II details the key issues with the existing regulatory framework and the need to harmonise regulatory requirements for various kinds of products. Chapter III suggests definite measures to be taken in order to rationalise regulatory reporting and ensuring uniform accounting and disclosure norms, while Chapter IV chalks out the roadmap for future development of the interest rate derivatives market.

Deregulation of interest rates, which helped in making financial market operations efficient and cost effective, has brought to the fore a wide array of risks faced by market participants. To manage and control these risks, instruments such as Forward Rate Agreement (FRA) and Interest Rate Swap (IRS) were introduced in July 1999 which could provide effective hedge against interest rate risks.

• Futures on 10-year Notional GOI Security with 6% coupon rate
• Futures on 10 year Zero coupon notional GOI Security
• Futures on 91 day Treasury bills

• Customer transactions -The transactions with customers to hedge their (customers’) interest rate risk.
• Balance sheet hedging - hedging an existing asset or liability on the books of the banks. The underlying can be explicitly identified or can be derived (e.g. for hedging of ALM mismatch).
• Proprietary trading/market making - where the bank deals as principal on its own account with a view to make trading gains from interest rate movements.

The regulations for exchange traded interest rate derivative contracts were introduced much later compared to those for OTC IRS/FRAs. There are significant differences in the regulatory framework for both kinds of products even though both represent the same family of derivative contracts i.e. - linear pay -offs with regard to the underlying.

At the same time, due to increase in market volume of IRS, there is a need to comprehensively review the regulatory reporting for these contracts as existing reporting framework does not adequately disclose the risk being carried by market players.

Consequently, there is a need to harmonise the regulatory and reporting framework for both OTC and Exchange traded products. The following sections elaborate upon the issues with regard to the regulatory and reporting framework.

1. Type of transactions

While the guidelines for IRS/FRA allow various entities to undertake both hedge as well as market making/trading transactions, the guidelines for IRF contracts allow only hedging of AFS and HFT portfolio of GOI Securities. Specifically, trading positions in IRF contracts are not allowed for commercial banks. Also while IRS can be entered into to hedge both assets and liabilities by the banks, the IRF can only be used to hedge GOI Securities portfolio under AFS and HFT category.

Both these products reflect the same kind of risks since both represent linear pay-offs on the underlying and hence the regulatory framework for both IRS and IRF should be symmetrical.

2. Regulatory Reporting

Current guidelines require the participants to report, as per the pro forma indicated in the RBI circular, their FRAs / IRS operations on a fortnightly basis to Adviser-in-Charge, Monetary Policy Department, Reserve Bank of India, with a copy to respective RBI departments. The said report captures only the volumes and the outstanding deal values with the benchmarks, but does not capture the interest rate risk arising from such activities. In case of Exchange Traded Interest Rate Derivatives, the specific return is required on monthly and basis.

Returns of IRS/FRAs transactions require the entities to report the number of contracts and the notional amount of deals executed during the period as well as outstanding as at the end of the period aggregated based on the benchmarks / underlying interest rate exposures. This report is a good indicator on the market volumes, however, the current reporting format captures only a segment of the total interest rate exposure of the participants and does not give an integrated view of the interest rate risk faced by the participant across asset classes and products. So far as the returns on Interest rate futures are concerned, since the banks can undertake only hedging transactions, the reporting format concentrates only on the hedge effectiveness reporting.

3. Credit exposure and capital for credit risk

Recently, there has been a revision in the guidelines on credit exposure norms for all the derivative products. The new recommendation is to follow current exposure method. However, for capital adequacy purposes, the original exposure method is still being followed.

Further, there is no prescribed methodology for disclosing credit risk in the balance sheet in case of IRS/FRA.

Also, currently 100% risk weight is specified for the clearing agencies like CCIL, NSCCL and BOI Clearing house. This needs to be reviewed.

4. Capital for market risk

Banks currently do not have to provide capital for market risk except for 2.5% risk weight on all investments. Given the volatility in the derivatives market, particularly in the MIFOR linked swap segment, it is appropriate to consider market risk charge on the derivatives portfolio. In this regard RBI is considering a transition from the current 2.5% risk weight based market risk charge to BIS duration/ maturity bucket mapping based capital adequacy requirements.

It is imperative that the banks which are desirous of playing a more active role in derivatives segment in the form of running trading book should be subject to a more robust and strict capital adequacy computation methodology .

5. Demand and Time Liabilities

The valuation of FRAs/ IRS / IRFs results in unrealised gains / losses on the balance sheet of the entity on the date of valuation. The guidelines are silent on the treatment of the same for the purposes of regulatory reporting involving the computation of demand and time liabilities of the banks which has a bearing on the determination of the cash reserve requirement, statutory liquidity requirement and assets in India. In absence of specific guidelines, there are different treatments being followed by various market participants.

 

6. Accounting and Disclosure

In addition to the above-mentioned regulatory issues, the committee also discussed a few other issues, which were hindering the growth of these markets.

The committee, based on its deliberations on the issues specified in the previous chapter, arrived at several suggestions to harmonise the regulatory framework for interest rate derivatives. The suggestions mentioned here are with regard to the trading portfolios of the banks, and do not cover the banking book.

In the general ledger, the unrealised gains / losses arising from mark to market of trading positions may be recorded in a separate account ‘Unrealised Trading gains/losses - Interest Rate Derivatives’. On settlement of the interest payments on fixing dates, the net payments may be accounted under ‘Realised Trading gains / losses – Interest Rate Derivatives’. In the ‘Profit and Loss Account’, the gains / losses from derivatives transactions may be reflected under the Schedule of "Other Income" as a separate line item – "Net profit / (loss) on derivatives transactions".

The circular on Interest rate swaps has not specified any particular hedge accounting norms except for the stipulation that the accounting treatment for the hedge should be similar to that of the underlying asset/liability. No particular hedge effectiveness test has been recommended to qualify for hedge accounting. However, the IRF guidelines stipulate such a test for fair value hedges. No suggestions have been made for cash-flow hedges since the underlying permitted to be hedged are only HFT/AFS portfolio of GOI securities which are subject to mark to market requirements.

In order to harmonise the accounting treatment of IRS and IRFs, there are two alternatives:

1. Introduce the hedge effectiveness test for IRS hedges for future transactions. This would necessitate laying down guidelines for cash flow hedges for both IRS as well as IRFs. This would enable eligible underlying for IRFs to be all interest rate risk sensitive asset / liability of the balance sheet.
2. To relax the IRF guidelines by removing the hedge effectiveness requirements.

The committee also recognised the fact that while RBI may specify selective accounting treatments for derivatives, it is recommended that a comprehensive derivatives accounting standard should be adopted by ICAI. Such a standard should be made applicable to all market participants including corporates to bring about uniformity in accounting treatment and balance sheet disclosures.

Netting in Accounting

• Each of two parties owes the other determinable amounts
• The reporting party has the right to set off
• The reporting party intends to set off
• The right of set off is enforceable at law

There has been secular growth in the market volumes of OTC interest rate derivatives in the recent past. It is expected that the harmonisation of regulatory regime and redesign of IRF products will further provide fillip to the interest rate derivatives market in India. Simultaneously, the sophistication and understanding of market participants about these products has grown. Consequently, market participants have been requesting RBI for allowing greater flexibility in terms of structure and array of products.

Accordingly, the committee makes the following recommendations with regard to further development of Rupee interest rate derivatives:

1. Swaptions

Vanilla Payers and receiver’s options on liquid swaps like OIS and IRS with MIFOR benchmarks could be introduced as a first step.

2. Options on interest rate benchmarks i.e. caps, floors etc

Vanilla caps and floors on liquid money market benchmarks like MIBOR, MIFOR, 91 day T-Bill rates should be introduced in the first stage.

3. Optionalities in swaps

The July 1999 circular prohibits use of optionalities in interest rate swaps. It is recommended that once the OTC interest rate options like caps and floors are allowed, the same may be permitted to be embedded in the IRS contracts.

4. Exchange traded Options on Interest rate futures

1. Physical settlement of interest rate futures

At present, interest rate futures are traded on the basis of cash settlement. Since the notional underlying in the case of these futures are hypothetical securities like a notional 10 year coupon bearing bond or a notional 91 day T-bill, to some extent the settlement prices are essentially theoretical. This can lead to situations whereby, the futures trade at significant basis as compared to the cash markets. To ensure that futures reflect true expectations about the evolution of cash market, physical settlement should be introduced .

2. Short selling in cash markets

The derivative pricing models including those for options, futures and swaps assume that it is possible to replicate the derivatives pay-offs in the underlying cash market in order to hedge the derivative positions. At present, while it is possible to take two-way positions (i.e. both long and short) in FX markets, the same is not true for GOI Securities and Corporate bonds. It could be argued that one reason for non-development of GOI Sec yield based swap benchmarks is the lack of hedging ability in case of certain structures since short-selling in these securities is prohibited. To provide for better price discovery of derivatives, it is recommended that allowing short-selling in GOI Securities should be considered with adequate checks and balances in place. Accordingly, short selling could be allowed in two phases:

1. In the first phase, banks could be allowed to hedge derivatives positions by short selling in the cash segment.
2. Based on the experience gained, the facility of short selling could be extended without any reference to derivative positions in the second phase.

3. Close-out netting - legal framework

At present, close out netting is not possible in case of derivative contracts. It may be noted that in the absence of close-out netting, banks calculate the counterparty exposure on trade-by trade gross basis not withstanding the fact that there may be offsetting transactions with the same counterparty. This leads to high utilisation of counterparty limits and restricts the liquidity in the interbank OTC derivatives market. The group, therefore, recommends that RBI should pursue necessary legal changes to allow close-out bilateral netting.

4. Multilateral netting using CCIL

The issue of enabling banks to take trading positions in exchange traded interest rate derivatives has been raised by individual banks as well as FIMMDA in various fora. The issue also needed to be relooked with a view to impart liquidity to exchange traded interest rate futures segment as banks are one of the major providers of liquidity in the cash markets of government securities. Also in view of the fact that Primary Dealers have already been allowed to run a trading position in IRFs , the issue of the banks participating in the IRF segment was revisited by the Group . Whilst it is desirable that the market for IRFs be as wide as possible so that liquidity in the segment gets enhanced, it is also felt that given the volatility in the underlying cash markets , participants desirous of running a trading book should need to fulfill some additional criteria .

To have a fix on the criteria , dealing rooms of some of the banks active in OTC derivatives segment was visited.

A wide disparity in terms of skills as well as infrastructure among participants active in OTC derivatives was observed while visiting the dealing rooms. It was also felt by the group that a minimum infrastructural needs have to be maintained in order to run a trading book in derivatives. According to the group the following issues need particular attention:

1. Fixation of product/portfolio wise risk limits (PV01/ ALM) and counterparty wise exposure limits.
2. Robust mid office systems to monitor interest rate risk exposure on an ongoing basis.
3. Documentation of product specific risk management guidelines, documentation of limits.
4. Appropriate exception reports for MIS/ control purposes.

While the Group notes that there have been alternative models for capturing the interest rate risks, it is of paramount importance that such risks be monitored on a real time basis. None of the banks, the group visited has yet set up infrastructure for trading in the exchange traded derivatives. The exchange traded derivatives require certain additional infrastructural requirements like availability of trading screen (proprietary / broker), allocation of trading limits on the trading terminals , online monitoring of the order book, margins account oversight by mid as well as front office etc. While most of the issues in this regard can be satisfactorily resolved in case the entity is a member of the stock exchange. But in case the entity trades through a broker account, satisfactory additional internal controls need to be put in place for independent oversight by the mid office.

Based on the deliberations of the group, the entry point criteria in respect of running a trading book in Interest Rate Futures are as follows:

1. CRAR of 10%
2. Minimum networth of Rs 200 crores

Banks satisfying the above criteria may apply for RBI’s consideration of granting them in principle approval to run a trading book.

On receiving in principle approval the banks may revert to RBI on the following issues :

1. Corporate interest rate risk limit ( in terms of loss in Rs crores on account of 100 basis point parallel shift in the yield curve) for trading portfolio which may not exceed a certain proportion of Tier I capital.
2. Board Policy on interest rate risk management
3. Clear definition of authority for setting, modifying, reviewing sub limits and periodicity of review of limits
4. Control lines and responsibilities for interest rate risk management
5. Past experience in management of trading portfolio in IRS/FRAs, securities, fx options.

RBI can consider authorizing the entities to undertake trading positions in Interest Rate futures after satisfying itself about the bank's capabilities to undertake the above activities and considering the quality of internal and regulatory compliance.