By Nachiket Mor
I was recently made aware of a fascinating speech2 on this topic given by Mr. V. K. Sharma (ED, RBI) in Mumbai on November 8th, 2012. In this speech he takes the example of three fixed income derivative contracts and examines why all three of them have failed to live up to their original expectations. He concludes his speech by making some important recommendations on what might be done to redress these failures.
He opens his remarks by commenting on the Interest Rate Swaps (IRS) market in which, “currently the 5 year IRS yield is trading at a negative spread of 120 basis points to 5 year G-Sec [Government of India Security]!” and as a consequence, “… while the G-Sec yield curve is almost flat, the IRS yield curve is steeply inverted…”. For fixed rate receivers, i.e., holders of government securities, he argues that this represents a very profitable and risk-less arbitrage opportunity “…involving buying corresponding maturity G-Sec in the cash market [therefore receiving fixed]3 by financing it in the overnight repo market4 [therefore paying the overnight repo rate], and paying fixed, and receiving overnight, in the IRS market!”. While it is not clear from the text of Mr. Sharma’s speech why, despite the existence of this enormous mispricing, the IRS market is so large (over Rs.50 trillion when the total G-Secs issued are only at Rs.30 trillion), he does express the concern that it represents a “veritable IRS ‘Super-Bubble’” and signifies a “massive ‘financial sector-real sector imbalance’”, created largely on account of, as I understood it, insufficient activity by arbitragers, in particular the public sector banks who have largely stayed out of the market5. This is certainly an interesting situation because it is the presence of arbitragers that is generally associated with existence of asset price bubbles and not the other way around.
In examining the Credit Default Swap6 (CDS) market, Mr. Sharma makes a similar point and argues that the massive mispricing in the IRS market made the CDS far too expensive to buyers and therefore the CDS market remained still-born and simply no arbitrage activity was even possible. He goes on to suggest that this is one of the reasons that the corporate bond market has itself not taken off because buyers of corporate bonds cannot purchase reasonably priced default protection. The Interest Rate Futures7 (IRF) in his view also suffered from insufficient arbitrage activity between the physicals market and the IRF market, allowing large levels of mispricing to persist.
He expresses the concern that in the absence of sufficient arbitrage activity not only have the derivative markets failed to evolve but their inability to transmit liquidity has led to continuing market fragmentation which in turn has been “…the biggest undoing of an efficient, deep, liquid, organically connected and seamlessly integrated financial market which is also a ‘sine qua non’ for effective, efficient, and instantaneous monetary transmission.”. In order to increase the level of arbitrage (and hedging) activity and to anchor the instruments and their prices to the real-sector in a manner that enhances liquidity and efficient price discovery in the physicals market, the following are a few of the recommendations that he makes8:
- Do not launch cash-settled IRF contracts because they will further increase the level of disconnection between the physicals and the futures markets.
- Do not permit IRF contracts that are just settled in the most liquid (and cheapest to deliver) G-Sec because it represents less than 10% of the physicals volume and will not therefore serve the liquidity transmission function.
- Removal of ‘hedge effectiveness’ criterion of 80% to 125% so that there is a great incentive to hedge even if the hedge is less than perfect9.
- Roll back the Held to Maturity (HTM) protection10 offered to banks. Given the very large size of the IRS market banks should easily be able to substitute this with hedges, particularly if they are allowed some leeway in computing effectiveness in accordance with the previous recommendation. This could particularly improve the participation of public sector banks in the fixed income derivative markets.
- Permitting delivery-based short-selling in the cash market and the introduction of term repo, and reverse repo, markets, both co-terminus with the tenure of futures contracts.
I found that the speech made very fascinating reading and offered important insights into why these markets have failed to take off and what might be done about it so that they can grow in an orderly manner.
- 1 – This blog post reflects my personal understanding of the speech given by Mr. Sharma and may not have accurately captured what he wanted to convey.
- 2 – Link to the full text of the speech: http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/SABF121112_F.pdf?cat_id=46&event_id=3
- 3 – Square brackets are mine.
- 4 – Overnight repo stands for Overnight “Repurchase Obligation” and represents the sale by the buyer of the G-Sec (or any other security) today for the agreement (or obligation) to repurchase it at an agreed upon price. The difference in the sale price and the agreed repurchase price represents the “repo rate”. For more detail see: http://en.wikipedia.org/wiki/Repurchase_agreement
- 5 – He reports that private banks constitute 18% of the market, foreign banks 80%, while public sector banks account only for 2% of the market despite controlling about 74% of the total assets of the banking system.
- 6 – A Credit Default Swap (CDS) is an agreement which refers to a specific Reference Bond and in which the buyer of the CDS makes to the seller a series of payments (comparable to a credit spread) and in return the seller agrees to compensate the buyer of the CDS, if the Reference Bond experiences a default. For more detail see: http://en.wikipedia.org/wiki/Credit_default_swap
- 7 – An Interest Rate Futures (IRF) contract is a futures contract in which the underlying asset is an interest bearing security or a basket of these securities chosen by the exchange on which the contract is listed in a manner consistent with regulatory guidelines. See the link for the RBI guideline on this: http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=6912&Mode=0
- 8 – Full list and their exact wording are in the text of the original speech.
- 9 – Most accounting systems require all derivatives to be marked-to-market but do not generally require this for the underlying financial assets (“physicals”). This could result in substantial volatility in the profit-and-loss accounts of firms and financial institutions. In order to help mitigate this and better align accounting reality with the underlying economic reality, firms and financial institutions are permitted to net off “effective hedges” against the underlying.
- 10 – The HTM protection allows the banks to classify a host of securities as being intended to be held until they mature so that they then need not be marked to market. This protection often severely inhibits trading and hedging activity by banks.