Why have IRFs not worked? Economic Times 29th September 2010

India is a nation of traders and the success of the United Stock Exchange (USE) in its first week of operations bears testimony to this observation. Coincidentally, the spot markets in equities, foreign exchange and government securities (G-secs) register an average daily turnover of around Rs 20,000 crore.

The derivative markets several multiples of this amount and the only exception is the interest rate (IRFs) market, which has witnessed little interest despite its many versions — the last being in 2008.

The response to F&O trading has been quite remarkable in the past few years, especially in new areas such as commodities and currencies. Currencies currently trade about 3.8 times the physical underlying (comprising foreign trade and external loans) and would go up to 5.5 times if volumes increase by a comparable level with USE coming in.

Gold trades at a multiple of 25, crude oil at four, farm products at unity while stocks three times the cap of the National Stock Exchange (NSE). The nagging thought here is as to why have IRFs not quite caught on.

The market for G-secs is large with the outstanding portfolio being Rs 14 lakh crore. If 25% is excluded, which is classified as ‘held to maturity’ securities, the physical underlying would be Rs 10.5 lakh crore. Institutions trade Rs 20,000 crore of such securities every day and, as interest rates have been volatile in the past, carry a big risk of mark to market (MTM) when they have to value their portfolios. Do IRFs actually satisfy the prerequisites for futures trading?

First, the basic driver of trade is volatility in any market, and NSE Primary Returns Index has witnessed volatility of 7% between April and September. This is comparable to that in other markets, and lies between agri products (5%) and forex (9.5%). Therefore, risk-cover is necessary given the large underlying — 1% change in rates can hit the portfolio by Rs 10,500 crore or 1 bps by Rs 100 crore.

Second, given that is a single product contract which can be settled with other pre-specified ones, for this to be a success, there should be strong correlation with other securities. Here, RBI data shows that there is strong correlation between change in yields on 10-year paper and those on 5, 11, 12 and 20 years and moderately high (around 60%) for eight and nine years. Hence, this too cannot be a reason to reject the product as the contract can be benchmarked with the other papers, though admittedly, the others are not as widely traded as the five- and 10- year securities.

Third, the cost of trading could be another militating factor. But, this segment, like the currency market, is free of this charge unlike the commodity or stock markets, where the charges vary between 0.002 and 0.003%. Therefore, this too could not be an explanation. Fourth, one can surmise that the absence of a yield curve, which is vibrant along all points, is the reason holding back the market, as liquidity in the spot market should enthuse the IRF market.

But still one should expect high volumes of trade for the most widely traded and held 10-year security.
Fifth, the market may not interested in such hedging, especially in an environment when interest rates are expected to move up as there would be less incentive to get into such contracts. Sixth, and probably the more plausible reason could be that players are making use of the volatility in the market through purchase and sale to book their gains and find no need to go in for a hedge.

This could explain why the 75% of G-secs, which are ‘available for sale’ or ‘held for trading’ is actually traded. Lastly, non-G-sec participants do not see this as a hedge as lending rates, for example, do not move in tandem with these rates and hence one could get left out of this market.

Globally, 60% of the derivative market is dominated by equities, followed by interest futures with 15% and currencies with 11%. In India, things are different with equities taking a share of 45%, followed by currencies with 38% (assuming that the Rs 60,000 crore daily volumes are maintained) and gold with just less than 10%. The IRF segment is the missing link that has to be connected. The unanswered question is, how?