Trades in interest rate derivatives expected to match government securities

Mumbai: Fitch Ratings, the international rating agency, said the recent phenomenal growth in derivatives markets in India has seen daily trading in interest-rate derivatives match that of government securities. In a special report released this week, the agency adds, however, that the market is still embryonic, both in terms of depth and sophistication.

This report draws on a survey undertaken in conjunction with the Indian Banks Association (IBA) on India's interest rate and foreign exchange derivative markets, written specifically for financial analysts, policy makers and other interested parties who may not currently be directly involved in the market. Fitch Ratings and IBA surveyed various commercial banks before compiling the report; Fitch also held one-on-one discussions with some of the key players in the market, and separately surveyed mutual funds and primary dealers.

While many responses to the survey were received, the agency understands that regulations in India prohibit mutual funds and primary dealers from participating in all areas of the market, limiting their input. Insurance companies were excluded from the survey, as at the time of the survey, they were prohibited from entering into derivatives contracts.

Fitch has chosen to report its findings given the relative paucity of hard data in this relatively unknown but important segment of the market. Fitch will follow up with those institutions that have reported large exposures to better understand the degree of risk assumed. Response quality and timeliness depends on reasons including risk-reporting systems that are crucial to the healthy functioning of the derivatives portfolio.

Commenting on the market, Amit Tandon, managing director, Fitch Ratings India said, "By trading volumes, derivatives now match government securities. Any disruption in the market could have far reaching ramifications. It is therefore important for policy makers to ensure that legal, accounting, valuation and risk-reporting policies are continuously monitored and improved to ensure market stability."

Some of the key points arising from the survey are listed below:

• Predominantly an inter-bank market, with maximum trading in overnight index swaps (OIS), followed by currency swaps, and currency options. Interest rate futures have yet to gain volumes.
• International swaps and derivatives association (ISDA) agreements have gained acceptance in the Indian marketplace.
• Tenors do not go beyond five years, which is probably due to the absence of counterparty lines for longer tenors. Therefore, the market still lacks the tools to manage interest-rate exposure beyond five years.
• Legal and documentation risks appear the main concerns for market participants. Illiquidity, accounting and tax treatment were also areas that were seen as impediments by survey respondents.
• The small number and varying quality of responses highlighted the lack of market depth. This was further emphasised by the fact that most respondents cited the need for greater investor education as important for the development of the market.

Fitch will continue to hold discussions with those institutions that have not provided comprehensive responses to the survey. Additionally, it may incorporate this in the rating process going forward.