Interest rate swaps are used as an insurance against adverse movement of bond yields. The relevance of this instrument has come into focus after the recent spike in bond yields. In the December quarter, the 10-year bond yields rose about 70 basis points, and banks had to book huge mark-to-market losses.
Along with IRS, the RBI will also allow ‘swaptions’, which is a derivative of a derivative (in this case interest rate option). Swaptions, or an option to enter into a swap transaction, gives better timing flexibility in managing interest rate risks, said the RBI.
“This proposal aims to tap into the active offshore rupee interest rate swap market to add depth and liquidity to the domestic interest rate swap market,” Acharya said in a post-policy press conference, adding the access would be subject to macro-prudential risk limits.
IRS is the most liquid among all interest rate derivative markets, but the volume traded is not readily available. It, however, “lacks depth to enable large banks to manage risks”, the RBI said.
“Thin participation and consequent absence of divergence of views result in pricing inefficiencies, which further discourage participation. At the same time, it is understood that there is an active market for rupee interest rate swaps offshore,” it said.
Besides, the Indian market has now wider range of non-resident players in the forms of foreign portfolio investors (FPIs) in debt.
The development of the market, therefore, would accommodate divergent participants, the central bank said.
The draft guidelines on this would be issued by the end of May.
In the interest rate option market, only plain vanilla products were allowed. Market participants, including the Fixed Income Money Market and Derivative Association of India (FIMMDA), have expressed the need for swaptions to effectively manage interest rate risk.
The RBI also said it would review the guidelines of STRIPS, which is an acronym for Separate Trading of Registered Interest and Principal Securities. As the name suggests, the principle and interest rates on these instruments could be traded separately.
While the instrument was introduced in 2006, it never really took off as investor demand for existing bonds is still low.
According to the head of treasury at a foreign bank, the instruments being introduced by the RBI are unlikely to have ready takers, but interest can build up slowly.
“This is a very niche market and unless public sector banks chip in, they are unlikely to take shape. As we have seen in the past, these banks queue up to build up volume in the first few days and then abandon the market,” said the treasurer.
- Move aims to develop a deep rupee interest rate swap market that accommodates divergent participants
- Detailed draft regulation will be issued for public comments by the end of May
- RBI to also allow ‘swaptions’, or an option to enter into a swap transaction
- The central bank will review the guidelines of STRIPS (Separate Trading of Registered Interest and Principal Securities)