Introduction of Government Securities Futures: An Indian Perspective
Government Securities futures, which are the most voluminous exchange traded products in the world, are back in focus with the RBI announcement to introduce Interest Rate futures. This article analyzes the move, in light of the recommendations made by the RBI committee, and the factors that led to the IRF market failure, when introduced in 2003. Presently, favorable factors in the economy- like banks being allowed to take trading positions- are pitted against impediments, like patchy liquidity. In such a conflicting situation, the success of this market will depend on the astute handling of these factors.
RBI's announcement regarding the introduction of Interest Rate Futures (IRF), with the underlying asset being notional coupon bearing 10 year government bonds, has brought these derivative agreements under the limelight. Such instruments are meant to assist institutions in managing interest rate risk in the wake of interest rate volatility. An interest rate futures contract1 is "an agreement to buy or sell a package of debt instruments at a specified future date at a price that is fixed today." The underlying assets of an interest rate futures contract are different interest bearing instruments like T-Notes, T-Bills, T-Bonds, deposits and so on. The main issue of contention currently is the manner in which RBI proposes to address the issues that led to the failure of the IRF market in 2003 and the evolution of the investment market thereafter. The article looks at the recommendations made by the RBI committee and also analyzes the factors that may act as impediments to the development of this market in India.
Bond Futures - An Overview
Bond futures were first listed in 1977 when the futures were written on the 30-year U.S. Treasury bond. Since then, we have seen innumerable central banks adopting them the world over. Bond futures are derivative contractual agreements between two parties to buy or sell bonds at a future date. The invoice value of the transaction is set on the date the agreement is reached. They are different from a forward contract which are traded over-the-counter (OTC) at an exchange. The exchange behaves as counterparty to both the short and the long, standardizing them to drive more liquidity into these products.
Bond Futures - Statistics
The top bond futures contracts worldwide by volumes are listed below in Exhibit 1. The world's most popular bond futures contracts are listed at the Chicago Board of Trade (CBOT). Statistics show that interest rate exchange traded derivates form 17.14% of the global exchange-traded derivatives. Importantly, trading in exchange derivatives in the Asia Pacific region has surpassed the European region in the year 2007. In general, the government debt bonds are more popular than the corporate-based bonds due to the higher risk of default associated with the corporates.
Top 10 Bond Futures in the World, by Volumes, 20072
|Rank ||Contract ||Vol. (no. contracts) ||Change %|
|1 ||10y Note, CBOT ||349,229,371 ||36.65|
|2 ||Euro-Bund, Eurex ||338,319,416 ||5.76|
|3 ||Euro-Schatz, Eurex ||181,101,310 ||9.55|
|4 ||Euro-Bobl, Eurex ||170,909,055 ||2.15|
|5 ||5y Note, CBOT ||166,207,391 ||33.1|
|6 ||30y Bond, CBOT ||107,630,211 ||14.8|
|7 ||2y Note, CBOT ||68,610,392 ||80.71|
|8 ||3y Bond, ASX ||33,585,015 ||8.28|
|9 ||Long Gilt, LIFFE ||27,367,489 ||24.35|
|10 ||JGB, TSE ||16,196,071 ||25|
Features of Bond Futures
Being exchange traded, the future contracts regulate all participants enforcing settlement and margin payments. Most of the contracts are not settled at expiry and either they get rolled over or they get closed out - hence it is not important to take positions in the underlying. Therefore the parties are able to short sell as well as take long positions bigger than what they could take in the physical market. Futures have different underlying tenors such as five yr, 10 yr and so on. Also, futures of next few expiry dates are traded simultaneously. This enables rolling of contracts into the next period easily. It is literally impossible to deliver an exact 10 year or a specific time maturity bond as they are issued or auctioned at different times depending on debt requirements of the governments. Therefore the futures contracts are either cash settled based on a calculation method or have a delivery grade3 for physical settlement. They are used for speculation in interest rates as well for hedging various loan portfolios.
History of Bond Futures in India
Post liberalization in 1991, owing to financial sector reforms interest rates have been deregulated in India making them volatile. To hedge and manage interest rate risks as a first step in 1999, the Reserve Bank of India (RBI) introduced over-the-counter (OTC) derivatives. Most prominent amongst them were the Interest Rate Swaps (IRS) and Forward Rate Agreements (FRA). The OTC trading experiment was by and large successful when measured against the satisfactory volumes it generated, but it seemed to suffer from shortcomings such as information asymmetries and lack of transparency and its concentration in major institutions. As an improvement in January 2003, the RBI committee headed by Jaspal Bindra, CEO, Standard Chartered Bank, recommended4 the idea of introducing the Exchange Traded Interest Rate Futures citing advantages such as listed anonymous trading, full transparency, lower intermediation costs and better risk management. In June 2003, the following cash-settled variants of interest rate futures were launched:
- Futures on 10-year notional zero-coupon Government of India (GoI) security
- Futures on 10-year notional GoI security with 6% coupon rate
- Futures on 91-day Treasury bill
However the IRF market attracted very few participants and transactions and effectively failed to take off. Two major reasons for this were:
- Cash settled on a curve (Zero Coupon Yield Curve) was not understood by common traders.
- Banks were prohibited from taking trading positions in these contracts, depriving early liquidity.
In February 2008, RBI constituted another working group under the chairmanship of Executive Director Mr. V. K. Sharma to look into the matter and the Group made a comprehensive set of recommendations5 .
RBI's Major Recommendations and Observations
As per the committee's recommendations, the banks would be allowed to take trading positions in the interest rate futures which are slated to be introduced. Taking a cue from historical failure, this is a correct step towards the success of the product. Presently short selling is allowed for five days in the cash market. The committee also suggest short selling intervals co-terminus with the futures contracts. This has to be added with increasing liquidity in Repo market by removing certain existing restrictions5.
The committee also presently counsels introducing 10-year bond futures with a notional coupon underlying, which has to be physically settled from a basket of bonds. Here two views arise - a battle between the cash-settled and physical settlement system. Whereas cash-settlement reduces chances of squeeze, they make the futures market decoupled from the debt market bringing about more speculation. But on account of being used in more developed markets, the physically-settled mechanism has been proposed7 .
In addition, the committee recommends that the deliverable grade has to be specified by the exchanges, but the best basket seems to be in the range where the time to maturity is 7.5 years to 15 years. Also it would be good if the trading hours of the futures matched those of the bond market to remove any wildcard options. One major restriction which the group specifies is that the total outstanding stock of the bond shouldn't be less than Rs. 20,000 crores for it to be eligible to be a part of the basket.
Potential for Development of the Market in India
The potential for development of bond futures market is much more than what could be perceived from the failure of the product last time around. To explore this, let us look at how investors are trading in Government bonds in India (G-Secs).
Growth of Bonds Traded in India8
|Year ||Traded (Rs. Cr.) ||% change|
|2002-03 ||1,545,672.71 || n.a. |
|2003-04 ||2,519,642.17 ||63.01%|
|2004-05 ||2,691,176.65 ||6.81%|
|2005-06 ||2,560,175.28 ||-1.58%|
|2006-07 ||3,578,845.29 ||39.79%|
|2007-08 ||5,603,376.17 ||56.57%|
The data in Exhibit 2 shows how the traded volume has increased in the G-Secs in India. Especially in the last two financial years, we see a 40-55% increase in participation in this domain. Also, the minimum lot size traded in the wholesale segment is Rs. 5 crores.
In terms of penetration, India's participation is still low, while having a right mix of investors presently. Let us look at some of the sources of investments in India.
Indian Household Savings
This very conservative segment constitutes around 80% of India's aggregate savings. Roughly 50% of this is in the form of Indian currency or deposits. The other major chunk of 30% goes into Indian pension and provident funds and various insurance products. They in turn are investors in the fixed market segment. Also, the very vibrant stock market sees only 4% of this segment getting invested. The rest of the pie goes into the direct investments in small saving instruments, government securities and others.
This segment goes the safe way through bank deposits earning less than 4% annualized returns. There is a potential of it being invested into the fixed income market if given greater leverage and better liquidity. The pension and provident funds could further use futures for their duration management. The saving schemes offered by government, earning from 3% to 9% returns, drive the chunk of fixed income investments. This could be well diversified, depending on how the risk appetite changes, per capita income increases and as the households become more educated.
The Life Insurance Corporation of India (LIC) and the Employee Pension Fund (EPF) are the major players in the long term investments by households. Most of their holdings (85%) are in public securities that have longer maturity periods. But with the dominant population of India current in the working age group, the redemption will come very late in the future. Therefore, we could clearly see that the investors are not managing the duration of their portfolio very effectively. Due to asset-allocation restrictions they are not able to enter other segments. Here, the bond futures would maintain the same allocation while bringing much better efficiency to their portfolios.
Foreign Institutional Investors (FIIs)
There is a cap on the amount FIIs can invest in the Government securities. Their large presence in the Indian market in various sectors gives them exposure to the Indian interest rates and hence they would be willing to invest in IRFs. The current investment limits in treasuries and corporate bonds have been enhanced and this can be seen as a step in the right direction.
They are one of the major sectors for long-term investing vehicle in India. They had $65 billion under their investment in September 2006, the amount being around 10% of GDP. At the current growth rate it is predicted that this amount will double in the next 10 years. Also the penetration into the household savings is currently pretty low. Therefore there is great scope of investment by Mutual Funds in the fixed income domain.
OTC Derivatives in India
Since 1999, the OTC derivatives market has grown rapidly. The major hedgers involved are financial institutions and corporate houses, who are large borrowers converting fixed debts to floating. But, one of the major hurdles has been the lack of a liquid money market curve, due to limited credit appetite and the capital constraints that banks face. Moreover, corporations can use OTC derivatives only for hedging purposes while no such restrictions apply in the case of exchange-traded derivatives. This would lead to a natural demand for exchange-traded derivatives such as bond futures.
Impediments to Growth in India
There a certain hindrances to the development of bond futures market in India and these need to be addressed by RBI. Some of them are listed below.
One very important condition in India is the patchy liquidity of Indian Government Securities (G-Secs). They show trading in some securities in different time periods. One reason for this is the major holding by banks due to the Statutory Liquidity Requirement.
If we consider the 10 year note futures contract, which might be deliverable in June 2008 (shown in Exhibit 3), considering the deliverable grade as 7.5 years to 15 years, a patchy basket is observed. This is a very wide range for a 10-year futures contract. This has led to a considerably big basket. The major liquidity lies in the two bonds - 7.49% and the 7.99% coupons. Hence, apparently there is a huge possibility of squeeze in such a scenario.
If we remove the bonds having a very small amount of outstanding, most of the bonds would be removed from the eligible basket. Then bonds like the 7.49% and 7.99% would mostly comprise the liquid basket. The RBI has therefore recommended that a requirement like Rs. 20,000 crore outstanding for the bond be imposed.
Basket of deliverables in an Imaginary futures Contract based on RBI's proposal
|Bond ||Liquidity (Avg. Daily Vol. for 12 months) (Rs. million)|
|5.59% 2016 ||30.00|
|12.30% 2016 ||-|
|8.07% 2017 ||2662.50|
|7.49% 2017 ||12215.83|
|7.99% 2017 ||19594.73|
|7.46% 2017 ||23.38|
|6.25% 2018 ||57.33|
|8.24% 2018 ||Hot run|
|5.69% 2018 ||103.13|
|12.60% 2018 ||4.78|
|5.64% 2019 ||25.87|
|6.05% 2019 ||-|
|10.03% 2019 ||-|
Further Imbalance of Liquidity
We can easily see that the liquidity in G-Secs is very varied. When the 10-year futures contract comes into the market, it could lead to liquidity of bonds in the basket having a little less than 7.5 year of maturity or more than 15 years of maturity to shift towards this active basket. Although the liquidity in the spot market is bound to increase due to the futures market, it could cause some bonds to suddenly lose their liquidity. This is an apparent risk which banks run, as they hold considerable amount of the G-Secs.
Ever since the deregulation of the financial markets in India, there has been a call for instruments that would help investors, especially banks, better manage the risk to fluctuations in the interest rates. In 2003, trading in Interest Rate future contracts was introduced but it failed to take off due to various reasons. RBI's recent move to introduce Interest Rate futures with a fresh set of guidelines as recommended by its Technical Advisory Committee brings these instruments back under limelight. This development provides an opportunity for Banks in India to speculate and hedge more through another fixed income product. The growth in the volume of bonds traded in India in the recent past as well as right investor profile are some of the factors that will help in the development of this market this time round. However, impediments like patchy liquidity across various government bonds as well as the possibility of further liquidity imbalance need to be kept in mind while analyzing the growth in the IRF market.
Narayan P. C. is a Visiting Faculty in the Finance and Control Area at IIM Bangalore. He has completed the Advanced Management Program at IFAP Rome, Italy and holds a PGDM from XLRI, Jamshedpur and Bachelor's degree in Engineering from the Regional Engineering College, Tiruchirapalli. He can be reached at firstname.lastname@example.org
Aditya Gupta (PGP 2007-09) holds a B. Tech. in Engineering Physics from Indian Institute of Technology (IIT) Delhi. He can be reached at email@example.com
Sunny Malhi (PGP 2007-09) holds a B. Tech. in Computer Science and Engineering from Thapar Institute. He can be reached at firstname.lastname@example.org
Finance & Control, Public Policy, Financial Services, Interest Rate, Futures, RBI, India
- Centre for Management Research (ICMR), 2003, 'A note on Interest Rate Futures', 2003, http://www.icmrindia.org/casestudies/catalogue/Miscellaneous/MISC011.htm. Last accessed on Dec 8, 2008
- Futures Industry Magazine, Mar-Apr '08
- The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered.
- Reserve Bank of India, 2003, 'Report of the Working Group on Rupee Derivatives', Jan 2003, http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/34148.pdf. Last accessed on Dec 7, 2008.
- Reserve Bank of India, 2008, 'Report on Interest Rate Futures', Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets, Aug 2008, http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/86253.pdf. Last accessed on Dec 7, 2008.
- The current penalties imposed against SGL bouncing should be replaced with a more transparent system.
- One of the committee members, Dr. Susan Thomas had contrary views. According to her, both cash settlement and physical settlement are legitimate choices in product design. Her comments are part of the RBI report.
- Clearing Corporation of India, www.ccilindia.com, Last accessed on: Dec 7, 2008.