OTC Derivatives: Trading, Reporting & Regulations

Udaipur 8

th

Jan 2011

Introduction

The family of OTC derivatives includes is classified by asset class - Interest Rate, FX, Credit, Equity and Commodity derivatives.

OTC Derivatives

Interest Rate Foreign Currency Credit Equity/ Commodity

2

Background

• • • • • • Includes the gamut of Interest Rate, FX, Credit and Currency Derivatives Primarily plain vanilla products involving currencies or interest rates Interest Rate Derivatives is the largest subset with Swaps predominating A gradual shift from OTC to exchange traded products − Fragmented Markets vs Concentrated Markets On line Trade reporting for Rupee IRS since 2007 has massively improved transparency and price discovery Initiatives underway around trade reporting and central clearing of all OTC products 3

Global Context

• • • • • 20% CAGR from 1995 in the use of Interest Rate and Currency Derivatives 70% growth in the use of Credit Derivatives since inception Current Estimated Outstanding − $400 Tn in Interest Rate and Currency Derivatives − − $ 65 Tn in Credit Derivatives $ 10 Tn in Equity Derivative Daily Estmated Turnover − − $1.7 Tn in Interest Rate Derivatives $0.3 Tn in Currency Derivatives Credit derivatives - heavily in the news due to the sub-prime crisis 4

Domestic Context

• • • • • Plain Vanilla IRS introduced in 1999 Currency Forwards in existence for long, FX Options introduced in 2005 Credit Derivatives, currently not allowed but in advanced discussion stage Equity and commodity derivatives due to the nature of their underlying markets have moved to exchanges Current Outstanding − − Rs 46 lac crore in Interest Rate Derivatives Rs 36 lac crore in Currency Derivatives 5

Products

• • • • Interest Rate Derivatives include IRS, FRAs The IRS dealt include OIS, INBMK, MIFOR Currency Derivatives include the basic FX forwards, Swaps and Options Credit Derivatives (CDS) currently disallowed but in the process of being introduced with appropriate safeguards 6

Interest Rate Derivatives

• • • • • • • Introduced in 1999 and has seen immense growth and popularity Gross Outstanding contracts in the region of Rs21 lac cr; however net is much lower Daily volumes in the region of Rs10,000cr In recent times has acted as useful hedge for interest rate risk Key applications include short term asset management and duration management Participation remains essentially foreign bank skewed Local banks can play a key role in balancing the market interest and closing the existing arbitrages 7

Interest Rate Derivatives - Benchmarks

OIS MIFOR INBMK



Overnight inter bank call money rate



Most Liquid - Average Daily Volume INR 200 bio



Liquid Up to 5 years



Implied rupee interest rate derived from USD vs INR forward rates.



Hedge for Currency swap positions with clients



Benchmark is the 1 year GOI yield



Used primarily for duration management of bond portfolios

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Currency Derivatives

• • • • • Gradual evolution from forwards to matched swaps to position taking FX Forwards represent the largest portion of this segment FX Options allowed in 2005 has tremendously benefited corporate wishing to put on shorter term hedges Underlying exposure continues to be a key requirement to ensure orderly markets Latest guidelines issued Dec 28 th 9

Key Issues in OTC Derivatives

• • • • • • Established Client need - customized solutions, hedge effectiveness OTC markets criticized for being opaque, but are the largest component of world financial markets − − 3 decades history Participants are large, professional institutions mostly banks hence regulated − Transparency to regulators versus transparency to all Capital charge on counterparty exposures and for market risk Reporting required for MTM, systemic stability, regulatory information Trade compression, focus on net risk or open interest Price impact of post-trade dissemination 10

Transparency

• • Pre-trade transparency 1.

Interbank quotes 2.

3.

Single screen offering Composite levels Post-trade transparency 1.

Trade repository 2.

3.

4.

5.

Confirmations Payment advice Collateral management Valuation 11

Road Ahead for OTC Derivatives

• • • • • • • Standardized contracts Trade repository Central Clearing Electronic Trading system, anonymous order matching Review of Capital charges Post trade services New Products (swaptions, caps/ floors) to be introduced in a phased manner 12