CENTRAL bankers are supposed to be obscure while in office and demure upon their retirement. But V.K. Sharma, a former executive director of the Reserve Bank of India (RBI), marked his recent departure by giving an almighty kicking to India’s over-the-counter interest-rate derivatives market. In a speech at the end of 2012 he called it disturbing, preposterous, perverse, the antithesis of responsible financial innovation, weird and warped.
Two things do look odd. First, there is the sheer scale of activity. Although India’s regulators tolerate frisky stockmarkets, they typically keep a lid on debt markets. Yet the notional value of outstanding interest-rate swaps is $685 billion, or 37% of GDP. They are mainly held by foreign banks’ local subsidiaries, which are puny. Their gross exposure may be 100 times core capital.
The second oddity is that prices are behaving strangely. That could be a sign of distress, much as haywire interbank rates portended the West’s financial crisis. In theory the interest rates indicated by India’s swap market should roughly match those in the government-bond market. For most of the past decade that has been the case, but since mid-2011 the two markets have diverged, with swap interest rates for five-year money as much as 1.5 percentage points below cash interest rates (see chart). The gap is an intellectual “dilemma a lot of us have struggled with over the last couple of years,” says one banker.
What is going on? The two markets are separate worlds. Government-bond trading is done by local banks and insurers, which are forced to buy lots of debt, partly for prudential reasons but also to help the state plug its deficit. Banks are scared that wild government borrowing will mean an excessive supply of new bonds. That has kept yields high. The interest-rate swap market, meanwhile, is dominated by foreign banks and seems to reflect directional bets on policy rates. Since 2011 traders at these banks have wagered that the RBI will ease policy to revive the economy. That has pushed swap rates down.
Textbooks say that arbitrage activity should eliminate this kind of gap. But that has not happened in India. The public-sector banks that dominate the bond market are not much interested in dabbling in derivatives: they are not required to mark their bonds to market and need not hedge. Regulators are unlikely to change this because banks might face losses if forced to book their bonds at market prices.
Without big institutions to straddle both markets, India is an inhospitable place for the hedge funds and hustlers who normally play the arbitrage game. Some outfits are prevented from trading swaps. The RBI frequently buys and sells bonds to massage the market. Foreign portfolio investors own just 1% of government bonds.
At least the rate gap has narrowed recently, thanks to government belt-tightening, hawkish noises from the central bank, and, say traders, a bit of arbitrage activity by banks. But India’s derivatives anomaly is likely to persist. And it raises a question: what on earth are foreign banks up to?
One view is that official figures grossly exaggerate their activity. To annul a swap trade most banks find it easier to write a new, offsetting contract rather than rip up the existing one; the effect of this is to inflate the total. But India has had three rounds of “trade compression” since 2011, aimed at tidying up such redundant contracts. The notional outstanding value of all swaps has already roughly halved. One official involved says the shrinkage does not have much further to go, suggesting foreign banks’ positions are not wildly overstated.
Traders retort that the figures exaggerate their activity in another way. If they use short-term swaps to hedge longer-term bonds (which are more sensitive to interest rates), the notional size of the derivatives position can legitimately exceed that of the underlying position by many times. “Most of derivatives outstanding are plain vanilla,” says a trader at a foreign bank.
India has a good record on monitoring derivatives. It stress-tests banks’ positions and had a central repository of trades before most rich countries. It is also keen to make its debt markets more sophisticated. Still, the swaps market has a slightly unnerving feel to it. Foreign banks seem to be involved in a trading game that dwarfs their balance-sheets and bears a minimal relationship to India’s real economy. It may be harmless but regulators should be on their guard.
Source: http://www.economist.com/news/finance-and-economics/21571901-retiring-official-raises-alarm-about-derivatives-india-derivatiff
Two things do look odd. First, there is the sheer scale of activity. Although India’s regulators tolerate frisky stockmarkets, they typically keep a lid on debt markets. Yet the notional value of outstanding interest-rate swaps is $685 billion, or 37% of GDP. They are mainly held by foreign banks’ local subsidiaries, which are puny. Their gross exposure may be 100 times core capital.
The second oddity is that prices are behaving strangely. That could be a sign of distress, much as haywire interbank rates portended the West’s financial crisis. In theory the interest rates indicated by India’s swap market should roughly match those in the government-bond market. For most of the past decade that has been the case, but since mid-2011 the two markets have diverged, with swap interest rates for five-year money as much as 1.5 percentage points below cash interest rates (see chart). The gap is an intellectual “dilemma a lot of us have struggled with over the last couple of years,” says one banker.
What is going on? The two markets are separate worlds. Government-bond trading is done by local banks and insurers, which are forced to buy lots of debt, partly for prudential reasons but also to help the state plug its deficit. Banks are scared that wild government borrowing will mean an excessive supply of new bonds. That has kept yields high. The interest-rate swap market, meanwhile, is dominated by foreign banks and seems to reflect directional bets on policy rates. Since 2011 traders at these banks have wagered that the RBI will ease policy to revive the economy. That has pushed swap rates down.
Textbooks say that arbitrage activity should eliminate this kind of gap. But that has not happened in India. The public-sector banks that dominate the bond market are not much interested in dabbling in derivatives: they are not required to mark their bonds to market and need not hedge. Regulators are unlikely to change this because banks might face losses if forced to book their bonds at market prices.
Without big institutions to straddle both markets, India is an inhospitable place for the hedge funds and hustlers who normally play the arbitrage game. Some outfits are prevented from trading swaps. The RBI frequently buys and sells bonds to massage the market. Foreign portfolio investors own just 1% of government bonds.
At least the rate gap has narrowed recently, thanks to government belt-tightening, hawkish noises from the central bank, and, say traders, a bit of arbitrage activity by banks. But India’s derivatives anomaly is likely to persist. And it raises a question: what on earth are foreign banks up to?
One view is that official figures grossly exaggerate their activity. To annul a swap trade most banks find it easier to write a new, offsetting contract rather than rip up the existing one; the effect of this is to inflate the total. But India has had three rounds of “trade compression” since 2011, aimed at tidying up such redundant contracts. The notional outstanding value of all swaps has already roughly halved. One official involved says the shrinkage does not have much further to go, suggesting foreign banks’ positions are not wildly overstated.
Traders retort that the figures exaggerate their activity in another way. If they use short-term swaps to hedge longer-term bonds (which are more sensitive to interest rates), the notional size of the derivatives position can legitimately exceed that of the underlying position by many times. “Most of derivatives outstanding are plain vanilla,” says a trader at a foreign bank.
India has a good record on monitoring derivatives. It stress-tests banks’ positions and had a central repository of trades before most rich countries. It is also keen to make its debt markets more sophisticated. Still, the swaps market has a slightly unnerving feel to it. Foreign banks seem to be involved in a trading game that dwarfs their balance-sheets and bears a minimal relationship to India’s real economy. It may be harmless but regulators should be on their guard.
Source: http://www.economist.com/news/finance-and-economics/21571901-retiring-official-raises-alarm-about-derivatives-india-derivatiff
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