By Archana Narayanan and Suvashree Dey Choudhury
MUMBAI (Reuters) - India plans to launch trading of government bond futures within the next two months as part of efforts to deepen its financial markets, according to several sources involved in the discussions with the central bank.
These interest rate futures would help banks and financial firms in Asia's third-largest economy assess expectations for borrowing costs and hedge the risks of rate changes to their bond portfolios.
It would also provide the country's policymakers with a valuable gauge to measure market expectations for their future rate decisions.
Although the plans are at an advanced stage, the sources said the Reserve Bank of India (RBI) has not yet finalized the structure of the product, which will allow investors to bet on the direction of interest rates. They declined to be identified publicly commenting on the closely-held discussions.
Getting the structure right is critical for the central bank, which failed in two previous attempts in 2003 and 2009 because of what market participants have said were faulty designs.
New RBI Governor Raghuram Rajan has made deepening India's financial markets a priority, in part to prevent trading of derivatives based on domestic products from shifting to overseas markets such as Singapore.
"This product is Rajan's baby so everyone is on their toes to make it a success. It will be launched in a month or two months at the most," said one senior market participant who has been in discussions with the RBI.
In response to a query from Reuters, an RBI spokeswoman said: "We are discussing the product with stakeholders."
Although India has active derivatives markets in currencies and equities, it has struggled to develop liquidity in debt derivatives, depriving banks and other financial firms of a hedging opportunity. Banks, insurers, primary dealers and provident funds own about 90 percent of Indian government bonds.
India has a vibrant exchange-traded equities derivatives market, with turnover about 14 times that of cash markets, reflecting the potential demand for rate derivatives.
IRFs are widely used in more developed markets. In South Korea, rate derivatives account for 14 percent of total derivatives traded on exchanges, according to official data.
Although Indian banks trade over-the-counter interest rate swaps (IRS), that structure does not lend itself to long-duration contracts and trading is mostly in the one- and five-year segments. In India, however, the benchmark 10-year bond is by far the most traded.
Sources said the RBI for now is leaning towards benchmarking interest rate futures contracts against a basket of bonds with varying maturities as opposed to using only the benchmark 10-year bond as the basis of pricing the contract.
Using only one bond future is the preferred option for many market participants since it would simplify the structure. However, the RBI is concerned that traders could seek to influence the market by aggressively trading the underlying bond, according to people involved in the discussions.
"Futures on a particular bond would be very desirable as that should help in hedging the risk on the bond portfolio as closely as possible and not a basket of bonds as that may not be a perfect hedge," said Nagaraj Kulkarni, senior rate strategist at Standard Chartered Bank in Singapore.
The RBI is also considering making settlements cash-based -- a more attractive option for investors than requiring financial firms to deliver the actual security, as was the case in a previous attempt to develop the market.
India's three main exchanges - the National Stock Exchange, Multi Commodity Exchange of India Limited (MCX) and BSE Ltd - are involved in the discussions and expected to allow trading of interest rate futures on their platforms, sources said.
The RBI also is in talks with banks, the Fixed Income Money Market and Derivatives Association of India (FIMMDA), and the Securities and Exchange Board of India (SEBI) to build consensus, the sources said.
The National Stock Exchange declined to comment, while MCX and BSE Ltd did not have immediate comment. FIMMDA declined to comment.
SEBI did not immediately respond to queries from Reuters.
THIRD TIME THE CHARM?
India has a spotty history with new market products. The launch in 2011 of credit default swaps did not gain traction with investors.
Market participants say demand for IRFs could be strong if the product is well-structured as banks and other big bond investors are keen for more hedging tools. Still, as with any derivative, IRFs could be prone to speculative trading that fuels volatility.
The RBI's push to deepen the domestic debt market comes as equities and currency derivatives trade increasingly migrate to markets overseas, such as Singapore.
The offshore market in the partially convertible rupee, for example, has seen average daily trading volumes rise to about $5 billion a day from a few hundred million dollars in 2006, traders say, putting it on par with India's onshore market, where daily spot volumes are around $5-$6 billion.
(Additional reporting by Se Young Lee in SEOUL and Abhishek Vishnoi in MUMBAI; Editing by Rafael Nam, Tony Munroe and Kim Coghill)