Guidelines on exchange traded
interest rate derivatives
Draft Circular for Quick Comments
Following recommendations of the Working Group on
Rupee Derivatives (Chairman: Shri Jaspal Bindra), the Securities and Exchange
Board of India (SEBI) has decided to introduce anonymous order driven system
for trading in Interest Rate Derivatives (IRDs)
with effect from April 28, 2003 on The Stock Exchange, Mumbai (BSE) and
National Stock Exchange (NSE). The consultative document on Exchange traded Interest rate derivatives placed
on the SEBI website considers the introduction of the following products:
The document has also outlined the introduction of
futures and options on MIBOR/MIFOR, futures and options on underlying
maturities less than 10 years but more than 3 months, swaps, swaptions, caps
and floors etc. in a phased manner.
2. With a view to enabling
regulated entities to manage their exposure to interest rate risks, it has been
decided to allow the Scheduled Commercial Banks excluding RRBs & LABs
(SCBs), Primary Dealers (PDs) and specified All India Financial Institutions
(AIFIs) to deal in IRDs in a phased manner. In the first phase, such entities
can transact only in interest rate futures on notional bonds and T-Bills for
the limited purpose of hedging the risk in their underlying investment
portfolio. Allowing transactions in a wider range of products, as also market making will be considered in the
next stage on the basis of the experience gained.
3. While derivatives present
immense opportunity for mitigating the market risks inherent in the balance
sheet, it can also expose one to substantial losses on account of inadequate
understanding of the product, absence of proper monitoring, poor risk control
measures, etc. SCBs and AIFIs desirous of transacting in IRDs on the stock
exchanges should take specific approval from their Board covering, inter alia, the products that they may
transact, size/composition of the investment portfolio intended to be hedged,
organizational set-up to monitor, rebalance, report, account and audit such
transactions. Further, it is desirable that derivative desks are created within
the treasury and the management level responsibility clearly assigned.
4. The following norms will be applicable for transacting
IRDs on the Futures and Options (F & O) segment of the stock exchanges:
i)
Stock exchange regulation: SCBs and AIFIs can seek membership
of the F & O segment of the stock exchanges for the limited purpose of
undertaking proprietary transactions for hedging interest rate risk. SCBs and
AIFIs desirous of taking trading membership on the F & O segment of the
stock exchanges should satisfy the membership criteria and also comply with the
regulatory norms laid down by SEBI and the respective stock exchanges
(BSE/NSE). Those not seeking membership of SEs, can transact IRDs
through approved F & O
members of the exchanges.
ii)
Settlement: As trading members of the
F&O segment, SCBs and AIFIs should settle their derivative trades directly
with the clearing corporation/clearing house. On the other hand, those
participating through approved F & O members shall settle proprietary trades
as a participant clearing member (PCM). No third party / broker intermediation
will be allowed in the settlement of IRDs.
iii)
Eligible underlying: For the present, only the
interest rate risk inherent in the government securities classified under the Available for Sale (AFS) and Held for
Trading (HFT) categories will be allowed to be hedged. For this purpose, the
portion of the AFS/HFT portfolio intended to be hedged must be identified and
carved out for monitoring purposes.
iv)
Hedge criteria: Interest Rate Derivative
transactions undertaken on the exchanges shall be deemed as hedge transactions,
if and only if,
a)
The
hedge is clearly identified with the underlying government securities in the
AFS/ HFT categories.
b)
The
effectiveness of the hedge can be reliably measured
c)
The
hedge is assessed on an ongoing basis and is “highly effective” throughout the
period.
v)
Hedge Effectiveness : The hedge will be deemed
to be “highly effective” if at inception and throughout the life of the hedge,
changes in the marked to market value of the hedged items with reference to the
marked to market value at the time of the hedging are “almost fully
offset” by the changes in the marked to
market value of the hedging instrument and the actual results are within a
range of 80% to 125%. If changes in the marked to market values are outside the
80% -125% range, then the hedge would not be deemed to be highly effective.
At present, the investments
held in the (a) AFS category are to be marked to market at quarterly or more
frequent intervals (b) HFT category are to be marked to market at monthly or
more frequent intervals. The hedged portion of the AFS/ HFT portfolio should be
notionally marked to market, at least at monthly intervals, for evaluating the
efficacy of the hedge transaction.
vi)
Accounting: The Accounting Standards
Board of the Institute of Chartered Accountants of India (ICAI) is in the
process of developing a comprehensive Accounting Standard covering various
types of financial instruments including accounting for trading and hedging. However, as the formulation of the Standard
is likely to take some time, the Institute has brought out a Guidance Note on
Accounting for Equity Index Futures as an interim measure. Till ICAI comes out
with a comprehensive Accounting Standard, SCBs and AIFIs may follow the above
guidance note mutatis mutandis for
accounting of interest rate futures also.
However, since SCBs and AIFIs are being permitted to hedge their
underlying portfolio which is subject to periodical mark to market, the
following norms will apply
a)
If
the hedge is “highly effective”, the gain or loss on the hedging instruments
and hedged portfolio may be set off and net loss, if any, should be provided
for and net gains if any, ignored for the purpose of Profit & Loss Account.
b)
If
the hedge is not found to be "highly effective" no set off will be
allowed and the underlying securities will be marked to market as per the norms
applicable to their respective investment category.
c)
Trading
position in futures is not allowed. However, a hedge may be temporarily
rendered as not “highly effective”. Under such circumstances, the relevant
futures position will be deemed as a trading position. All deemed trading
positions should be marked to market as a portfolio on a daily basis and losses
should be provided for and gains, if any, should be ignored for the purpose of
Profit & Loss Account. SCBs and AIFIs should strive to restore their hedge
effectiveness at the earliest.
d)
Any
gains realized from closing out / settlement of futures contracts can not be
taken to Profit & Loss account but carried forward as "Other
Liability" and utilized for meeting depreciation provisions on the
investment portfolio.
vii)
Capital adequacy: The notional face value of
each interest rate futures contract should be multiplied by the conversion
factor given below to arrive at the credit equivalent:
Original
Maturity
|
Conversion Factor
|
Less than one year
|
0.5 per cent
|
One year and less than two years
|
1.0 per cent
|
For each additional year
|
1.0 per cent
|
The credit equivalent thus obtained shall be multiplied by
the applicable risk weight of 100%. The risk weight for market risk charge on
the underlying government securities will remain unchanged at 2.5%.
viii)
ALM classification: Interest rate futures are
treated as a combination of a long and short position in a notional government
security. The maturity of a future will be the period until delivery or
exercise of the contract, as also the life of the underlying instrument. For
example, a short position in interest rate
future for Rs. 50 crore [delivery date after 6 months, life of the notional
underlying government security 3½ years] is to be reported as a risk sensitive
asset under the 3 to 6 month bucket and a risk sensitive liability in four
years i.e. under the 3 to 5 year bucket.
ix)
Use of brokers: The existing norm of 5% of
total transactions during a year as the aggregate upper contract limit for each
of the approved brokers should be observed by SCBs and AIFIs who participate
through approved F & O members of the exchanges.
x)
Disclosures: The regulated entities
undertaking interest rate derivatives on exchanges may disclose as a part of the notes on accounts to balance sheets
the following details:
(Rs. Crores)
|
Sr.No. |
Particulars |
Amount |
|
1 |
Notional face value of exchange traded interest
rate derivatives undertaken during the year (instrument-wise) a) |
|
|
2 |
Notional face value of exchange traded interest
rate derivatives outstanding as on 31st March ____
(instrument-wise) a) |
|
|
3 |
Notional face value of exchange traded interest
rate derivatives outstanding and not “highly effective” (instrument-wise) a) |
|
|
4 |
Mark-to-market value of exchange traded interest
rate derivatives outstanding and not “highly effective” (instrument-wise) a) |
|
xi) Reporting:
Banks and Specified AIFIs should submit a
monthly statement to DBS or
DBS (FID) respectively as per the enclosed format .
5. The above guidelines are subject to review based
on the feedback and experience.
6. These guidelines may be placed before the Board
of Directors for formulating the policy, framework and appropriate risk control
measures before the regulated entities undertake trades in interest rate
futures on the stock exchanges.
(Similar guidelines
will be issued to Primary Dealers
enabling them to participate in exchange traded interest rate derivatives)
Monthly Return
on Exchange Traded Interest Rate Futures
Name
of the Bank/ specified AIFI:
As on last working day of the month:
I. Analysis of outstanding futures position :
|
Settlement dates of
the Futures Contract outstanding in the books |
Underlying interest
rate exposure of the futures contract |
Number of Contracts
outstanding in the books |
Open Interest position
of the futures contract |
II. Activity during the month :
|
NFV*
of the futures contract outstanding at the beginning of the month (settlement
date / underlying interest rate exposure wise break up ) |
NFV*
entered into during the month (settlement date /
underlying interest rate exposure wise break up) |
NFV*
of the futures contract reversed during the month (settlement date /
underlying interest rate exposure
wise
break up ) |
NFV*
outstanding at the end of the month (settlement date / underlying interest
rate exposure wise break up) |
II. Analysis of “highly effective” hedges:
|
Size
of the underlying investment portfolio being hedged |
Change
in MTM*** value of the underlying hedge portfolio since inception of hedge |
Change
in MTM*** value of the futures position since inception of hedge |
PV01**
of the underlying investment portfolio being hedged |
PV01**
of the hedging futures position |
III. Analysis of not “highly effective” hedges:
|
Size
of the underlying investment portfolio intended to be hedged |
Change
in MTM*** value of the underlying hedge portfolio since inception of hedge |
Change
in MTM*** value of the futures position since inception of hedge |
Duration
for which the hedge was ineffective |
Remark
: Action if any, to restore hedge effectiveness |
*
NFV- Notional Face value
**PV01-Price value of a basis point
***MTM- Marked to market