This IRF market has been one of the biggest mysteries of India’s financial markets. It just doesn’t kick-off.
It was first started in 2003 and collapsed in a few days of trading. The problem then was that IRF was based on Zero Coupon Yield curve (ZCYC) whereas Indian bind market was based on Yield to maturity and no one really understood the famed ZCYC.
The other reason for its failure was earlier IRF products required physical settlement and not cash settlement. Physical settlement is when people have to give the bond at settlement (or commodities in case of commodity derivatives) where as in cash one adjusts the differences based on cash.
In 2010 (or was it 2009, it was again tried to restart this based on YTM and only for 10 year. Again regulators kept physical settlement and again it failed to pick up.
This time people also said we need IRF for short-term as well. The hedging was improper etc. As a result 91 day T-Bill IRF was started but trading has become zilch again. There was some euphoria after 91 day T-bill launch but nothing as of now.
BS in an article said SEBI planning to start IRF in 2-year and 3-year bonds. They will be cash settled and not physical settlement:
Sebi to allow launch of derivatives based on two- and three-year bonds on a cash-settled basis. The Securities and Exchange Board of India (Sebi) will soon introduce new products in the sagging interest rate futures (IRF) segment. The coming months will see the regulator launch derivatives based on shorter-tenure bonds that can be cash-settled.
According to people familiar with the development, the regulator will give its go-ahead for derivatives based on two- and five-year bonds as underlying. The joint technical committee, comprising officials from Sebi and the Reserve Bank of India (RBI), are deliberating on the specifications of the instrument and a decision is expected in the next two-three months. More important, the new contracts will be allowed to be settled in cash, which has been a long-standing demand of industry participants.
There seems to be some demand for them:
“It is felt that there is a need for shorter duration instruments that can be settled in cash,” said a person privy to the regulatory developments. “Bonds with a residual maturity of two and five years can be factored in while determining the settlement price of the new contracts. The industry has been asking for such products and the policymakers are hoping that it will provide new life to the IRF segment,” he added.
However, similar demands were made earlier as well and were satisfied but volumes remain nil:
Interestingly, the regulators would indeed be keeping their fingers crossed after the new products are launched as all the previous attempts of infusing life in the segment have proved futile.
NSE has been registering almost nil volumes for many months now. According to market players, the prime reason for the failure of this segment is that banks are staying away from it. While the over-the-counter (OTC) market sees huge participation from foreign and private sector banks, the exchange platform has not been able to attract the same players.
“These (exchange-traded IRF) instruments do not fit in the risk appetite of public sector banks, while foreign and private banks do not want to get in the standardised exchange product,” says a fixed income dealer with a domestic brokerage. “The market has totally shunned these instruments and the current environment do not guarantee any success for the new products too. No one is willing to bet on rates on account of inflation and high borrowing,” he explains.
Now planning to make this whole thing cash-settled but this was done for 91-day but still no trading:
Initially, the IRF segment was launched with futures on 10-year government bonds. The contracts were allowed to be settled with delivery of government securities with a tenor between nine and 12 years. The segment, however, failed to enthuse market participants with the biggest fear being that of dumping of illiquid bonds.
Market players want the entire segment to be moved to cash-settlement basis, a demand that the capital market regulator is looking into. Thereafter, in July this year, 91-day treasury bill futures contract were launched on cash-settlement basis that fizzled out in just a few days.
This blog has argued in the past that there is a serious problem with this market. It needs a lot of help and may be should look at Al Roth for help..