In the Governor’s Statement on Mid-term Review of Monetary and Credit Policy for the Year 2002-03 of October 29, 2002, it was stated in Paragraph 88 that a Working Group is being set up with appropriate representations from the market to look into, inter alia, the possible ways of developing a market for over-the-counter (OTC) rupee derivatives. The Group will also review the existing guidelines for OTC rupee derivatives in India.

Accordingly, it has been decided to constitute a Working Group under the Chairmanship of Shri Jaspal Bindra, CEO, Standard Chartered Bank. The Working Group will comprise:

The Terms of Reference of the Working Group are as under:

1. To suggest the modalities for introducing dealing in derivatives having explicit/implicit option features such as caps/floors/collars in the rupee derivatives segment.
2. To suggest norms for capital adequacy, exposure limits, swap position, asset-liability management, internal control and other risk management methods for these derivatives.
3. Any other related issue.

The Working Group may invite members of the Financial Markets Committee, officials of other Departments of RBI and representatives from corporate sector for wider participation and interaction.

The Working Group may submit its report by December 31, 2002.

1. Increasing Participation in OTC Derivative Market Co-ordinator - Shri Chetan Shah (Deutsche Bank) Members: SEBI, FIMMDA, PNB Gilts, BOI, Prudential ICICI Mutual Fund and RBI
2. Exchange-traded Derivatives Co-ordinator - Shri N. Parakh (SEBI) Members: HSBC, NSE, ICICI Bank and RBI
3. Accounting, Valuation, Legality of OTC Derivatives and Master Agreement Co-ordinator - Shri Sudhir Joshi (FIMMDA) Members: Citi Bank, SBI and RBI
4. Board Policies, Regulatory Requirement and Risk Management Policies Co-ordinator - Shri B.D. Sumitra (SBI) Members: Citi Bank, ICICI Bank and RBI
5. Products that can be allowed without short selling Co-ordinator - Shri A. Mahajan (BOA) Members: Deutsche Bank, Standard Chartered Bank, Reliance Industries and RBI.

Interest Rate Caps are designed to provide insurance against rising interest rates by payment of a premium to the other party, who promises to make interest payments on specified future dates based on the excess, if any, of interest rates above a certain specified rate.

Interest Rate Floor is opposite of an interest rate cap agreement. It refers to the purchase of insurance against falling interest rates by payment of a premium to another party who promises to make a payment if a specified floating rate falls below a specified floor rate.

Collars are the combined purchase and sale of an interest rate cap and an interest rate floor so as to keep interest rate exposure within a defined range. One party agrees to make interest payments to the other party if interest rates exceed a certain rate (i.e. "sells" a cap) and the other party agrees to make interest payments if interest rates drop below a certain rate (i.e. "sells" a floor).

Swaptions are options on forward-starting interest rate swaps. A swaption gives the buyer the right, but not the obligation, to enter into an interest rate swap at a specific date in the future, at a particular fixed rate (the strike rate), and for a specified term. The option is called a receiver swaption if the buyer has the right to receive fixed interest in the swap, and is called a payer swaption if the buyer has the right to pay fixed and receive floating interest in the swap.

A bond call/put option is an option to buy or sell a bond for a certain price on a certain date. In an interest rate call/put option, the underlying is a floating interest rate.

Interest rate futures are forward contracts on a benchmark interest rate traded on a stock exchange. A typical example is the futures contract on 3-month sterling Libor traded on the London International Futures & Options Exchange (LIFFE), which is known as a short sterling future.

1. American. "American" means a style of Option Transaction pursuant to which the right or rights granted are exercisable during an Exercise Period that consists of a period of days.
2. Bermuda. "Bermuda" means a style of Option Transaction pursuant to which the right or rights granted are exercisable only during an Exercise Period which consists of a number of specified dates.
3. European. "European" means a style of Option Transaction pursuant to which the right or rights granted are exercisable only on the Expiration Data.

Suppose a corporate has a rupee liability maturing in the next three months. The corporate Treasurer is confident of funding this liability through an issue of 5-year paper around the same time. But the Treasurer wants to hedge the rate of this debt placement now. This rate would be composed of the 'Treasury' rate and a 'corporate spread' representing the credit risk charge. Suppose for the moment, that the corporate wants to hedge the 'Treasury' risk only. Once options are permitted, the corporate could hedge the downside risk of rates moving sharply higher by buying a payer’s swaption on 5-year G-Sec rates expiring in 3 months. This product is nothing but a European swaption.

An option, which is only exercised when the underlying item reaches a predetermined price.

These options are only exercised when the underlying item reaches a pre-determined price and then only pay a fixed amount regardless of how far in-the-money the option settles.

A cap, floor with a notional principal amount that declines as a function of a short term money rate such as Libor. The use of an index protects the client from unanticipated or erratic prepayment risks.

Suppose that a bank offers an option, expiring in 3 months time, on a 5-year swap to a client (having a floating rate liability) where the client has the right to receive the prevailing one year government security yield from the bank on every interest payment date (say, annual) and pay a fixed rate, say, 6% on those dates for a certain notional principal. Also suppose a case where this is the only transaction outstanding in the bank’s books. Assuming that the 'delta' of this swap is, say, 50%, i.e., the bank needs to hedge 50% of the notional amount of the 5-year received risk immediately. The ideal way, perhaps, would be to short the 5-year G-sec. However, the current regulations do not allow short selling. Therefore, the bank has to find some other way to pay the 5-year fixed rate, which may be done by looking for a counterparty that may want to hedge a fixed rate liability and hence receive a fixed rate from the bank. Alternatively, the bank may decide to hedge by selling some securities in the discretionary portfolio of similar duration to hedge the swap. But this portfolio approach of hedging is fraught with different kind of risks, particularly 'basis risks' as 'like for like' hedging is not achieved.

1. Section 6(1) of the Banking Regulation Act, 1949 (BR Act), inter alia, states as under:

'In addition to the business of banking, a banking company may engage in any one or more of the following forms of business, namely:-

(a) the acquiring, holding, issuing on commission, underwriting and dealing in stock, funds, shares, debentures, debenture stock, bonds, obligations, securities and investments of all kinds; the purchasing and selling of bonds, scrips or other forms of securities on behalf of constituents or others; ……'

2. From the above it is clear that a banking company can deal in obligations. Derivatives, being in the nature of obligations, will be covered within the ambit of 'obligations' and hence a banking company will be able to deal in derivatives.

3. Alternatively, the above section also permits a banking company to purchase and sell 'other forms of securities'. The term 'security' has not been defined under the BR Act. Therefore, it may be pertinent to look into the definition of security under the Securities Contract (Regulation) Act, 1956 (SCRA). Section 2(h)(ia) specifically includes 'derivative' under the definition of 'securities'. Whilst OTC derivatives may not strictly be ‘securities’ or ‘derivatives’, as defined under SCRA 2(aa), it may be germane, given some of the views in the market, to rely upon the same in regarding dealing in OTC derivatives as permissible for banking companies to engage in.

4. Lastly, section 6(1) (m) of the BR Act also states as under:

'Doing all such other things as are incidental or conducive to the promotion or advancement of the business of the (banking) company;'

In terms of the same, engaging in buying, selling or otherwise dealing in OTC derivatives may be regarded as within the scope of permissible activities for banking companies to engage in/undertake.

A wide range of services is offered to the OTC derivatives markets to facilitate the trading and settlement of transactions. This annex lists six services and their providers that have been mentioned by market participants as potentially significant: two matching services, two collateral management services and two clearing services.

S.W.I.F.T. is a major provider of secure messaging services for use in interbank communications. Its services are extensively used in the foreign exchange, money and securities markets for confirmation and payment messages in the OTC derivatives market. It establishes standards for messages that can be used to confirm transactions to counterparties via the S.W.I.F.T. network. It provides a matching service called 'Accord', which receives messages from the two counterparties to a transaction, identifies where the fields match (or fail to match) and reports back.

OPEX (Open exchange) is a confirmation matching and collateral reconciliation service developed by Londex International Limited. OPEX offers two main services to subscribers: trade matching and collateral reconciliation. It will match confirmation messages sent between dealers according to tolerances agreed by dealers. It will also enable subscribers to send documents, either in conjunction with a confirmation or separately.

The system will also provide for collateral reconciliations - both of the individual transactions covered by a collateral agreement and of the mark-to-market value of each trade. There will be scope for matching on the basis of agreed tolerances on an automatic basis (e.g., where counterparties have agreed to match each day at a specific time) or on a manual basis, enabling them to match as often as they choose, including matching the whole portfolio or parts of the portfolio more than once intraday.

3. Cedel Bank: Global Credit Support Service (GCSS)

Global Credit Support Service (GCSS), launched in September 1996, is Cedel Bank’s current collateral management service for the OTC derivatives market. Under the fiduciary agreement with Cedel Bank, a GCSS participant transfers assets from/to the fiduciary (Cedel Bank). All cash and securities lodged in GCSS are held in the GCSS’s omnibus account at Cedel Bank. Transfers into and out of GCSS are made through Cedel Bank’s clearing and settlement system using its normal depositories and cash correspondents. In GCSS, collateral management operates on a bilateral basis. GCSS participants calculate their bilateral net exposures and send the information to Cedel Bank. The system then calculates the collateral amount to be transferred, referring to the terms of the agreement between the parties. Deliveries may be executed in real time. Alternatively, collateral may be moved in the daily batch processing cycle.

4. Euroclear: Integrated Triparty Derivatives Support (ITDS)

This new service, launched in 1997, is one of a series of settlement-integrated collateral management arrangements developed by Euroclear for different markets, including repo and securities lending. ITDS is designed to facilitate the collateralisation of net exposures resulting from OTC derivatives transactions. A Derivatives Service Agreement is executed between two parties, both of which must be Euroclear participants, and the Morgan Guaranty Trust Company of New York, Brussels Office (MGTC), acting as collateral agent. Under the Derivatives Service Agreement, the two parties can request MGTC to calculate the amount of collateral to be transferred (the credit support amount), based on data for current net exposures reported by the two parties and on the terms of the agreement (e.g., the threshold): on receipt of the collateral taker’s and collateral giver’s notifications indicating their net credit exposures, MGTC matches them, calculates the credit support amount and notifies both sides. Alternatively, the two parties may agree on the credit support amount and notify MGTC, which then matches the two notifications.

OM Stockolm (OM) operates a centralised clearing system for both exchange-traded and OTC derivatives. OTC-traded instruments cleared by OM fall into three categories:

1. off-exchange transactions in standardised instruments that could be traded on OM Stockholm as an exchange but which are matched outside the exchange and later sent to OM Stockholm for clearing;
2. fixed income derivatives, including FRAs, Treasury bond and bill futures and interest rate swaps; and
3. tailor-made derivatives (the 'Tailor-made Clearing' service - TMC): a wide range of OTC contracts for which stocks, currencies, bonds or commodities may be the underlying asset.

As with off-exchange trades, fixed income and tailor-made contracts are matched between counterparties and then sent to OM, electronically in the case of fixed income derivatives, for matching and registration. Off-exchange and fixed income trades eligible for clearing can be divided into cross-trades (internal trades among end-users, or internal trades between a clearing member and its client) and interbank trades (trades among clearing members).

OM’s clearing of OTC derivative contracts is the same as its clearing of exchange-traded business. OM guarantees the performance of contracts by substituting itself as counterparty to both sides of the transaction - i.e., as a seller to the original buyer and a buyer to the original seller - on registration of the contract. Participants must provide initial margin and variation margin requirements which are calculated and collected daily. Counterparty losses not covered by margin requirements are met from OM’s own resources.

Under the TMC facility, OM accepts contracts for clearing only after the customised financial instrument has been subject to risk analysis. The majority of business consists of 'Plain vanilla' contracts and the service is not used for exotic derivatives. This is due to the significant margins required for these products.

The London House (LCH) introduced clearing of certain widely-traded OTC derivatives from August 1999. There are two types of SwapClear user: SwapClear Dealers (SDs) and SwapClear Clearing Members (SCMs). For a trade to be cleared through SwapClear, both counterparties must be approved by LCH as SDs. An SD has arrangements for clearing its business through an SCM (an SD could be its own SCM). Margin, reset amounts and coupon flows will be determined by the clearing house. All payments, including those arising on contracts that have been traded on the exchanges for which LCH clears, are netted into a single payment flow per currency with each member each day. Exposures to members are monitored intraday and additional intraday margin may be collected. In the event of a member default, LCH is able, under its default rules, to terminate all outstanding transactions with that member and enter into replacement transactions or hedge its resulting exposure as necessary. Any losses are offset against the defaulting member’s margin and other LCH resources, including the member Default Fund, as necessary.

Source: BIS (1998) - Report on OTC Derivatives : Settlement Procedures and Counter party Risk Management.

LCH’s SwapClear which was introduced in 1999 offers an interesting model for clearing and settlement of OTC swap contracts through the clearing house. A similar facility may be introduced in India through CCIL. Key aspects of this model are highlighted below.

All swaps cleared by LCH are governed by its rules and byelaws. SwapClear is essentially an inter-bank facility meant to clear trades of banks and investment banks who are members of LCH. LCH becomes the central counterparty to each transaction. SwapClear also accommodates existing swap contracts. A swap contract can initially be entered into with bilateral ISDA documentation. At any time during the currency of the swap, it can be registered with LCH with the consent of both parties in which case the bilateral ISDA document will be replaced by the terms and conditions of LCH.

CCIL should consider introducing a clearing system for swap contracts. Any existing CCIL member would have the facility to enter into contracts with CCIL becoming the central counterparty. This would obviate the need for bilateral documentation between parties. Unlike in the case of LCH, where such clearing is optional, RBI may consider making clearing of swap contracts through CCIL mandatory (for such products as are cleared by CCIL) in view of the several advantages of such a facility.

Due to central clearing, the products need to have some standardisation. LCH clears all plain vanilla swaps up to 30 years’ maturity in five major currencies. Several benchmarks are supported. While technically OTC products are non-standard, most contracts entered into carry standard terms that can be cleared through a clearing house. As seen in the case of LCH, a fairly large universe of contracts can be cleared, the only major exceptions being ones with embedded options, which could also be standardised.

LCH collects initial margin on contracts, usually in the form of approved securities. LCH also conducts daily mark-to-market settlement of all outstanding contracts to manage its counterparty risk. The amounts are paid by members in the form of variation margin. The result is that LCH has only intra-day risk, which is managed through initial margin and exposure limits. LCH also reserves the right to make intra-day margin calls if required. LCH further operates a Settlement Guarantee Fund from members’ contributions which is another source of risk containment. These margining arrangements protect the clearing house from defaults. Risk to the system as a whole from counterparty defaults is reduced as there is daily settlement of profits and losses. CCIL may implement a similar margining system and use the existing Settlement Guarantee Fund for swap contracts as well.

Settlement on payment or reset dates as well as mark-to-market settlements are made using multilateral netting. Every counterparty thus makes or receives a single payment to or from the clearing house. This obviates the risks and costs of bilateral settlement.

Deals continue to happen in the OTC market in the case of LCH and are registered with LCH (using SWIFT messaging) for settlement. Such deals may be reported over the NDS in India so that it brings transparency. NDS may download trades to CCIL, just as in the case of government securities.

LCH allows clearing members to clear swap contracts for non-members, such as their clients, in a system analogous to the CSGL system or the PCM system in equity derivatives markets in India. Thus corporates and other participants who are not members of CCIL may participate in the clearing system through other clearing members.

Annex V.5

Some Salient Features of the International Accounting Standards - FAS 133 and IAS 39

The basic premise is that derivatives create assets and liabilities that should be captured on the balance sheet at fair value. However, they do allow historical cost or other specific accounting treatment in many circumstances. Thus fair value treatment will apply to Interest-Rate / Currency Swaps, Purchase / Written Options, Futures / Forwards, Free standing credit derivatives - permissible exclusions are financial guarantees, climactic variable contracts, equity indexed contracts, traditional insurance, etc.

Hybrid contracts (e.g., debt with call / put options, or with cap / floor feature) comprising both a standard host contract and an embedded derivative must be bifurcated with the derivative portion being fair valued. If the embedded derivative cannot be reliably identified and measured then the entire hybrid contract must be fair valued. As an exemption from this treatment, embedded derivatives that do not materially alter the nature of the host contract are deemed 'clearly and closely related' and may be excluded from the scope of fair value accounting.

In essence, all derivatives within the scope of the standard must be fair valued at least on a quarterly basis. The changes in fair value must be reported in current earnings unless hedge accounting is allowed in which case some or all of the change in the value of the hedging instrument should be posted directly to the Other Income (OI) account on the balance sheet. This amount would be reversed out of OI and matched in earnings with the impact of the offsetting hedged exposure.

In order to qualify for hedge accounting treatment, a hedge must be classified as an allowable hedge type (i.e., cash flow hedge in the form of floating rate assets / liabilities or fair value hedge in the form of fixed rate assets / liabilities, firm commitments or foreign currency hedge, etc.) In addition, an exposure and relationship with the hedging instrument must be documented. Hedge strategies for which premium is received (e.g., option sold) cannot qualify for hedge accounting. However, forwards, futures, purchased options and zero cost structures explicitly qualify. The hedging instrument must be shown prospectively to be 'highly effective' in offsetting the change in value of the underlying exposure. Effectiveness is defined as the hedge instrument’s ability to generate offsetting changes in the Cash Flow or Fair Value of the hedged exposure; time value of the option is to be excluded from effectiveness tests leaving only intrinsic value for consideration. Some other conditions should also be met to qualify for this treatment. Along with this, requirement for disclosure have increased substantially and the following information needs to be disclosed as footnote to the financial statement - amount of hedge ineffectiveness, amount excluded from effectiveness testing, amount recognised in P&L due to failure to pass the effectiveness test or due to forecast errors or failed firm commitments, etc.

The following issues were discussed with regard to the valuation of options:

1. Likely Benchmarks

2. Information about spot rates and forward rates and its sources.

3. Information about the term structure of volatilities

4. The interest rate model to be used

The benchmarks, which will be used for interest rate options such as caps and floors, will depend on where the activity takes place in the market. As such the following types of benchmarks are available in the Indian context

1. The Government Securities curve, notably the one-year T-bill yield
2. Interest rate curve derived from currency forwards and their corresponding long term swap rates, notably Mumbai Inter-Bank Forward Offer Rate (MIFOR) and Mumbai Inter-Bank Offered Currency Swaps (MIOCS).
3. Overnight rates and the OIS curve.

Each of these types have different behavioral characteristics and these curves will require their own interest rate models. Information about forward rates can be determined from the corresponding swap rate curve.

The sources of these curves will be as follows:

1. The GOI-Sec curve used will be the FIMMDA-PDAI-Bloomberg yield curve. There are some conceptual difficulties with the implementation of an interest rate model based on this curve. These arise because of jumps in forward rates determined from this curve. These will be addressed subsequently in the section on volatility.

2. The MIFOR and MIOCS curves used will be the FIMMDA-Reuters MIFOR and MIOCS benchmarks.

3. The overnight benchmark used will be the FIMMDA-NSE MIBOR and the FIMMDA-Reuters MIOIS curve will be the benchmark for overnight swap curve.

There are several ways of getting information about the term structure of volatilities.

Historical volatilities of forward rates can be determined from a database of historical forward rate curves. Some kind of a weighing scheme such as the Exponentially Weighted Moving Average method can be used to give greater weight to recent changes in the underlying rate. However, this approach is flawed for three reasons:

What drives option valuation is not the volatility that the market has experienced but volatility that the market is expecting in future. In this sense, using historical volatilities is conceptually unsound.

Time dependence of the volatility of the forward rate cannot be explicitly modeled using information about historical vols.

Most of the benchmarks that are used in the Indian Market are 'Fitted' curves. Forward rates determined from these tend to jump a lot because of large kinks in the underlying zero coupon curve. Many forward rates are not accessible because a forward market does not exist. Because of this, using these rate to determine volatilities is likely to significantly overestimate the volatilities.

An alternative to historical volatilities is polling the term structure of volatilities for each of these individual benchmarks. The time-dependence of forward rate volatilities can be explicitly modeled or fitted in this case and this information can be used in the implementation of an interest rate model.

FIMMDA would publish the prices to be used by the Banks/PD for the valuation. Moreover it will also publish the volatilities using a suitable model. Banks are free to use the volatilities or the prices as per their requirement.

The most commonly followed approach in the international context for the implementation of interest rate models for option pricing is to use traded prices of caps and floors in the market to calibrate the model. This eliminates the need to get explicit volatilities because the implied volatilities in the traded options give information about the term structure of volatility, as long as there exist sufficiently traded options across the spectrum for which the model has to be implemented. This model can then be used for the valuation of other options.

If a polling process is followed, FIMMDA will ensure that there are sufficient number of market participants who are quoting the pricing. As in the case of other polling process, the outliers will be discarded at the time of arriving at the average.

Crucial to this approach is the presence of a market. However, in the absence of a market, it should be possible to poll prices of certain standard options and use this information. This only requires that a sufficient number of market participants be present. The advantage of this method is that it can be used even after the market develops fully. Its robustness increases as the market develops and as the polled prices converge with actual traded prices.

Since the Indian market is not likely to involve exotic options at inception, it is suggested that a model similar to the LIBOR Market Model (LMM) suggested by Brace, Gaterek and Musiela (1997) be used, with day-count conventions appropriate to the benchmark for which it is being implemented. The model makes several assumptions which include the presence of a complete forwards market and log-normality in forward rates. While most of these assumptions hold true in developed liquid markets and while market practice in developed markets has been to use the valuation formulae of this model (which are the same as the formulae given by the Black model developed in 1975), it has not yet been tested whether many of these are applicable in the Indian market. In view of the popularity and conceptual soundness of the LMM model, FIMMDA suggested using it for calculation of implied volatilities.

On estimation of volatilities for pricing and valuation, it was seen that OTC interest rate derivatives will be mostly customised products. Thus, pricing of these will require market makers to have sufficient expertise to estimate volatilities to be used for pricing these products. For some standard maturities and standard benchmarks, market makers can quote volatility estimates. Gradually the growth in the volumes will see products becoming standardised. As OTC markets develop, the extent to which market participants engage in large numbers of transactions with similar terms increases, because certain instruments serve the risk-management needs of a large number of market participants. At this stage of development, for valuation or marking to market purpose an independent agency like FIMMDA could publish on a regular basis, the volatility matrix for different maturities for different benchmarks with the different strikes based on the market poll.

The market participants will be free to use any model for marking to market / model of their option portfolio, provided the regulatory guidelines (for market risk management) in respect of management and internal controls of models are adhered to.

Annex VI.3

Risk Measures for OTC Derivatives Contracts by Tenor