Banks, dealers barred from trading in IRF for clients

The Reserve Bank of India has barred banks and primary dealers from taking positions on behalf of clients in the interest rates futures (IRFs) market.

However, standalone primary dealers are allowed to deal in IRF for both hedging and trading on own account and not on client’s account. Basically, IRF is a derivative instrument to hedge the risk associated with interest rate movements, would be permitted on 91-day treasury bills, two, five and ten-year government bonds.

In the first phase, banks and primary dealers will be permitted to 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," RBI said in its guidelines on exchange-traded interest rate derivatives.

A notification issued by the apex bank last evening stated that although the new set of guidelines is a better set than those of previously attempted ones, its success needs to be seen based on how investors use the instrument.

To start with, RBI has asked banks to set up derivatives desks within the treasury and clearly assign management-level responsibility.

Its guidelines states, "Only the interest rate risk inherent in the government securities classified under the Available-for-Sale, or AFS, and Held-for-Trading, or HFT, categories will be allowed to be hedged. For this purpose, the portion of the AFS and HFT portfolio intended to be hedged must be identified and carved out for monitoring purposes."

Banks would have to monitor the hedged portion of the AFS/ HFT portfolio and notionally mark-to-market the portfolio every month to evaluate the efficacy of the hedge transaction. 

"If changes in the mark-to-market values are outside the 80-125 percent range, then the hedge would not be deemed to be highly effective," said the central bank. Regulators have been experimenting with various ideas and versions of IRFs for nearly a decade.