Govt may launch interest rate futures

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 finalised 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."

Banks, insurers, primary dealers and provident funds own about 90 percent of Indian government bonds.

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.

“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.

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.

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