The financial innovations that never were

Responsible financial innovation is not an end in itself, but a means to an end of sub-serving the real sector and in that sense it is consistent with public policy purpose of “financial sector-real sector balance”.

There is broad consensus and unanimity among all key stakeholders that it was the unsustainable “financial sector-real sector imbalance” due to certain financial innovations that was the real cause of the last global financial crisis.

Generic financial innovation has evolved in the form of both on-balance sheet and off-balance sheet derivative instruments.

While Collateralized Debt Obligations (CDOs), CDO-squared, CDO-cubed, Credit Linked Notes (CLNs) etc., are the typical examples of on-balance sheet financial innovations, Currency Swaps, Interest Rate Swaps (IRS), Futures, Options, Credit Default Swaps (CDS) etc., are off-balance sheet financial innovations. In both, the underlying theory and practice has been the so-called law of one price or the no-arbitrage argument, involving replication of derivatives cash flows in the cash markets.

Cash market

In other words, a derivative of an underlying cash market asset will be so priced/valued that it is not possible to arbitrage between the cash market and the derivative market, provided the derivative in question is fairly priced/valued. For, if a derivative was expensive relative to the underlying asset, an arbitrageur will engage in riskless arbitrage by selling the expensively priced derivative and buying the asset in the cash market by financing it at the going repo rate.

In the opposite case, an arbitrageur will engage in riskless arbitrage by shorting the asset in the cash market, investing the proceeds of short sale at the higher going repo rate and buying the relatively cheap derivative until, in equilibrium, the derivative was fairly priced/valued relative to the asset in the cash market. Another way to posit the above is to say that a derivative’s cash flows/pay offs can be exactly replicated in the cash market provided seamless and frictionless arbitrage is allowed. Significantly, and interestingly, such seamless and frictionless arbitrage also applies to derivatives themselves.Specifically, I propose to cover three derivative instruments — Interest Rate Swap (IRS), Credit Default Swap (CDS) and Interest Rate Futures (IRF).

Interest Rate Swap Market

The Report of the Committee on Financial Sector Assessment noted that the notional principal amount of outstanding Interest Rate Swaps (IRS) of all commercial banks increased from over Rs 10 lakh crore as on March 31, 2005 to over Rs 80 lakh crore as of March 31, 2008. However, due to trade compression the notional principal amount of outstanding IRS of commercial banks declined to over Rs 50 lakh crore as of June 30, 2012.

A granular analysis reveals that of all the commercial banks engaging in IRS, public sector banks with about 74 per cent of total bank assets accounted for less than 2 per cent of notional principal amount of outstanding IRS and private sector and foreign banks, with about 19 per cent, and 7 per cent of total bank assets, accounted for 18 per cent, and 80 per cent, of total notional principal amount of outstanding IRS, respectively. In other words, with combined assets of just Rs 6 lakh crore or so, foreign banks accounted for notional principal amount of outstanding IRS of Rs 40 lakh crore.

G-Sec yield curve

Significantly, it is disturbing to note that, the IRS yields trade way below yields of comparable maturity Government securities.

Currently the five-year IRS yield is trading at a negative spread of 120 basis points to 5 year G-Sec.

Besides, while the G-Sec yield curve is almost flat, the IRS yield is steeply inverted to the extent of 120 basis points defying term, credit risk and liquidity risk premia which typically characterise a normal yield curve of risk assets.

Being pure time value of money, G-Secs are influenced by, and immediately price in, inflationary expectations arising from higher fiscal deficit which, in turn, is the cause of additional supply of G-Secs and not the other way round. Thus, here we have an IRS market completely upside down and running on its head. This is completely anti-thetical to the law of one price, or the no-arbitrage argument.

For, if this law held, given hugely negative spreads to Governments, fixed rate receivers, who far exceed, and overwhelmingly outnumber, fixed rate payers, would have engaged in a very simple arbitrage, involving buying corresponding maturity G-Sec in the cash market by financing it in the overnight repo market, and paying fixed, and receiving overnight, in the IRS market.

This very normal, and logical, arbitrage would have had the effect of benefiting all the three stake-holders — (a) fixed rate receivers receiving much higher yield than they are currently, (b) Government of India borrowing at much lower cost, and (c) business and industry in general, and infrastructure sector, in particular, getting long-term-fixed-rate-low-cost financing solutions. In other words, this would have been a win-win for all key stake- holders but, the fact of the matter is that, if anything, this is just not happening.

The IRS segment is almost getting to the point where the IRS market, instead of being a means to an end of sub-serving the real sector is, existing, almost entirely for its own sake creating a massive “financial sector-real sector imbalance”.

Credit Default Swap

Credit Default Swap is no exception to cash market replication principle of derivatives pricing.

The price of a CDS, in spread terms, is reasonably approximated by the difference between the spread of a reference bond to corresponding maturity G-Sec yield and the spread of IRS to the same maturity G-Sec yield. Since G-Sec yield is common to both spreads, another way to approximate CDS price is simply to take the difference between the yield of the reference bond and the same maturity IRS yield.

Finally when the product was launched on December 7, 2011, it was a stillborn. Because of hugely negative IRS spread, fair price of a CDS would be so high as to make it both pointless to buy a reference bond and also hedge it with a CDS. In other words, one is much better off straightaway buying a corresponding maturity risk-free G-Sec itself.

Interest Rate Futures

After their second launch in August 2009, Interest Rate Futures on 10-year notional government bond had seen two settlements, viz. the December 2009 contract and March 2010 contract.

Significantly, both traded volumes and Open Interest (OI), witnessed decline over the two settlements, eventually decaying very quickly to zero permanently.

In particular, the December 2009 contract, which had a peak Open Interest of Rs 98 crore declined to a pre-settlement Open Interest of Rs 61 crore and settled “entirely” by physical delivery, representing physical settlement of 62 per cent of the peak Open Interest. In contrast, the March 2010 contract, which witnessed a peak Open Interest of Rs 57 crore declined to a pre-settlement Open Interest of Rs 42 crore and also settled entirely by physical delivery, representing physical settlement of 72 per cent.

Both these settlements were a far cry from the hall-mark of an efficientphysically-settled futures market even where physical delivery typically does not exceed 1 per cent to 3 per cent of the peak Open Interest.

This happened because of the inefficient ‘disconnect’ and ‘friction’ in the IRF market due to only one way arbitrage viz. buying the cheapest-to-deliver (CTD), with the highest implied repo rate (IRR), by financing the same at the actual repo rate and simultaneously selling futures.

Market Segmentation

Continuing market segmentation is the biggest undoing of an efficient, and seamlessly integrated financial market.

Market fragmentation/segmentation contributes to price distortion and inefficiency. The most tangible and manifest evidence of market segmentation in India is the ‘dis-connect’ between IRS, IRF and government securities markets as reflected in the IRS (bank credit risk) yields being 100 to 125 basis points below G-Sec yields and IRF yields (when last traded) being about 70 basis points higher than their fair value, signifying almost complete absence of arbitrage and thus a pernicious violation of the ‘no-arbitrage’, or what is the something as, the ‘law-of-one-price, argument’ which, as the discerning audience is by now well aware, is the most fundamental basis of ‘fair value derivatives pricing’.

Suitable measures

Such ‘dis-connect’ militates against the development of a seamlessly integrated financial market.However, this market segmentation can be addressed by following suitable measures.

First, the totally misplaced temptation to introduce/launch cash-settled IRF must be firmly and decisively resisted.

What must certainly not be done is even to contemplate, much less permit, the most-liquid-single-bond IRF as this benchmark security represents less than 10 per cent of the current 10-year IRF deliverable basket and would amount to veritable ‘exclusion’ of 90 per cent of the 10-year Government securities from the benefit of hedging which arguably runs counter to the public policy purpose of IRF providing hedging to as wide a universe of government securities as possible. What also must certainly not be done is allocate specific government securities to different Primary Dealers for market making.Symmetrical and uniform accounting treatment of both cash and derivatives (IRF/IRS/CDS) markets.

Removal of the ‘hedge effectiveness’ criterion of 80 per cent to 125 per cent which militates against use of derivatives for hedging purposes for it is better to have ‘ineffective’ hedge than to have no hedge at all.Roll-back of the HTM (Held to Maturity) protection i.e. substituting the current “accounting hedge” with “derivative hedge”. Delivery-based short-selling in the cash market for a term co-terminus with that of the futures contract and introduction of term repo, and reverse repo, markets, co-terminus again with the tenure of futures contract for borrowing and lending of cash and G-Secs.

Both for IRS and IRF, actual notional/nominal amount of IRS/IRF must be allowed on duration-weighted basis unlike the current regulation which restricts the maximum notional/nominal amount of hedging instrument to no more than the notional/principal amount of the exposure being hedged resulting in under-hedging of risk.

(Edited excerpts of the keynote address delivered by V. K. Sharma, Executive Director, Reserve Bank of India, at Finnoviti 2012 organised by Banking Frontiers, in Mumbai on November 8. The views expressed are those of the author and not of the RBI.)