MUMBAI: Investors in debt will be better placed to hedge against interest rate risks, with an RBI panel recommending trade in interest rate futures (IRFs). The report by RBI’s technical advisory committee comes at a time of increased volatility in debt markets, with yields swinging by 100 basis points in a month.

The report follows the guidelines on currency futures released on Thursday. An interest rate future is a contract where the buyer agrees to purchase a debt instrument at a future date. If the committee recommendations are accepted, RBI may disallow banks from classifying all their statutory investment in government bonds under the held-to-maturity category. The panel is of the view that banks were allowed to shield their bond portfolios from accounting losses to ensure stability.

Since the purpose of interest rate futures is to provide stability to debt investors, the provision allowing banks to freeze their bonds in a held-to-maturity portfolio should go, the report said. The panel further suggested that interest rate futures should be exempt from securities transaction tax. It added that once interest rate futures pick up, RBI must look at introducing options too. Treasury officials feel that the recent volatility in interest rates could have been a key trigger for the central bank to introduce IRFs as a hedging instrument for risk management. To begin with, the panel has recommended that futures contracts should be based on the 10-year government bond.

This could eventually be extended to 2-year, 5-year and 30-year government securities based on market response. RBI may impose capital requirements on the lines of what it has introduced for banks participating in currency futures, where it has prescribed a minimum net worth of Rs 500 crore and a minimum capital-to-risk assets ratio of 10%.

In a bid to allow banks to cover risks on a comprehensive basis, the committee has highlighted that banks should be allowed to hedge interest rate risks, even on off-balance sheet items. The technical committee has proposed that the duration for short-selling must be extended, in such a manner that the tenor of the short sale transaction coincides with the futures contract.

The panel feels that at least in the initial stages, only banks and bond houses should be allowed to undertake short-selling for a longer duration, but on the condition that the transaction is delivery-based. Said a senior treasury official, “Interest rates are currently headed northwards and there has been a lot of interest shown in IRFs, especially by multinational banks. In the past, there were few participants in the market and even derivatives contracts were not used widely. Now, even public sector banks trade actively in overnight interest swaps.

” In its earlier set of recommendations, the panel has mooted that bond futures would need to be physically settled, in line with international practices. For foreign institutional investors (FIIs), who are a significant community in bond trading these days, the working group has advised that they could be allowed to take long positions in the futures market, keeping in mind that their gross long positions in the cash market does not exceed the maximum-permissible cash market limit of $4.7 billion.