Locals give cautious welcome to exotics’ passage to India

Corporates still wary about structured derivatives five months after lifting of trading ban

Indian-currency

Corporates in India remain cautious about adopting exotics five months after the country’s central bank allowed trading in the derivatives to resume.

The Reserve Bank of India lifted its ban on the derivatives on January 3, 12 years after Indian corporates and banks suffered massive losses from trading the products during the aftermath of the global financial crisis. Zero-cost derivatives, a form of currency derivatives that were inexpensive and popular at that time among Indian corporates with large foreign exchange exposures, were the main cause of the ban.

Vijay Santhanam, head of the risk solutions group at Barclays Bank India, believes corporate management teams in the country are keen to avoid a repeat of past mistakes. “There is clearly a difference in the way they approach this,” he says. “They want internal policy and controls to be in place because, after a gap of about a decade, obviously not all companies are ready for these products. Most organisations are looking at liquidity in the market and how the market is developing before they deep dive into the market.”

The risk capital provision prescribed by the central bank on all derivatives following the 2008 crisis also remains far higher than the standards imposed elsewhere. Manoj Rane, managing partner at financial services consultancy Sionic, says that these standards, “coupled with the very stringent suitability and appropriateness frameworks that banks have had to adopt in the aftermath of the 2008 crisis, implies that there are very few corporates that qualify and are willing to transact derivatives”.

Parul Mittal Sinha, head of financial markets, India, and head of macro trading, South Asia, at Standard Chartered Bank, says the uptake of exotics has been slow because many corporates need strong governance frameworks in place before allowing their treasury departments to trade new products. They also need to assess the frameworks and their risk appetites and obtain approval from their boards and compliance functions.

“The broader market is still going through that cycle,” says Sinha. “We expect the uptake to increase over time.” She expects to see more trading of structured derivatives by the end of this year.

Santhanam says the larger, more sophisticated corporates – with well organised treasury functions, a better understanding of structured products, and internal pricing expertise – have executed a few transactions since January.

“People who take the risk, people who have insights, people who are sophisticated treasury – that’s one type of corporates,” he says. “The other type of corporates are those who have the size and exposure but are taking longer because they need to first have the right people, mandates, systems and controls in place.

“That is a work in progress because, after a gap of 12 years, you already have your system set up [and your] valuation set up… for a particular set of products.”

During much of this period, Indian corporates were only able to hedge risk by using vanilla products. Santhanam says that adopting structured derivatives will mean a complete change to the way transactions will need to be executed. Exotics will need to be managed throughout their lifecycle, and this will involve valuing the trades and having the internal expertise and skillsets needed to price them.

“Those are the things that are taking longer, and therefore it is taking corporates longer to come to the market,” he says. “Having said that, based on conversations, we know there are people considering it.”

However, Santhanam points out that companies that are managed globally have larger portions of their balance sheets hedged through vanilla products: “Previously, companies that needed to manage their international trades in terms of imports and exports, or manage their balance sheet using interest rates derivatives – or [those that] have off-balance sheet items that need to be swapped into local currency swaps – tended to be offered products such as swaps, interest rates swaps, options and forwards. Those were easily available, whereas exotic suites of derivatives products were not made available.”

Trimming the hedges

The reintroduction of exotics is giving corporates a chance to re-examine their hedging strategies. Santhanam says those corporates with an understanding of exotics and the ability to access the market will have a huge advantage in terms of hedging costs and in achieving better hedging outcomes, as long as they hedge in a controlled manner.

“They are making cost decisions based on what they need, but they need to get the accounting treatment right for the structured products,” he says. “It is possible to save cost even with a single structured product.”

Sinha sees a risk appetite among corporates for exotics that will enable them to increase their hedge ratios at a lower cost through zero-cost structures, where upside is capped to reduce upfront execution costs. Many corporates that import large amounts of goods or that have foreign currency borrowings with long tenors leave their exposures unhedged because hedging through vanilla products is already expensive. “These clients have the appetite to use the new products,” she says. “It just has more to do with the governance and giving the right education to key stakeholders.”

Rane says the lower uptake of FX digital options and swaptions points to corporates’ limited appetite for exposures that could result in significant losses. He believes this will impede corporates’ ability to hedge their currency risks, but that it will also limit the kind of systemic risk that built up as a result of the widespread use of exotic options between 2004 and 2008.

Santhanam expects strong demand for structured options. India’s technology companies, which have a large pool of export receivables, are one sector in which the products could enhance yield.

Given that Indian corporates tend to access capital markets to issue foreign currency bonds or tap bank borrowings, hedging in some form is essential. Against this backdrop, Santhanam expects dollar/rupee options and longer-tenor options to have a better uptake than other exotics: “The structured option market is where you will see more activity, in my view, and a faster uptake.”

He says liquidity is likely to improve gradually, depending on which structured products are in demand at a given time: “Once you see the market developing towards a particular set of products, given the number of players in the Indian market, I don’t think liquidity will be an issue.”

Rane says banks will need adequate pricing and risk assessment systems to quantify and manage the risks inherent in structured derivatives before offering them to clients. The financial crisis and its aftermath showed that banks’ clients were being offered such products even though the banks were unable to price and manage the risks.

“Banks would transact the exact opposite of those transactions with multinational banks,” he says. “They would presume they were fully hedged. However, with the clients not being fully conversant with the risks, this approach was what led to the suitability and appropriateness issues.”

Nevertheless, Barclays’ Santhanam believes most large investment banks are familiar with structured derivatives and well positioned to offer them.

“It is not something new for banks but for local or government banks in India,” he says. “As volumes pick up, I think there will also be a healthy interbank market which will help price these products and help people do large volumes.”

Delivering on the non-deliverables

The easing of the exotics ban comes after regulators in 2020 allowed domestic banks to trade onshore non-deliverable forwards, in an attempt to tame volatility in the rupee.

Sinha points out that when authorised dealer category I banks in Gujarat International Finance Tec-City – a business district under development in Ahmedabad – were allowed to trade NDFs in onshore markets in 2020, volumes increased significantly from a market that had started practically from zero. She adds that many banks operating in India with large balance sheets and a significant risk appetite are now able to do spread transactions and monetise trades on the onshore market.

Such developments have reduced excess volatility in the non-deliverable forward market. Many offshore clients that did not have access to the onshore market and hedged their requirements via NDFs are also getting better pricing and final bid-offers.

Santhanam adds that since the rules were eased, offshore counterparties previously restricted from trading in India have expressed an interest in accessing the onshore market, and activity has been rising.

Editing by Daniel Blackburn

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