RBI announces norms for forward rates, interest swaps

Participants, who wish to undertake FRAs and IRS, would have to ensure that appropriate infrastructure and risk management systems are put in place. They should also set up internal control systems so that a clear functional separation of trading, settlement, monitoring, control and accounting activities is provided, it said.

While currency hedging was permitted, interest rate hedging was not allowed to be indulged in by the Indian financial sector earlier and those who needed such a cover had to resort to overseas financial intermediaries.

The Reserve Bank has already formulated the guidelines for the products, which was made public a few days ago. An FRA is a financial contract between two parties to exchange interest payments for a notional principal amount on the settlement date, for a specified period from the date of commencement to the maturity date.

An IRS is exchanging or swapping a stream of interest payments for a notional principal amount on multiple occasions during a specified period. According to the RBI guidelines on FRAs and IRS released here today, banks, FIs and PDs can also offer these products to corporates for hedging their own balance sheet exposures while no specific permission from the RBI would be required to undertake the contracts.

However, only plain vanilla contracts are allowed and swaps having explicit or implicit option features such as caps, floors and collars are not permitted.

The benchmark rate in all such swap agreements should evolve on its own in the market and should have market acceptance. “The parties are, therefore, free to use any domestic money or debt market rate as benchmark rate for entering into FRAs and IRS, provided methodology of computing the rate is objective, transparent and mutually acceptable to counter-parties” the RBI guidelines read.

No restrictions have been put on the size of the notional principal amounts. In fact, according to the RBI “norms with regard to size are expected to emerge in the market with the development of the product.”

There is no floor or ceiling on the tenor of the FRAs and IRS. The central banking authority has told banks, FIs and PDs to exercise caution while dealing with corporates “to ensure that they (corporates) are undertaking FRAs and IRS only for hedging their own rupee balance sheet exposures and that the size and tenor of the transactions undertaken are not in excess of their underlying rupee exposures.

The RBI, realising the need for market making for swap products, has allowed participants to undertake market making activity “which will involve at times dealing in the market without underlying exposure.”

However, in order to ensure that market makers do not over extend themselves, the apex bank has said that they should place prudential limits on swap positions. The prudential limits would require vetting by the RBI — the internal debt management cell would do the vetting for PDs while RBI’s financial institutions divisions and department of banking supervision would be responsible for banks and FIs.

The prudential limits to be fixed should be done on the basis of the asset liability management systems set up in banks and FIs, the RBI said. Transactions for hedging and market making purposes have to be recorded separately. Those for market making should be marked to market and those for hedging could be accounted for on accrual basis.

According to the RBI, the guidelines are intended to form the basis for development of rupee derivative products in the country and would be subject to review from time to time.