Saturday, February 18, 2017

The Introduction of Interest Rate Options In India

[The following guest post is contributed by Niharika Choudhary, who is a 4th year student at the National Law University, Jodhpur]


Trade in financial derivatives has led to an enormous growth of the Indian financial system. New instruments have proliferated and trading volume has exploded. The use of financial derivatives has transformed the way financial institutions deal with risk. In February 2016, the Reserve Bank of India (RBI) for the first time proposed to introduce interest rate options in India in order to enable all domestic entities, including banks that have underlying interest rate risk, to hedge their risk by trading in interest rate options. Interest rate options were finally introduced in the Indian financial market by way of the Interest Rate Options (Reserve Bank) Directions, 2016 (RBI Directions) in December 2016, which have become effective from 31 January 2017.

Before this, interest rate swaps (IRS) and forward rate agreements (FRA) in the OTC segment and interest rate futures (IRF) on the exchanges were the only interest rate derivatives traded in India. The need for interest rate options came to the fore when the RBI’s Technical Advisory Committee of the Financial Market Regulation Department held a meeting on 21 April 2015 and constituted a Working Group headed by PG Apte. The Working Group on Interest Rate Options perceived that the financial entities and intermediaries, including banks, lacked any instrument to manage the engrossed risks on their balance sheets, such as premature withdrawal of deposits, prepayment of loans, and the like.

What are Interest Rate Options?

The most common options provided by over the counter derivatives[1] are options on foreign exchange and various interest rate options. Interest rate options are options that derive value from changes in the underlying interest rate. The value of these options is based on Rupee interest rates or Rupee interest rate instruments.

Interest rate options largely include caps, floors, and collars. These concepts are dealt with in detail in the RBI Directions. Interest rate caps are designed to provide insurance against rising interest rates by payment of a premium to the other party, who promises to make interest payments on specified future dates based on the excess, if any, of interest rates above a certain specified rate. In a cap, the insurer on the payment of a premium ensures that its interest payment will not rise above the cap provided and, in case it rises, the writer of the option pays the difference. A floor (on the payment of premium) guarantees that the interest received will not fall below some stated minimum. In a collar there is no requirement of payment of premium and it combines the purchase of a cap with a sale of a floor on the same reference rate for the same maturity and notional principal amount. Therefore, the borrower’s net interest cost cannot rise above the cap nor fall below the floor. In a reverse interest rate collar, there is a purchase of a floor and a sale of a cap on the same reference rate for the same maturity and notional principal amount. Another kind of interest rate option, which was proposed by the Working Group on Interest Rate Options, was Swaption. A Swaption is an option for interest rate swap. Swaptions are a kind of insurance contracts issued on the interest rate swaps i.e., on the decision to change floating into fixed rate loans.

Key Highlights

1.         Types of Interest Rate Options

The Working Group on Interest Rate Options in its report had recommended that simple call and put options, caps, floors, collars and swaptions be permitted. However, the RBI Directions seem to have excluded swaptions in the list of permitted product types. Swaptions are options on forward-starting interest rate swaps. Swaption is defined under the Report of the Working Group on Rupee Derivatives, 2003 as an option to enter into an interest rate swaps. A swaption gives the buyer the right, but not the obligation, to enter into an interest rate swap at a specific date in the future, at a particular fixed rate (the strike rate), and for a specified term. The option is called a receiver swaption if the buyer has the right to receive fixed interest in the swap, and is called a payer swaption if the buyer has the right to pay fixed and receive floating interest in the swap. One of the greatest advantages of using swaptions is that it is possible to lock the rate at present for exchange in the future without incurring any opportunity cost except the expense of the premium. The other advantage is that swaptions can be used for hedging an off-balance sheet item by purchase of a swaption for hedging a loan commitment, which is yet to be drawn down. But the premiums in swaptions are very expensive, liquidity is low and the transaction is very difficult to unwind in case of frequent price fluctuations.[2]

2.         Exercise

The Working Group on Interest Rate Options had recommended that only European options be permitted in the OTC market and also suggested that American options be allowed in next phase.[3] Another recommendation of the Working Group on Interest Rate Options was to allow stock exchanges to introduce both European and American options, keeping in mind the practice in the international markets. However, the RBI Directions do not provide for any special allowance of American options on registered stock exchanges. While executing an American option at any time during the contract provides more flexibility, generally these options are costly in comparison with European options. Also, determining the value of that flexibility further complicates the pricing or valuing American options more complex. Currently, in India, only European options are permitted in terms of option products.

3.         Venue/ Market in which IROs can be traded:

As proposed by the Working Group on Interest Rate Options, the RBI Directions permit both OTC markets and stock exchanges for trading in IROs.

4.         Benchmarks/ Underlying to be used

The benchmark here refers to the reference rate[4] (strike rate) on which the interest rate option is based. It is a moving index, and is usually used in the adjustable rate mortgages. The RBI Directions direct the Fixed Income Money Market and Derivative Association of India (FIMMDA), in consultation with market participants, to publish a list of money or debt market rates or instruments as the underlying such as G-Sec, T-Bills, MIBOR, OIS MIFOR,IRF etc. Also, the Financial Benchmark India Pvt. Ltd. (FBIL) shall publish rates / prices for the reference rate / asset/derivatives for assessing the settlement value in the OTC market.

5.         Market Participants

Market Makers: Market makers include banks and primary dealers and other regulated institutions and entities subject to the approval of their respective regulators.

Users: The users include all entities carrying underlying interest rate risk. They can enter into interest rate option contracts for hedging underlying risk. As per the RBI Directions, ‘users’ shall not be permitted to run net short position[5] in interest rate options.

6.         Reporting

Following the recommendations Working Group on Interest Rate Options, the RBI Directions propose that all OTC transactions are to be reported within 30 minutes of the trade to the Trade Repository of the Clearing Corporation of India Ltd (CCIL). All market makers are required to report client trades on the same day by close of business hours to the Trade Repository of CCIL.

7.         Settlement

The RBI Directions provide that OTC transactions shall be settled bilaterally or through RBI-approved clearing arrangements. FIMMDA is to specify the settlement basis and other market conventions for interest rate option transactions in the OTC.

8.         Suitability and Appropriateness Policy

Market makers ought to comply with the requirement of board-approved ‘Suitability and Appropriateness Policy’[6] read along with the Guidelines on Derivatives, 2007.[7]

Benefits of Interest Rate Option Products

The introduction of interest rate option products in India, being complementary to the currently existing interest swap market, can lead to the following benefits:

1.         Constructive Hedging

Interest rate options can be used to hedge current and future borrowing requirements against sharp rises in interest rates. It is a useful instrument to hedge both on-balance sheet and off-balance sheet exposures. An example of hedging an on-balance sheet exposure would be the purchase of a cap that can be used to hedge a floating rate liability; similarly, a floor can be purchased to hedge a floating rate asset.

2.         Managing Contingency

Options are very useful in managing risks on contingent exposures. For example, if a company participates in the bidding of a project where a sizeable amount of funding is required, but it does not know whether it would be awarded the bid, it may make use of options to hedge the risks of an adverse move in the interest rate markets.

3.         Liquidity

Fixation of interest cost of debt increases cash flow certainty for borrowers of floating rate loan and thus imparts reasonable liquidity.

4.         Price Discovery

Without interest rate options, it was not possible to accurately price a number of products such as floating rate bonds and constant maturity treasury (CMT) swaps, since their pricing requires some estimate of interest rate volatility. After the introduction of interest rate options, the implied option volatilities can be used to infer volatilities in the underlying market, leading to better price discovery.


Interest rate options are versatile tools available to the investors, which would allow the investors to control their exposure to interest rate fluctuations. These will also allow speculation on interest rate volatility. Interest rate options, being hedging instruments, are particularly attractive for those who do not have any strong view on the direction of rates. Interest rate options operate as hedging instruments where the size of risk is highly uncertain. The use of interest rate options would give rise to advantageous hedging and trading opportunities in the derivatives market in India.

- Niharika Choudhary

[1] An over the counter option is negotiated directly between the buyer and the option writer that is usually a bank.

[3] European Option is an option that can be exercised only on the expiration date. American Option is an option that can be exercised at any time before and on the expiration date.

[4] The most common reference rate is the LIBOR Rate.

[5] Short Position refers to selling of securities.

[6] Market makers, while selling such structured products, should carry out due diligence, risk identification, management and control, and should ensure that the products are sold to the users following prudent accounting and disclosure norms.

[7] Circular DBOD No.BP.BC.86/21.04.157/2006-07 (April 20, 2007).

Tuesday, February 14, 2017

Regulating India’s FinTech

[The following guest post is contributed by Vaibhav Parikh, who is a business lawyer associated with the Aditya Birla Group]

“Disruption” is often used as a generic term to describe situations where smaller and newer companies with fewer resources are able to successfully challenge established incumbent businesses and upset status quo. Although a case has been made that it brings visibility to an enterprise, disruption is far more nuanced, and can result from a variety of factors ranging from technological innovation and disintermediation to regulatory arbitrage.

The distinction is, however, more than just academic, as knowing the nature of disruption can help assess its regulatory viability, sustainability and the ability of the underlying enterprise to retain value.

The Wave of FinTech Disruption

India’s resilient economy, along with a swelling middle class and recent governmental policies, has certainly increased the demand for financial services in the country. Traditional banks that were once sheltered by regulations are now sailing in unchartered waters. And it is the lack of innovation on their part that has resulted in the usage of FinTech as a tool, which is growing leaps and bounds. It is creating significant opportunities for innovators to take a leap of faith in the existing market.

Also, India’s FinTech firms are focusing more on untapped customer segments and are certainly fulfilling the needs of the customers. Businesses with unfavorable financing requirements from traditional banks have turned to unconventional lenders for funding. This under-developed consumer banking system has paved the way for FinTech firms to approach the unbanked population who are seeking better offerings elsewhere.

Further, the developing technology infrastructure in the country has also given FinTech firms an impetus to flourish. Ubiquitous connectivity in major cities and unprecedented changes in the government policies have translated to mature digital penetration in payment methods. With payment cards to digital wallets, FinTech firms have led the way in retail disruption.

Lastly, the readiness on the part of the bankable population in adopting these products has offered disruptors an opportunity to gain scale. India’s FinTech scenario is therefore at an inflection point in reshaping the financial landscape.

Why is there A Need for Regulating the Wave?

An emerging set of disruptors is seeking to operate in sectors not usually amenable to disruption by reason of their being heavily and actively regulated. Such regulation is often justifiable in the light of the systemic importance of these sectors, and the risks associated with them. This is proving to be a prominent disruption where FinTech firms are seeking to facilitate direct small and medium ticket loans to individuals and small-and-medium enterprises through third party lenders. They also seek to facilitate disbursements, repayments and contracting in consideration for service fees.

Their objective is to render payment services more efficiently and to drive loans which are not addressed by existing means. This would require participation by non-traditional lenders, simplified enrollments and lending procedures and unconventional lending and repayment mechanisms and terms. These FinTech platforms may be subject to limitations on interest rates chargeable, prudential and capital adequacy norms for participation in risk, reporting requirements, regulations governing KYC requirements and restrictions surrounding potential enforceability of electronic documentation for recovery. Again, proactive compliance and regulatory engagement will bring distinct advantages.

Also, investors investing into potentially disruptive businesses need to be mindful of the nature of the disruption, its long term sustainability, and how prepared their potential investee is for regulatory interventions. An analysis of trends from legal issues affecting investments into various sorts of disruptive businesses indicates that it is in the interest of the investors to future-proof business models and operations against emerging regulatory changes and trends.

One way this could be achieved is through conducting thorough due diligence (financial, legal and technical) on potential investees with special emphasis on the regulations governing their more entrenched competitors and investee compliance with such regulations. Investors must also analyze investee business operations and put in place suitable processes and documentation to comply not only with best practices but also at the very least with the spirit of applicable rules and regulations. Further, analyzing, estimating and classifying risks, and structuring businesses in such manner as to compartmentalize riskier, more regulated portions thereof from the remainder of the their operations will also go a long way in ensuring that the investment into a disruptive business is in the investors’ best interests.

Disruptive operations in highly regulated sectors like financial services are subject to very substantial and proximate regulatory risks. Last year, the Reserve Bank of India (RBI) set up an inter-regulatory Working Group to study the entire gamut of regulatory issues relating to FinTech and Digital Banking in India. One of the terms of reference of the working group is to chalk out appropriate regulatory response with a view to re-align/ re-orient regulatory guidelines and statutory provisions for enhancing FinTech associated opportunities while simultaneously managing the evolving challenges and risk dimensions.

The focus on this nature of investment has moved from risk mitigation to risk classification, with the intent being to mitigate the most serious risks as much as possible. Given the recommendations of Ratan Watal Panel mooting an independent payment regulator, expect disruptive behavior in the regulations for FinTech regulations in the form of sandbox regulations. Some level of regulatory crystal ball gazing is also called for by investors into these sectors.

Therefore, given the current strengths in terms of government policies, talent resource pool and the current contribution of the FinTech to the Indian economy, there is an opportunity to create best-in-class standards, practices, resources, regulation and technology in order to play a leading role in global as well as Indian development of FinTech.

- Vaibhav Parikh

Monday, February 13, 2017

A New Book on India’s Intellectual Property Dilemmas

[Guest post by Prashant Reddy (Research Fellow, School of Law, Singapore Management University) and Sumathi Chandrashekharan (Senior Resident Fellow, Vidhi Centre for Legal Policy) on their new book]

About four years ago, in a game-changing case, the pharmaceutical giant Novartis AG, lost the rights to their patent in India covering one of their best-known chemotherapy drugs, Gleevec, after a decision of a two-judge Bench of the Supreme Court of India. The decision hinged on an interpretation of Section 3(d) of the Indian Patents Act, which governed the patentability of new forms or uses of known drugs.

In our new book titled "Create Copy Disrupt: India's Intellectual Property Dilemmas", we write about, among other things, the build-up to the drafting of Section 3(d), through the lens of history and politics. Although the provision came into its own only after India's signing of the Agreement on Trade Related Aspects of Intellectual Property (TRIPS), the story really began in early post-independent India. The 1950s and 1960s were incredibly exciting times for Indian lawmaking, not just because it was breaking away from colonial legal legacies, in the hope of defining India's development trajectory afresh, but also because it was the battleground between opposing ideologies – with the Congress and communist parties on one side of the aisle, and the Swatantra Party on the other side, staunchly advocating for free markets.

In intellectual property (IP) law, the outcome of this battle took the shape of a patent law designed to serve the domestic industry, operating in a closed market, insulated from competition from the West. Stalwarts of the Swatantra Party like Minoo Masani and Dahyabhai Patel staunchly opposed these moves, batting instead for more IP protection with the aim of attracting technology transfer to India. However, the fact of the matter is that a law supported by the socialists and communists eventually gave birth to one of the most successful capitalist industries in the Indian manufacturing sector. In the 1980s and 1990s, the compulsions of becoming a part of the international trading community forced India to sign TRIPS. Consequently, our patent law turned on its head, again, in the backdrop of high-decibel political debate, culminating in the Novartis case, among other things. The politics and history of this story, starting from 1948 and concluding with the Supreme Court’s decision in the Novartis case, involves not only Indians but also several foreign players. Understanding this history is crucial to understanding the future of Indian approach to pharmaceutical policy. In order to keep things interesting, we attempt to tell this story through a narrative that relies on parliamentary debates, standing committee depositions and archival research from that era. 


In this book we also cover the history and politics of Indian copyright law post-independence and the manner in which these changes affected all creative industries like the movies, music, book publishing and internet intermediaries.

In a multi-crore rupee film industry, when actors and producers were making fortunes, many entertainers were left behind. Lyricists and composers, for instance, who made many a memorable melody, were scrounging for their share of the profits from the success of soundtracks, because the copyrights in the industry were skewed against their favour. The run up to the 2012 amendments to the Copyright Act saw a parliamentary revolution led by the poet-parliamentarian Javed Akhtar which ensured that the new law tilted the law in favour of the creators in the industry. In this book, we uncover the murky goings-on behind the scenes of the Indian Performing Right Society (IPRS), which is responsible for collecting and distributing royalties pertaining to film music, and detail how Akhtar fought a lone battle against the powerful film industry, and how the Parliament was won.

One of the other important copyright stories that we examine is the safe harbour exception in Indian copyright law that shields Internet intermediaries from claims of copyright infringement. The absence of a safe harbour exception had in the past led to promising ventures like being shut down in the early days of startup India because T-Series got the founders arrested for copyright infringement.


Before we end this post, we would like to mention that this book is not written in a typical academic format. The idea rather was to reach out to a wider audience of readers who are not specialists in intellectual property but are interested in knowing more about India’s IP regime.

Book details
Title: Create, Copy, Disrupt: India's Intellectual Property Dilemmas
Hardcover: 400 pages
Publisher: OUP India (23 December 2016)
Language: English
ISBN-10: 0199470669
ISBN-13: 978-0199470662
- Prashant Reddy & Sumathi Chandrashekharan