FPI limit in interest rate futures may revive segment

The move by the Reserve Bank of India (RBI) to set aside a ~5,000-crore limit for foreign portfolio investors (FPIs) in interest rate futures could breathe life into the lacklustre market.

The RBI did not specify if the limit would be a temporary arrangement.

Interest rate futures are among the best hedging tools for bonds. Since these are settled in cash, these futures can also be treated as a separate asset class.

Till now, investment in interest rate futures and gilts was allowed within overall limits set by the RBI. If 90 per cent of the limit was exhausted, FPIs had to bid for permission for fresh investment.

FPIs have exhausted 99.34 per cent of their limit in gilts.

“To ensure FPIs’ access to futures remains uninterrupted during the phase when FPI limits on government securities are under auction, it is proposed to allocate FPIs a separate limit of ~5,000 crore for long position in IRFs (Interest Rate Futures). The limits prescribed for investment by FPIs in government securities will then be exclusively available for acquiring such securities,” the RBI said in its monetary policy statement on Wednesday.

“If it is a separate and exclusive investment limit, it will be great news for the interest rate futures market,” said Jayesh Mehta, head of treasury at Bank of America Merrill Lynch.

He added this would encourage more players to take up position and the instrument could become mainstream.

“Interest rate futures have not attracted long-term investors as they should have. If foreign portfolio investors are nurtured as a distinct investor class, it will cut down on volatility in trading, improve price discovery and eventually draw more retail investors,” said Harihar Krishnamurthy, head of treasury at FirstRand Bank.

When interest rate futures were launched in February 2014, the total traded volume on three exchanges, the BSE, NSE and MCX, had touched ~4,500 crore. In a fortnight, the volume crashed to less than a tenth as the RBI contemplated changing its benchmark from wholesale to retail inflation.

The daily average turnover in interest rate futures in July on all three exchanges was ~2,124.70 crore.

Bond dealers said the futures segment was now mostly used by rich individual investors and private and foreign banks.

Much of the trading volume is generated because of ultralow margins in interest rate futures, usually not more than three per cent of the volume.

Interest about gilts was strong among foreign investors and the extra limit allowed foreign portfolio investors a chance to take fresh position in government paper, said bond dealers.

“Interest rate futures are a surrogate for government bonds,” said Krishnamurthy.

The RBI had recently stated only long-term investors could have incremental positions in gilts. In Wednesday’s announcement, it said the latest positions were also for long positions in interest rate futures.