Lynn Strongin Dodds looks at ISDA’s recommendations for taking the industry to the next level of development
Over the past two years, India has been dazzling investors with its growth story. Stock markets have soared, but OTC derivatives have also featured prominently in portfolios. As a result, the International Swaps and Derivatives Association (ISDA) has published a new whitepaper, presenting a review of India’s OTC derivatives market and a roadmap for the future.
Room to Grow
The paper notes that efforts led by Indian policymakers over the past few years have driven a significant expansion of the OTC derivatives market, with its notional value reaching around $9.27 trn in 2022, catapulting it to the 20th largest OTC derivatives markets globally. However, according to the latest Bank for International Settlement triennial report, it is still a relative minnow accounting for just 0.1% of the overall global universe.
In other words, there’s plenty of room to grow especially as S&P Global forecasts the country will leapfrog over Japan and Germany to become the world’s third largest economy from its current fifth position by 2030.
These expectations are further fuelled by Moody’s Investor Services which recently raised its GDP outlook for the country to 6.8%, for this year from 6.1% on the back of ‘stronger-than-expected’ economic data of 2023 and fading global economic headwinds. The country’s economy expanded by 8.4%, last year surpassing economists’ consensus of 6.6%. It was the fastest pace in one-and-half years in the final three months of 2023, led by strong manufacturing and construction activity, according to the ratings agency.
The potential of OTC derivatives
To date, the country’s stock markets have been the main beneficiaries, but ISDA believes the country’s OTC derivatives market holds great potential thanks to government initiatives and regulations over the last few years. One of the most notable has been the Bilateral Netting of Qualified Financial Contracts Act in 2020, which was based closely on the ISDA Model Netting Act and gave statutory recognition to close-out netting.
This was followed by the Reserve Bank of India’s (RBI’s) guidelines on qualified financial contracts and revisions to capital charge, provisioning and net stable funding ratio (NSFR) requirement. “This was a landmark reform as it permitted banks to calculate their exposure relating to derivatives on a net basis which enabled banks to reduce counterparty credit risk and regulatory capital and helped in the reduction of hedging costs on derivatives,” said the ISDA paper.
Other key drivers highlighted in the report include the extension of market access to non-residents, the introduction of central clearing services for OTC derivatives to manage counterparty credit risk, and a regulatory shift towards principles-based regulation. This not only facilitated market access but also created an environment for financial innovation.
How to keep momentum
However, despite these foundations being laid, there is more work to be done and ISDA set out five pillars to keep and increase the momentum. The first is to broaden product development. This ranges from creating standardised term benchmarks to reduce basis risk to expanding the scope of the credit derivatives market beyond the current limited universe of bonds, debentures, and money market instruments. It also includes enabling onshore OTC commodity and equity derivatives markets.
Moreover, it recommends greater adoption of similar market and risk principles across regulatory regimes in the country. In other words, rules governing the use of derivatives by various market participants need to be in tune. This is particularly the case with the rules relating to the use of OTC interest rate and credit derivatives which should be harmonised.
In addition, ISDA believes initial margin (IM) requirements for non-cleared derivatives should be on the same page as global standards to ensure domestic markets are secure. This means allowing full substituted compliance for Indian branches of foreign banks and expanding the list of eligible collateral.
Also, on the list are improving market access and encouraging diversification of participants in the OTC derivatives market. ISDA notes that regulators and industry participants have a role to play and should work together to develop skills and expertise across the market by holding targeted educational and awareness initiatives.
Last but not least, a risk management culture needs to be cultivated and enhanced through the use of OTC derivatives by corporates, and further alliance with international principles and practices such as the adoption of the standardised approach for counterparty credit risk (SA-CCR) or finalisation of initial margin rules for non-centrally cleared derivatives.
Presently, the current exposure method (CEM) is being used to calculate counterparty credit risk exposures. “Adoption of the SA-CCR method would be beneficial for banks in India as it improves risk sensitivity by differentiating between margined and unmargined trades, considering asset class wide volatilities and recognising the risk-reducing effect of netting and hedging sets thus leading to a suitable risk charge,” the paper added.
