Market writes to RBI on bond forward draft norms


Informist, Friday, Jan 12, 2024

--Sources: Mkt participants wrote to RBI on bond fwd draft guidelines

--CONTEXT: RBI released draft bond forward guidelines on Dec 28

--Mkt sources: Sought tweak in proposed bond fwd covered shorts norm

--CONTEXT: Draft bond forward norms mandate all shorts covered fully

--Mkt sources: Raised concerns on FPI limits in bond forwards 

--Mkt sources: Bond fwd pricing may get distorted if FPI limit high

--Sources: PSU banks in recent mos urged RBI to allow bond forwards

By Aaryan Khanna

NEW DELHI – The bond market has broadly welcomed the recently-released draft guidelines on bond forwards, but some market participants have written to the Reserve Bank of India seeking changes to a couple of the proposed rules on hedging their exposure and limits for foreign portfolio investors, sources said.

Bond forwards refer to derivative contracts in which one counterparty agrees to buy a specific debt instrument from another counterparty on a specified future date and at a price determined at the time of the contract.

Although such contracts are common globally, the RBI had been wary of allowing the product in India ever since the securities scam of 1992, which was executed through forward contracts.

However, the central bank has now warmed up to the idea of allowing bond forwards, following extensive internal discussions and market representations. On Dec 28, the RBI issued draft directions for bond forwards, seeking comments on the same by Jan 25.

Quoting sources, Informist had reported in September 2022 that some banks had urged the RBI to allow bond forward contracts.

Market participants have flagged to the RBI the requirement of "covered shorts", under which sellers of bond forwards must hold an equivalent amount of the underlying instrument. Adherence to the norm will deprive market makers of flexibility in managing their portfolios, dealers said.

"Market makers should be allowed to have some leeway on things; they can't be fully-hedged and lock away a bond for the entire duration of the contract," a dealer at a private bank said. "It makes sense for the final investor to be locked in, but some leeway or leverage play should be allowed, otherwise the product won't grow."

The norm also makes it difficult for these market makers to cater to client demands if they arise because the bonds held against forward contracts will not be fungible under the letter of the law, dealers said. 

However, others said a full coverage on forward contracts was necessary to mitigate settlement risk for end users, and should not be disruptive as it was standard practice in the bond forward-rate agreements, which hitherto served as a proxy for bond forwards.

Bond forward rate agreements, which have gained popularity since 2020, have a structure similar to bond forwards. Under these, banks have been buying long-term gilts with an agreement to sell these to insurers at a later date on a cash-settled basis. On the other hand, bond forwards are typically settled by physical delivery, although the RBI's draft guidelines allow for either of the settlement mechanisms.

These bond forward rate agreements did not have specific regulatory guidelines, but were typically fully hedged by market makers, dealers said.


Market makers have sought more clarity on limits for participation by foreign portfolio investors. While the RBI has not put limits on the quantum of bond forwards entered into by residents, there are unannounced limits for FPI buyers that will be framed in the operational guidelines the central bank said it would put out.

The concern among market players is that if the FPI limits are large, their activity might distort market pricing.

These concerns have been conveyed to the Fixed Income Money Market and Derivatives Association of India, as the body is likely to meet with the RBI ahead of the next Monetary Policy Committee meeting of Feb 6-8, dealers said.

All scheduled commercial banks--except small finance banks, payment banks, local area banks, and regional rural banks--are eligible to undertake bond forward transactions as market makers, where they would provide prices to users. Standalone primary dealers are also eligible for the same, the RBI said in the draft norms.

The other concern related to foreign participation in bond forwards is that it would lock up balance sheets of domestic players, drying up demand for government bonds in the market while also not reflecting in bond prices immediately.

This would be increasingly detrimental at a time when India's gilts are being included on global bond indices such as those operated by JP Morgan and Bloomberg, dealers said. While JP Morgan will add gilts to its Global Bond Index – Emerging Markets starting Jun 28, Bloomberg has proposed to add India's fully accessible route bonds to its Emerging Market Local Currency Index from September.


The above concerns notwithstanding, bond forwards are likely to see a quick adoption by the market, unlike the previously launched fixed income derivative products in India.

The prevalence of bond forward rate agreements has ensured there is already a readymade market for the new product. In fact, bond forwards are likely to emerge as the preferred option going ahead, given the flexibility to choose between physical delivery and cash settlement, only the latter of which was allowed earlier.

"Nearly 80% of the bond-FRA (forward rate agreement) rollovers were first being settled for cash, and then the bond used to change hands in the secondary market as a loophole," a dealer at a primary dealership said. "The forwards circular makes things much easier for market makers and investors as well, and most of the volumes in bond-FRA right now would be replicated in bond forwards."

Bond forwards may also witness enthusiastic participation from large state-owned banks, who are said to have pushed for the product to be permitted in India, according to people in the know. These lenders have been keen to become market makers for derivatives instruments, particularly to leverage their balance sheets.

But some domestic bank treasuries were unable to obtain management approval to enter into bond forward rate agreements, as these fell into a regulatory grey area without RBI norms. As a result, these lenders have been losing business in this segment to foreign banks that write a majority of bond forward rate agreements, with a few private banks also in play, dealers said.

The new guidelines will enable more market makers to offer bond forward contracts, and state-owned banks such as State Bank of India and Bank of Baroda are expected to be first movers, though it will still take a few months after the final norms are released, sources said.

"There's no doubt it's an opportunity for us now, and we're in a good position to take it up now that it has come under the RBI," a treasury official at a state-owned bank said. "We have already started getting queries from interested counterparties, but we will pursue them only after we figure out an internal framework based on the final guidelines."

In addition to more market markers, the duration spectrum of these kinds of derivative contracts is also likely to expand. While bond forward rate agreements were concentrated in long-term bonds, bond forwards are likely to permeate to short-term debt instruments of less than six months as well as long, as premiums were attractive for end users, dealers said.  End

Edited by Ranjana Chauhan

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