OTC Derivatives Market in India: Recent Regulatory Initiatives and Open Issues for Market Stability and Development

Dayanand Arora, Francis Xavier Rathinam
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The OTC derivatives markets all over the world have shown tremendous growth in
recent years. In the wake of the present financial crisis, which is believed to have been
exacerbated by OTC derivatives, increasing attention is being paid to analysing the
regulatory environment of these markets. In this context, we analyse the regulatory
framework of the OTC derivatives market in India. The paper, inter alia, seeks to
prove the point that the Indian OTC derivatives markets, unlike many other
jurisdictions, are well regulated. Only contracts where one party to the contract is an
RBI regulated entity are considered legally valid in India. A good reporting system
and a post-trade clearing and settlement system, through a centralised counter party,
has ensured good surveillance of the systemic risks in the Indian OTC market.
From amongst the various OTC derivatives markets permitted in India, interest rate
swaps and foreign currency forwards are the two prominent markets. However, by
international standards, the total size of the Indian OTC derivatives markets still
remains small because credit default swaps were conspicuously absent in India until
now. It appears that Indian OTC derivatives markets will grow fast once again after
the present financial crisis is over. This research paper explores those open issues that
are important to ensure market stability and development. On the issue of the much
discussed competition between exchange-traded and OTC-traded derivatives, we
believe that the two markets serve different purposes and would contribute more to
risk management and market efficiency, if viewed as complementary. Regarding the
introduction of new derivative products for credit risk transfer, the recent
announcement by the RBI that it would introduce credit default swaps is a welcome
sign. We believe that routing of credit default swaps through a reporting platform and
managing its post-trade activities through a centralised counterparty would provide
better surveillance of the market. Strengthening the position of the Clearing
Corporation of India Ltd. (CCIL) as the only centralised counterparty for Indian OTC
derivatives market and better supervision of the off-balance sheet business of
financial institutions are two measures that have been proposed to ensure the stability
of the market.