Market regulator Sebi plans to liven up trading in interest rate futures (IRF) which was introduced a few years ago as a hedging tool to cover risks arising from rate fluctuations.

Sources familiar with the development say that Sebi is considering several measures, like cash settlement in 10-year government bond, allowing HNIs and FIIs to trade and permitting banks to trade on behalf of their clients, to widen investor base. If implemented, the proposed measures will help entities, like banks, corporates and mutual funds, cover their losses from hardening interest rates.

IRF is a standardised interest rate derivative contract traded on a bourse to buy or sell an interest bearing instrument at a specified future date, at a price determined at the time of the contract. Experts say these measures alone may not be enough to attract liquidity. Other changes, like higher open interest limit, a more flexible IRF basket, and permitting short sales could help. They also feel IRF in maturities of 3-5 years could also help. In case of IRFs on 91-day T-bills, there is a need for a larger lot size and a lower tick size.

Unlike stocks and currency futures, in IRF trading the seller has to deliver the bonds instead of settling the difference between the predetermined and market price in cash; this is called physical delivery in 10-year bonds. However, the IRF against 91-day T-bill, which was launched in July, is a cash settled product.

"Liquidity dries up after a few days of trading. Cash settlement alone is not sufficient, as it has not helped in case of 91-day product. One has to address other issues too. For instance, we either have three months or 10 years instrument," says Ajay Manglunia, head, fixed income, Edelweiss Financial Services. He said there is lack of risk management instruments across yield curve .The failure of IRF was attributed to its faulty product design. Regulators had felt that cash settlement could cause manipulation. (Economic Times)