ISLAMABAD, 20 December 2004 — Pakistani banks have launched financial derivatives business in a market that is expanding and introducing new products and financing modes. The State Bank of Pakistan (SBP) has allowed commercial banks and development finance institutions (DFIs) to start financial derivatives business (FDB), for which it has just announced the financial derivatives business regulations (FDBR) for the first time.
The regulatory framework for the FDB lays down the essential risk management standards and operational arrangements for this business. The regulations revolve round the fact that FDB involves a high level of inherent risks. The SBP said, “ now banks and DFIs that want to undertake derivatives transactions will be required to get approval from SBP to work as authorized derivatives dealer (ADD) or non-market maker financial institution (NMI) status.” They will be allowed to undertake derivative business within the FDBR framework. Non-ADDs or non-NMIs will have to obtain specific approval from SBP for such transactions.
SBP had, previously, selectively allowed over the counter (OTC) financial derivatives in Pakistan, under which banks are permitted to undertake interest rate swaps (IRS), foreign currency (FX) options and forward rate agreements (FRA) with SBP’s approval.
However, such prior approval will no longer be required for the IRS, FX Operations and FRAs, once SBP grants a bank or a DFI is granted an ADD or NMI status. These moves will bring Pakistani financial markets at part with advanced countries in providing a variety of financial products.
The FDB initiatives has been unveiled as OTC financial derivatives have globally seen a major growth in the last 10 years, because these are a good mode to hedge risks and make profit. FDB and the forex market in Pakistan are being developed simultaneously to establish a mechanism to hedge risks to the stakeholders.
ADDs and NMIs will be allowed to undertake derivatives transactions in forex under the guidelines laid down by SBP. FX options dealings are allowed in G-7 currencies only. No entity will offer any Pakistan rupee/US dollar, or other currency options unless SBP specifically allows. There is no restriction on the minimum or maximum size of the notional principal amounts of forex options. The maximum tenor of the option may not exceed one year, but for longer tenors, separate approval will be required from the relevant approving authority. All forex options will be covered by ADD or NMI on a back-to-back basis and financial institutions will not be allowed to carry any market risk in this connection. All exposure should be covered on a back-to-back basis from a foreign bank or their foreign branches. In order to cover long or short FX position ADDs may purchase FX options with a maximum maturity of six months. The banks may enter into packaged products, involving cost reduction structures for customers, provided the structure does not involve customers receiving a premium.
The banks are allowed to quote option premium in US dollars or in the currency of the underlying option and can remit abroad the premium required to cover the transaction on a back-to-back basis. Hedges entered against a particular exposure for a given time period should not exceed the total principal or duration of the underlying exposure. Option contracts can be settled on maturity by delivery on spot or by net cash settlement. Option can be booked against all existing FX exposures arising out of trade transactions and loan exposures.
In cases where exposures are against PKR, the customer can either run dollar/rupee exposure or cover this separately in the interbank forward market. Interest rates swaps will be allowed in fixed to floating or floating to floating modes of exchanges of interest rates. This creation of a formal derivatives market will enormously help businesses that need to hedge interest rate and currency risks, speed up transactions, standardize contracts, and provide banks with a framework to expand the range of their products.
SPB has provided two safety features in derivatives: Back-to-back coverage, and the facility to be used only against existing risk— and not to take speculative positions. The borrowers now have more instruments to choose from, for their risk-related credits. As a significant expansion and modernization of industry is currently going on with increasing quantities of imported plant and machinery, the volume of business facing these risks, has increased.
The new derivatives cater to this need. More companies are now asking banks for interest rate swaps for floating loans. Banks will, in future, provide fixed rates and get floating rates. At the moment FX options are also being sought for hedging against exposure to euros, yen, US dollar and other currencies.
New products are being launched as the overall financial market is growing. The total bank deposits in Pakistan are an equivalent of $33 billion. In addition, the state-operated National Savings Schemes (NSS) that provide far higher profits to depositors and are an easy way for the government to raise non-inflationary funds, now total around the equivalent of $15 billion. The two together form 20 percent of the GDP.
