Business Standard

Jamal Mecklai: Great expectations

MARKET MANIAC

Jamal Mecklai  |  New Delhi 

The earlier this month has been, in my view, a great step forward in the liberalisation of the Indian economy. For the first time, an Indian entity can bet on the external value of the rupee, whether or not it has an underlying foreign exchange exposure. This, in fact, is capital account convertibility, and the is to be congratulated on taking this step.

Of course, there are huge constraints on the step so that while, in principle, it is a great leap forward, in actual application, it is considerably smaller than that. Indeed, the volume of trading in the first few days — although quite impressive as compared to start-up futures contracts anywhere in the world — has barely crossed $50 million on a single day, a drop in the ocean compared to even our own OTC market. Of course, futures volumes are unlikely to ever be much more than a bucket in the ocean — in the global market, for instance, currency futures trades constitute just about 2-3 per cent of the OTC market. So, while I applaud the move, it is important that we don’t get carried away with great expectations — we need to understand what is the real role that currency futures can play in an economy, and as a step towards greater deregulation of financial markets.

First of all, for the economy at large, the impact will likely be relatively minor and at a second order. Contrary to the belief apparently held by the regulators, the government and the ever-eager exchanges, I can’t see currency futures having any value as a hedging tool. They are not used as such anywhere in the world and there are several reasons for this. First of all, while futures do enable the hedging of price risk, they do so by creating basis risk (if your exposure falls due on a date other than the settlement date), and cash flow risk (mark-to-market margin requirements). The cost of managing these risks, when added to the total cost of trading (margins, brokerage, etc), will not, in most cases, outweigh the price risk that is sought to be hedged.

While there may certainly be some hedging — most of which will come from commodity arbitrageurs who do not have access to any other market for hedging — it is hard to see the futures market providing significant economic value to the corporate sector. [Once options are permitted and tenable, which requires the build-up of considerable futures liquidity, they may provide something of a hedging window for companies, in general.]

However, there is a second-order impact that currency futures will provide to the economy, which is of increasing liquidity in the forex market, albeit modestly. The real impact will come from enabling domestic players, like mutual funds, PDs, arbitrage houses and hedge funds, which are currently at a disadvantage to banks, to access this additional window for diversifying risk as they seek trading profits. This will attract more savings into the market, enhancing liquidity, generally leading to better allocation of capital and a deeper, more liquid market.

Of course, to get there the current start-up regulations need to be substantially amended. First of all, regulators need to recognise that banks are a key player in currency futures markets, functioning largely as liquidity providers. The current regulations hit banks with a double whammy, since any position they take in the futures market has to be backed by margin (as does that for any other player), while also being carved out of the banks’ existing overnight position limit, which is also backed by capital. Thus, they are being double charged and it will be impossible for them to really step into this arena — a few $5 million or $10 million deals notwithstanding.

The second important change that is needed is to quickly permit FIIs and NRIs to access this market. Not only would this begin to hammer a nail into the coffin of the NDF market, it would also add to domestic liquidity, which, needless to say, is the only criterion for the success of a futures contract. The good news is that at the launch both the SEBI chairman and the Finance Minister spoke of opening this notch quite soon, and with Dr Subbarao apparently ready to accelerate reforms, we could see this change sooner rather than later.

And, finally, of course, the regulators need to step back from product design, and permit the exchanges to offer any contract specifications they like, whether in terms of size, settlement date, trading hours, etc. The goal, after all, is to create a successful product, which job is best done by people who have a commercial interest in listening to their customers and designing a product that people want to trade.

No doubt, some of these changes will be forthcoming in short order — there is considerable political capital invested in making currency futures successful. Most important, in my view, is the apparent commitment to move quickly to relaunch interest rate futures, once currency futures are successfully under way. Now, there’s a product that can certainly add huge value to the economy, provided that, in parallel, public sector banks are released from the shackles of government ownership.

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Jamal Mecklai: Great expectations

MARKET MANIAC

The launch of currency futures earlier this month has been, in my view, a great step forward in the liberalisation of the Indian economy.

The earlier this month has been, in my view, a great step forward in the liberalisation of the Indian economy. For the first time, an Indian entity can bet on the external value of the rupee, whether or not it has an underlying foreign exchange exposure. This, in fact, is capital account convertibility, and the is to be congratulated on taking this step.

Of course, there are huge constraints on the step so that while, in principle, it is a great leap forward, in actual application, it is considerably smaller than that. Indeed, the volume of trading in the first few days — although quite impressive as compared to start-up futures contracts anywhere in the world — has barely crossed $50 million on a single day, a drop in the ocean compared to even our own OTC market. Of course, futures volumes are unlikely to ever be much more than a bucket in the ocean — in the global market, for instance, currency futures trades constitute just about 2-3 per cent of the OTC market. So, while I applaud the move, it is important that we don’t get carried away with great expectations — we need to understand what is the real role that currency futures can play in an economy, and as a step towards greater deregulation of financial markets.

First of all, for the economy at large, the impact will likely be relatively minor and at a second order. Contrary to the belief apparently held by the regulators, the government and the ever-eager exchanges, I can’t see currency futures having any value as a hedging tool. They are not used as such anywhere in the world and there are several reasons for this. First of all, while futures do enable the hedging of price risk, they do so by creating basis risk (if your exposure falls due on a date other than the settlement date), and cash flow risk (mark-to-market margin requirements). The cost of managing these risks, when added to the total cost of trading (margins, brokerage, etc), will not, in most cases, outweigh the price risk that is sought to be hedged.

While there may certainly be some hedging — most of which will come from commodity arbitrageurs who do not have access to any other market for hedging — it is hard to see the futures market providing significant economic value to the corporate sector. [Once options are permitted and tenable, which requires the build-up of considerable futures liquidity, they may provide something of a hedging window for companies, in general.]

However, there is a second-order impact that currency futures will provide to the economy, which is of increasing liquidity in the forex market, albeit modestly. The real impact will come from enabling domestic players, like mutual funds, PDs, arbitrage houses and hedge funds, which are currently at a disadvantage to banks, to access this additional window for diversifying risk as they seek trading profits. This will attract more savings into the market, enhancing liquidity, generally leading to better allocation of capital and a deeper, more liquid market.

Of course, to get there the current start-up regulations need to be substantially amended. First of all, regulators need to recognise that banks are a key player in currency futures markets, functioning largely as liquidity providers. The current regulations hit banks with a double whammy, since any position they take in the futures market has to be backed by margin (as does that for any other player), while also being carved out of the banks’ existing overnight position limit, which is also backed by capital. Thus, they are being double charged and it will be impossible for them to really step into this arena — a few $5 million or $10 million deals notwithstanding.

The second important change that is needed is to quickly permit FIIs and NRIs to access this market. Not only would this begin to hammer a nail into the coffin of the NDF market, it would also add to domestic liquidity, which, needless to say, is the only criterion for the success of a futures contract. The good news is that at the launch both the SEBI chairman and the Finance Minister spoke of opening this notch quite soon, and with Dr Subbarao apparently ready to accelerate reforms, we could see this change sooner rather than later.

And, finally, of course, the regulators need to step back from product design, and permit the exchanges to offer any contract specifications they like, whether in terms of size, settlement date, trading hours, etc. The goal, after all, is to create a successful product, which job is best done by people who have a commercial interest in listening to their customers and designing a product that people want to trade.

No doubt, some of these changes will be forthcoming in short order — there is considerable political capital invested in making currency futures successful. Most important, in my view, is the apparent commitment to move quickly to relaunch interest rate futures, once currency futures are successfully under way. Now, there’s a product that can certainly add huge value to the economy, provided that, in parallel, public sector banks are released from the shackles of government ownership.

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