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| A V Rajwade: The currency futures market | |
| WORLD MONEY | | A V Rajwade / New Delhi September 22, 2008, 0:27 IST | |
There will be more transparency, but will it lead to lower bank margins for small and medium industries?
The currency futures market started functioning about three weeks back and, hopefully, it will have a more prosperous future than the interest futures contract, introduced with equal fanfare, in June 2003 — that contract did not take off at all, primarily, to my mind, because banks were only permitted to hedge. They could, therefore, only be sellers, and the market had a still birth. The strange part of the regulatory prohibition was that banks could effectively trade on bond yields in the over-the-counter (OTC) interest rate swap market, but not in the far safer exchange-traded one. (Interest/bond futures are also expected to be re-introduced shortly.)
Regulations regarding currency futures are more practical and hence the optimism for the success of the contract. On the other hand, one should not forget that the Dubai exchange introduced a USD: INR currency futures contract in the middle of 2007 but volumes have not really picked up, belying expectation based on the fact that there is a significant commercial interest in the rupee because of exposures to the diamond and gold trade. It was also expected that the market may be able to attract foreign investors from the OTC non-deliverable forwards (NDF) market in Singapore/Hong Kong. But this does not seem to have happened.
The currency futures market in India is, of course, no threat to the NDF market since, at least at present, only residents can participate. One natural end-user of the market would be corporates having “economic” exposures to exchange rates. These comprise a large segment of producers and consumers of commodity-type goods — metals, basic and petro-chemicals, etc — whose domestic prices get determined through the exchange rate. Under current regulations, such exposures cannot be hedged in the OTC forward exchange market despite recommendations from various committees appointed by the RBI (This is another regulatory anomaly: Companies have been permitted to hedge economic exposures to import duties in the OTC market, but not economic exposures to domestic prices of goods). In the normal course, such businesses would have taken recourse to the futures market where there are no restrictions about the underlying. However, for such businesses, the client level limit of open interest of $5 million is too small to be of much use. Reports indicate that this limit is likely to be reviewed and one does hope that a favourable view is taken by the authorities considering the genuine needs of the end-users.
How liquid can the market be? Will it, at some stage, dwarf the transaction volumes in the forward exchange market? There is a precedent of course: The transaction volumes in the equities derivatives market is far bigger than in the cash market. On the other hand, globally, despite the existence of exchange-traded currency derivatives, the market is predominantly over-the-counter. As per the latest BIS report, currency trading in the OTC market was of the order of more than $3 trillion every day; this compares with the notional principal of $72 billion traded on exchanges. The average transaction volume in the domestic OTC foreign exchange market is of the order of $49 billion, including $24 billion of outright forwards and swaps. In comparison, in the initial weeks, the daily volume on the futures exchange has been of the order of $50 million. But these are early days.
There is another technical issue in the forward/futures market in India. Globally, a one month forward transacted today (September 22) would mature on October 24 (i.e. one month from the spot date corresponding to September 22 — there are rules about maturity when the date happens to be a holiday etc., which we need not go into). Indeed, forward contract maturities correspond with the maturities of loans and deposits in the off shore market, leading to a close integration between the money and exchange markets. In contrast to the global market, the practice in India is that a one month forward contract traded today would mature on the last working day of the following month. The futures contract is also using the same rule. This is an old practice and probably needs to be changed in the interest of greater integration of the forward exchange market and term interbank money —in the latter market, one month maturity is broadly similar to the practice of the off-shore market, and not the last trading date of the following month.
Clearly, the futures market will have greater price transparency for the end-user. Will it, however, lead to lower bank margins for the small and medium industries segment? This is unlikely because while the underlying exposure could be hedged in the futures market at market prices, the settlement will remain in rupees and the final delivery of the foreign currency will take place only through the banking system. Indeed, FEMA precludes any foreign exchange transaction except through authorised dealers.
One other loose end: the tax treatment of the gains/losses in the futures market. Would this be treated as business income as in the case of equity derivatives?
avrajwade@gmail.com
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