FIIs in currency futures may curb RBI's clout in forex mart

Market participants fear that the Securities and Exchange Board of India’s (Sebi) proposal to allow foreign institutional investors (FIIs) in currency futures trading may curtail the Reserve Bank of India’s (RBI) ability to intervene in the foreign exchange market.

Currently, FIIs are permitted to hedge their currency risk in the over-the-counter forward market. In the forward market, they are required to maintain an underlying exposure to hedge against currency risks. But in the futures market, there is no such requirement to maintain an underlying exposure, giving FIIs the scope to take speculative positions.

FUTURE TENSE

Currently, FIIs are permitted to hedge their currency risk in the over-the-counter forward market

In the currency futures market, there is no requirement to maintain an underlying exposure, giving FIIs the scope to take speculative positions

FIIs and hedge funds may take one-sided positions and make life difficult for the central bank

“FIIs’ entry into currency futures trading can curtail RBIs ability to intervene in the foreign exchange market,” said Clearing Corporation of India (CCIL) Chairman R H Patil. All currency forward contracts with a daily volume of $35-40 billion are settled by CCIL.

If FIIs would be allowed in the currency futures market, then the country should be ready for investors like George Soros, added Patil.

In 1992, George Soros had sold the pound in a big way in the UK’s currency futures market by only paying the margin. This had led to a plunge in the British currency, forcing the Bank of England (BoE) to buy all the pounds to support the currency, thereby forcing the UK’s central bank to spend a lot of money. The move ultimately led BoE to give up the fixed rate for the pound and go for a free float.

India is certainly not prepared for such eventualities, said Patil, suggesting: “If FIIs have to be allowed, there should then be a cap on their open interest position in currency futures.”

Since there is no need for an underlying exposure in the currency futures market as in the case of currency forwards, FIIs and hedge funds may take one-sided positions and make life difficult for the central bank.

The positive side of the entry of FIIs and non-resident Indians (NRIs) in the market will be that they will bring in huge volumes and liquidity into the market. There will be a plenty of arbitrage opportunities between forwards and futures. A rise in liquidity and open interest positions will also help the hedgers. At present, the volume in currency futures is thin, mostly as a result of proprietary trade by banks and speculators.

“With arbitrage, forward premia will start reflecting the interest rate differential between two countries,” said K N Dey, CEO, BasixFx, a forex advisory firm. At present, forward premia are determined by supply and demand.

When more overseas players come with a variety of hedging tools available, including currency futures, demand for forwards will also go up and premia will start reflecting the difference between interest rates in India and the US, he added.