Throwing the baby out with the bathwater

Policy on derivatives needs to be informed by the evolution of these markets in India and the benefits of risk management

A sophisticated and efficient market economy is ruled by prices. Prices fluctuate and send signals that generate a demand and supply response. These fluctuations can be painful in the short run. The financial derivative markets create tools through which, in exchange for a payment, protection from price fluctuations can be obtained in the short and medium term.

The establishment of gross domestic product (GDP)-scale, deep and liquid markets for financial derivatives runs alongside the establishment of a market economy. Over a generation, progress has been made in India on these fronts, albeit at a great cost. There is undoubtedly room for doing better on the problem of mis-selling of some derivatives. For the rest, reversing the basic direction will be costly.

In socialist India, the government controlled many prices. Sometimes, the law defined a fixed price and inflicted punishments for violations. Other times, the law restricted who could transact (e.g. only banks and primary dealers permitted) or where transactions could take place (e.g. at Agricultural Produce Marketing Committees only), and punished transgressors. The state built up a large arsenal of controls upon the economy, which were used to influence prices, such as export and import bans, regulatory requirements, etc.

A market economy is one in which the actions of myriad uncoordinated actors make the supply and the demand, which determine the price. On the path from socialism to prosperity, we move from prices controlled by the government to prices controlled by nobody — prices made by everybody. Reforms essentially mean freeing both quantity and price restrictions. This is a world in which prices and output fluctuate. Price fluctuations are a good thing as they send out signals into the economy that trigger adjustments. When the rupee depreciates, imports become more expensive, exports become cheaper, and Indian financial assets become more attractive to foreigners.

The market economy delivers a great bounty of prosperity in return for the ceaseless process of adjustment in response to fluctuating prices. But this comes with pain. Some people would like their tomorrow to be exactly the same as their today. But the world keeps changing, and adjustments are required — adjustments that are efficiently induced by the price system.

Is there a middle road through which the full gain from the price system is obtained, but the full pain of fluctuating prices is partly avoided? Yes, this can be done, using financial derivatives. Financial derivatives help their users buy time. When the rupee depreciates, an importer faces higher prices, and ultimately will have to reconsider business strategy. But in the short run, for a certain number of months or quarters, protection can be obtained through financial derivatives.

At the high table of development strategy, then, there is a need for vibrant and liquid financial derivatives markets, alongside the emergence of India as a market economy. We should remove all barriers against prices that fluctuate. This would yield economic growth, but also impose the pain of continuously adjusting to a changing world, which would irritate some people who want an unchanging life. If policymakers enable the emergence of deep and liquid markets for financial derivatives, this would help reduce the cost of transitioning into a market economy.

To matter, these markets need to be very big. In 2023-24, about $1 trillion came into the Indian economy from the rest of the world and a similar value left. Out of these $2 trillion of activity, if half used currency derivatives for protection, then we would have end-users of currency derivatives amounting to $1 trillion per annum. The actual market size has to be many times higher, where finance professionals (termed “speculators” and “arbitrageurs”) undertake enormous activity in order to produce this $1 trillion of protection. All this is done by private people, with no requirement of government money.

These numbers — e.g. $5 trillion to $10 trillion a year of currency derivatives activity — look scary to the uninitiated. Development strategy thinkers in India understood these things by the 1990s. Enormous amounts of blood and sweat were invested to help make these things happen. Key milestones towards this journey included the launch of equity derivatives trading at BSE, followed by NSE in 2000, and the launch of currency futures trading in 2008. Gradually, private players learned how to operate on these markets, and they started acquiring liquidity and correct prices.

Commodity futures trading is equally important, and India can become a global maker of derivatives trading services in over 20 agricultural commodities where it is an important player. Former Finance Minister Yashwant Sinha wisely utilised one supportive sentence from the report of the Joint Parliamentary Committee (JPC) on the Ketan Parekh scandal when initiating commodity futures trading that had been shut down in the 1950s in the prevailing socialist environment. General Khanduri wrote a standing committee report that led to important amendments of the Securities Contract Regulation Act in 2007.

The Reserve Bank of India tried for years to block the emergence of some of these markets. However, this was important enough for the government to announce in the Budget speech of 2008 its intention to take measures to develop the bond, currency and derivatives markets, including launching exchange-traded currency and interest rate futures, and developing a transparent credit derivatives market with appropriate safeguards. All these got launched subsequently but not without intense policy and regulatory intellectual jousting and serious exercise of leadership qualities in the Union government.

Creating GDP-scale derivatives markets, then, is hallowed ground with hard-won gains. The recent actions to curb the scope and participation in derivatives are retrograde. They will push activity overseas, so foreigners will be able to get protection while residents will be deprived. Losing ground today makes the economy more backward and will increase the requirement of sweat and blood by policymakers in the future. The political and policy leadership of India is clearly envisioning India as an advanced economy and a major player in the affairs of the world. Bringing back ideas and actions prevalent in poor countries in the 1950s does not align with these dreams.

The writer is an honorary senior fellow at the Isaac Centre for Public Policy, and a former civil servant