Now, currency futures

Financial Express, 22 August 2008

Exchange-traded currency futures is the first building block of the Bond-Currency-Derivatives Nexus, and the first important accomplishment of the UPA in financial sector reforms. Despite five mistakes in the launch, it could be bigger than Nifty futures.

With globalisation, the Indian economy is littered with currency risk, often in unexpected places. A key driver is `import parity pricing'. For example, the domestic price of copper is now defined by the global price of copper. When the rupee depreciates by 1%, the domestic price of copper goes up by 1%. A buyer of copper is thus exposed to currency risk - even if he is buying domestic copper. The producer of copper is also exposed to currency risk - even if he is selling to a local buyer.

Infosys is an export-oriented company. An analysis of the historical data shows that, on average, a 1% depreciation of the rupee generates a 1.1% rise in the price of Infosys shares. Thus every Infosys shareholder, and every Infosys employee with stock options, is carrying currency risk.

All these kinds of risk can be managed using exchange-traded currency derivatives. We are used to the Nifty futures, which cash-settle to the Nifty level on expiration date. In identical fashion, currency futures cash-settle to the exchange rate on the expiration date. It is easy for exchanges, brokerage firms, and investors to integrate currency futures as one more product into the existing exchange-traded derivatives business. This launch marks the first opportunity for the dynamic non-bank financial firms of India to enter the Bond-Currency-Derivatives Nexus, which has so far been preserved as a club of the banks and PDs.

The government is to be commended for having got the right institutional structure: exchange-traded currency derivatives have been squarely placed with the stock exchanges, with regulation by SEBI. This makes sense, since there is no real difference between currency futures and Nifty futures. All manner of derivatives are securities, and their regulation should move to SEBI.

Setting up a currency futures market, as a preamble to greater currency flexibility, is the right foundation for strengthening the ideas and execution of monetary policy. Instead of the government holding out a umbrella protecting the entire country from rain -- by running a de facto pegged exchange rate (at enormous cost to the country as shown by the recent inflationary spiral) -- each person should be buying an umbrella that is appropriate for himself.

The daily volatility of the rupee-dollar is roughly one-fourth that of Nifty. If macroeconomic policy in India improves, the trading by RBI on the currency market will subside, and rupee-dollar volatility will go up. This would increase demand for currency risk management.

There are five mistakes in the launch:

  1. Derivatives trading on currencies other than the dollar is prohibited.
    At a time when China is pushing for futures trading of the yuan outside China, which would have been an ideal opportunity for us to have traded rupee-yuan and dollar-yuan contracts, we have gone in the wrong direction.
  2. Options trading is banned.
  3. FII participation is banned.
  4. NRI participation is banned.
  5. Positions larger than $5 million are banned - a tiny limit when compared with the size of exposure that is found in a trillion dollar economy.

None of these bans are grounded in economic logic. After all, RBI oversees a non-transparent market - the `currency forward market' - where each of these bans are absent. If these features are permitted in a non-transparent club market, they surely belong in a superior market design.

At the early stages of a market, policy makers should be trying to create a supportive environment to increase the probability of success of new products and markets. In India, instead, policy makers have worked to reduce the probability of success of the market. The first task of the next RBI governor should be to overturn these five bans.

Despite these efforts at preventing progress, the currency futures market is quite likely to take off. The positive factor in favour of this market is India's massive GDP and burgeoning internationalisation. Trade and capital flows are growing at very high rates, so a large number of individuals and firms are exposed to currency risk. Electronic trading on exchange screens has a way of capturing attention; even dealers on the OTC market will soon be riveted by the flickering quotes on the NSE screen.

I am reminded of the early launch of NSE. Mr. D. Balasundaram, who lives in Coimbatore, once told me that in the bad old days, people outside Bombay saw the drama of the stock market in the newspapers every day, but couldn't participate in it. Then NSE came along, and all these onlookers became participants. In similar fashion, for all these years, most of India has seen the drama of exchange rate fluctuations, but has been blocked from trading it. For the first time now, these onlookers can become participants. It is quite liberating.

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