Monday, June 11, 2007

Will the Indian government mount a meaningful response to the Dubai currency futures?

Financial Express has an editorial on the currency futures question where they say:

Mounting an effective response to the rupee currency futures trading that has begun in Dubai is a national priority. So far, all that the government has been able to muster is a group of RBI employees who are to form a working group on the suggestion of a local currency futures market to keep the business from flying overseas. The formation of committees or working groups by the RBI should be viewed with scepticism. In a famous episode recently, when the Prime Minister reopened the issue of capital account convertibility, the RBI swiftly cobbled together the Tarapore II Committee. And what did this Committee do? It did the expected. It presented a report that nothing should be done about it, thus effectively laying to waste the bold initiative of the Prime Minister. A few years ago, the RBI ensured that interest rate futures trading would not succeed on Sebi-regulated exchanges. This was done by blocking the participation of banks in this market.

Expect similar issues to arise with currency futures. By definition, currency futures trade on stock exchanges, and therefore, ought to involve Sebi regulation. The RBI, however, is loath to see any currency-related matter slip out of its control, and will surprise nobody if it uses all its power to thwart any currency futures market in India. Blocking banks from taking part, throwing in capital controlsthese are old familiar devices. Given such intransigence, what the government needs to do is distance the RBI from all securities markets, as has been recommended in the Mumbai International Financial Centre report. This means transferring several of its current functions to Sebi, which is well equipped to oversee a currency futures market. The RBI abounds with conflicts of interest, being saddled with multiple contradictory functions. Sebi has no such conflicts of interest. Specifically, Sebi does not run either an exchange or a depository. If a currency market in India matches the market design and regulatory framework of the Nifty futures, then India has a chance to be a player in this crucial market. If the RBI manages to exert itself on the prospects of an onshore currency futures market, then it could end up as a failure, and the Dubai Gold and Commodities Exchange will be very happy. The government must decide what is in the countrys best interests.

Also see this previous editorial on June 5 on this subject in Financial Express, which is quoted in this Reuters story about the issue. And Economic Times also has an editorial on the same issue, which also sees the question in the context of the MIFC report, where they say:

The rising rupee is beginning to present considerable challenges and opportunities to policy makers. As reported by ET (June 7) the RBI has formed a committee to examine the details of introducing trading in currency futures on exchanges.

This would enable investors to hedge currency risks. The RBIs hand may have been forced by the fact that Dubai is allowing rupee-dollar contracts to be traded. According to reports, trading in rupee futures on the Dubai Gold and Commodity exchange crossed $23 million on Friday. The lure of the rising rupee has led to some overseas investors opting for rupee denominated debt instruments (ET, 8 June). This means that holder of the instrument needs to pay back the dollar equivalent of, say, Rs 1,000 crore. If the rupee rises, the lender gains.

These transactions have nothing to do with India. The point about all this is that markets are ahead of the authorities. It is faintly embarrassing that Indian rupee risks should be hedged on an overseas exchange. The RBI needs to move fast so that these transactions can take place on Indian exchanges.

The opportunity is that Indian authorities can now harness what is already happening naturally in order to expedite the conversion of Mumbai into an international finance centre. If that were to happen, the fund raising and subsequent trading in rupee-denominated instruments could take place on Indian exchanges, with considerable value addition for the domestic economy.

The high powered expert committee set up by the government estimated that purchase of international financial services by Indian clients was $13 billion in 2005. It projects this rising to $48 billion by 2015. Currently, these financial services are provided by markets such as Singapore and London. The committee lays out a road map of what needs to be done, but a core element of their recommendation is the creation of markets in bonds, currencies and derivatives (BCD). Certain parts of this package, such as currency derivatives, interest rate derivatives and the creation of a corporate bond market, all of which are in the works, should be carried out on a war footing. This should be followed by fully liberalising foreign investment in GoI and corporate bonds.


  1. The article mentions the turf wars over interest rate futures. I remember reading something from around the time of their inception to the effect that their design was faulty, making them bad for hedging (too much basis risk). I also believe that you were personally involved in their design, and by impliction, their failure, Dr. Shah. So what was it: a turf issue or a design issue?

  2. Was there a design problem? The correlations between ZCYC `model prices' and market prices for the most-liquid `benchmark bonds' (e.g. the 2015 bond) were in excess of 85%. Is that high enough to be useful for speculation and hedging? While I believe this was the case, some people disagree.

    Was there a problem with banking regulation? That was unambiguous. RBI prohibited banks from adopting long positions on the interest rate futures market (while permitting them to do this on the OTC market). With banks holding ~ 80% of all government bonds in existence, and with all banks being forced to only short sell interest rate futures, the game was up. Here, there is no debate.

    Design problems could have been iteratively solved. But until RBI solves the mistakes of banking regulation, there is no point in trying. Even if you get a 100% correlation, the fact remains that when banks are forced to only short sell interest rate futures, there can be no market. So the interest rate futures are dead.

    I was admittedly more optimistic about the `design problems' in 2002 than I am today. I had failed to anticipate (in 2002) how badly things would work out in the 2002-2007 period for the spot market. It's really remarkable, how one of the biggest debt/GDP ratios in the world goes with one of the weakest government bond markets. But in the bottom line, statistical precision on the bond market is really elusive.


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