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Wednesday, April 18, 2007

Currency futures now

There has been an upsurge in currency volatility in India. Many firms, who were lulled into complacence by the pegged exchange rate, are unhappy at being taken by surprise by this upsurge in currency volatility. I wrote a piece in today's Business Standard titled Currency futures now saying that the most important policy issue in the present situation is to start an INR cash-settled futures and options market, where citizens and firms can do their own currency trading, and thus obtain private solutions to their own risk management problems. Achieving a strong currency derivatives market is a critical ingredient of the `BCD Nexus' which has been emphasised in the MIFC report, so starting a currency futures market today dovetails into the MIFC agenda.

There are actually two balls up in the air right now. The first is the rise in currency volatility. The second is the rapid developments on internationalisation of the INR. A. V. Rajwade had a piece in Business Standard yesterday on this theme. Aside: Earlier I had talked about the `first' INR denominated bond issue outside India. Rajwade points out that I was wrong; it was the 2nd such issue.

In continuation of his article, Business Standard has a good edit today:

Capital controls were introduced in India many decades ago; so for almost everyone living today, a life in India has been one where the government has had an intrusive system of controls affecting the Indian rupee. There is, hence, a high degree of surprise and novelty in seeing a blossoming of India-related trading, particularly involving the Indian rupee, taking place outside the country. The non-deliverable forward (NDF) market is a cash-settled OTC forward market on the rupee-dollar rate. On some days, and for some transaction sizes, the liquidity of the NDF market has come to exceed the liquidity of the Indian rupee-dollar forward market. The recent Mumbai International Financial Centre (MIFC) report has highlighted the trading on Indian underlyings taking place outside the country. It estimates that there is a turnover of $1 billion a day of derivatives trading on the Indian currency and Indian interest rates. In the case of interest rates and credit risk, it appears that the bulk of innovation and market development is taking place outside India. There is no OTC derivatives market on Indian equity in India, but there is a vibrant market of this nature in Hong Kong. As A V Rajwade's article in Business Standard on Monday emphasised, there is a remarkable appetite globally for rupee-denominated bonds. The Inter American Development Bank (IADB) - which does no business in India - has issued a rupee-denominated bond in response to this interest on the part of customers. FT/MCX will soon have an INR/USD currency futures market running in Dubai, at a safe distance from the system of controls that smothers Indian finance.

Owing to the new phenomenon of outbound FDI, every significant Indian company now has arms operating elsewhere in the world. It is now easy for those foreign arms to place orders on these currency/interest rate/credit risk markets, on Indian underlyings, which are taking place outside India. Hence, the international financial services business, which could have been transacted in India, is being transacted outside the country. Instead of India achieving export revenue from selling the international financial services to foreigners, what is happening is that the Indian licence-permit raj in finance is pushing domestic business out of the country into the hands of finance practitioners in Hong Kong, Singapore, Dubai and London.

Indian financial regulators have excelled in banning products and business activities. Every time the staff has been threatened by the intellectual complexity and hard work required in supporting and enabling financial innovation, the government response has been to ban it. What these developments highlight is that by running a licence-permit raj within India, the ministry of finance and its clutch of agencies are presiding over a shrinking component of Indian finance. Indian companies will increasingly get their equity issuance, bond issuance, risk management, etc. done from overseas providers, who benefit from world-class regulators as is found in London or Singapore.

The global game of international finance is, to a significant extent, competition between regulators. There is no alternative for the ministry of finance but to build up the staff quality of the RBI to match the Bank of England in doing monetary economics; to build up the staff quality of Sebi to match the Financial Services Authority in dealing with policy and regulatory questions on currency options or interest rate futures.


  1. Just to play the RBI's advocate for a sec, what's wrong with the current OTC "market" for currency forwards? I'm not implying that there aren't problems, of course, just that you haven't juxtaposed them to the potential benefits of exchange-traded futures. What vol can futures handle that forwards can't?

    Further, there seems to be an "if-you-have-a-hammer-the-whole-world-
    looks-like-a-nail" syndrome going on: why are we so gung-ho about one market microstructure? Has financial history not witnessed very deep and liquid OTC markets, be they currency or fixed income? Sure, this microstructure worked in India, but that's because it gelled with the RBI's need for control. How can a good libertarian like yourself countenance all the centralization and surveillance that modern markets and exchanges entail? And how can a good modernist like yourself be afraid of a little Darwinian competition between microstructures? Indeed, competition needs enabling regulation, but your talking about rigging the game in favour of one outcome by means of regulation. So the regulator knows best after all...?

  2. anoymous raises a good question.

  3. Could you please help me with following queries
    How do Indian companies operate in NDF market?

    What regulations do they face?

    Is there is any site or article that can throw light on this?

    I would really be obliged if you can help me with the same.

    Thank You


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