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Currency futures market will be as transparent as NSE Nifty index

Currency futures market will be as transparent as NSE Nifty index
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First Published: Fri, Aug 29 2008. 01 10 AM IST

Updated: Fri, Aug 29 2008. 01 10 AM IST
The US dollar was worth Rs40 a short while ago and is now worth almost Rs44. Given the precipitous fall in equity markets and rising commodity prices, most of us may have anticipated the appreciation of the dollar but had no way to profit from it.
All that is about to change—India is launching currency futures.
For the uninitiated, currency futures (or foreign exchange futures, or fx futures) are standardized contracts, traded on an exchange, to buy or sell an underlying asset at a certain date in the future at a specified price—or how much a currency is worth in terms of another at a certain date.
Investors may soon be able to open a currency futures trading account with their broker, buy (or sell) US dollar-rupee exchange rate futures and aim to make money on the basis of their view.
Currency futures are similar to equity futures and commodity futures except that the underlying asset is the exchange rate. Currency futures were initially created in the early 1970s in the US as a tool for commodity importers, exporters and traders so that they could hedge their currency risks. Even today, importers and exporters of several commodities remain significant users of this market.
With the introduction of exchange-traded currency futures, the next few weeks will see a major step forward for Indian financial markets. It signifies a determination to put in place a very crucial piece in the globalization puzzle and marks a significant step towards full convertibility. After all, you can’t have full convertibility without a transparent market to dynamically fix exchange rates. In fact, currency futures were first introduced in the US after the gold-exchange standard was abandoned (the gold-standard itself flopped after the first world war) and after the fixed exchange rate mechanism was discarded in favour of market driven rates.
Volatile certainty
The last few weeks have seen a serious erosion in rupee’s value and dented the balance sheets of many importers. Exporters, software and otherwise, are better off now but they were at the receiving end for much of 2007 when the rupee gained against the dollar.
At any time, both exporters and importers would have liked to hedge their currency risk but were forced to go to banks to do so—and the systems of banks are, to put it mildly, opaque. Currency futures will be as transparent and hopefully as liquid as the Nifty, the benchmark index of the National Stock Exchange. And exchange-traded instruments are easier to regulate and manage. Because the underlying is a financial asset, currency futures come under the category of “financial futures”. This market, like other futures markets, is a price-discovery and risk-management mechanism and is not meant for physical exchange of currency. For that, there is the spot market with banks and money-changers as the main participants.
Though the only contract initially listed may be the rupee–US dollar contract and though the size of the contract may be only $1,000 (Rs43,700) to start with, this will see India’s full-fledged entry into the world’s biggest financial market—currency futures. In fact, the $1,000 contract size will help to get retail traders to provide liquidity. The limit per client will be small given that $25 million is the member’s limit, and may currently not attract large players (who will continue to use the over the counter, or OTC, markets via banks) but it is a beginning and could soon lead to higher limits.
Moreover, this market must be grown gradually. The next contracts could be rupee-euro ones. This, too, will attract corporates and they will soon appreciate the transparency provided by the futures markets vis-à-vis OTC markets—even though there are no margins there. Recent losses incurred by corporates due to the non-transparency of such instruments should help settle the matter. Therefore, the spotlight will be on the new exchange from day one.
Strict risk-management and disclosure criteria are expected to strengthen the system in currency markets further. Like the commodity futures in India, liquidity will be provided by retail traders and high networth individuals till such time the regulators are convinced of the infrastructure and process execution. Currency markets are trader’s paradise because of continuous trading opportunities due to the immediate effect of news flow on exchange rates. The Reserve Bank of India has allowed banks and brokers to start currency futures on specified exchanges. Banks will also help provide liquidity to the markets. The memberships of brokers will be stringently regulated with objective and subjective criteria, such as net worth, track record and reputation.
Companies too can trade but may have to make suitable disclosures in their annual reports and to their shareholders—and they are expected to hedge, not speculate. Currently, foreign institutional investors are not allowed but will soon be when the market reaches some stability and depth. The idea is to not have large players sway the exchange rate due to order size. Nevertheless, restrictions distort markets and there should be a transparent mechanism for their removal based on volume and other parameters.
The market will be regulated by stock market regulator Securities and Exchange Board of India and the contracts will be listed as a separate segment on exchanges. Worldwide, currency futures are more considered part of the commodities basket and that is probably natural because importers and exporter as well as hedgers and arbitrageurs who deal in international commodities such as agricultural products, bullion, energy and metals, are exposed to currency risk and would like to hedge that alongside their commodity position. Being a new market, there could initially be a shortage of trained, certified personnel but there is no reason why the currency futures markets in India will not be larger than other futures markets soon.
Over a period of time, India can aim to become a centre for currency futures trading and try to be the financial hub for Asia for all financial products. This is also a step towards full convertibility of the rupee. And this is not the last stop. Another important market is soon going to get open up—interest rate futures!
Jayant Manglik is head of commodity business at Religare Commodities Ltd.
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First Published: Fri, Aug 29 2008. 01 10 AM IST