India’s soon-to-be-launched exchange-traded currency futures market could have provided good competition to the existing over-the-counter (OTC) currency derivatives market. Unfortunately, the rules are loaded in favour of the existing OTC framework.
The Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi) had formed a joint standing technical committee in February to “evolve norms and oversee the implementation of exchange traded currency futures”. The committee has decided that the maximum position that can be taken at the client level will be $5 million (Rs21.6 crore). That rules out the possibility of any meaningful participation from most companies that have a need for hedging currency risk.
There are no such restrictions in the OTC segment. The message the committee is sending is, “If anyone has a need to hedge a position larger than $5 million, go to the OTC market.” Most corporations that use the derivatives market take much larger positions. As a result, the introduction of currency futures trading is a non-event for them. They still have to endure the non-transparency of the OTC market, where deals are struck based on quotes given by banks. Large companies have installed Reuters screens that provide online quotes from banks to make sure that they are striking deals at prevailing rates. But surely this can’t match the transparency of the exchange-traded platform.
One of the major benefits the OTC set-up provides firms is the luxury of not having to pay mark-to-market margins. This can be an asset as far as cash flow management goes, but it comes at the cost of lower transparency in the pricing of OTC contracts. Many firms may still prefer the trade-off of not having to pay margins over lower transparency. But the launch of the exchange-traded platform was an excellent opportunity to provide them an alternative. They could then take the decision of which platform suits their needs better.
That decision has been taken away. With the abysmally small $5 million limit, it’s the joint RBI-Sebi committee that has decided where Indian companies should hedge their currency risk. The committee has also said foreign institutional investors can’t trade in the futures segment. They can continue doing so in the OTC forward market.
It’s perplexing that the rules favour the OTC set-up, especially after the recent controversy over OTC currency derivatives, where banks and customers are taking each other to court. If anything, this was an opportunity to encourage the exchange-traded platform, which is not only more transparent, but also safer in terms of the settlement of trades, thanks to the system of having a central counterparty.
The pertinent question is whether all this will lead to the premature death of the currency futures market. Perhaps not. Although it’s unfortunate that natural participants such as large companies have been restrained, retail participants and high networth individuals, who make up for the majority of stock market trades, could well provide the initial liquidity. Many stocks these punters trade have an underlying currency exposure and this should evince interest in the product. Then there are small firms that may not have access to the OTC market because of their insignificant order size. Such players can hedge their exposure on the currency futures market, where the minimum contract size is just $1,000. The upfront margin payable (the initial investment) will be much lower. Also, since the same underlying asset is being traded in the OTC market, there would be plenty of opportunity for arbitrage, which banks can take advantage of. This will also contribute to liquidity.
The market for currency futures may still take off, but it would certainly have evolved much better if participation by large companies and banks was encouraged, not restrained.
Equity derivatives signal caution
The markets may be near their 52-week low, but not many derivative traders expect that a bottom has been formed. Near-month futures on the National Stock Exchange’s Nifty index trade at a discount of about 47 points. A number of the index’s constituent companies are expected to pay out dividends this month, but that explains only a small part of the discount. While investors holding a stock can benefit from dividend payments, those with futures positions do not, which explains why futures of dividend paying firms could trade at a discount to the spot price. According to derivatives analysts at Edelweiss Securities, dividend payments can explain away only a discount of 6.5 points. Adjusted for that, the discount is nearly 15% on an annualized basis.
The discount, which is caused by excessive selling of futures contracts, isn’t restricted to the Nifty contract. About one-third of the stocks on which futures trading is permitted trade at a discount, after adjusting for the dividend impact. That’s a high proportion based on historical evidence. A futures contract should normally trade at a reasonable premium to the spot price of the underlying asset. Otherwise an investor can make risk-free profit by selling the asset in the spot market and earn interest by deploying those funds, in one leg of the transaction. The other leg would be to buy back the asset cheap in the futures market and take delivery at the expiry of the futures contract.
There are some restrictions on this kind of arbitrage, because not all investors have stock available to sell and the securities lending mechanism hasn’t taken off. Still, the fact that futures contract have been battered to an extent where the markets are collectively giving away a risk-free 15% return points towards extreme caution.
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