Hardly any week goes by lately without some Indian company alleging mis-selling of currency derivatives products. Banks are equal to the task, claiming that since customers gave explicit approval for these products, they should pay up. Each side has equally good reasons why the other is to blame for the mess. In some specific cases, perhaps, one side was more blameworthy, but if one were to generalize, both the buyer and the seller are equally to blame for entering the wrong contracts.
The regulator for this market, the Reserve Bank of India (RBI), has by and large come out unscathed from the whole ordeal. But by fostering a non-transparent over-the-counter (OTC) market for currency derivatives, instead of first establishing a robust exchange-traded market, RBI has played no small role in the currency derivatives saga. Now, thanks to a push from the ministry of finance, the central bank is actively working on launching exchange-traded currency and interest rate derivatives. The increasing number of lawsuits and regular news of large mark-to-market losses have only made the atmosphere more conducive for exchange-traded derivatives.
How could an exchange-traded format help vis-à-vis an OTC one? Buyers and sellers of exchange-traded derivatives deal with a central counterparty, the clearing house of the exchange. Even if one side defaults, the clearing house will make good the payment to the other. It’s able to do this by collecting adequate margins from both sides, in the form of upfront deposits and then daily mark-to-market margins. OTC contracts, on the other hand, are difficult to enforce, as banks are now discovering to their horror.
Besides, exchange-traded derivatives are standardized contracts and are relatively simple to understand, thus providing transparency to buyers and sellers. Firms who need a simple hedge against their foreign currency exposure needn’t go to banks, but can directly trade on the market. Of course, one could still be lured to the OTC segment for speculative gain, but at least such incidents would be less when the option of exchange-traded derivatives is available.
Note that the first instance of a soured currency derivatives contract became public as early as November last year, when Hexaware Technologies Ltd made a provision for potential losses that were nearly as high as its yearly profit. And similar news keeps pouring in even now—last week, Himatsingka Seide Ltd disclosed a mark-to-market loss of Rs175 crore and said that it has sued the bank that sold the derivative product. Contrast that with huge losses faced by traders and brokers in the equity derivatives market in January—none of the involved parties are reported to be tangled in legal cases and the event itself has faded into distant memory. The no-nonsense approach of collecting margins and guaranteeing trades by a clearing house resulted in all trades being honoured.
RBI and Sebi (Securities Exchange Board of India) are now jointly working on the rules for exchange-traded currency derivatives, since these products will be launched on stock exchanges. According to a news report, bankers expect tight controls after the losses reported by many firms on account of currency derivatives. It would be unfortunate if rules were so tight that they discourage participation. In 2003, when interest rate futures were launched on the National Stock Exchange, not only was the product design flawed, but there was also a restriction on bank participation. In the exchange-traded format, they had to put up full margin, while for OTC swaps there were no margin requirements.
Overseas markets that have succeeded with exchange-traded currency and interest rate derivatives have designed them keeping in mind end users such as banks, who take the biggest exposure. This helps build critical mass, which in turn draws other players.
Banks, of course, prefer the OTC format simply because they can earn higher fees—in many exotic currency derivatives contracts, it isn’t even clear how much the fees are or how they are calculated. But RBI can encourage exchange-traded derivatives on the one hand and have more stringent disclosure and margin requirements in the OTC segment on the other, which will result in greater participation by banks. This is the least it can do to correct its past mistake of fostering an OTC culture.
Sebi has been in overdrive ever since the change in its leadership earlier this year. Earlier this month, the stock market regulator allowed cross-margining of institutional trades between the cash and derivatives market. The move came soon after it imposed margins on cash market trades. The idea is to provide relief on margin payment on cash market trades if an institutional investor already has an offsetting position in the derivatives market.
Cross margining: few takers at first, but good first step
But custodians and brokers say there are few takers for the cross-margining benefit. For starters, only a few institutions engage in arbitrage trades between the cash and derivatives market. Secondly, margins are now payable within a day of the trade (T+1), while full payment for cash market transactions are to be made within two days (T+2), and so the margin relief is just for a day. A derivatives broker adds that arbitrage trades have in any case reduced after the change in the accounting treatment of securities transaction tax (STT) this fiscal year.
Still, Sebi’s move towards cross-margining is welcome especially since it had been talked about for years and hadn’t yet been implemented. The regulator has said that this is a first step, which implies that one can expect more in the future. Allowing margin relief on derivatives trades against offsetting stock holdings would be one area traders would applaud. But this may require quite some work, in terms of co-ordination between the clearing house and depositories regarding stock holdings. In any case, traders can use stock holdings as part (50%) of their margin payment in the derivatives segment.
What Sebi can move a lot quicker on are offsetting trades within the derivatives segment, where the risk is considerably reduced due to hedges but full margin is collected on both legs of the trade. This would help unlock considerable amount of capital for derivatives traders and improve the liquidity in the market.
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