The non-deliverable forward (NDF) market for the rupee is rearing its head once again. The NDF market accounted for about 50% of dollar-rupee market, according to a triennial central bank survey on foreign exchange and derivatives market activity by the Bank for International Settlements (BIS) released last year. An NDF is a cash-settled, short-term forward contract on a foreign currency.
It now appears that the offshore market’s share is growing. A recent article by Dow Jones Newswires says trading in currencies of key emerging markets is growing at a fast pace. It quotes FXall, whose trading platform provides dealing for more than 1,000 companies and investors globally, drawing on prices from almost 80 banks, as saying, “Our overall non-deliverable volume is up 120% in Q1 2011 from Q1 2010, with the most active currencies being—in order by highest volume—the Brazilian real, Korean won, ruble, yuan and Indian rupee.” The article also states that electronic trading volumes in emerging-market currencies on Citigroup’s Velocity dealing platform were up 39% year-over-year in the first four months of 2011.
While India’s onshore currency futures market has been growing at a fast pace as well, the larger over-the-counter market has been more or less stagnant. Undoubtedly, the share of offshore markets should be larger by now. In fact, Jamal Mecklai, an expert on the foreign exchange market, said in a recent column in the Business Standard newspaper: “The bulk of price discovery for the Indian rupee has migrated offshore. The onshore market closely follows its now full-grown foreign cousin as arbitrage channels have widened, as banks have sophisticated their processes to escape detection and more and more Indian companies have learned to capitalize on the opportunity.”
He also said that, based on anecdotal evidence, most of the intra-day price movement in the dollar-rupee takes place when the Indian market is closed. The gap between the rupee’s closing and opening price is getting wider because of the large amount of trading in markets that are open when Indian markets are shut.
Indeed, one of the key revelations from the BIS data was that the NDF market for the rupee existed not only in Singapore and Hong Kong, but also in other centres including New York and London. While the two Asian centres accounted for around 27% of the total (offshore and onshore) dollar-rupee market, New York and London accounted for 9% and 12%, respectively. Anecdotal evidence suggests currency funds are now active in the market, betting that emerging market currencies will appreciate in the long term, tracking the superior growth rate of their economies. Such players would be adding to the liquidity and depth of the NDF markets in New York and London. It appears NDF markets have been gaining momentum in the past few years and have reached a level where their depth and liquidity will only attract more participants.
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The only competition for this in the domestic market is the currency futures segment, which has relatively less restrictions on participation, and is growing at a fast pace. But again, it isn’t open for foreign investors and can’t compete with NDF markets, which offers foreign investors unrestrained access.
Needless to say, the central bank’s influence on the rupee will decrease with an increasing proportion of trading happening overseas. Policy steps must be taken to correct this. Of course, this is not to say that the central bank should allow unrestrained access in onshore markets to compete with NDF markets. But some steps can clearly be taken.
For instance, foreign institutional investors should be given access to the futures market with position limits. Besides, exchanges should be allowed to increase trading hours in order to meaningfully compete with other financial centres. Even with the OTC market, there are steps that can be taken to arrest the decline in market share. The Tarapore committee on fuller capital account convertibility had recommended in mid-2006 that restrictions on foreign institutional investors should be reduced and they should be allowed to cancel and rebook forward contracts and other derivatives contracts booked to hedge rupee exposures. The central bank made some changes in this regard in early 2007, but there continue to be restrictions.
It will only be a matter of time before overseas exchanges such as Chicago Mercantile Exchange notice the increasing demand for trading in dollar-rupee in centres such as New York and London and decide to launch currency futures on their own 24-hour trading platforms. In any case, it’s evident that the share of offshore centres is rising quickly and it’s high time policymakers responded.
Illustration by Shyamal Banerjee/Mint
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