It is ironical that just when there is a huge debate on Mumbai’s chances of becoming a global financial centre, yet another financial product that should have been ideally traded in India is born elsewhere. The Dubai Gold and Commodities Exchange said last week that it would offer rupee-dollar forward contracts to those who want to hedge their rupee exposures or trade in the Indian currency.
India’s tight financial controls have, despite much easing in recent years, created similar situations before, too. When market participants can’t find a financial product they desire locally, smart organizations outside the country start offering products that are banned or restricted in India. That’s the nature of the modern financial world. Blanket bans are ineffective.
The market for rupee non -deliverable forward (NDF) contracts, where investors can take positions in the rupee while settling trades in dollars, is now estimated to have a daily trading volume of around half a billion dollars. This is an over-the-counter market, mostly run out of Singapore. What Dubai is now offering is an exchange-traded version—it will be possible to trade rupee NDF contracts on an exchange, rather than over the phone.
Earlier, Singapore took the lead in offering select futures based on Indian stock exchange indices. Mumbai followed. The limit on foreign institutional investments in the local debt market has been one reason why companies have had to go abroad to borrow billions. And the suspicion of hedge funds, which now seems to be easing, has not prevented hedge-fund money from coming into India. It has merely meant that these funds buy Indian equities indirectly through derivative participatory notes (PNs).
The most immediate impact of the creation of such offshore financial products is the loss of income for the domestic financial sector. It has been estimated that hedge funds, for example, pay global investment banks fees as high as 2% of the value of the PNs they buy. That’s perhaps four times more than what they would have to pay to a brokerage in Mumbai if they had bought Indian shares directly. So, the ban on hedge funds creates rent-seeking opportunities for global financial houses, which charge amounts to help hedge funds get around regulatory restrictions.
Others suffer, too. India has no market for credit derivatives. Bond investors can’t buy protection against the possibility of a company defaulting on its payments.
But there is an active market for Indian credit default swaps, a type of credit derivative, outside the country. So, foreign investors in Indian bonds can buy protection; Indian investors can’t.
Such examples are in abundance. And these global instruments can create ripples in India. The offshore rupee market, which is beyond the control of the Reserve Bank of India, often moves the onshore price of the rupee. Hedge-fund money continues to pour in, and there will be less systemic risk if the Securities and Exchange Board of India knew exactly what the colour of this money is.
This is not to scoff at regulatory concerns. It is still unclear whether fancy derivative products increase or decrease risks to the stability of a financial system. But these innovations can’t be wished away.
It is time our regulators do what some parents do when their children turn 18. They prefer the child to drink at home rather than binge in secret elsewhere.
We think this is a decent approach for India’s regulatory fathers to inculcate, too. New financial products will keep emerging in the world’s money centres. Soon, there will be a demand for Indian variants. If these variants cannot be offered in India, they will be bought and sold abroad. Out of sight, out of mind is not necessarily a good regulatory strategy.
Shouldn’t India allow new financial products emerging abroad? Comments are welcome at firstname.lastname@example.org