New Delhi: Attempting to bring about better price discovery in foreign currency markets, the Reserve Bank of India (RBI) has thrown its lot behind a government proposal to allow both companies and individuals to buy exchange-traded futures contracts on the rupee-dollar exchange rate.
Mint had reported on 9 April that the government was considering such a proposal and was awaiting RBI’s response before setting out a timetable for its implementation.
An RBI internal group put out its final recommendations on the central bank’s website on Monday night, five months after it came out with draft recommendations. In the interim, the group modified its draft recommendations following talks with the finance ministry and public comments to allow existing exchanges to offer currency futures. The draft recommendations had suggested a stand-alone exchange be set up for currency futures.
The RBI-government move, which will provide companies with a transparent and simple way of hedging their foreign exchange exposures, is particularly significant these days. The decision comes at a time when several companies have suffered losses on currency hedges that they had purchased from banks in so-called over the counter (OTC) transactions, which, unlike exchange-traded futures, lack transparency and, hence do not reflect true prices.
In fact, such opaque trades have triggered legal battles between banks and several of their former clients, who incurred losses on account of buying complex derivative products, or “exotics”, and are now refusing to pay up arguing that the banks had not spelt out all the risks.
Currency futures are derivatives that allow investors to buy or sell a currency on a future date at a previously fixed price. Derivatives are instruments that take a call on the way an underlying instrument (such as stock or currency) will move—essentially, they are akin to a side-bet on a bet.
Some studies show that 85% of price discovery in global foreign exchange markets is on account of futures markets even if forward markets (OTC) account for most of the trade volume, an expert panel headed by Percy Mistry had said in 2007.
As a result of allowing existing exchanges to offer trading in currency futures, capital markets regulator Securities and Exchange Board of India could regulate contracts in currency futures, though RBI is the final authority on foreign exchange issues.
The RBI report on currency futures has emphatically stated that the central bank will have overriding powers over currency futures as it oversees the Foreign Exchange Management Act (Fema), the legislation governing foreign exchange issues. To clear the legal obstacles to start currency futures, Fema needs to be modified a bit to dilute trading norms.
Typically, companies need to have an underlying foreign exchange exposure (as in the case of export receivables) to enter into forward contracts in the OTC market. The requirement will have to end to allow for greater participation in currency futures, the RBI report said.
All currency futures contracts can be for a period up to a year and need to be settled in cash, the report recommended. Currency futures should be gradually opened to foreign entities, including foreign institutional investors, it said.
Though the RBI report has made a strong case for currency futures, it is not expected to replace the existing OTC market. The report has made a couple of recommendations that show the central bank wants them to function in a harmonious manner. Banks should be allowed to become broking members of exchanges that offer currency futures and also be allowed to trade on their own account, the report said. Banks are the foundation of the OTC market for foreign exchange, and the RBI report suggests they serve as a link between OTC and exchange-trade futures.
The RBI report has also recommended the settlement cycle on currency futures be “co-terminus” with settlement of OTC contracts.
International experience also shows that exchange-traded futures have not been able to phase out OTC contracts, but have been able to influence pricing in a significant way.