The government could soon allow exchange-traded futures contracts on the rupee-dollar exchange rate in an effort to provide companies with a transparent and simple way of hedging their foreign exchange exposure. The move comes in the wake of losses several firms have incurred on account of buying complex derivatives products, or “exotics”, and the resultant legal battle between them and the banks that sold these products.
Trading on rupee-dollar contracts will be allowed on existing exchanges and will be governed by the capital market regulator, Securities and Exchange Board of India, or Sebi, said a government official familiar with the developments who did not wish to be named.
The official added that this would be extended to other currencies too.
The Reserve Bank of India, or RBI, which oversees issues related to foreign exchange, has been in discussions with the finance ministry since November 2007 on the architecture and mechanism of rupee-dollar futures contracts. RBI is likely to make an announcement to this effect soon, the official added.
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 a stock or currency) will move—essentially, they are akin to a side-bet on a bet. Exchange-traded futures provide transparency when compared to the prevailing over-the-counter (OTC) market for foreign currency derivatives. In an OTC market, deals are done over the telephone and the transactions lack the transparency of an exchange-traded contract whose value is reflected in the price at which it trades on the exchange.
The government’s concerns on such OTC transactions in forex derivatives stem partly from the fact that there has been a spike in the volume of the same over the past two years. As Mint reported on 12 March, banks operating in India had Rs127.86 trillion of derivatives on their books as on 31 December 2007. That number, which refers to the “outstanding notional principal amount of derivatives”, was 291% higher than the corresponding number on 31 December 2005. Foreign banks operating in India, as a group, accounted for an exposure of Rs98.91 trillion, a growth of 389% over the 2005 number.
The move to introduce rupee futures contracts started a year ago after an exchange in Dubai said it would allow trading in rupee-dollar contracts. The contracts are settled in the country’s local currency.
Trading rupee futures in India would serve two purposes: prevent a potential market fr-om shifting overseas; and offer more variety and opportunities to Indians to hedge foreign exchange transactions, a finance ministry official had said.
At the time, the finance ministry’s interest in rupee futures was also driven by a desire to add depth and transparency to the foreign exchange markets. The ministry hoped the futures would encourage more people to participate in the market, thereby allowing for two-way movement of the rupee. In 2007, the rupee consistently appreciated against the dollar, hurting Indian exports and leaving RBI to deal with a significant liquidity problem.
Subsequently, a RBI panel came out with a blueprint for the architecture that would govern exchange-traded rupee futures. RBI wanted stand-alone exchanges for these, small contract sizes that would increase greater participation, and initial trading restricted to rupee-dollar contracts.
In subsequent discussions with the finance ministry, RBI accepted suggestions related to using existing exchanges to economize on infrastructure, while the ministry came aro-und to beginning the process with rupee-dollar contracts.
RBI has conceded Sebi will oversee trading on rupee futures. The Raghuram Rajan panel on financial sector reforms, which submitted its report to the government this week, has suggested Sebi oversee trading in all financial instruments.
Since the process to start rupee futures contracts began last year, the finance ministry’s concerns have widened to include the trend of some existing foreign exchange contracts between banks and companies ending up in courts on charges of mis-selling. Several courts across the country are already grappling with the issue.
The controversial contracts are a by-product of the existing OTC structure in foreign exchange transactions. The OTC market is a decentralized market that is not as transparent as an exchange. Entry barriers in the OTC market in India are high on account of stringent regulations. “The main advantage of currency futures over the closest substitute product, forwards traded over the counter, lie in price transparency, elimination of counter-party credit risk and wider reach,” said the RBI’s internal panel report on rupee futures.
“The exchange-traded environment is better in two key respects: products are simple and standardized, and there is an inherent ‘best price guarantee’; and daily marking to market takes place, so there is no surprise when a large loss suddenly shows up,” said Ajay Shah, senior fellow, National Institute for Public Finance and Policy. Shah added there were other “bigger” benefits. “It is all about opening up market access; about shifting away from a small club in south Bombay to participation from all over the country. It is all about moving away from the control notion of RBI micro-managing who can trade on the currency forward market, to what extent, and for what purpose—to a world where individuals and firms are free to trade on the currency futures market as and when they please for reasons that they do not have to justify to anyone else.”
Some studies show that 85% of price discovery in global foreign exchange markets is on account of futures markets ev-en if forward markets account for most of the trade volume, said the report of the high-powered expert panel headed by Percy Mistry in 2007. The panel had looked at ways of transforming Mumbai into an international financial centre.
Udit Misra contributed to this story.