The policy response of attacking speculators is flawed.
Reserve Bank of India (RBI) and Securities and Exchange Board of India (Sebi) moved decisively against the chief enemy of the state (read currency speculator) last week. The central bank told commercial banks they couldn’t trade on their own account in the exchange-traded currency derivatives market, while the markets regulator cut position limits drastically and doubled the upfront margin requirements.
In the past five trading sessions, volumes have crashed, open positions have been cut and the rupee has appreciated by, hold your breath, 1.2 percentage points. It’s important to note here that the US dollar index has fallen by 1.1% in the past five trading sessions. If speculative activity was disproportionately high, and if the futures market was driving price discovery, the rupee should have appreciated much more than other currencies have against the dollar. The fact that it hasn’t shows that the attack on the speculators has proved to be a damp squib.
In the process, however, the regulators have dealt a severe blow to the exchange-traded market, and it may be a long while before this market recovers. In the five years since the market was launched in 2008, it had grown significantly, attracting not only speculators, but also hedgers such as companies with foreign exchange exposure. Small and medium-sized companies accessed the market at a relatively early stage, because they could either not access the over-the-counter (OTC) market with their small orders or were taken for a ride by large banks.
More recently, though, with open interest on the National Stock Exchange (NSE) having risen to over $5 billion, the maximum permissible open position at the client level had risen to over $300 million (6% of open interest). Coupled with the much better transparency of exchange-traded contracts, the market had become attractive for even large hedge positions.
But now, the maximum position limit at the client level has been capped at $10 million. Trading members can have a total open position of $50 million. And banks can’t trade, except for positions taken on behalf of a client. NSE’s dollar-rupee futures and options volumes have crashed by 74% to $1.39 billion in the past week, while those of MCX-SX have fallen by 61% to $1.36 billion. Open interest on the two exchanges has fallen by 35.3% and 18.8% to $3.4 billion and $1.4 billion respectively. Traders have time until the end of this month to cut positions and so open interest positions can be expected to drop gradually to much lower levels. Unless the regulators’ harsh measures are reversed quickly, the damage to the exchange-traded currency derivatives market could even be permanent. This will work against the interest of genuine users such as companies that hedge foreign exchange risk, as well as against the onshore currency market as a whole, since some trading can shift to offshore centres.
As pointed out in this column earlier, data by the Bank for International Settlements show that about half of dollar-rupee trading happens in overseas markets, over which RBI has no jurisdiction. Even if the central bank is successful in reining in all speculation in the onshore market, a large amount of trading will continue to happen in offshore centres. By hurting the onshore markets, regulators are unwittingly strengthening the hand of these offshore markets. Another fallout of prohibiting banks from trading in the exchange-traded segment is that arbitrage between the OTC and the futures markets has been effectively banned, since banks were the only players who could straddle both. Prices in the futures market, however, have remained largely in line with the underlying spot price, thanks to the fact that these contracts will be settled on expiry at the underlying spot price. Even so, without active arbitrage, intra-day volatility can be high which, coupled with the drop in overall volumes and open interest, will drive away genuine users. Finally, as many commentators have already pointed out, attacking freely functioning markets only amounts to ‘shooting the messenger’. The underlying message that the weak rupee carries (weak economy, high current account deficit etc.) requires an altogether different set of policy responses. To be sure, some of these involve structural changes that will yield fruit only in the medium-long term. But even in the short term, it helps to have the rupee weaken to levels where those bringing in foreign exchange are confident that the depreciation in the domestic currency is over. Short-term measures such as those taken last week only delay the inevitable, increasing the uncertainty for investors. In sum, the policy response of attacking speculators is flawed. It’s evident that it hasn’t even delivered the desired results. Regulators should now reverse these measures quickly before some permanent damage is inflicted on these markets.
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