The decision to introduce currency futures for dollars last year and to extend it now to euro and yen is a sign that Indian regulators are learning the right lessons from the global financial crisis. Instead of shunning the market, they seem to be focusing on improving its depth and transparency. Besides, the large trade volumes with Europe and Japan make a compelling case for introducing hedging instruments in their currencies. Trade with the EU was about $56 bn in 2007-08 and $10 bn with Japan. The implication of introducing currency futures and, hopefully, allowing more exchange-traded hedging instruments in the near future has to be understood in the context of the “mini” derivatives crisis that Indian firms and banks faced in 2008.
With India’s integration with the international economy and markets growing, the demand from Indian companies for instruments that enabled them to hedge their foreign currency exposures grew exponentially. In the absence of exchange-traded instruments, companies turned increasingly to banks for customised instruments, referred to, in market parlance, as over-the-counter (OTC) derivatives or “structures” to hedge. Often, companies used these structures not to hedge but to speculate on currency movements (as some analysts claim). Things went well as long as currencies moved predictably. However, as the sub-prime crisis unfolded in the US, currencies like euro and yen broke from their trend paths and moved into uncharted territory. As this happened, these derivative structures went “out of the money”. That is, companies found themselves owing large sums of money to their counterparties, the banks. At the peak of the crisis, India Inc’s losses on these instruments were estimated at close to Rs 30,000 crore. A common complaint from companies was that these OTC instruments were so complex or opaque that they had not understood either the pay-off or the penalties. Introducing exchange-traded products like futures addresses the problem of lack of transparency directly. Unlike OTC products, the exchange-traded currency futures involve standardised contracts with fixed expiry dates and transparent market-determined prices.
There is another advantage of exchange-traded products that has to do with legal structure. Exchanges are backed by clearing corporations that act as a legal counterparty to both buyers and sellers of the instrument. This eliminates the counterparty risk associated with the bilaterally-negotiated OTC contracts. Currency, futures alone might not satisfy companies’ hedging needs but if other products like options are allowed on the exchanges, it would create a comprehensive alternative to the OTC market.
That said, while greater transparency of instruments is a step towards reducing systemic risk, it is not the definitive solution. It is possible, even with the simplest standardised instruments to take a considerable amount of risk despite things like margins that exchanges insist on. Besides, while currency futures ensure greater transparency, they enable pure speculators who do not have either trade or capital account exposures to take currency positions. This was not possible with OTC contracts. Expert bodies such as the Warwick Commission that analysed the roots of financial crises point out that these episodes are precipitated fundamentally by a mismatch between the capacity and willingness of entities to bear risk. Matching the two is the key challenge for regulators going forward. That needs a comprehensive overhaul of the regulatory process. Ensuring transparency is just one step in that direction.