Should currency futures be introduced in India?

DEBATE

The impact on volatility will be a key factor in the RBI's decision to allow leading commodity and stock exchanges to introduce rupee-dollar futures.

David Arputharaj,
Managing Director,
Basix Forex & Financial Solutions Pvt Ltd

"If individuals and corporates are free to buy or sell futures, the rupee's volatility will increase"

While the introduction of currency futures in India may put in the hands of hedgers one more instrument to hedge their currency exposures, reduce the monopoly of the banks in the area of providing hedging instruments, and introduce transparency to the pricing mechanism, the area of concern would be the manner in which currency futures would be introduced and the regulations governing who can buy or sell currency futures and the extent of speculation one can do using currency futures. For instance, would resident individuals be allowed to buy or sell currency futures just like stock futures and will corporates be allowed to hedge or speculate using currency futures without any restriction. If individuals and business entities are freely allowed to buy or sell currency futures contracts, it would definitely increase the volatility of the exchange rate of the rupee through unbridled currency speculation. It is quite possible that individuals who don't quite understand how currency markets work may be enticed into speculating in it and end up losing a lot of their wealth. Exporters and importers, who are playing in the currency markets in a pretty controlled environment as of now, may over extend themselves if they were allowed unrestricted access to the futures markets. While the over-the-counter (OTC) market is governed by regulations such as entry to only exporters or importers or other market players, to the extent they are genuinely exposed to currency risk in their business- and investment-related transaction, the futures markets have no such rules. There are instances in other markets where several unscrupulous intermediaries have promised to bring in unimaginable profits through currency trading and gullible investors have easily fallen prey to such overtures.

Whereas perfect hedge can be achieved through OTC forex forward contract for the precise date and for the precise amount of the currency exposure, the same is not possible when hedging is done through currency futures, as each futures contract is for a standard amount fixed by the futures exchange and the contract delivery date is the date ( only one date in a month ) fixed by the futures exchange. This results in the hedger either over-hedging or under-hedging his exposure and further in the mismatch of the maturity dates of the exposure and the futures hedge. This standardisation of contract amount and maturity date of currency futures makes it a very imperfect and cumbersome instrument for genuine hedgers who want to hedge their underlying exposures completely for the correct amount and maturity date. There is always a basis risk when hedging is done through futures contracts.

The handling of the margining requirement of futures contract "" both the payment processes towards margin calls and the accounting thereof "" will increase work for the company. Whereas there is no funds outlay involved when hedging through forward contracts, initial margin and maintenance margin have to be paid when hedging through currency futures and this would increase the cost of the hedge.

Double margin is another issue. As delivery of currency will not be happening under cash-settled futures contracts, the hedger will have to cancel the futures contract on or before maturity of the futures contract, booking the gain or loss thereof and has to do a spot of forward deal with his bank for actual delivery under his exposure. While the hedger cannot escape the margin charged by the bank on his forex transaction, he will have to additionally bear the brokerage cost on his futures contracts if he chooses to hedge through currency futures.

While it is a good vehicle for trading and speculation, it is a cumbersome, costly and imperfect tool for hedging existing currency exposures. If unhindered speculation by individuals, corporates, currency funds and hedge funds is permitted using currency futures, there will be a steep rise in rupee exchange rate volatility and the RBI will have a tougher time managing or controlling it.

Before introducing currency futures, the RBI should help develop an efficient interest rate and bond futures market because of the linkages between currency futures and interest rates. It is to be recalled that the earlier attempt by the RBI to introduce an interest rate futures market sans banks and financial institutions ended up in failure.

Jignesh Shah,
MD and CEO,
Multi Commodity Exchange of India Ltd

"If we don't develop a domestic market, this business opportunity will take place overseas"

Looking at the current volatility in the currency rate, it is a genuine business demand to develop a currency futures market in India. Of late, vibrant bilateral NDF markets have emerged overseas, but they suffer from lack of transparency, higher impact and transaction cost. The recent developments at Dubai reflect an overwhelming international interest in the rupee.

But the ideal solution is to have a domestic, transparent, demutualised and electronic currency futures market, which caters to the need of Indians to hedge currency risks. It should be a market in India "" by Indians and for Indians.

In order to ensure smooth and seamless development of this market, it should be developed by entities having expertise in running exchanges in India. The NSE, which is the number one stock exchange, and MCX, which is the number one commodity exchange, are the logical choice. At the same time, the BSE and NCDEX are equally equipped to handle this responsibility.

However, internationally, currency futures contracts are mostly conducted on the commodity exchanges. The examples are the Chicago Mercantile Exchange, Euronext, Dubai Gold and Commodities Exchange and so on, as apart from the commodity price volatility, the domestic users have the integral business need to hedge currency risk. This is not the case with domestic equity investors. Hence national commodity exchanges are technically the natural choice for launching this product, providing single window to importers/exporters to hedge commodity as well as currency risk on the same platform.

However, the Securities Contract Regulations Act, which regulates stock exchanges, and the Forward Contract Regulations Act (FCRA), which regulates commodity exchanges, have inherent restrictive regulatory provisions that do not allow the currency market under the aegis of existing stock or commodity exchanges. "Currency" is neither a security, nor a "commodity". It is a sovereign instrument and it is bearer bond payable on demand, which has got wide spread engagement on ecosystem and much beyond stock or commodity asset class. Even by executive order or just defining currency as security, the basic preamble of an Act cannot be overruled, as suggested by some academicians.

However, the FCRA in its amended avatar may be able to take care of it, because it would provide for futures in intangibles, futures on index and also cash-settled futures contracts. Therefore, after implementation of the amended FCRA, commodity exchanges can develop currency index followed by launching of futures contracts based on such index. Ideally, currency futures market should be developed as a separate exchange, so as to avoid any regulatory overlap and legal non-compliances. Also market risks do not spill over from one market to the other. We should also avoid concentration of all market segments at one point.

Another model for putting the currency futures market on the fast track, which is 100 per cent confining to present legal compliance, is by assigning this responsibility to existing entities conducting inter bank currency dealings, like CCIL, FX direct and Reuters. They can launch currency futures trading in one month, as they have proper technology solutions, management bandwidth and years of experience. Such entities are regulated by the RBI through FEDAI and hence there is no regulatory overlap.

Currency futures should not be construed as a proxy to full convertibility, rather they should be viewed as a precursor to litmus test the results. This can be achieved by having cash settlement of outstanding positions on maturity date as per the RBI reference rate. Such settlement system will not impact policy restrictions on remittance of funds and inflow of foreign investments.

However, going by the current developments, the writing on the wall is clear. If we don't develop a domestic market; this business opportunity will be done overseas. The RBI has got excellent expertise to develop and regulate the currency futures market. We are confident that the RBI will take the most appropriate decision under given circumstances. The only caution point is that the RBI should not allow monopoly in this field. Let different entities, which comply with the RBI norms, set up currency futures exchanges. This will lead to the emergence of a vibrant currency futures market in India and help position the country as an international financial centre.