Thursday, July 19, 2007

The official and the illegal currency market

A Nigerian diplomat was recently found converting Rs.100 million in cash into USD in New Delhi. This hints at the existence of a substantial INR/USD market outside the reach of capital controls.

I think there are two factors shaping this black market. The first is the capital controls - rapidly globalising India is increasing chafing at the bit. The second is the incredibly bad market design of the currency market.

In India, the equity market sets the benchmark for transparency of financial transactions. There is pre-trade transparency (order books are visible in realtime) and post-trade transparency (exact transaction information is put out in realtime). In addition, equity market intermediaries separately reveal (a) the price at which a transaction was executed on the market as opposed to (b) the brokerage fees charged by the intermediary. On the equity market, liquidity resides in the public, nationwide market, and the broker is only a transactional pathway to the market.

In contrast, the Indian currency market fares poorly on all three counts. It is highly non-transparent from the viewpoint of customers, lacking post-trade and pre-trade transparency. This makes it difficult for customers to ensure that they are getting best-price execution. Banks do not unbundle the price on the currency market as opposed to their intermediation fees.

To look back into the history of the equity market, in the early 1990s, all these features were absent. When BSE brokers were first asked to separately show brokerage fees as opposed to the price at which a transaction was executed, they went on strike. In the early 1990s, BSE brokers would routinely lie to customers, claiming that a purchase was executed at a higher price than it really was. Lacking transparency, customers were not able to cross-verify these claims. These very abuses are found on the currency market today: customers are not able to cross-check prices owing to the lack of pre-trade or post-trade transparency, and customers are not told what they are being charged for financial intermediation services as opposed to market prices. The people who work on policy issues of the currency market have not adequately learned from the success story of the equity market.

Owing to the deficiencies of the market design, currency trading is extremely profitable for banks. Customers pay high prices for buying and get low prices when selling. If a bank gets a buy and a sell order which it is able to serve internally, it earns the full spread (that is shown to customers). Only the net imbalance at a bank reaches the interbank market.

The excessive intermediation charges imposed by banks on the currency market reach all the way to retail transactions. A traveller who seeks to buy or sell on the rupee-dollar market faces a bid/offer spread of roughly Rs.1.50 (3.67%). As a consequence, an extensive black market has sprung up all over the country. This involves a network of dealers who do run a book on the rupee-dollar. Your friendly neighbourhood paanwala is often a currency trader. They offer a bid/offer spread of roughly Rs.0.15 (0.37%). This black market helps undercut the intermediation charges of the banks, and on avoiding the constraints which prevent competing trading systems from emerging.

The equity market is able to deliver a spread of Rs.0.1 on a base of Rs.4500 for the Nifty futures - this is like a spread of Rs.0.001 for a base of Rs.45 (roughly the INR/USD rate). Like the Nifty futures, currencies are also "macro" underlyings with little asymmetric information. Currency vol is lower than Nifty vol. Hence, if the market design is done right, currency spreads ought to be lower than the Nifty spread - in other words the spread should be lower than Rs.0.001. Such a tight spread directly saves money for market participants who trade - for the spread is the round-trip transactions cost faced by the customer. In addition, fine spreads improve market efficiency by reducing the overheads faced by speculators.

In short:

  1. There is much more convertibility than meets the eye;
  2. The currency spot market is one of the most important commanding heights of the economy, and it's a real shame that it has a 19th century market design, aimed at perpetuating entry barriers, profits for banks, non-transparency and high transactions costs for customers;
  3. If policy makers want more of the currency market to come above the ground, then an exchange-traded currency spot market is required, where brokers clearly unbundle their brokerage charge from the price seen on the public limit order book.

As an aside, with commodity futures also, there is a substantial `number 2 market', which competes with the official regulated markets. These parallel currency and commodity futures markets reflect an exit from the mainstream regulated markets by some players. If wise policy making is able to unify all liquidity into the public markets - as has pretty much happened with the equity market - we will be able to reap substantially more liquidity than is presently the case.


  1. Ajay,

    Is rupee traded elsewhere similar to Eurodollar (beyound the derivates in Dubai)? Does that market have similar spread issues?

  2. Chandra, there is a good deal of INR trading activity outside the country. In large parts of East Asia, the Indian rupee is accepted over the counter at many shops. The formal financial sector is also doing many things that are INR related, outside the country. See page 56 of the MIFC report.

  3. There is one more important point you did not elaborate. How did this Nigerian get this much money? Its every body's knowledge that apart from the Nigerian email frauds, its the drugs many of them peddle on the streets of Mumbai and elsewhere which provide them with this money.

  4. Ajay,

    But isn't it the fact that banks have to keep the inventory of foreign currency (say USD) to meet customer's needs and they face price fluctuation risk. bid-ask spread is charged to offset that risk. Plus in retail forex customer deals, handling cost is very high compared to deal size. But in corporates I dont think bid ask spread is that high (I might be wrong). Btw you have not elaborated on as to what shud be done to improve this bad market design. Does it make a difference that currency market is OTC rather than exchange traded.


  5. Banks have to keep the inventory of foreign currency (say USD): The paanwalas have to do this too.

    Handling cost is very high compared to deal size. Paanwalas cope with this same small deal size. As an aside, the mean transaction size at NSE is Rs.25,000 or so which is probably not that far from retail currency transactions.

    With corporates I dont think bid ask spread is that high (I might be wrong). The market is a terrible place for corporate customers also. Imagine equity market trading where there is no NSE screen giving transparency, where there are entry barriers faced by intermediaries, where the stockbroker does not unbundle the price from the market vs. the price you paid him. I have a name for this market. It is the BSE circa 1991. That's where the currency market is today.

    Btw you have not elaborated on as to what shud be done to improve this bad market design. One natural idea is: Do currency trading on NSE and BSE exactly like equities trading. The same NSE /BSE members who are doing equities trading for a brokerage fee of 2 bps and a spread of 2 bps will do currencies also at an all-in cost to the customer of below that seen for equities.

  6. the natural idea Thats a brilliant idea to deal currency similar to stocks, giving more transperance. But I bet all the banks that bank on currency trade will go on strike as stock brokers did in 1990s...


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