Analysis of recent regulations on currency futures

by Anjali Sharma.

Background

India has a successful equity market and has done poorly in other aspects of organised financial trading. There is a natural opportunity to use the knowledge and institutional capabilities of the equity market in order to improve other areas. One priority in this evolution has been the currency market. Almost everything that happens on the currency market would work better on exchange, and SEBI/NSE/BSE know how to make trading on exchange work. By importing the good practices of exchange-traded equities trading, we can make easy progress.

Trading in Exchange Traded Currency Derivatives (ETCD) began in India in August, 2008 [link]. From 2008 till June 2013, this market did reasonably well. In Apr-Jun 2013, the traded volume in this segment had reached USD 5.2 billion (daily average) and the maximum open interest (OI) was USD 5.1 billion. Position limits were set at a percentage of open interest(OI) and were determined at client and member level. Since the OI was building up, these limits were blocking big firms but for others it looked okay. For a while, it looked like we were making progress.

In July 2013, a set of measures were taken by RBI and SEBI which sharply restricted the exchange traded market:

1. Banks were disallowed from taking proprietary positions by RBI (Risk Management and Inter-bank dealings, July 08, 2013), and
   
2. Position limits on ETCD were brought down to USD 10 mn for clients and USD 50 million for members, by SEBI. In addition, initial and extreme loss margins were increased by 100%.

As a result of these measures, in the quarter of Oct-Dec 2013, the ETCD market volume dropped to USD 3.2 billion and the OI dropped to USD 1.06 billion. For an analysis of the impact of these restrictions, see Impact of restrictions on the trading of currency derivatives on market quality by Rajat Tayal, IGIDR FRG, October 2013.

Recent actions

On 20th June, 2014, RBI issued two major notifications with respect to participation rules for Exchange Traded Currency Derivatives. These are the most significant actions taken in this segment after July, 2013. One notification addresses participation rules for Foreign Portfolio Investors (FPI ETCD notification). The other is for residents and banks (Residents/Banks ETCD notification). These induce four changes:

1. FPIs are allowed in ETCD for the first time.
   
2. ETCD rules have been aligned with OTC currency market rules. All positions beyond USD 10 million can be taken only after demonstrating underlying rupee exposure.
   
3. For any participant, the sum of its ETCD + OTC positions cannot exceed its underlying exposure.
   
4. AD category I banks are allowed back in ETCD subject to Net Open Position Limits (NOPL). They can net-off their ETCD and OTC positions.

What these rule-changes imply

Foreign investors and NRIs face three choices:

1. To use the overseas market, where there are no documentation requirements or hedging requirements.
   
2. To use the onshore OTC market, where there is a documentation requirement and a hedging requirement.
   
3. Now, for the first time, to use the exchange, and face the same documentation and hedging requirements.

Further, unregistered foreign investors are able to effortlessly use the overseas market, while in India there is the additional hurdle of becoming an FPI without which the onshore exchange market is barred off.

Hence, we may expect that the RBI action will be irrelevant. The biggest asset that India has, in competing for the global market for the rupee, is the efficiency of the exchange. The exchange remains barred off for foreign investors. For domestic participants, underlying rupee exposure has to be demonstrated through a traditional RBI way of thinking about currency exposure. This way of thinking about the currency exposure of firms is analytically wrong.

RBI has also taken this opportunity to hurt non-bank financial intermediation. Any position beyond USD 10 million can only be taken through AD category I banks as members. This will cause the agency business to move from non-bank members to banks. Clients who look for a comprehensive solution, ETCD and OTC and small and large positions, will prefer AD category I banks.

This is not progress

1. In the interim budget for 2014-15 presented in February, 2014, para 66 says:
   

   To deepen and strengthen the currency derivatives market to enable Indian companies to fully hedge against foreign currency risks.

   The RBI actions appear to be checkbox compliance which frustrates the true objective.
   
   
2. In the Budget speech for 2013-14 presented in February, 2013, para 95 says:
   

   FIIs will be allowed to participate in the exchange traded currency derivative segment to the extent of their Indian rupee exposure in India.

   The RBI actions are late: they come after the year 2013-14 has ended. And, they are checkbox compliance which frustrates the true objective.
   
   
3. The issuance of these regulations is in violation of the Handbook regulation making progress. If the due process in the Handbook had been followed, the quality of regulations would go up. The formal process of identifying the market failure, stating a clear objective, doing the cost benefit analysis and consultation would have caught the mistakes.
   
   
4. In 2013, in his inaugural statement on taking charge as RBI governor, Raghuram Rajan had said:
   

   But for our financial markets to play their necessary roles of providing risk absorbing long term finance, and of generating information about investment opportunities, they have to have depth. We cannot create depth by banning position taking, or mandating trading only on well-defined legitimate needs.

   The recent action runs in the opposite direction.
   
   
5. In July, 2008, the RBI-SEBI Standing Technical Committee on Exchange Traded Currency Futures had recommended that over time, once the exchange traded currency derivatives segment stabilizes, OTC markets rules may be changed to align with them. What's being done now is completely the opposite: the bad practices of the OTC market are being brought into the exchange traded market.

Once the draft Indian Financial Code is enacted, such regulations would be struck down when faced with judicial review. The fear of judicial review would strengthen the staff work and process manuals for the regulation making process.

Conclusion

Rupee-cash settled currency futures are the simplest imaginable financial product. After protracted delays, trading began in a small way in 2008. It was expected that we would make progress. Instead, we have steadily moved in the opposite direction. The damage to the exchange traded market from 2013 onwards is not a bunch of small accidents. Deeper institutional change is required in order to break the barriers to progress.