-Jamal Mecklai, ASSOCHAM, Delhi, February 2, 2011
In looking at the learning from the evolution of the currency futures market over the past three years, it is instructive to compare it with the global market for currency futures. At first glance, it would seem that the Indian currency futures market is dramatically more developed than the global one, particularly if you look at volumes relative to the OTC market.
Globally, the ratio has been stable in the range of 3 to 7% for several years, whereas, at $ 6 bn a day, our futures market is around 15% of the OTC FX market. Significantly, open interest, at around 45% of daily volume is comparable with what obtains globally.
However, before we jump to any self-congratulatory conclusions, we need to recognize that our OTC market is severely constrained in terms of allowing speculation. RBI has very clear guidelines on volumes for banks and, of course, the all-important control of requiring an underlying exposure to access the OTC market. Globally (at least for the major currencies, which form the bulk of both futures and OTC volumes), there is no such control, as a result of which there are hundreds of bucket shops that collate speculative volume and dump them into the OTC market through banks that act as back-end liquidity providers.
Thus, a more appropriate comparison would be the ratio of total daily volume to underlying business volume. Adding up the OTC and futures volume, we get about $ 45 bn a day; given that India’s underlying trade (imports plus exports) is about $ 480 bn a year, add in another maximum of $ 50 bn or so for annual capital flows, translates to about $ 2.1 bn a day. Thus the multiplier is around 20-22. In the global market, the multiplier is much higher, between 80 and 100, which suggests that volumes in Indian markets will continue to grow as more and more people become economically involved and financially aggressive and, of course, as India grows.
Much of this growth will be in the futures market, until such time as RBI releases its controls on the OTC market, which, in my view, doesn’t seem on the immediate horizon given the huge problems of monetary management that our government’s lax fiscal and reform attitude creates.
Thus, currency futures business is likely to continue to grow – taali bajao.
Having said that, I believe there are some changes that both RBI and SEBI need to implement to make this market more relevant to its real users, which should be small companies and investors. Currently, it largely benefits brokers – no problem with that – and a small number of astute speculators.
Now it is hard to believe that the regulators created the market for this end. Rather the goal was probably to assist small enterprises that do not have effective access to the OTC market – whether due to problems with bank limits or exorbitant bank charges – to hedge their FX risk. Let us remember that around 45% of India’s $ 200 bn plus of exports comes from the SMEs, many of whom, particularly in smaller towns, suffer these problems – 50 paise per dollar is not an unheard of bank spread. Indeed, given that USD/INR volatility is around 8-10% and that many small companies work on net margins of not more than 5%, their survival depends on their being able to manage currency risk in a cost effective manner.
However, under current regulations, the currency futures market does not really serve this purpose. First of all is the fact that they have to pay cash margin – and as we all know, nobody likes to do that. Secondly, is the fact that risk management is not an easy science and even large, experienced companies are often uncomfortable with the fact that hedging sometimes results in losses. On top of that is the cash flow risk (for daily margins) and basis risk that hedging with futures adds in. Finally, there is the issue of delivery, or lack of it, which means that even if a company surmounts these obstacles and makes a good hedge, he has to ultimately sell his dollars to the bank and probably still end up paying a huge bank spread.
The best way to make futures more attractive to this group is to permit futures contracts to be settled by delivery ONLY from EEFC accounts. This would require the clearinghouse to be permitted to access the OTC market or to designate specific banks to act as delivery agents. Neither of these would require a dramatic change in the level of deregulation and I believe RBI should act on this at earliest.
Another element that could enhance meaningful access for small companies would be to authorize specific entities – perhaps, selected NBFCs or AD2 dealers – to aggregate positions from small enterprises. In other words, permit them to buy and sell exposures from SMEs. Banks already do this but, as we know, in many, many cases the pricing they offer is terrible, often because they have to amortize their own costs. Increasing competition in this market could go a long ways to assisting small exporters to manage their price risk.
Turning to the other segment that the market should have been designed for – investors – I believe SEBI should immediately permit portfolio management in currencies. While I have to acknowledge my own interest in promoting this idea – we have, after all, been involved with the FX market for over 25 years and have direct access to the OTC market through our sister broking concern, Mecklai & Mecklai – the reality is that currencies as an investment class, often as an overlay to fixed income investment, is well recognized the world over. For decades, we have had companies (and now individuals) coming to us and asking us to make money for them in the FX market. In the OTC market, this is possible, since regulations permit companies to book and cancel forward contracts; in the futures market, SEBI needs to authorize portfolio managers.
Let me say as a caveat, though, that making money in the currency market, as in any market, is not easy. It requires a deep understanding of the market, reasonable expectations and, critically, ironclad discipline. From our decades of experience, we have found that even getting the market right even 55%of the time is a tall order but is sufficient to make reasonable returns provided you run a disciplined operation. [I know there are people who say they can get the market right 60 or 70% of the time – I was one of those myself 25 years ago. My only comment to those people is, Why are you talking to me? You should be on a beach in the Bahamas enjoying your millions.]
In sum, currency futures volumes are likely to grow; RBI should permit delivery only through EEFC accounts and permit authorized entities to aggregate exposures from small and medium enterprises; and SEBI should permit portfolio management in currencies.