Another Brick in the Wall: Financial Express: 26th November 2007

The RBI’s draft report on currency futures is significant and pragmatic for six reasons. The first is that we will have a forex futures market where there are large numbers of players who will determine the price of the dollar in future. This is a big change from what we see today in the OTC market where the banks have the upper hand in price setting.
The second is that these contracts will be for a whole year, and hence market players can choose their tenures for trading. This is unlike the commodity market, where there are generally fewer contracts that are running simultaneously. The third is that the contracts are to be settled in cash, which is again different from commodity Markets where compulsory delivery is the rule. In the currency futures market, this would have been chaotic if dollars had to be delivered because there would be a parallel market for the supply of physical dollars. The RBI has taken this decision ostensibly on the grounds of there being no capital account convertibility.
The fourth is that the RBI has taken on the role of the regulator and also advised the creation of new exchanges. This is pragmatic because it eschews the issues related to having multiple regulators overseeing different activities of the same exchange. Fifth, the settlement price would be announced by the RBI through its spot reference rate on the expiry date, which will do away with the settlement problems faced by the commodity market where no unique and singular price exists and the onus is on the exchange to provide this price. This would lead to an automatic convergence of futures with spot rates on this day. And lastly, the RBI does see a valid role for speculators to play, which comes as a breath of fresh air, considering that the commodity market has had to defend the existence of such players within its fold. Such a market will surely address the grievances of exporters, software firms, euro market borrowers or anyone else getting into a dollar transaction, since they will be able to use currency futures to safeguard themselves from forex fluctuations. Investors in these instruments can make money while adding both liquidity and vital information (through their actions) to the system.
However, some questions need to be posed here, given the structure of the proposed market. Futures prices are determined by the interaction of the demand for and supply of dollars at a future date. This is similar to the futures price of, say, pepper four months hence. The theoretical price is the point at which demand would balance supply. While future demand may be unknown, the participant needs to guess the supply. Can one guess the FII/FDI inflows or the trade balance or the remittances that are coming in? Unlikely, as this is a complicated game where even econometric models have failed. The other issue is that the likely movement of the futures dollar rate would depend on educated guesses taken on RBI action. The exchange rate, though market determined, is not entirely influenced by the forces of demand and supply because the RBI has to keep in mind the monetary implications. This means one has to track credit expansion as well as inflation numbers.
Two issues come up here. The first—one has to keep guessing when the RBI would intervene, which means reading the mind of the Governor as well as Finance Minister. Any statement made by either of them would give rise to more “reading between the lines” conjectures. Volatility would be particularly high during the four credit policy/review periods. The second is an even more fascinating implication—the RBI, which is the regulator, will actually be deciding which way the exchange rate will move. This highlights an anomaly. In the stock or commodity market, the regulator does not intervene so significantly in any way, except through the normal routes of margin and position limits. But, here, the regulator’s own action would necessarily be moving the market, which, though not wrong, is certainly different. Haven’t we heard all about the sterilisation of capital inflows, or RBI interventions to prevent an appreciation of the rupee? If this is how currency rates are set, how much space do market forces have to operate?
What’s more, the existence of the OTC or forward market would be questioned by the futures market, because all the players in the forward market would also be potential candidates for the futures one, with the added attraction of speculators also playing their role to the utmost. If the two exist, then the price has to converge, or else there would be arbitrage opportunities for those on these exchanges.
For all that, the currency futures market is an exciting opportunity. It was the glaring missing link in India’s financial market. It certainly needs to be developed to provide depth to the sector, and the RBI needs to be commended for this initiative. Also, last but not the least, there will be more jobs for analysts and economists alike.