Gold has always been an enigma for investors all over the world. India is, of course, the world’s largest consumer of the metal — Indians have traditionally invested in gold more as a necessity driven by social compulsions. But now it has also become an attractive
investment option, since it’s viewed as a natural hedge against inflation. At a more academic level, it’s also a substitute for the dollar.
The price of gold has been increasing sharply in the last couple of months to cross $1,300 an ounce and analysts have not ruled out its touching the $1,500 mark in near future. The question is whether this trajectory will continue upwards or whether it will stabilise and then drift downwards after a while.
The price of any product is driven by demand relative to supply, and gold is no exception to this rule. At the moment, demand is moving faster than supply and that’s pushing up prices. Look at the demand side. Conventional demand has increased as more people are moving towards gold as an asset class. The weakening dollar is the economic justification and the rising price of gold on its own is creating further demand for this class of users. Second, the gold exchange traded funds have been busy buying gold and accounted for around a third of the physical demand for gold in Q2 of 2010. On the back of these purchases of gold, financial products are then offered in the market for investors. The third category of entities which demand gold are the consumers who buy jewellery, where demand has been rising, albeit moderately. Therefore, it’s the investor class, more than the consumer class, which has really driven demand.
How about supply? The World Gold Council has stated that supplies are more or less fixed in terms of what is mined annually — which is valued at around $200 billion. Q2 had witnessed a supply valued at around $40
billion. Central banks have also been active in the gold market. In the past, gold was held as a non-remunerative asset and central banks preferred to invest their surpluses in bonds rather than gold. It may be recollected that, not long ago, the fear that such sales may depress prices had led central banks of Europe to impose restrictions among themselves on the sale of gold. However, after the financial crisis there have been doubts cast on the US economy and the strength of the dollar. Hence, it’s not surprising that central banks have gone back to acquiring gold instead of selling it — a change in role from a supplier to an active buyer in the market.
In this scenario, where are gold prices headed? Gold has a direct relation with the dollar. As long as the dollar weakens, investors will move to gold, and the correlation here is as high as between 80-90 per cent. The dollar is weakening against the euro in the range of around 1.35-1.40 and this scenario will probably persist given that the US economy is shaky while the euro region is
relatively better off. However, a strong euro may not work in favour of the eurozone, and there would be resistance to the extent to which the dollar can fall. Therefore, this particular factor may not persist for too long.
Besides, the US is trying to lower its deficits, which could also help to strengthen the dollar.
This leaves the other factors at play — central banks and funds. Central banks are still in shopping mode and funds would leverage the conditions to keep their incomes ticking. Gold is traditionally a good investment option and gives returns between 15-18 per cent and can be positioned somewhere between government bonds and the stock market. This interest will always remain and hence the price may not really recede and would tend to stabilise even after global adjustments occur. As long as there is scepticism about the world monetary order, interest in gold will remain strong.
What does it mean for us in India? India, though the largest consumer of gold, is a price taker. This means we take the price that’s determined on COMEX. The prices would replicate global trends, which in turn are influenced by our demand. With income levels increasing and high inflation prevailing there has been a tendency at the margin for households to look at gold progressively — though there is not much evidence of substantially higher imports of gold by India. There will hence be a tendency for the prices to move up during this festival season.
Thursday, October 28, 2010
A clearer route for foreing banks: 21st October Financial Express
The choice is really between operating as a branch of an entity that is incorporated overseas or functioning as a subsidiary of the same. The former means that they operate in the current manner where there are apparent barriers to expansion. They pay higher corporate tax rates but have it easy when meeting the preemption norms in the form of priority sector lending. The subsidiary route would imply that they would work like any domestic bank, except that the equity holding would be different.
The issue has come up for two reasons. RBI, for its part, would like to be better able to regulate foreign banks in the country considering the role they could play, given their financial strength. But the financial crisis showed that there is a major risk in the current model wherein the branch would be jeopardised in case the overseas parent had severe problems. This could be destabilising at the limit for the domestic banking system. Therefore, from the point of view of risk management, RBI would prefer to have better oversight over their operations.
As far as foreign banks are concerned, they would like to expand their operations in the country but are constrained in terms of the number of branches that they could set up as the rules are clear—not more than 12 branches a year as per the WTO agreements. There are 31 foreign banks operating in the country with 310 branches as of March 2010—with 75% being held by 5 banks. The market is vast and they do have the skill sets to reach out and expand their business in rural India, provided they are allowed to do so. The current regulatory environment may be considered to be inhibiting.
From the point of view of the banks, the subsidiary route would help them expand their business, which would probably apply to these 5 banks. They would get more operational flexibility and can push forth their business plans. Further, they would be able to grow inorganically through M&A activity, which is not available currently. Therefore, there would be certain gains for them in operating as a subsidiary as their market share increases. Also, given the financial strength of the parent company, they would be able to bring in the requisite capital to support their enhanced operations. In fact, given that there would be more new private banks operating in the interiors, the foreign banks would get left out from this business and would, hence, find the subsidiary route a convenience.
However, what is not clear is whether or not there would be the encumbrance of priority sector lending the way it is defined for Indian banks. There will probably be no concession here, which means that they would perforce have to go into the rural interiors and cater to the agriculture, small scale industry sector, weaker sections, etc. Currently, they get away with 32% ratio, which also includes export finance. Also, the tax rules governing capital gains or stamp duty are not quite clear when they convert from a branch to subsidiary, which will have to be examined before taking a decision. The DTC, however, has addressed the issue of corporate taxation, which used to be at a higher level for foreign companies, which will be restored to that for domestic companies.
RBI would also have to provide clarity on the listing requirements for such subsidiaries as there would be stipulations for new private banks. A public offering would be good for the country as domestic shareholders could get a slice of the benefits of the operations of these banks. This would be a major consideration for banks, which would want to convert to a subsidiary. Management issues would probably not be a major issue as the branches too operate with an Indian management and changes would only be at the fringe.
Setting the stage for the expansion of foreign banks is pragmatic but given that they are heterogeneous, all may not prefer the subsidiary route. Ideally, they should have the right to choose the route. They would have, to use the cliché, to decide to be or not to be a subsidiary.
The issue has come up for two reasons. RBI, for its part, would like to be better able to regulate foreign banks in the country considering the role they could play, given their financial strength. But the financial crisis showed that there is a major risk in the current model wherein the branch would be jeopardised in case the overseas parent had severe problems. This could be destabilising at the limit for the domestic banking system. Therefore, from the point of view of risk management, RBI would prefer to have better oversight over their operations.
As far as foreign banks are concerned, they would like to expand their operations in the country but are constrained in terms of the number of branches that they could set up as the rules are clear—not more than 12 branches a year as per the WTO agreements. There are 31 foreign banks operating in the country with 310 branches as of March 2010—with 75% being held by 5 banks. The market is vast and they do have the skill sets to reach out and expand their business in rural India, provided they are allowed to do so. The current regulatory environment may be considered to be inhibiting.
From the point of view of the banks, the subsidiary route would help them expand their business, which would probably apply to these 5 banks. They would get more operational flexibility and can push forth their business plans. Further, they would be able to grow inorganically through M&A activity, which is not available currently. Therefore, there would be certain gains for them in operating as a subsidiary as their market share increases. Also, given the financial strength of the parent company, they would be able to bring in the requisite capital to support their enhanced operations. In fact, given that there would be more new private banks operating in the interiors, the foreign banks would get left out from this business and would, hence, find the subsidiary route a convenience.
However, what is not clear is whether or not there would be the encumbrance of priority sector lending the way it is defined for Indian banks. There will probably be no concession here, which means that they would perforce have to go into the rural interiors and cater to the agriculture, small scale industry sector, weaker sections, etc. Currently, they get away with 32% ratio, which also includes export finance. Also, the tax rules governing capital gains or stamp duty are not quite clear when they convert from a branch to subsidiary, which will have to be examined before taking a decision. The DTC, however, has addressed the issue of corporate taxation, which used to be at a higher level for foreign companies, which will be restored to that for domestic companies.
RBI would also have to provide clarity on the listing requirements for such subsidiaries as there would be stipulations for new private banks. A public offering would be good for the country as domestic shareholders could get a slice of the benefits of the operations of these banks. This would be a major consideration for banks, which would want to convert to a subsidiary. Management issues would probably not be a major issue as the branches too operate with an Indian management and changes would only be at the fringe.
Setting the stage for the expansion of foreign banks is pragmatic but given that they are heterogeneous, all may not prefer the subsidiary route. Ideally, they should have the right to choose the route. They would have, to use the cliché, to decide to be or not to be a subsidiary.
Of paramount importance: Financial Express: October 14, 2010
The news about Paramount Airways and Oriental Insurance Company is interesting as it opens up a debate on a larger question on credit cover in the form of credit insurance. This is even more relevant, given the backdrop of the financial crisis, which has brought credit risk to the forefront. A debate is necessary, even though there have not been many instances of such defaults leading to turmoil in the financial sector.
The case is quite straightforward. We have an airline company that took a guarantee from a set of banks against which it bought fuel from oil companies. These loans were covered by an insurance company for credit default. Now the company is unable to pay, invoking the guarantee, which means that the banks have to pay the oil company. The banks, in turn, claim the loss on the account from the insurance company. As a result, Irda has decided to do away with such credit insurance schemes until a regulatory structure is put in place. The problem is significant because the insurance company did not reinsure these loans. Reinsurance would have helped diversify the risk across more players.
Credit insurance schemes are generally used for foreign trade and not commonly used by banks to cover defaults on their books. Banks covering credit risk is not uncommon in countries like the US where insurance can be procured on loans. AIG had to pay banks when the CDOs failed, and the rest as they say, is history. Credit default swaps can also be used, wherein the third party picks up the risk in exchange for a fee—the swap spread.
In India, RBI has published guidelines for CDS for bonds to make the market more robust. However, bank loans are not covered. Thus, credit insurance does appear to be a fairly good form of financial engineering for diversifying risk and expanding business—for the borrower, lender, guarantor and cover provider. This way banks would be better able to lend or provide a guarantee when loans are on the borderline.
Irda has recently barred insurance companies from selling such policies as it felt that the market is not transparent and has little regulatory oversight. The participants from different segments covering different financial arenas has led to a regulatory overlap. The concern is that insurance companies may not be sufficiently equipped to evaluate such loans when providing a cover. The system can, therefore, be gamed by intermediaries who could get the borrower to actually pay the premium to the insurance company, embedded in the bank guarantee cost for the bank. Hence, the risk from one sector would get transferred to the insurance segment, jeopardising the balance sheets of these companies. There has been reason for separating the banking sector from the insurance sector and while this concept of credit guarantee would work well in good times, it could be destabilising in times of crisis.
From a bank’s point of view, this raises issues of the quality of credit appraisal. Banks that are insured would be tempted to be more liberal in credit appraisals, knowing that the insurance company is there to back it up. In fact, the reason for a bank's intermediation job is that it bridges the information asymmetry between savers and borrowers, and takes on risk based on its superior credit skills, earning a spread on the money. If they were to go back to the insurance company, however, then they are not efficient.
Theoretically, insurance companies should insure any product that carries risk. But, when there are efficient derivative markets that price risk well, insurance companies should not participate—they are not equipped to gauge this risk. Alternatively, insurance companies could hone their skills and have a proper line of business where credit is insured.
A solution here is to take recourse to the CDS market and allow a bank to get cover from it. This implies that RBI should open the CDS market for bank loans as well, possibly in the second stage of expansion.
The case is quite straightforward. We have an airline company that took a guarantee from a set of banks against which it bought fuel from oil companies. These loans were covered by an insurance company for credit default. Now the company is unable to pay, invoking the guarantee, which means that the banks have to pay the oil company. The banks, in turn, claim the loss on the account from the insurance company. As a result, Irda has decided to do away with such credit insurance schemes until a regulatory structure is put in place. The problem is significant because the insurance company did not reinsure these loans. Reinsurance would have helped diversify the risk across more players.
Credit insurance schemes are generally used for foreign trade and not commonly used by banks to cover defaults on their books. Banks covering credit risk is not uncommon in countries like the US where insurance can be procured on loans. AIG had to pay banks when the CDOs failed, and the rest as they say, is history. Credit default swaps can also be used, wherein the third party picks up the risk in exchange for a fee—the swap spread.
In India, RBI has published guidelines for CDS for bonds to make the market more robust. However, bank loans are not covered. Thus, credit insurance does appear to be a fairly good form of financial engineering for diversifying risk and expanding business—for the borrower, lender, guarantor and cover provider. This way banks would be better able to lend or provide a guarantee when loans are on the borderline.
Irda has recently barred insurance companies from selling such policies as it felt that the market is not transparent and has little regulatory oversight. The participants from different segments covering different financial arenas has led to a regulatory overlap. The concern is that insurance companies may not be sufficiently equipped to evaluate such loans when providing a cover. The system can, therefore, be gamed by intermediaries who could get the borrower to actually pay the premium to the insurance company, embedded in the bank guarantee cost for the bank. Hence, the risk from one sector would get transferred to the insurance segment, jeopardising the balance sheets of these companies. There has been reason for separating the banking sector from the insurance sector and while this concept of credit guarantee would work well in good times, it could be destabilising in times of crisis.
From a bank’s point of view, this raises issues of the quality of credit appraisal. Banks that are insured would be tempted to be more liberal in credit appraisals, knowing that the insurance company is there to back it up. In fact, the reason for a bank's intermediation job is that it bridges the information asymmetry between savers and borrowers, and takes on risk based on its superior credit skills, earning a spread on the money. If they were to go back to the insurance company, however, then they are not efficient.
Theoretically, insurance companies should insure any product that carries risk. But, when there are efficient derivative markets that price risk well, insurance companies should not participate—they are not equipped to gauge this risk. Alternatively, insurance companies could hone their skills and have a proper line of business where credit is insured.
A solution here is to take recourse to the CDS market and allow a bank to get cover from it. This implies that RBI should open the CDS market for bank loans as well, possibly in the second stage of expansion.
How much am I worth: DNA October 13, 2010
Irony seldom escapes the characters on the economic stage; and when the issue pertains to one’s own well-being, Adam Smith’s free market self-interest or Ayn Rand’s virtue of selfishness prevails.
And why not, since we all want to partake a portion of the wealth of success. It was not a long time back that the prime minister asked private sector honchos to be abstemious in their remuneration. Now, all the MPs have gone ahead and given themselves a rise in their salaries.
When Lehman became a euphemism for the greed that the private sector represents, government officials ascended the high horse to say how they were different and that the private sector stinks when it comes to remuneration. Now, we have the RBI as well as the public sector banks arguing for parity with the private sector. What is one to make of it considering that each segment thinks that it deserves the hike and, as a corollary, the others don’t?
The extremes in salaries are stark. US Fed chairman Ben Bernanke takes home $200,000 per annum while European Central Bank president Jean-Claude Trichet earns $500,000.
Bank of England chief Mervyn King has package of $450,000 while Japan’s Masaaki Shirakawa is paid $400,000. Our own RBI governor Duvvuri Subbarao gets the rupee equivalent of around $30,000. In contrast, in 2009 Goldman Sachs was reported to have had a wage bill of $16.2 billion for 32,500 workers, giving an average of $498,246 — half a million dollars per head!
Clearly, the regulated take home larger pay cheques than the regulators, though the latter admittedly have greater powers. The question is how are salaries to be fixed?
In a free economy, salaries should be the function of the owners or shareholders. If it is the private sector, it is the proprietor or the shareholders. This holds just like it does for, say, a household where it determines the salary to be paid to the maid or watchman or driver. However, structures are amorphous here.
Most big companies have shareholders and even an owner-driven company may not really have a majority. Salaries are fixed by the owner on the premise that the majority has voted for it but the majority never really gets together to take a decision and hence the process of salary determination remains fuzzy.
At times it ends up with the owner, who is the management, also appointing the board which ratifies one’s own salary.
This should be treated as an internal affair but it becomes a public concern if bailouts have to be invoked when things go awry. The crisis did not stop at the financial sector, where public money was involved, but also overflowed into manufacturing, which then brought to the fore the issue of executive pay.
When it comes to the government, it is even more complicated. There are hierarchies where a bank chief is at the level of a secretary and one cannot go up without the other doing so. Hence, either all salaries have to move up, or all stagnate. The public sector enterprises are better placed even though there is government ownership, as here the CEOs get better pay packets, which can range between Rs30-40 lakh per annum, though this is still lower than that in the private sector.
Now, there is a strong case for salary revisions in the public sector banks, especially when they perform as well as those in the private sector. But there is a conundrum. A just way of going about it is to increase all salaries by x%.
This is democratic but allows free riders to benefit. It is actually the middle and senior levels where personnel can move to the private sector quite easily and the threat of attrition is real. There are a number of IAS officials who have gotten lucrative deals in the private sector to become heads of commodity exchanges or infrastructure companies. A number of private banks took in public sector officials and have grown really well.
However, does an executive, who is two years away from retirement, deserve a private sector salary? Yes, if the organisation is doing as well as its private counterpart. Critics aver that there are few public sector employees who find jobs after they retire. Salary hikes are needed to prevent attrition and the present system of backdoor increases through the recruitment of consultants with fixed tenures is not sustainable.
The solution is really to leave it open to the companies or banks to decide their pay packets which should be linked to profitability. This will create a problem for the bureaucrats as there is no profit and the incentives must be linked with performance in terms of expense management or implementation of projects.
As a corollary, the grades should be delinked from the bureaucracy charts. This would also mean that banks must have their own system of picking their CEOs with the ministry being out of the picture. This is the only way to make it work and should hence be looked at holistically.
And why not, since we all want to partake a portion of the wealth of success. It was not a long time back that the prime minister asked private sector honchos to be abstemious in their remuneration. Now, all the MPs have gone ahead and given themselves a rise in their salaries.
When Lehman became a euphemism for the greed that the private sector represents, government officials ascended the high horse to say how they were different and that the private sector stinks when it comes to remuneration. Now, we have the RBI as well as the public sector banks arguing for parity with the private sector. What is one to make of it considering that each segment thinks that it deserves the hike and, as a corollary, the others don’t?
The extremes in salaries are stark. US Fed chairman Ben Bernanke takes home $200,000 per annum while European Central Bank president Jean-Claude Trichet earns $500,000.
Bank of England chief Mervyn King has package of $450,000 while Japan’s Masaaki Shirakawa is paid $400,000. Our own RBI governor Duvvuri Subbarao gets the rupee equivalent of around $30,000. In contrast, in 2009 Goldman Sachs was reported to have had a wage bill of $16.2 billion for 32,500 workers, giving an average of $498,246 — half a million dollars per head!
Clearly, the regulated take home larger pay cheques than the regulators, though the latter admittedly have greater powers. The question is how are salaries to be fixed?
In a free economy, salaries should be the function of the owners or shareholders. If it is the private sector, it is the proprietor or the shareholders. This holds just like it does for, say, a household where it determines the salary to be paid to the maid or watchman or driver. However, structures are amorphous here.
Most big companies have shareholders and even an owner-driven company may not really have a majority. Salaries are fixed by the owner on the premise that the majority has voted for it but the majority never really gets together to take a decision and hence the process of salary determination remains fuzzy.
At times it ends up with the owner, who is the management, also appointing the board which ratifies one’s own salary.
This should be treated as an internal affair but it becomes a public concern if bailouts have to be invoked when things go awry. The crisis did not stop at the financial sector, where public money was involved, but also overflowed into manufacturing, which then brought to the fore the issue of executive pay.
When it comes to the government, it is even more complicated. There are hierarchies where a bank chief is at the level of a secretary and one cannot go up without the other doing so. Hence, either all salaries have to move up, or all stagnate. The public sector enterprises are better placed even though there is government ownership, as here the CEOs get better pay packets, which can range between Rs30-40 lakh per annum, though this is still lower than that in the private sector.
Now, there is a strong case for salary revisions in the public sector banks, especially when they perform as well as those in the private sector. But there is a conundrum. A just way of going about it is to increase all salaries by x%.
This is democratic but allows free riders to benefit. It is actually the middle and senior levels where personnel can move to the private sector quite easily and the threat of attrition is real. There are a number of IAS officials who have gotten lucrative deals in the private sector to become heads of commodity exchanges or infrastructure companies. A number of private banks took in public sector officials and have grown really well.
However, does an executive, who is two years away from retirement, deserve a private sector salary? Yes, if the organisation is doing as well as its private counterpart. Critics aver that there are few public sector employees who find jobs after they retire. Salary hikes are needed to prevent attrition and the present system of backdoor increases through the recruitment of consultants with fixed tenures is not sustainable.
The solution is really to leave it open to the companies or banks to decide their pay packets which should be linked to profitability. This will create a problem for the bureaucrats as there is no profit and the incentives must be linked with performance in terms of expense management or implementation of projects.
As a corollary, the grades should be delinked from the bureaucracy charts. This would also mean that banks must have their own system of picking their CEOs with the ministry being out of the picture. This is the only way to make it work and should hence be looked at holistically.
Look beyond FCRA amendments: Financial Express: 5th October 2010
The possibility of the Forward Contracts (Regulation) Act (FCRA) being amended raises some interesting issues in the context of financial markets in India. There is, of course, the question of what this means for the commodity market. But, at the broader level, it also provokes some introspection of the regulatory issues in the financial space.
The immediate euphoria is in the commodity markets, as the constituents have been hoping for the same for quite some time now. What this means is that if Parliament passes these amendments, then the FMC would become autonomous and could bring in the changes that are needed to galvanise a market that is quite lopsided today. The immediate thoughts that strike us are that the market can expect options and indices to be introduced soon. Also, the FMC will have more powers to control the markets, though admittedly, the FMC and market have functioned well so far without such explicit power being given to the FMC.
Once the amendment is passed, four questions may be posed. The first is whether FMC, being an independent regulator, will really help the cause? The FMC will have to gear up and hone its skills to understand the market and defend it. Being independent is one thing, to act independently is another. Suppose prices of chana or sugar were to increase sharply leading to high food inflation, can the independent FMC stand up and tell the government to lay off? Second, the issue of regulatory overlap is still not addressed. It may be recollected that the FMC had given permission to FIIs and mutual funds to trade in non-agricultural commodities several years ago. Yet their own regulators have not allowed this action. Will the FCRA amendment address this issue?
Third, while options sound good, the prospects for business per se are quite limited. Today, globally, around 10% of energy contracts, 7-8% of metals and almost nil of agriculture trading are in options. One should not overstate the case of farmers using options, considering that they have yet to trade in futures and trading in options on futures (which is what it will be) will be even more daunting for them. Fourth, commodity indices are not widely traded on exchanges unlike stock indices, which should curb the enthusiasm on the business front.
The second set of issues is institutional, which has to be addressed at some point in time. Today, there are a plethora of regulators in the financial markets: RBI, Sebi, FMC, Nabard, Sidbi, Irda, PFRDA, CEA, APMCs, etc. There are evidently no answers to the question of whether there should be more or fewer regulators. The Raghuram Rajan committee pitched for fewer while there is another school of thought that argues that specialisation is better than creating a behemoth that loses touch with reality—the same debate as with centralisation or decentralisation and empowerment.
The issue is more about the players being caught between different regulators. Today, financial products stretch across markets and regulators, which create potential conflict. Electricity is under CEA but FMC runs the derivatives market, which can involve delivery. The same holds for any physical commodity or ETF where the underlying has a different set up from the derivative product. Physical gold is not regulated but futures are under FMC but the ETF falls under Sebi. If it is a physical product, APMCs regulate, say, wheat, while the derivative is under FMC and we could have the ETF being traded on NSE under Sebi? The Ulips created their own controversies with Sebi and Irda coming to the discussion table. Banks can operate through subsidiaries in the stock market but on their own can sell mutual funds products but not deal directly as they deal with deposit money, which is RBI’s domain. Forex derivatives impact currency markets but come under Sebi though technically this is okay since RBI deals with physical currency, which does not come into the picture now. Also, the institutions have different capital structures. RBI allows 40% ownership for individual entrepreneurs while Sebi has a 5% ceiling for exchanges. FMC gives time for shareholding patterns to evolve while Irda provides a longer window.
Therefore, the broader issue is that while there is merit in having more regulators with specialisation, we need to iron out these conflict zones so that markets can evolve with minimum upheavals. Currently, there is excess caution being exercised to ensure that risk from one segment does not spill over to another when the players are the same. This has led to a certain level of intransigence between regulators, which has been compounded by the differences in ministries overseeing these departments. The next stage of regulatory reform should logically be in this area before moving down to the markets per se. That will be pragmatic and useful.
The immediate euphoria is in the commodity markets, as the constituents have been hoping for the same for quite some time now. What this means is that if Parliament passes these amendments, then the FMC would become autonomous and could bring in the changes that are needed to galvanise a market that is quite lopsided today. The immediate thoughts that strike us are that the market can expect options and indices to be introduced soon. Also, the FMC will have more powers to control the markets, though admittedly, the FMC and market have functioned well so far without such explicit power being given to the FMC.
Once the amendment is passed, four questions may be posed. The first is whether FMC, being an independent regulator, will really help the cause? The FMC will have to gear up and hone its skills to understand the market and defend it. Being independent is one thing, to act independently is another. Suppose prices of chana or sugar were to increase sharply leading to high food inflation, can the independent FMC stand up and tell the government to lay off? Second, the issue of regulatory overlap is still not addressed. It may be recollected that the FMC had given permission to FIIs and mutual funds to trade in non-agricultural commodities several years ago. Yet their own regulators have not allowed this action. Will the FCRA amendment address this issue?
Third, while options sound good, the prospects for business per se are quite limited. Today, globally, around 10% of energy contracts, 7-8% of metals and almost nil of agriculture trading are in options. One should not overstate the case of farmers using options, considering that they have yet to trade in futures and trading in options on futures (which is what it will be) will be even more daunting for them. Fourth, commodity indices are not widely traded on exchanges unlike stock indices, which should curb the enthusiasm on the business front.
The second set of issues is institutional, which has to be addressed at some point in time. Today, there are a plethora of regulators in the financial markets: RBI, Sebi, FMC, Nabard, Sidbi, Irda, PFRDA, CEA, APMCs, etc. There are evidently no answers to the question of whether there should be more or fewer regulators. The Raghuram Rajan committee pitched for fewer while there is another school of thought that argues that specialisation is better than creating a behemoth that loses touch with reality—the same debate as with centralisation or decentralisation and empowerment.
The issue is more about the players being caught between different regulators. Today, financial products stretch across markets and regulators, which create potential conflict. Electricity is under CEA but FMC runs the derivatives market, which can involve delivery. The same holds for any physical commodity or ETF where the underlying has a different set up from the derivative product. Physical gold is not regulated but futures are under FMC but the ETF falls under Sebi. If it is a physical product, APMCs regulate, say, wheat, while the derivative is under FMC and we could have the ETF being traded on NSE under Sebi? The Ulips created their own controversies with Sebi and Irda coming to the discussion table. Banks can operate through subsidiaries in the stock market but on their own can sell mutual funds products but not deal directly as they deal with deposit money, which is RBI’s domain. Forex derivatives impact currency markets but come under Sebi though technically this is okay since RBI deals with physical currency, which does not come into the picture now. Also, the institutions have different capital structures. RBI allows 40% ownership for individual entrepreneurs while Sebi has a 5% ceiling for exchanges. FMC gives time for shareholding patterns to evolve while Irda provides a longer window.
Therefore, the broader issue is that while there is merit in having more regulators with specialisation, we need to iron out these conflict zones so that markets can evolve with minimum upheavals. Currently, there is excess caution being exercised to ensure that risk from one segment does not spill over to another when the players are the same. This has led to a certain level of intransigence between regulators, which has been compounded by the differences in ministries overseeing these departments. The next stage of regulatory reform should logically be in this area before moving down to the markets per se. That will be pragmatic and useful.
Look beyond FCRA amendments: Financial Express: 5th October 2010
The possibility of the Forward Contracts (Regulation) Act (FCRA) being amended raises some interesting issues in the context of financial markets in India. There is, of course, the question of what this means for the commodity market. But, at the broader level, it also provokes some introspection of the regulatory issues in the financial space.
The immediate euphoria is in the commodity markets, as the constituents have been hoping for the same for quite some time now. What this means is that if Parliament passes these amendments, then the FMC would become autonomous and could bring in the changes that are needed to galvanise a market that is quite lopsided today. The immediate thoughts that strike us are that the market can expect options and indices to be introduced soon. Also, the FMC will have more powers to control the markets, though admittedly, the FMC and market have functioned well so far without such explicit power being given to the FMC.
Once the amendment is passed, four questions may be posed. The first is whether FMC, being an independent regulator, will really help the cause? The FMC will have to gear up and hone its skills to understand the market and defend it. Being independent is one thing, to act independently is another. Suppose prices of chana or sugar were to increase sharply leading to high food inflation, can the independent FMC stand up and tell the government to lay off? Second, the issue of regulatory overlap is still not addressed. It may be recollected that the FMC had given permission to FIIs and mutual funds to trade in non-agricultural commodities several years ago. Yet their own regulators have not allowed this action. Will the FCRA amendment address this issue?
Third, while options sound good, the prospects for business per se are quite limited. Today, globally, around 10% of energy contracts, 7-8% of metals and almost nil of agriculture trading are in options. One should not overstate the case of farmers using options, considering that they have yet to trade in futures and trading in options on futures (which is what it will be) will be even more daunting for them. Fourth, commodity indices are not widely traded on exchanges unlike stock indices, which should curb the enthusiasm on the business front.
The second set of issues is institutional, which has to be addressed at some point in time. Today, there are a plethora of regulators in the financial markets: RBI, Sebi, FMC, Nabard, Sidbi, Irda, PFRDA, CEA, APMCs, etc. There are evidently no answers to the question of whether there should be more or fewer regulators. The Raghuram Rajan committee pitched for fewer while there is another school of thought that argues that specialisation is better than creating a behemoth that loses touch with reality—the same debate as with centralisation or decentralisation and empowerment.
The issue is more about the players being caught between different regulators. Today, financial products stretch across markets and regulators, which create potential conflict. Electricity is under CEA but FMC runs the derivatives market, which can involve delivery. The same holds for any physical commodity or ETF where the underlying has a different set up from the derivative product. Physical gold is not regulated but futures are under FMC but the ETF falls under Sebi. If it is a physical product, APMCs regulate, say, wheat, while the derivative is under FMC and we could have the ETF being traded on NSE under Sebi? The Ulips created their own controversies with Sebi and Irda coming to the discussion table. Banks can operate through subsidiaries in the stock market but on their own can sell mutual funds products but not deal directly as they deal with deposit money, which is RBI’s domain. Forex derivatives impact currency markets but come under Sebi though technically this is okay since RBI deals with physical currency, which does not come into the picture now. Also, the institutions have different capital structures. RBI allows 40% ownership for individual entrepreneurs while Sebi has a 5% ceiling for exchanges. FMC gives time for shareholding patterns to evolve while Irda provides a longer window.
Therefore, the broader issue is that while there is merit in having more regulators with specialisation, we need to iron out these conflict zones so that markets can evolve with minimum upheavals. Currently, there is excess caution being exercised to ensure that risk from one segment does not spill over to another when the players are the same. This has led to a certain level of intransigence between regulators, which has been compounded by the differences in ministries overseeing these departments. The next stage of regulatory reform should logically be in this area before moving down to the markets per se. That will be pragmatic and useful.
The immediate euphoria is in the commodity markets, as the constituents have been hoping for the same for quite some time now. What this means is that if Parliament passes these amendments, then the FMC would become autonomous and could bring in the changes that are needed to galvanise a market that is quite lopsided today. The immediate thoughts that strike us are that the market can expect options and indices to be introduced soon. Also, the FMC will have more powers to control the markets, though admittedly, the FMC and market have functioned well so far without such explicit power being given to the FMC.
Once the amendment is passed, four questions may be posed. The first is whether FMC, being an independent regulator, will really help the cause? The FMC will have to gear up and hone its skills to understand the market and defend it. Being independent is one thing, to act independently is another. Suppose prices of chana or sugar were to increase sharply leading to high food inflation, can the independent FMC stand up and tell the government to lay off? Second, the issue of regulatory overlap is still not addressed. It may be recollected that the FMC had given permission to FIIs and mutual funds to trade in non-agricultural commodities several years ago. Yet their own regulators have not allowed this action. Will the FCRA amendment address this issue?
Third, while options sound good, the prospects for business per se are quite limited. Today, globally, around 10% of energy contracts, 7-8% of metals and almost nil of agriculture trading are in options. One should not overstate the case of farmers using options, considering that they have yet to trade in futures and trading in options on futures (which is what it will be) will be even more daunting for them. Fourth, commodity indices are not widely traded on exchanges unlike stock indices, which should curb the enthusiasm on the business front.
The second set of issues is institutional, which has to be addressed at some point in time. Today, there are a plethora of regulators in the financial markets: RBI, Sebi, FMC, Nabard, Sidbi, Irda, PFRDA, CEA, APMCs, etc. There are evidently no answers to the question of whether there should be more or fewer regulators. The Raghuram Rajan committee pitched for fewer while there is another school of thought that argues that specialisation is better than creating a behemoth that loses touch with reality—the same debate as with centralisation or decentralisation and empowerment.
The issue is more about the players being caught between different regulators. Today, financial products stretch across markets and regulators, which create potential conflict. Electricity is under CEA but FMC runs the derivatives market, which can involve delivery. The same holds for any physical commodity or ETF where the underlying has a different set up from the derivative product. Physical gold is not regulated but futures are under FMC but the ETF falls under Sebi. If it is a physical product, APMCs regulate, say, wheat, while the derivative is under FMC and we could have the ETF being traded on NSE under Sebi? The Ulips created their own controversies with Sebi and Irda coming to the discussion table. Banks can operate through subsidiaries in the stock market but on their own can sell mutual funds products but not deal directly as they deal with deposit money, which is RBI’s domain. Forex derivatives impact currency markets but come under Sebi though technically this is okay since RBI deals with physical currency, which does not come into the picture now. Also, the institutions have different capital structures. RBI allows 40% ownership for individual entrepreneurs while Sebi has a 5% ceiling for exchanges. FMC gives time for shareholding patterns to evolve while Irda provides a longer window.
Therefore, the broader issue is that while there is merit in having more regulators with specialisation, we need to iron out these conflict zones so that markets can evolve with minimum upheavals. Currently, there is excess caution being exercised to ensure that risk from one segment does not spill over to another when the players are the same. This has led to a certain level of intransigence between regulators, which has been compounded by the differences in ministries overseeing these departments. The next stage of regulatory reform should logically be in this area before moving down to the markets per se. That will be pragmatic and useful.
Wednesday, September 29, 2010
Why have IRFs not worked? Economic Times 29th September 2010
India is a nation of traders and the success of the United Stock Exchange (USE) in its first week of operations bears testimony to this observation. Coincidentally, the spot markets in equities, foreign exchange and government securities (G-secs) register an average daily turnover of around Rs 20,000 crore.
The derivative markets several multiples of this amount and the only exception is the interest rate (IRFs) market, which has witnessed little interest despite its many versions — the last being in 2008.
The response to F&O trading has been quite remarkable in the past few years, especially in new areas such as commodities and currencies. Currencies currently trade about 3.8 times the physical underlying (comprising foreign trade and external loans) and would go up to 5.5 times if volumes increase by a comparable level with USE coming in.
Gold trades at a multiple of 25, crude oil at four, farm products at unity while stocks three times the cap of the National Stock Exchange (NSE). The nagging thought here is as to why have IRFs not quite caught on.
The market for G-secs is large with the outstanding portfolio being Rs 14 lakh crore. If 25% is excluded, which is classified as ‘held to maturity’ securities, the physical underlying would be Rs 10.5 lakh crore. Institutions trade Rs 20,000 crore of such securities every day and, as interest rates have been volatile in the past, carry a big risk of mark to market (MTM) when they have to value their portfolios. Do IRFs actually satisfy the prerequisites for futures trading?
First, the basic driver of trade is volatility in any market, and NSE Primary Returns Index has witnessed volatility of 7% between April and September. This is comparable to that in other markets, and lies between agri products (5%) and forex (9.5%). Therefore, risk-cover is necessary given the large underlying — 1% change in rates can hit the portfolio by Rs 10,500 crore or 1 bps by Rs 100 crore.
Second, given that is a single product contract which can be settled with other pre-specified ones, for this to be a success, there should be strong correlation with other securities. Here, RBI data shows that there is strong correlation between change in yields on 10-year paper and those on 5, 11, 12 and 20 years and moderately high (around 60%) for eight and nine years. Hence, this too cannot be a reason to reject the product as the contract can be benchmarked with the other papers, though admittedly, the others are not as widely traded as the five- and 10- year securities.
Third, the cost of trading could be another militating factor. But, this segment, like the currency market, is free of this charge unlike the commodity or stock markets, where the charges vary between 0.002 and 0.003%. Therefore, this too could not be an explanation. Fourth, one can surmise that the absence of a yield curve, which is vibrant along all points, is the reason holding back the market, as liquidity in the spot market should enthuse the IRF market.
But still one should expect high volumes of trade for the most widely traded and held 10-year security.
Fifth, the market may not interested in such hedging, especially in an environment when interest rates are expected to move up as there would be less incentive to get into such contracts. Sixth, and probably the more plausible reason could be that players are making use of the volatility in the market through purchase and sale to book their gains and find no need to go in for a hedge.
This could explain why the 75% of G-secs, which are ‘available for sale’ or ‘held for trading’ is actually traded. Lastly, non-G-sec participants do not see this as a hedge as lending rates, for example, do not move in tandem with these rates and hence one could get left out of this market.
Globally, 60% of the derivative market is dominated by equities, followed by interest futures with 15% and currencies with 11%. In India, things are different with equities taking a share of 45%, followed by currencies with 38% (assuming that the Rs 60,000 crore daily volumes are maintained) and gold with just less than 10%. The IRF segment is the missing link that has to be connected. The unanswered question is, how?
The derivative markets several multiples of this amount and the only exception is the interest rate (IRFs) market, which has witnessed little interest despite its many versions — the last being in 2008.
The response to F&O trading has been quite remarkable in the past few years, especially in new areas such as commodities and currencies. Currencies currently trade about 3.8 times the physical underlying (comprising foreign trade and external loans) and would go up to 5.5 times if volumes increase by a comparable level with USE coming in.
Gold trades at a multiple of 25, crude oil at four, farm products at unity while stocks three times the cap of the National Stock Exchange (NSE). The nagging thought here is as to why have IRFs not quite caught on.
The market for G-secs is large with the outstanding portfolio being Rs 14 lakh crore. If 25% is excluded, which is classified as ‘held to maturity’ securities, the physical underlying would be Rs 10.5 lakh crore. Institutions trade Rs 20,000 crore of such securities every day and, as interest rates have been volatile in the past, carry a big risk of mark to market (MTM) when they have to value their portfolios. Do IRFs actually satisfy the prerequisites for futures trading?
First, the basic driver of trade is volatility in any market, and NSE Primary Returns Index has witnessed volatility of 7% between April and September. This is comparable to that in other markets, and lies between agri products (5%) and forex (9.5%). Therefore, risk-cover is necessary given the large underlying — 1% change in rates can hit the portfolio by Rs 10,500 crore or 1 bps by Rs 100 crore.
Second, given that is a single product contract which can be settled with other pre-specified ones, for this to be a success, there should be strong correlation with other securities. Here, RBI data shows that there is strong correlation between change in yields on 10-year paper and those on 5, 11, 12 and 20 years and moderately high (around 60%) for eight and nine years. Hence, this too cannot be a reason to reject the product as the contract can be benchmarked with the other papers, though admittedly, the others are not as widely traded as the five- and 10- year securities.
Third, the cost of trading could be another militating factor. But, this segment, like the currency market, is free of this charge unlike the commodity or stock markets, where the charges vary between 0.002 and 0.003%. Therefore, this too could not be an explanation. Fourth, one can surmise that the absence of a yield curve, which is vibrant along all points, is the reason holding back the market, as liquidity in the spot market should enthuse the IRF market.
But still one should expect high volumes of trade for the most widely traded and held 10-year security.
Fifth, the market may not interested in such hedging, especially in an environment when interest rates are expected to move up as there would be less incentive to get into such contracts. Sixth, and probably the more plausible reason could be that players are making use of the volatility in the market through purchase and sale to book their gains and find no need to go in for a hedge.
This could explain why the 75% of G-secs, which are ‘available for sale’ or ‘held for trading’ is actually traded. Lastly, non-G-sec participants do not see this as a hedge as lending rates, for example, do not move in tandem with these rates and hence one could get left out of this market.
Globally, 60% of the derivative market is dominated by equities, followed by interest futures with 15% and currencies with 11%. In India, things are different with equities taking a share of 45%, followed by currencies with 38% (assuming that the Rs 60,000 crore daily volumes are maintained) and gold with just less than 10%. The IRF segment is the missing link that has to be connected. The unanswered question is, how?
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