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Currency futures for a vibrant market

Indian financial markets will make further headway once currency futures are introduced. Futures trading in currencies assumes importance in the context of growing integration of the economy with the rest of the world and rapid development of the financial markets.

Essentially futures contracts are standardised forward contracts traded on an exchange. The standardisation of the futures contract will typically be in terms of quantity, expiration months, delivery and settlement amounts, date and mode, trading days and hours. The biggest feature in favour of futures is the existence of a clearing house to guarantee the fulfilment of contract obligations and virtually eliminate the counterparty risk.

Recently ‘Rupee Futures’ started trading in Dubai.

Though the Reserve Bank of India has realised the need to make available a wider choice of hedging instruments to market participants to enable them to cope better with their currency risk exposures, and the Government is pressing for an early launch of futures contracts in currencies, there are a few legal and operational issues that need to be resolved.

“Indian financial markets are past the no-return point of deregulation and we no longer have the luxury of trying to maintain status quo; the recent break-out of inflation proves that. With substantial capital account convertibility a huge step, currency futures could be a perfect halfway house, enabling the RBI to get greater comfort in managing a deeper, broader market,” said Jamal Mecklai of Mecklai Financial.

Currency futures usually operate in markets that have fully convertible currencies. In India, currency futures have not been allowed so far because of controls on capital account in the external sector. However, in the context of increased capital account liberalisation, wider hedging opportunities can strengthen economic agents’ ability to cope with market-induced currency movements, according to the RBI’s working group which submitted its report on the subject recently. The experience of select countries like South Africa and South Korea suggests that currency futures can co-exist with over-the-counter (OTC) currency markets as well as capital controls. The latest country to introduce currency futures is South Africa which allowed its securities exchange, the Johannesburg Stock Exchange, to trade in rand futures since June 2007.

The Committee on Fuller Capital Account Convertibility has observed that internationally, many investors use futures rather than the cash market to manage the duration of their portfolios or asset allocations because of the low upfront payments and high speed of transactions. Entities also trade in futures with the hope of making profits out of speculation or arbitrage opportunities between the futures market and the underlying market.

Thanks to widespread membership and a large number of interested parties, the futures market provides liquidity, making transactions possible and providing immediate information on prices. Since futures like any other derivatives are linked to the underlying cash market, its availability improves trading volumes in the cash market as it improves any arrangement for handling risk.

Though the origin of futures can be traced to 1851 when the Chicago Board of Trade introduced standardised forward contracts, the birth of currency futures is of recent origin and was a sequel to the breakdown of the Bretton Woods currency system in the early 1970s. The resultant currency volatility (after the breakdown of the Bretton Woods system) provided a business opportunity for launching futures contracts in foreign currencies. The Chicago Mercantile Exchange first conceived the idea of a currency futures exchange by launching it in 1972, amidst considerable scepticism, since traditionally futures markets had traded in agricultural commodities and not financial instruments.

The main implications of a currency futures market for monetary and exchange rate policies arise from the risks of possible dollarisation (This refers to the broad use of a foreign currency in the place of the domestic currency for transaction and other purposes) of an economy; risks of possible increased volatility in the exchange rate, which could then spill over to other segments of the financial market and in the process have an impact on interest rates, pace of economic activity, inflation and financial stability. The recommendations of the working group only permit resident Indians to access currency futures. Non-resident Indians and foreign institutional investors will be permitted only after the processes have run for a while ensuring that there is no fallout on domestic monetary policy.

“While these risks exist, their probability is relatively low,” according to the working group, which adds, “At the sametime, the loss value of the extreme events could be large.” Hence the committee has pointed to the need to be better prepared to cope with such low probability extreme events.

However, the working group felt that the potential gains from the introduction of currency futures are multi-dimensional in terms of availability of better risk management tools to the market players, better price discovery mechanism and the resultant potential to lower transaction costs, apart from improved two-way information flows between the market and the policy-makers. Currency futures will also contribute to a higher level of sophistication of the financial market and impart greater confidence in economic agents within and outside the country.

The Reserve Bank has taken measures for the development of the financial markets from time to time, as part of its long term policy. “This is also part of that exercise and a market driven mechanism would always determine real levels and rates,” said K. D. Lamba, Assistant General Manager, Treasury, Bank of Baroda. Today, in India, investors and intermediaries are familiar with futures contracts on equities and commodities.

“What we require is basically to develop the skill by improving the knowledge of the people, procedures and accountability and legal and regulatory norms for currency futures. All these have to come together to implement currency futures, traded through an exchange”. However, Mr. Lamba feels it will take time.

At present, forward contracts (rupee forward) are actively traded in the domestic inter-bank foreign exchange market. The RBI has also allowed vanilla derivative products like currency options, which are also traded actively in the domestic market. The foreign exchange futures market coexists worldwide with a very active forward market.

The RBI has been working continuously towards the development of sound and efficient intermediaries and markets in order to provide a foundation for a robust and diversified financial system which in turn promotes effective transmission of monetary policy. While there is emphasis on strengthening structural factors in the economy, the Reserve Bank has also endeavoured to moderate the cyclical and excessively volatile elements of the economy that interfere with the achievement of its goals of price stability and growth.

There is general recognition that larger hedging opportunities will be required with capital account liberalisation. The RBI has taken several steps in the recent past to allow economic agents to benefit from dynamic hedging tools. B Sambamurthy, Chairman and Managing Director, Corporation Bank, says that futures trading should take place onshore also. For a starter, the regulator can look at a specific currency trade (rupee-U.S. dollar or rupee-euro) and a standardised type of instrument. The implementation of currency futures will improve the pricing system but there is a long way to go in this direction.

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