The Hindu Business Line : The long and short of rupee futures

In the context of the proposed dollar-rupee futures market, although the central bank has demonstrated its seriousness, there are still some important issues that need to be clarified and tackled to impart a good start to rupee futures.

Vikram Murarka

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The RBI has been working on the introduction of rupee futures for some time now. It is widely believed that the RBI was prompted to take this step after the Dubai Gold and Commodity Exchange (DGCX) started trading rupee futures in June 2007.

For a while it seemed that the biggest roadblock to the introduction of exchange traded rupee futures in India would be potential jurisdiction issues between the RBI, which has oversight of the banking sector (including the currency market), and SEBI, which has regulatory powers over the NSE and the BSE, the two most active exchanges in the country. However, it is commendable that the RBI has chosen to sublimate its position to the higher goal of introducing a new market into the country.

Success of any market is measured by the depth, liquidity and volumes traded therein which, in turn, is a function of the (low) cost of transacting in that market.

In the context of the proposed dollar-rupee futures market, although the central bank has demonstrated its seriousness by dissolving the first roadblock, there are still some important issues that need to be clarified and tackled to impart a good start-off to rupee futures.

A very laudable aspect of the proposed futures, which is nothing less than revolutionary, needs to be pointed out. The lot size has been kept at a mere $1,000, which is just about Rs 42,500 at today’s rate. This is the one single feature that has the power to overcome all other difficulties, because it is an amount that can be easily afforded by a wide swathe of the populace. To put things in perspective, the value of one lot of rupee futures is going to be half that of one lot of the Mini Nifty.

The shortcomings

However, going by the report, there appears to be some serious issues with the present conception of the rupee futures market, wherein dollars can neither be delivered nor be taken delivery of, and the futures can only be cash-settled. This feature not only divorces, at the very time of birth, the rupee futures market from the thriving OTC dollar-rupee market but may also give rise to a number of challenges.

One may well say, “How come? Isn’t it a good thing, trying to bring the offshore NDF (non-deliverable forwards) market back on shore. That has to be good — it is stopping the export of India’s financial market!” Look a little deeper, though. First, it may be pointed out that the extant OTC dollar-rupee market is supposed to be, at least in spirit, a non-speculative market.

Corporates are supposed to access the market only to hedge their forex exposures, not for speculative purposes. Of course, a large section of the market may scoff at this intention, for the practice often differs from theory.

However, the fact that, by regulation, the OTC market is supposed to be used only for hedging is a very important consideration when firms account for the profits and losses on “hedges”. Many a loss-making hedge is taken/given delivery of against the actual underlying exposures so that the trading bases do not show up as such.

Cut to the futures market. Since there will be no delivery involved, all the trades will be termed speculative. Corporates will not be able to camouflage speculative losses against their exposures under the garb of hedging. This may present a problem. Company boards, even those of SMEs, may hesitate to give the go-ahead to their treasury departments, to ‘speculate’ in the rupee futures market.

Second, even if a small exporter were to ‘hedge’ himself on the futures market, when it comes to realising rupees against his dollar receivables, he would still need to transact with a bank, which would charge him a steep 20 paise per dollar for obliging him. Effectively, therefore, the futures market may do nothing to bring down the costs transactions or the costs of hedging.

Third, let us suppose that skilled speculative trading gives rise to profits. Will corporates want to pay capital gains tax thereon, if the taxman deems it appropriate to tax such profits? Remember that there is no capital gains tax on forex profits in the OTC market.

However, there is a probability that the Finance Minister will want to levy STT (securities transaction tax) on the exchange traded dollar-rupee futures. If so, this will impose an additional cost on futures trades, further driving a wedge between the OTC and the exchange-traded markets.

Finally, RBI’s report prescribes a client level open position limit of $5 million, at least in the beginning. This appears to be too meagre an amount to justify participation by corporates, even small ones, further distancing the OTC and the futures markets.

What is the intention?

It might then be worthwhile examining the intention behind the introduction of rupee futures. The intention could be to open access to the forex market to a larger section of the populace, bring greater transparency into the market and to reduce the costs of transaction.

If so, perhaps the objectives might have been much more easily achieved by simply allowing existing inter-bank forex brokers to offer forward contracts (which are and would be deliverable) to non-bank clients and to allow a proliferation of such forex brokers. The idea would be to simply create competition for the banks, which currently run the forex market like a cartel. Whether the market is OTC or exchange traded is not what matters. What matters is whether the client can buy dollars from or deliver dollars to anyone else apart from the banks and at what cost he can do so.

Globally, exchange traded futures form a very small part of the total volumes in the global currency markets. The ones which have survived and thrived all have the facility of delivery-based transactions.

This has been duly noted by the RBI’s own working group on currency futures in reports in November 2007 and again in April 2008. The reason the bank has refrained from allowing physical delivery for dollar rupee futures is feat of dollarisation of the economy. The probability of this, according to RBI’s own internal workings, is low.

If the futures market is to provide an avenue for small and medium enterprises to hedge their forex risk, delivery against the futures contracts has to be allowed. Apart from that, larger gross open position limits need to be permitted at the client level.

(The author is Chief Currency Strategist at Kshitij Consultancy Services and can be contacted at vikram@kshitij.com).

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