The currency derivatives segment on the NSE and MCX has witnessed consistent growth both in traded value and open interest since its inception. The total turnover in the segment has increased incredibly from $3.4bn in October 2008 to $84bn in December 2009. The average daily turnover reached $4bn in December 2009. Open interest in the segment on the NSE and MCX stood at around 4 lakh contracts till end-December 2009.
India already has an active over-the-counter (OTC) market in currency derivatives where the average daily turnover was $29bn in 2008 and $21bn in 2009 (till September 2009). This market is being driven by its ability to meet the respective needs of participants. For example, it is used by importers/exporters to hedge their payables/receivables; foreign institutional investors (FIIs) and NRIs use it to hedge their investments in India; borrowers find it an effective way to hedge their foreign currency loans and resident Indians find it an effective tool to hedge their investments offshore. Further, for arbitrageurs it presents an opportunity to arbitrage between onshore and non-deliverable forward (NDF) markets.
The exchange-traded currency futures market is an extension of this already available OTC market, but with added benefits of greater accessibility to potential participants; high price transparency; high liquidity; standardised contracts; counterparty risk management through clearing corporation and no requirement of underlying exposure in the currency. As the market participants are realising these benefits of exchange-traded market in currency, they are choosing this market over OTC.
However, it is too early to see a major shift in activity from OTC to exchange-traded market as it has created a niche for itself and it would perhaps take some time for the currency futures market to create one for itself. Globally, too, the foreign exchange market is largely OTC in character. While the notional amount outstanding of OTC derivatives was as high as $63trn in June 2008, the exchange-traded market is rather non-existent with notional amount outstanding as end-June 2009 being only 0.5% of that in the OTC segment.
However, there is a renewed debate on the level of transparency and counterparty risk in the OTC market kindled by the sub-prime mortgage crisis in the US and the need to regulate OTC transactions effectively. This throws up certain important issues which, at best, may need to be handled separately.
India has, in this light, embarked upon an experiment by attempting to make the exchange-traded currency market popular and a first choice for investors. Though the market has not been able to evince the kind of activity that the OTC market has witnessed as yet, the recent phenomenal growth is a pointer towards better days ahead for this market. Some of the issues plaguing the market at present include the fact that many corporates using currency derivatives for hedging their foreign currency exposure find the requirement of margin and settlement of daily mark-to-market differences cumbersome, especially since there is no such requirement for OTC trades. It would conceivably take some time for them to realise the concomitant benefits of these risk containment measures. Also, there is a perceived resistance to change and switchover from OTC to exchange-traded framework following a level of comfortability reached by market players with the OTC market framework.
Further, the market has been restricted in a number of ways. Till recently only USD-INR futures contracts were permitted. One hopes to see more activity in the segment with more currency pairs being added. Also to start with, FIIs have not been permitted to participate in this market. This has in effect restricted the liquidity that FIIs could have otherwise created. FIIs are already active in Dubai Gold and Commodity Exchange (DGCX). There is an opportunity for business for domestic exchanges and intermediaries to be created in bringing this market onshore. According to the latest release from DGCX, Indian rupee futures volume rose 530% in 2009 to 66,346 contracts on the exchange. Volume in December 2009 was 346% higher compared with the same period last year. Though small in comparison to volumes being traded on Indian exchanges, there is still merit in getting this market onshore. Additionally, the offshore NDF market in Indian rupee has also been witnessing increasing volumes. The average daily volumes on the NDF rupee market have increased from $38mn in 2003 Q1 to $800mn during 2008-09 (Asian Capital Markets Monitor of ADB, April, 2009). Most of the major foreign banks offer NDFs, but Indian banks are barred from doing so. These markets have evolved for the Indian rupee following foreign exchange convertibility restrictions. It is serving as an avenue for non-domestic players, private companies and investors in India to hedge foreign currency exposure. It also derives liquidity from non-residents wishing to speculate in the Indian rupee without exposure to the currency and from arbitrageurs who try to exploit the differentials in the prices in the onshore and offshore markets. Though foreign investors can now transact in the onshore Indian forward markets with greater flexibility following various measures taken by RBI in recent years, allowing them access to the exchange-traded currency futures platform would further help in getting the volumes in the NDF market onshore and enhance liquidity on domestic exchanges.
India has witnessed enhanced foreign investment inflows and trade flows in recent years. The Indian currency is now becoming an important international currency. Though India accounts for a very small proportion of the total foreign exchange market turnover in the world as compared to other countries, its share has been slowly but continuously increasing. According to BIS estimates, the percentage share of Indian rupee in total daily average foreign exchange turnover has increased from 0.1% in 1998 to 0.2% in 2001 to 0.3% in 2004 and to 0.9% in April 2007 (updated data will be available in April 2010). All of this implies greater need for hedging currency risk in Indian rupee, particularly given that the exchange rate has been quite volatile during the last few years and hence increased importance of exchange-traded currency market.
In conclusion, considering the nascent stage of development of exchange-traded currency market in the country, the cautious approach of the regulators is understandable. One hopes to see further developments in the markets regulatory framework over time. There is no doubt that this is a market which will eventually establish its own forte and will be an area of activity to watch and gain from for all market participants in the near future.
The author is a civil servant. Views are personal