Rupee futures open to foreign investors, but find few takers

Through a circular on June 20, the Reserve Bank of India (RBI) has allowed, for the first time, foreign portfolio investors (FPI) access to exchange-traded currency futures market without the need to prove underlying exposure up to $10 million of open positions.

The central bank has allowed banks back into the currency futures market to trade on their own accounts, after barring them from the market in July last year in a bid to curb apparent rupee speculation that exacerbated currency volatility.

Corporates can also take positions of up to $10 million in the futures market without proving an underlying exposure.

Although the RBI has returned some of the FX freedoms to banks and corporates it took away last year, market participants caution that the regulatory green light for banks’ proprietary trading is unlikely to trigger a jump in volumes.

The guidelines put exchange trading in the futures market almost at par with the heavily regulated over-the-counter (OTC) FX markets, causing some to shrug off the changes as inconsequential, and others to stress this move will hinder the growth of the market.

Pradeep Khanna, managing director and head of FX trading for HSBC India, doesn’t believe that much will come in the short-term from regulatory efforts to boost liquidity in the market.

“We don’t see any major impact, because ultimately the same FPIs could still buy the same amount of dollars through the OTC market,” he says.

“So, if the regulation and freedom are similar in both, we really didn’t see that there would be a huge interest to start trading or hedging in futures. That’s how it has played out till now – we don’t really expect it to change any time soon.”

Anil Bhansali, vice-president at Mecklai Financial in Mumbai – which provides FX risk research and advisory to corporates – says that with almost no clear advantage to trading on the exchange, there is little incentive to access the currency futures market for either hedging or speculative purposes.

“These guidelines are reminiscent of similar restrictions in the corporate bond market, which, too, failed to develop,” he says. “Corporates are not really interested in trading in this market and find it more beneficial to trade OTC.”

The bid to develop a currency futures market in India is long-standing. In 2008, the National Stock Exchange of India launched rupee-dollar futures after the then finance minister Palaniappan Chidambaram promised in a budget speech that an onshore market for currency futures will be introduced to compete with the rupee futures trading on the Dubai and Singapore exchanges.

Until the market was restricted in July 2013, the currency futures market in India saw decent volumes averaging about $5 billion a day. According to market participants, local banks – which were in the business of providing liquidity on the exchange at around 0.01 INR away from where it was trading on the OTC market – provided liquidity on the exchange.

Regulatory arbitrage

This regulatory arbitrage, which took advantage of more lax rules on the exchange vis-à-vis the forwards market, which had strict documentation requirements on underlying exposures, meant that banks were the main conduit between the OTC and futures market.

So when volatility in the rupee spiked in July 2013, the RBI sought to remove the main source of liquidity and speculation in the rupee futures market – the banks.

Since then, the Raghuram Rajan-led central bank has built up dollar reserves and brought rupee trading back to stable, range-bound levels. The 2013 budget promised foreign investors access into the currency futures market as well.

However, MS Gopikrishnan, regional director for south Asian FX, rates and credit for Standard Chartered, finds solace in the RBI’s regulatory stance on the FX markets this move indicates.

“Although there is no immediate impact, this is the right direction in general,” he says. “Foreign investors who were previously trading in the offshore NDF [non-deliverable forward] markets now have a more liquid curve to trade on. So you are bringing some flows back onshore, which would’ve gone to the NDF market.”

Gopikrishnan further says allowing banks back into the market has narrowed the spread between the one-month implied forward price in the OTC market and the futures price from 20 to 30 cents after the restrictions were put in place to about five to six cents now, converging at times to zero cents.

However, barring the arbitrage opportunities for banks, there seems to be less utility in the futures market for legitimate traders and hedgers. Positions on the exchange must be taken through exchange members and authorized deposit-taking institutions, mirroring exactly the requirement in the OTC market.

Further, as Mecklai’s Bhansali points out, the advantage that exchanges have of providing faster quotes is offset by the fact currency futures are not liquid beyond the immediate two months. “For trading more than two to three months, you have to go back to the OTC market, which is not a very big advantage in favour of the exchange,” he says.

Lot sizes on the exchange go up to $1,000, which makes it less straightforward and more time-consuming to put together a $10 million position on the exchange compared with the OTC market, where the same position can be built in a few seconds through an FPI or corporate’s relationship bank.

However, FPIs can sell up to $10 million on the exchange, something they can’t do in the OTC markets. Yet the rupees generated must be re-invested as rupee accounts, for FPIs are not interest bearing. Whether this proves to be a selling point remains to be seen.