This paper presents background information to the assessment of competitiveness and exchange rate policy in India, as well as challenges to monetary policy from financial globalization. This paper discusses the role of communication in enhancing the effectiveness of monetary policy and strengthening the financial system in India. Currency derivatives can provide important benefits for financial systems. This paper aims to document the extent to which Indian growth has benefited the bottom of the income distribution and how India can achieve significantly better social outcomes.

Abstract

This paper presents background information to the assessment of competitiveness and exchange rate policy in India, as well as challenges to monetary policy from financial globalization. This paper discusses the role of communication in enhancing the effectiveness of monetary policy and strengthening the financial system in India. Currency derivatives can provide important benefits for financial systems. This paper aims to document the extent to which Indian growth has benefited the bottom of the income distribution and how India can achieve significantly better social outcomes.

V. Developing the Foreign Exchange Derivatives Market—The Case of India1

A. Introduction

1. Currency derivatives can provide important benefits for financial systems.2 The sound management of currency risk is one of the most critical elements of adapting financial systems to greater globalization in order to preserve financial stability. Like other types of derivatives, foreign exchange derivatives facilitate risk diversification, promote efficient price formation, and enhance financial intermediation. They supplement cash markets, improve market liquidity, and facilitate the unbundling, decomposition and/or transformation of risk, which can be customized to risk preferences.

2. Currency derivatives markets are particularly important for countries like India that have flexible exchange rates and are moving towards fuller capital account convertibility. In the context of a flexible exchange rate, well-functioning derivatives markets help reduce financial fragility by allowing the corporate and financial sectors to better manage their exchange rate risks, ease financial surveillance, and provide useful price signals about market views on economic and financial conditions. Currency derivatives also complement the development of domestic capital markets.

3. This chapter proceeds as follows. It first analyzes the present development of currency derivatives markets in India. It then reviews current market reforms. The chapter concludes by considering policy measures to promote the benefits of foreign currency derivatives markets while mitigating attendant risks.

B. Current Situation

4. The origins of India’s foreign exchange markets can be traced back to 1978, when banks were permitted to undertake intra-day currency trades for the first time. However, market activity did not take off until after the adoption of a managed-floating exchange rate regime in March 1993 amid a series of ongoing financial and capital market that followed the recommendations of the Report of the High Level Committee on Balance of Payments. The gradual relaxation of capital account restrictions provided an economic rationale for the creation of onshore currency derivatives markets as corporates started tapping foreign markets.

5. Amid India’s growing global financial integration, domestic currency derivatives trading has tripled since 2004 to nearly US$34 billion per day. The rupee’s share in global turnover of traditional foreign exchange products (cash, spot and forward derivatives market)3 more than doubled between 2004 and 2007 to 0.7 percent of global turnover (or US$26 billion per day)—remarkable given the 70 percent annual growth in global trading during recent years. Moreover, the share of global foreign exchange trading taking place in India (not all involving the rupee) also more than doubled to 0.9 percent of global trading.

6. Despite the surge in currency derivatives trading, it lags that in other major emerging economies. For example, it remains small compared to South Korea, Mexico, or South Africa (see Figures V.1 and V.2), which have registered similar increases in capital inflows and rising domestic exchange rate exposures. At end-2007, the daily gross volume of currency derivatives turnover represented less than 20 percent of all foreign exchange trades in India.

Figure V.1.
Figure V.1.

Fx Derivatives Markets in Selected EM Countries 1/

(Annual trading volume, notional amounts in billions of U.S. Dollars)

Citation: IMF Staff Country Reports 2008, 052; 10.5089/9781451947502.002.A005

Sources: World Federation of Exchanges; Bank for International Settlements; and IMF, World Economic Outlook; and staff estimates.1/ OTC and ETD trading data for 2007 is estimated. OTC data for the years 2005 and 2006 are interpolated based on historical trends.
Figure V.2.
Figure V.2.

Fx Derivatives Markets in Selected EM Countries 1/

(Annual trading volume relative to GDP, in percent)

Citation: IMF Staff Country Reports 2008, 052; 10.5089/9781451947502.002.A005

Sources: World Federation of Exchanges; Bank for International Settlements; and IMF, World Economic Outlook; and staff estimates.1/ OTC and ETD trading data for 2007 is estimated. OTC data for the years 2005 and 2006 are interpolated based on historical trends.

7. Foreign-currency transactions in India occur mostly over-the-counter (OTC), with the Clearing Corporation of India Ltd. (CCIL) acting as settlement agent (it settles 90–95 percent of the interbank transactions in the U.S. dollar-rupee market). The daily average gross volume of interbank trades in the U.S. dollar-rupee currency pair has increased from US$6–7 billion in 2006 to about US$11–12 billion in 2007. The peak volume settled on a single day was US$39 billion in 2006 and US$67 billion in 2007.4

8. Inter-bank currency swaps account for the largest share of currency derivatives turnover. Hedging can be performed through swaps and OTC inter-bank forward or option contracts—both cross-currency as well as foreign currency/rupee. Turnover in forward (US$2.5 billion daily) and swap contracts (US$3.1 billion daily) represent about 90 percent of gross daily derivatives trading. Since the issue of foreign exchange swaps and options by corporates and institutional investors is restricted to long positions to hedge demonstrated exposure, trading in nontraditional instruments (swaps and options) essentially reflects inter-bank transactions (Mohan, 2007).

9. Options trading remains nascent, with trading around US$400 million daily. Authorized dealers (ADs) were allowed to trade foreign currency/rupee options only since July 7, 2003, when the Reserve Bank of India (RBI) expanded the spectrum of hedging products for currency exposure. ADs can offer “plain vanilla” European options and customers can purchase call or put options. As in the spot and forward markets, customers who have legitimate foreign currency exposures are eligible to enter into options contracts but cannot write options. ADs can use options to hedge trading books and balance sheet exposure.

10. In terms of trading book values, short-term forward contracts claim the largest share of the derivatives market. As of end-August 2007, total foreign exchange contracts outstanding in the banks’ balance sheets amounted to US$1.1 trillion, of which 84 percent were forwards and the rest swaps and options. Despite the steady increase in foreign exchange market liquidity, trading has been mainly concentrated in short-term instruments with maturities of less than one year (see Gambhir and Goel, 2003, and Figure V.3). One-fifth of all currency trades settled at the CCIL are forward contracts5, including forward contacts in swap agreements (see Figures V.4 and V.5). Forward contracts are generally traded to month-end value dates and involve smaller notional volumes than cash/spot markets, where deal sizes are two and a half times larger than in the forward market. A high netting factor6 reduces actual settlement flows to less than ten percent of overall volume, thereby limiting settlement risks.

Figure V.3.
Figure V.3.

India: Tenorwise Settlement of Forward Fx Trades

(Share, in percent of total value)

Citation: IMF Staff Country Reports 2008, 052; 10.5089/9781451947502.002.A005

Source: Clearing Corporation of India Ltd.
Figure V.4.
Figure V.4.

India: Analysis of Traditional Fx Trades by Trade type

(Share, in percent of total value)

Citation: IMF Staff Country Reports 2008, 052; 10.5089/9781451947502.002.A005

Source: Clearing Corporation of India Ltd.1/ Cash and Tom settlements with effect from February 2004. Spot figures are inclusive of spot leg of swaps.
Figure V.5.
Figure V.5.

India: Analysis of Traditional Fx Trades by Volume

(Annual volume, in billions of U.S. Dollars)

Citation: IMF Staff Country Reports 2008, 052; 10.5089/9781451947502.002.A005

Source: Clearing Corporation of India Ltd.1/ Cash and Tom settlements with effect from February, 2004. Spot figures are inclusive of spot leg of swaps.

11. Registered foreign banks and domestic public sector banks are the main players in an increasingly concentrated forward market (see Figure V.6). They account for more than 90 percent of demand and more than 87 percent of supply of forward contracts. Concentration is increasing, with the top 20 entities increasing their share from 73.6 percent in 2004 to 83.8 percent at end-September 2007. This situation could reflect restrictions on market access: foreign institutional investors (FIIs), investors through inward foreign direct investment (FDI), and nonresident Indians (NRIs) can access the forward market and are permitted to hedge currency risk only to the extent of their cash market exposure (equity and/or debt).7

Figure V.6.
Figure V.6.

India: Analysis of Fx and Forward Trades by Category

(As of end-October 2007, buy-side)

Citation: IMF Staff Country Reports 2008, 052; 10.5089/9781451947502.002.A005

Source: Clearing Corporation of India Ltd.

12. Onshore currency trading is subject to increased competition from offshore trading. Amid limits on full capital account convertibility and on foreign market participation, currency derivatives trading activity is springing up offshore. In June 2007, the Dubai Gold and Commodities Exchanges started trading of rupee futures, while liquidity in the nondeliverable forward (NDF) market has been growing noticeably, allowing nonregistered foreign investors and Indian corporates to hedge their rupee exposure. However, despite rising liquidity, offshore trading is still only about a quarter of onshore trading. Moreover, offshore derivatives activity is mainly in short-term transactions.

C. Regulatory Framework and Proposed Reforms

13. The currency derivatives market is regulated by the RBI, which issued comprehensive guidelines on derivatives in April 2007.8 To alleviate legal uncertainty about cash-settled OTC derivatives, the RBI Act was amended in October 2006 to define the regulatory purview of RBI over derivatives (with interest rates, foreign exchange rates, credit ratings/credit indices, or securities prices as underlying assets) if one of the transacting parties is a scheduled bank or other entity regulated under the RBI Act, Banking Regulation Act or Foreign Exchange Management Act (FEMA). In the wake of the Annual Policy Statement for the Year 2007–08 (April 2007), the RBI adopted a new regulatory framework for derivatives, which defines: (i) a classification of market participation into market makers, who undertake derivatives transactions to act as counterparties, and users, who undertake derivatives transactions to hedge or transform risk exposure; (ii) broad principles for undertaking derivatives transactions, including valuation and market pricing; (iii) prudential measures to control the risks in derivatives activities, including an integrated risk management process; and (iv) “suitability” and “appropriateness” of policies governing the due diligence of market-makers in offering derivative products.

14. Against the background of growing financial integration and benign macroeconomic conditions, the RBI is liberalizing foreign exchange markets as a critical element of continued capital market development. Based on recommendations of the Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets, the RBI has taken steps to further broaden and deepen financial markets in line with real sector developments and phased capital account liberalization. In the past, capital account restrictions have been maintained in order to preserve financial and economic stability. However, given India’s increasing financial integration and the high level of foreign exchange reserves, the RBI is now easing certain restrictions, which renders greater importance to the efficiency of foreign exchange and currency derivatives trading (as discussed in the recommendations of the 2006 report of the Tarapore Committee on Fuller Capital Account Convertibility (CFCAC)).

15. Regulatory efforts are underway to widen the domestic derivatives market, with a view to facilitating onshore currency hedging in India. Reforms in the currency derivatives market have followed the FEMA, which calls for development of orderly foreign exchange markets with a view to meeting both development and stability objectives. For example, in April 2007, the RBI published supervisory guidelines on derivatives. The new rules propose inter alia the permissibility of various types of derivative instruments, in particular, currency futures, in the effort move currency derivatives trading to organized exchanges.9 In addition, the RBI has proposed several initiatives to simplify procedures in the conduct of currency derivatives transactions (especially regarding the use of forwards and options) and is exploring other hedging instruments, which would allow market participants greater flexibility to undertake foreign exchange operations and risk management practices.

16. The RBI recent raised hedging limits for documented exposures as the first measure in series of regulatory reforms. As part of the comprehensive guidelines on derivatives adopted in April 2007, corporates are permitted to reinstate eligible hedging limits upon both declaration of (anticipated and economic) exposure and past performance criteria (if supporting documentation is produced during the term of the hedge undertaken).10 for SMEs, the RBI has simplified procedural hedging requirements by waiving complex documentation formalities.11 Similarly, individuals have been permitted to hedge up to US$100,000 on self-declaration basis.

17. The RBI may require banks to exercise greater caution when engaging in hedging activities on behalf of corporate clients. In December 2007, the RBI announced that it might tighten the norms for currency derivatives as banks and companies are facing losses from exchange rate positions. In an effort to enhance market surveillance of derivatives trading, banks will be required to ascertain the risk management usage of currency derivatives, which would include documentation of corporate clients’ risk management practices and approval from senior management.

18. The RBI also plans to expand option-based hedging facilities available to firms. The RBI proposes to allow importers and exporters having foreign exchange exposure to sell covered call and put options in both foreign currency/rupee and cross-currency (“dynamic hedging”). Currently, corporates are allowed only to purchase options on a stand-alone basis as “users.” Only in zero-cost structures are corporates permitted to write options. Since corporates cannot be net sellers, they would need to enter simultaneously into an offsetting sell option, which generates a similar amount of premium income. In contrast, the new regulations would remove this constraint and allow premium income. In addition, exporters will be allowed to use American options (relaxing the restriction to European options), which allow them to square off their positions any time until maturity upon receipt of export earnings. Proposed measures also call for greater scrutiny of exotic structures used by companies for speculative gains rather than for hedging their exposures.

19. At the same time, the RBI is reviewing existing guidelines and supervision standards for derivatives. Following the Mid-term Review of Annual Policy for the year 2006–07, the RBI plans to intensify supervision of banks’ exposure to derivatives beyond the annual inspection cycle and off-site monitoring through specified returns. OTC trading in currency derivatives could pose operational and credit risks related to trade confirmation, margining, and contract enforceability, which in turn could create systemic vulnerabilities in the absence of mutual risk-sharing mechanisms and prudential standards that maintain market integrity and limit externalities from counterparty default (see Box V.1). The proposed supervisory oversight structure for enhanced market surveillance includes stress testing of banks’ derivatives portfolios, particularly in view of banks resorting to multilateral netting of counterparty exposures in OTC markets, which are currently not subject to a supervisory process for settlement.

20. The RBI’s plans to revamp general supervision of derivatives complement efforts to move currency derivatives trading to organized exchanges. In 2006, the CFCAC had recommended that currency futures be introduced to enable market participants to better manage currency risk exposures, with risks contained through a more formal trading mechanism, structure of contracts, and regulatory environment. Following the Annual Policy Statement for the Year 2007–08 (April 2007), the RBI appointed an Internal Working Group on Currency Futures to study the international experience of exchange–traded currency derivatives (mostly in OECD countries) and suggest a suitable market structure consistent with the current legal and regulatory framework. The working group issued its draft report on November 15, 2007, recommending trading in currency futures on dedicated exchanges, with diversified ownership structure and market participation limited initially to resident entities only. The report also assigns supervisory responsibility to the RBI.

D. Analysis of Proposed Reforms

Greater Hedging Flexibility

21. The latest move by the RBI to allow greater flexibility of hedging activities is a step in the right direction, but whether it will spark much wider participation in currency derivatives markets remains a question. Current changes to documentation and exposure limits are expected to incrementally improve the flexibility of larger exporters to use hedging techniques. However, smaller participants might lack the expertise and may require other solutions, such as retail-friendly market access and centralized trading platforms for greater price transparency.

22. while more flexible use of options could help complete the derivatives market, it could also encourage hedging strategies that result in capital inflows. The current configuration of exchange rate expectations in India results in more long-hedgers than short-hedgers,12 which makes it difficult to complete derivatives markets. In this situation, the only way for all the long buyers to find short sellers is for speculators or arbitrageurs to take contrarian positions in the market, but such trading is limited by current regulations. Thus, hedgers would need to create synthetic long local currency positions to lay off the risk of taking short positions, creating temporary capital inflows.13 Creating a synthetic long position would involve (i) borrowing in a depreciating currency abroad, (ii) exchanging the funds into rupee in the spot market, and (iii) investing in rupee-denominated assets domestically. Such a money market hedge increases demand for external borrowing and temporarily inflates capital inflows (until the hedge is unwound). While RBI’s plans to allow hedgers to receive premium from writing covered call and put options could increase the supply of much needed short positions, the tendency to hedge these positions (or to speculate) determines the effect on capital inflows.

Introduction of Currency Futures

23. Both OTC and exchange-based trading forums may be needed for the development of a well-functioning foreign exchange market, provided that they are supported by adequate infrastructure. Plans to introduce currency futures markets should recognize the importance of a well-functioning electronic settlement and clearing system for effective monitoring of trading activity and efficient execution of trades, asset diversity, and a broad investor base. In particular, reaping the full benefits of foreign exchange derivatives requires careful management of risks arising from the mode of trading (see Box V.1).

24. OTC markets are essential for exporters and importers who need to hedge specific cash flows in a customized fashion. The bulk of currency trading in emerging markets occurs in OTC markets. However, OTC markets can also involve specific risks, including poor record keeping by intermediaries and inadequate arrangements for dealing with counterparty credit and settlement risk. In volatile environments, the disorderly unwinding of positions in OTC markets could be destabilizing. Customized products may also be costly and may shift excess risk to end users.

25. Exchange-based markets may be needed for institutional investors seeking to manage wholesale positions. More generally, derivatives trading without central clearing counterparties and full disclosure could raise system-wide vulnerabilities. Such vulnerabilities must be managed through appropriate prudential regulation and supervision of market participants, sound structuring and regulation of exchange-based trading, margin requirements, position and exercise limits, centralized clearing and settlement, mark to market requirements, market surveillance, mutualization of risks through loss-sharing arrangements, and capital deposits of members and international excess-of-loss insurance.

26. At the current stage of development, an exchange-traded currency derivatives market usefully complements the growing OTC market in India. Existing OTC derivatives trading in India lacks the centralized risk management and inherent transparency of exchanges. Exchange-based trading platforms can increase transparency, while measures for greater disclosure can provide additional information of importance to users, such as (i) enhanced monitoring and supervision of credit exposures, trading positions, and market movements, and (ii) prescriptive standards for internal risk management (credit and operational risk) based on real-time market monitoring of credit exposures, trading positions, and market movements to reduce information asymmetries.

27. The introduction of exchange-based currency derivatives in the form of currency futures would broaden demand for hedging facilities and increase transparency in foreign exchange markets. Currency futures contracts enhance price discovery in the spot market and improve the efficiency of OTC derivatives markets (forwards, options, and swaps) by providing pricing benchmarks and liquidity management facilities. The existing currency forward market is opaque and concentrated in interbank trading with high transaction charges. The migration of currency markets to exchanges will also allow automated trading strategies to establish high market efficiency and better-functioning spot and derivatives markets on currencies as well as interest rate and credit risks, integrated by arbitrage and liquid trading.

28. Existing trading platforms in the equity market could be an alternative to creating separate currency futures exchanges. The proposal to create dedicated exchanges should be assessed against the merits of adopting the design and risk management standards of stock exchanges in India. While fixed income trading in the government securities market is well advanced and could support futures trading through centralized clearing and settlement in compliance with the “Lamfalussy Standards,”14 a centralized limit order book with an electronic order matching—as in equity markets—might prove even more useful for currency trading, which involves large order flows for a few asset classes.15

29. Separate currency futures exchanges would fail to harness the economies of scale and scope of India’s established stock exchanges. India’s stock exchanges already have economies of scale, and currency futures trading could be woven into the existing infrastructure at low cost. Moreover, the trading platforms of both BSE and NSE, coupled with internet trading, would allow transparent market access at low cost through the country.

30. Market participation during the initial phase of currency futures trading might be narrow. According to the current proposal, only a standardized product will be offered across various exchanges (in terms of contract size, final settlement dates, settlement procedure, tenors, etc.) to encourage proper price discovery and facilitate retail participation. Although foreign institutional investors (FIIs) claim the lion’s share in domestic foreign exchange markets, the RBI intends to limit market access to residents in the initial phase, after which participation is expanded to include two categories of residents outside India—FIIs and NRIs-but only as hedgers through designated banks, subject to position limits.

31. The proposed regulations are ambiguous about the participation of domestic institutional investors and might fail to create complementary hedging interest. In existing currency derivatives markets in India, the exclusion of institutional investors (barring a few exceptions) limits counterparty lines and longer-term contracts. However, a broad and balanced investor base for genuine hedging is critical for effective derivatives markets.16 For example, commercial banks with short-term liabilities and long-term fixed-rate assets, and institutional investors with long-term liabilities, have complementary term structures, and therefore make natural counterparties in derivatives markets.

32. Recent experiences of other countries provide some perspective on market participation and trading infrastructure of currency futures markets. In June 2007, South Africa debuted foreign exchange futures trading on the Johannesburg Stock Exchange, allowing investors to trade rand futures in a regulated market for the first time. South Africa’s experience has informed many elements of the proposed implementation guidelines, such as the minimum contract size of US$1,000 for retail investors, limited product diversity17 and a greater retail focus than other currency derivatives markets. That said, there are several significant differences as regards market participation and trading infrastructure. Although the Internal Working Group on Currency Futures recommends that no quantitative restrictions may be imposed on residents to trade in currency futures, it is silent on the market participation of institutional investors. In South Africa, institutional investors are subject to the foreign allocation allowance18, and corporates need a special permission from the central bank to participate. In addition, currency futures in South Africa are traded separately using the same infrastructure as the existing interest rate exchange.

E. General Policy Implications

33. India’s commitment to greater capital account openness requires broader and deeper financial markets, including greater availability and flexibility of currency hedging facilities. Developing currency derivatives markets with greater size, diverse product profiles, and enhanced infrastructure would be crucial to provide domestic entities with the tools they need to manage the risks associated with an open capital account. In this connection, early steps to strengthen financial supervision and gradual financial liberalization can complement the development of currency derivatives markets. In Australia, for example, there was an initial period of exchange rate volatility following the liberalization of the forward markets, though the market matured soon (see Box V.2). While an earlier strengthening of supervision and more cautious steps in liberalizing transactions could have eased the macroeconomic side effects, the speed of development of the financial markets, in particular those for hedging, would likely have been slower.

34. Development of currency derivatives markets would likely cause the offshore market to wither.19 This would not necessarily be problematic, as by nature, offshore nondeliverable forward (NDF) markets are difficult to regulate fully and are less transparent than onshore markets. Moreover, given higher transactions costs, they are less useful to smaller investors.

35. The current regulatory framework for hedging activities would need to allow two-sided markets to develop, with a diverse and balanced investor base. Regulatory guidelines should be flexible enough to establish symmetry of the demand for hedging and the supply of risk protection through counterparty lines, in transparent markets and with low barriers to entry for small investors. Policies should allow participants in the market to sell derivatives and encourage foreign participation. Regulators should allow short sales and fails, and allow market participants to take positions without having the underlying security.

36. Establishing greater transparency and improving the infrastructure of OTC currency derivatives markets will facilitate the introduction of currency futures. Many prudential mechanisms of derivatives exchanges are now being used in OTC derivatives markets, most notably requiring collateral and allowing only highly rated entities to engage in OTC transactions, using close–out netting for central, multilateral clearing and settlement (which limit the risk that a defaulting counterparty will demand payment on contracts that are in his favor while refusing to pay those on which he owes money), and copying disclosure practices used for futures markets. Other measures include: (i) central counterparties with strong risk management systems, including capital rules and collateral requirements (for example through margining) as well as membership rules, (ii) the promotion of intermediaries as both market makers providing two–way quotes and settlement agents collecting and paying the financial obligations, and (iii) market provisions that limit externalities from the default of a systemically important counterparty.

Over-the-Counter (OTC) vs. Exchange-Traded Derivatives (ETD)—the Most Salient Differences

All exchange-based trading of derivatives is governed by rules designed to ensure market stability and financial integrity for the purpose of safeguarding the collective interest of market participants. While orderly market rules and prudential measures govern conduct, mutualize risk, and impose limits on leverage and margining, formalized risk management regulations on the soundness, disclosure, and transparency of individual positions, limits and transactions promote investor protection and ensure market integrity against the threat of manipulation when supplies of underlying assets are limited (IMF, 2000).1/

In contrast, OTC derivatives are traded in an informal network of bilateral relationships without (i) formal centralized limits on individual positions, leverage, or margining, (ii) collective risk—and burden sharing, and (iii) prudential rules or mechanisms to ensure market stability and integrity. The operational aspects trading, clearing and settlement are decentralized and credit risk management is located within individual institutions. Counterparties prefer to deal only with highly rated and well capitalized intermediaries to minimize counterparty risk. The concentration of OTC derivatives in major financial institutions entails lower transaction cost and information asymmetries than ETD. Although OTC instruments are essentially unregulated, they are affected indirectly by national legal systems, regulations, banking supervision and market surveillance. Nonetheless, the absence of formal requirements of disclosure and limits on positions and trades does not bode well for the preservation of collective interest in times of stress.

The flexibility of contract structures in OTC markets cuts both ways. While OTC trading can be efficiency enhancing as participants deliberately choose the upside potential of lower transaction cost and customization over the downside risk of contract failure in bilateral transactions, lightly and only indirectly regulated trading is also prone to induce financial instability and may trigger system-wide failures. That said, the benefit of OTC depends on how market participants manage some of the most acute risks from the absence of centralized clearing, such as (i) difficulties in the complete elimination of confirmation backlogs, (ii) deficient post-default settlement protocols, and (iii) the prospect of market risk from multiple defaults that could overwhelm the existing settlement infrastructure and undermine the efficacy of risk transfer in general.

There are practical means to curb concerns about systemic vulnerabilities in OTC markets through the introduction of centralized mechanisms for the mitigation of counterparty risk. Remedial prudential standards to improve the stability of OTC markets aim at the prevention of manipulation and coordination failure, such as the introduction of the widely accepted ETD market practice of “circuit breakers” and price limits for trading, as well as requirements of OTC dealers to act as market makers by maintaining binding bid and offer quotes throughout the day to prevent dealers from market withdrawal at times of stress.

1/Note, however, that the risk of manipulation in OTC markets is limited by the extent to which contracts serve a price discovery role as do ETDs.

The Australian Experience of Developing Foreign Exchange Derivatives Markets

Prior to floating the Australian dollar in December 1983, the exchange rate policy was underpinned by a comprehensive system of exchange controls on the capital account. There was little demand for hedging. Forward markets were only allowed on trade–related transactions. Most of the capital account transaction risk was transferred to the central bank. The NDF market developed out of the necessity to manage risk from increased volatility of major currencies in early 1970s (IMF, 2005).

Establishment of the government securities market underpinned the development of money markets, which, together with a liberalization of foreign portfolio investment in 1980, laid the foundation for a well functioning currency market. In a preparatory step, restrictions on trading in the forward market were eased in October 1983, which helped to deepen trading in advance of the float.

The subsequent floating of the Australian dollar made it possible to liberalize capital flows and the financial system. A lesson from the Australian experience suggests that strengthening bank supervision earlier in the process would have been useful (Australian Treasury, 2003). Perhaps more gradual liberalization of the capital account and the financial system could have eased the macroeconomic side effects, but the development of key financial markets, such as those in currency hedging instruments, would likely have slowed.

Currency hedging is now extensive, reducing vulnerability to exchange rate fluctuations. Private sector experience with a floating currency reinforced by corporate disclosure requirements and prudential regulations, increased demand for hedging instruments to manage foreign exchange risk. Markets in these instruments have become deep, with turnover in forwards, swaps, and derivatives being 2½ times that in the spot market (BIS, 2005).

In 2001, Australia introduced derivatives regulations as part of an exhaustive regulatory overhaul of the entire financial services sector according to the Wallis Inquiry.1/ The principal purpose of this reform was to introduce uniform licensing and disclosure requirements for the provision of all financial products, including derivatives, within Australia. A generic legislative definition of derivatives has been adopted, bringing within the scope of this regulation, all derivatives transacted within Australia, regardless of the nature of the parties to the derivatives transaction and whether the derivatives have been transacted on an exchange or in the over-the-counter markets.

1/In 1997, the so-called Wallis Inquiry recommended the creation of a flexible and effective regulatory structure that would inter alia address how financial innovation and expanding consumer needs are changing the financial system of Australia. By 2001, many of its recommendations have now been implemented. As a result of those recommendations new institutions have been created or already established institutions have been reorganized. APRA is one such new institution created to regulate the financial services industry sector of Australia.

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1

Prepared by Andreas Jobst, MCM-CD.

2

A “derivative” is a financial contract whose value derives from one or more underlying reference assets, such as securities or market indices, with settlement at a future date.

3

Spot and derivatives.

4

About 50 percent of the CCIL-settled volume constitutes spot trades, while the remainder is accounted for by swap contracts (cash vs. TOM (tomorrow) or cash vs. forward).

5

The daily turnover of forwards is similar to stock futures, the most frequently traded, noncurrency derivative asset class.

6

The netting factor denotes the reduction of individual fund obligations (arising from every trade) to a single net fund obligation after multilateral offsetting of all outstanding positions.

7

For FDI investors, forwards are permitted to hedge exchange rate risk on (i) the market value of investments made in India since January 1, 1993 (ii) dividends receivable on the investments in Indian companies, and (iii) proposed investment in India.

8

The RBI is also the official supervisory authority for interest rate and credit derivatives.

9

However, according to current proposals, the use of currency swaps by corporates is limited to hedging purposes for genuine long-term foreign currency exposures only. Market participants express concerns that the new regulation hampers some existing products, such as swaptions and short-term currency derivatives corporates use to hedge their currency exposures. Currently, 30–40 percent and 25 percent of existing currency hedging occurs within the one- to three-year basket respectively.

10

Moreover, the process of booking cancellation and rebooking of forward contracts has been improved, and exporters and importers are also allowed to book forward contracts based on past performance.

11

Hedging facilities can only be offered by banks that maintain an ongoing credit relationship with the SME and should be commensurate with the turnover of the SME.

12

The term “long” refers to an investment position that is equivalent to holding the local currency. “Long” is what one owns or buys, and “short” is what one owes or sells.

13

This assumes that dealers maintain a flat (neutral with respect to exchange rate risk) or nearly flat book of positions.

14

The “Lamfalussy Standards” of the European Central Bank define six minimum standards for the design and operation of cross-border, multi-currency netting schemes or systems (see http://www.ecb.int/home/glossary/html/glossm.en.html).

15

The National Stock Exchange (NSE) offers an electronic order book with open access for financial firms and retail customers, and the elimination of counterparty risk via the National Securities Clearing Corporation (NSCC) as central clearinghouse.

16

Along with flaws in security design, limits on market access were a main cause of the unsuccessful 2003 launch of interest rate futures in India.

17

The futures market in South Africa started with U.S. dollar/rand trading, adding Euro and pound sterling at a later date.

18

Pension funds and insurance companies are subject to a 15 percent foreign allocation allowance, in line with exchange control regulations. Asset managers and registered collective investment funds are limited to a 25 percent foreign allocation.

19

In Poland, for example, when foreign exchange swap operations were liberalized in 1998, a deep domestic swap market developed quickly, squeezing out the vibrant offshore NDF market for zloty in London.

India: Selected Issues
Author: International Monetary Fund
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    Fx Derivatives Markets in Selected EM Countries 1/

    (Annual trading volume, notional amounts in billions of U.S. Dollars)

  • View in gallery

    Fx Derivatives Markets in Selected EM Countries 1/

    (Annual trading volume relative to GDP, in percent)

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    India: Tenorwise Settlement of Forward Fx Trades

    (Share, in percent of total value)

  • View in gallery

    India: Analysis of Traditional Fx Trades by Trade type

    (Share, in percent of total value)

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    India: Analysis of Traditional Fx Trades by Volume

    (Annual volume, in billions of U.S. Dollars)

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    India: Analysis of Fx and Forward Trades by Category

    (As of end-October 2007, buy-side)