On December 9, the Reserve Bank of India declared its intent to intervene in the currency derivatives market on India’s exchanges. This has caused much speculation in the media over whether the RBI feels that there is excessive speculation in this market or expects increased rupee volatility ahead of a rate hike by the US Federal Reserve.
As these speculative mind games unravelled, I was reminded of a lunch conversation in Mumbai on December 7 with Larry Summers, the Treasury Secretary of the US, during Bill Clinton’s presidency. He had been informed by officials of India’s stock exchanges that their currency derivatives volumes have grown at a compounded rate of 30 per cent over the last five years. In his trademark repartee, he quipped, “Why should that be the case when India’s external trade has not grown that rapidly?”
De-linked from trade
Currency derivatives are products intended primarily for businesses in the areas of import and export to hedge their currency risks. Institutions dealing in foreign capital flows are the other large consumers of currency derivative products. India’s share of world trade in dollar terms has ranged between 1.7 per cent in 2009 and 2.4 per cent in 2014. India’s share of global exchange-traded currency derivatives volumes has ranged from 30 per cent to 70 per cent in this period. This is not to imply a need for a tight relationship between external trade and currency derivatives volumes in any economy. In 2014, Indian exchanges traded 800 million currency derivatives contracts of the total of two billion traded on exchanges across the world — 40 per cent of all volumes.
Currency derivatives traded on India’s exchanges in 2014 was five times more than on the Chicago Mercantile Exchange in the US, whose share of world trade was 12 per cent. Trading in currency derivatives on India’s exchanges started in 2008. Within three full years of operations, India’s exchanges traded 2.5 times more currency derivatives than all the other exchanges across the world combined. But all these extravagant numbers are in volume terms, i.e. numbers of contracts traded. In dollar terms, India’s exchange-traded currency derivatives constitute only 2-4 per cent of global market, in line with its share of world trade. So, it’s a curious case of a large number of small value currency derivative contracts exchanging hands on a daily basis on India’s exchanges.
Authorised dealers who trade for their own account (proprietary traders) constitute 60 to 70 per cent of all such currency derivatives volumes . Retail individual investors contribute another 10 to 12 per cent. Thus, proprietary traders and retail investors together constitute 70-80 per cent of all currency derivatives volumes. Corporates presumably involved in foreign trade and banks involved in foreign capital flows constitute only 20-30 per cent of the volumes. Evidently, the RBI suspects that such large volumes of transactions by retail and proprietary investors are more speculative in nature than intended to hedge underlying rupee risks of businesses. There seems to be prima facie evidence for the RBI’s suspicion of excessive speculative activity in India’s exchange-traded currency derivatives market.
The intent to curb this speculation in the rupee perhaps explains the RBI’s recent move to intervene in the exchange-traded currency derivatives markets. One could argue that speculation is essential for markets to function efficiently. This, in principle, is the big challenge confronting modern finance. In the absence of a defined Lakshman Rekha to separate the essential from the excess, regulators have to use their discretion and make policy judgments to curb what they deem as excesses.