TOWARDS A STABLE, SECURE AND SUSTAINABLE INDIAN MARKET
Submitted
To
UNNATI-08
School of Management Studies
University of Hyderabad
Prepared
By
Ashish Bhagat
Sasmit Kumar Sahu
(Students of MBA Finance
Christ College Institute of Management
Bangalore)
Email: ashish.bhagat1@gmail.com
sasmitksahu@gmail.com
Mobile No. – 9886820900, 9945104327
Abstract
For the sole purpose of the study, the Indian Market has been subdivided into four segments - Capital Market, Forex Market, Debt Market & Financial Services market. The paper tries to highlight the need for stability, security & sustainability in the context of Indian market. The study also shows the reasons that have made the Indian market vulnerable to various external & internal risk factors. It deals with some of the contemporary issues vis-à-vis the global market scenario. It specially focuses on some of the regulatory norms pertaining to these markets, which questions the role of the regulatory bodies. The coupling of the Indian indices with various global indices has changed the face of the capital market due to increased foreign investments. The Insurance & Mutual Fund Industry is not mature enough to provide a potential investment alternative. The recent crash of bond prices shows that even the most secure Bond market is also not free from the epidemic of volatility. The volatile exchange rate due to unpredictable capital flow has exposed some major sectors to a higher exchange rate risk. It also shows the ways to use India’s huge Foreign Exchange Reserve efficiently. Also emphasis has been laid on the measures to make the markets a safe heaven for all the stakeholders.
Adam Smith once said the group does its best when each individual does his best. Incomplete - The group does its best when each individual does best for himself as well as for the group.
In parlance to this Indian Financial system will perform better if all the financial sectors do good for themselves as well as contribute together to build a secure, stable & sustainable Indian Market. A market is a place where risk can be shared by many people. For the sole purpose of our study the market has been divided into four segments, discussed in the paper.
Capital Market
The roughly 3,000 firms that are traded in India have a market value of Rs 57 lakh crore. Taking corporate bonds into account, the market has a value of roughly Rs 65 lakh crore, and the total turnover exceeds Rs.1 lakh crore per day on most days. This market has become the foundation of financing for India's corporations and is thus central to India's growth prospect.
Still Capital market of India can safely be called to be in its nascent stage in comparison with global standards. India stands at number 10th with market capitalization of more than US $1,090 billion. (see exhibit 1)
Irrational Exuberance
The ups and downs of the financial markets are always in the news. There is plenty to report. Wide price fluctuations are a daily occurrence on the Indian stock markets as investors react to economic, business, psychological and political events. Of late, the markets have been showing extremely erratic movements, which are in no way tandem with the information that is fed to the markets. The reaction to negative news is many times more than the reaction to positive news, which can be observed in any stock market index. (see exhibit 2) The reversal since January 10 shaved 16 per cent off the BSE Sensex, with many stocks losing much higher value.
There are two schools of thought that have divergent views on the reasons of volatility. The economists in their fundamentalist approach argue that these market movements can be explained entirely by the information that is provided to the market.
Others have argued that these movements have nothing to do with economic or external factors. It is the investor reactions, due to psychological or speculative motive, which exert a greater influence on the markets.
But our study shows that both are major contributors to the volatility prevailing in the Indian Capital Market.
Factors responsible for Volatility
i) IPO rating
Soon SEBI will be introducing IPO rating system, where all IPOs before floating in the market has to be rated by a rating agency. Though the motive behind this decision is investor protection, but our prediction says this will increase market volatility. The investors will relatively put more money in the IPO which has been rated higher to make listing gains & for other psychological reasons. The IPO which has been rated higher that can charge a high premium price as well. Hence the sell off will be huge on the first day of listing, which will contribute to the volatility. And because of not having a good rating many good IPOs may not perform well.
ii) Foreign Flow
It has been rightly said that the Indian indices are at the mercy of FIIs. The coupling of Indian indices with global indices has made the market more volatile. (see exhibit 3 & 4)Though the volume of purchase has gone up in the last 3 months, so as the sale, keeping the net investment almost same. This gives us an indication that the major chunk of the investment is for speculation purpose which makes the market more volatile.
iii) Insider Trading
Insiders in several small and mid sized companies did manage to offload shares just before the correction struck, with insiders “sells” exceeding insider “buys” during the correction period. During the week before the crash (when stocks were at or near life-time highs in some cases) 35 such insider trades were struck, two-thirds of which were sale transactions. Insiders make the severity of volatility more. Though it cant be stopped but real time reporting of these transactions should be done to SEBI, so that the market can keep be cautious.
iv) Grey Market
There are many vibrant under the rug grey markets exist, which is a parallel unofficial stock market. They operate both in primary & secondary market. This gives a wide scope for speculation contributing to severe volatility.
v) Dematerialization
One of the major steps of SEBI, was to introduce dematerialization of stocks, which reduced the bad deliveries in the stock market. This also had the added benefit of faster share delivery, which was reduced drastically from 45 days to 21 days. This reduced the inventory period for stocks during delivery. This results in higher circulation and lead to increase in the availability of stocks for trading. Thus the coupled affect of reduced inventory period and reduced bad delivery risk lead to higher volatility.
vi) Rolling Settlement
Rolling settlement was introduced to reduce the speculative activities, which ultimately increased capacity. This might be due to the free-fall in the share prices that occurred after the introduction of rolling settlement.
vii) The information boom
It has helped to provide information on stock movement round the clock. This has resulted in markets adjusting to such information faster than before which in turn increase market volatility. The information technology & Internet boom has resulted in real time information processing which makes the process faster & the index volatile.
Measures to Make the Capital Market Stable, Secure and Sustainable
i) Concept of Tobin Tax
If stock markets had shock absorbers, they would have a system to curb speculative profits and losses. When speculative profits are restricted, volatility will come down automatically. We need a tax law, can be called the stock market shock observer that penalizes those who make unearned profits by speculation. Nobel Prize winner Professor Tobin proposed a tax to curb currency speculation in international markets.
The Tobin Tax — a levy on the fluctuations in stock prices, should be equally effective in stabilizing stock markets. Then, every one who sells high (or buys low) pays a tax. That tax will become a disincentive to push prices too high or too low. Tobin Tax has never been accepted possibly because powerful vested interests make a lot of unearned money by speculation.
It is possible that sometime in the future, some Finance Minister will put into practice Professor Tobin’s idea. We may have to wait till that time for an equivalent of Tobin Tax to be imposed on stock market speculation too. The Finance Minister can do much more to reduce financial volatility than he realizes.
ii) Transparent Money Flow
The ban on the Offshore Derivative on participatory Notes was a move taken in the right direction. The country should receive only those funds that are accounted for and is transparent about the investor. It can be observed from exhibit 4 that a major chunk of the fund is used for speculation & the real net investment is very low. Hence the speculation done by FIIs should be discouraged with the help of instruments like Tobin tax.
iii) Low value derivatives.
The mini contract will definitely add further liquidity in the market, as more number of investors can trade with low value & volume. Such more steps has to be taken by exchanges with the cooperation of the regulator that will increase liquidity in the market, which will reduce the severity of volatility, as fair price discovery will be easy.
iv) Depth & Width
In a stable & secure market no single entity should be able to influence the market. The market should have depth & width as well. No market is perfect but should strive for perfection. The reservation of 30% in an IPO for retail investors has been a right move in this direction.
The market regulators have been trying their best to curb these speculative uprising but have not been able to keep it in control so far. We believe that such bubbles cannot be curbed by imposing circuit breakers or margins but by allowing free trade, new products & market expansion. A more analytical media reporting which highlights better risk management coupled with investor learning will surely lead to more stable market.
FOREX MARKET
India maintains an official policy of a managed float with no target or preannounce path for the exchange rate. Consistent with this, there has been significant flexibility in the exchange rate, although volatility has increased over time, but now it is at a level on par with that of other large emerging markets countries.
In nominal bilateral terms vis-a-vis the dollar, the appreciation has been particularly notable, reaching successive nine-year highs as it rose about 12 percent.
Amid sharply rising capital inflows, the Reserve Bank of India has intervened with the stated aim to smooth volatility in the exchange rate. During January–October 2007, intervention amounted to about $64 billion, consisting of purchases of foreign currency. This represents a sizeable increase over 2005 and 2006, when intervention through October registered around $15 billion. During 2007, intervention has been highly variable from month to month, ranging from under $2 billion (in August) to over $12 billion (in October) but has consisted entirely of purchases:
The appreciation of the rupee appears to be largely an equilibrium phenomenon.
Consistent with this, the rupee does not appear to be out of line with medium-term macroeconomic fundamentals. Export performance has remained favorable, underpinned by structural improvements in the export sector, and more broadly by strong productivity
growth. While intervention has risen in tandem with swelling capital inflows, empirical```
evidence suggests that intervention has served to dampen the volatility in the rupee, rather than to influence the level or rate of change in the currency. Going forward, continued efforts to maintain strong productivity growth, while allowing due flexibility in the currency, would be the best way to cope with any pressures on competitiveness likely to arise from any emergent currency appreciation pressures.
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.
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.
Despite the surge in currency derivatives trading, it lags that in other major emerging economies. At end-2007, the daily gross volume of currency derivatives turnover represented less than 20 percent of all foreign exchange trades in India. (See Exhibit 5)
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).
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. Options trading remains nascent, with trading around US$400 million daily.
REGULATORY FRAMEWORK
The currency derivatives market is regulated by the RBI, which issued comprehensive guidelines on derivatives in April 2007. 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.
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. Regulatory efforts are underway to widen the domestic derivatives market, with a view to facilitating onshore currency hedging in India. The RBI recent raised hedging limits for documented exposures as the first measure in series of regulatory reforms.
Greater Hedging Flexibility
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 is not a surety. While more flexible use of options could help complete the derivatives market, it could also encourage hedging strategies that result in capital inflows.
Introduction of Currency Futures
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. OTC markets are essential for exporters and importers who need to hedge specific cash flows in a customized fashion.
Exchange-based markets may be needed for institutional investors seeking to manage wholesale positions.At the current stage of development, an exchange-traded currency derivatives market usefully complements the growing OTC market in India.
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.Existing trading platforms in the equity market could be an alternative to creating separate currency futures exchanges.
Separate currency futures exchanges would fail to harness the economies of scale and scope of India’s established stock exchanges. Market participation during the initial phase of currency futures trading might be narrow.
Currency derivatives can provide important benefits for financial systems.
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.
Currency derivatives markets are particularly important for countries like ours 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.
Debt market
It has been rightly said that the debt market in India though has width but does not have depth. More than 90% of the market is dominated by government Bonds & treasury bills. Corporate bonds account for less that 2%. Retail investor participation is restricted to 5% only. The secondary market has also not full fledged like secondary equity market. Debt market is a shock observer or safety net for institutional investors that take high financial risks. Recently the bond market has also seen volatility because of the interest rate fluctuations & the recent SLR status statement.
Recommendations
i) Time & cost of public issuance should be reduced
ii) Simplify disclosure and listing for private placement.
iii) Encourage retail investors to participate through mutual funds and exchanges if preferred.
iv) Increase transparency by ensuring all trades are reported, especially OTC trades.
v) Upgrade procedures of DVP to international standard.
vi) Widen investor base.
Banking Sector
The sector that that binds all other financial sectors is the banking sector. The stability of the entire financial market depends on how stable & sustainable the banking sector is. The recent Sub prime collapse has lead to a wakening call for all the financial institutions all round the globe and has laid emphasis on use of Basel-II norms for giving loans. Basel-II is based on the following three pillars.
The first pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk.
The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.
The third pillar
The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.
Mutual Fund & Insurance Sector
Indian indices should not move at the mercy of the foreign investments. For that the Domestic Institutional Investors have to be big enough. Mutual Fund & Insurance in India has not reached that level of maturity to dominate the indices. They should be big enough to provide healthy alternative investment opportunity to the retail investors to do passive trading. And also should be able to provide perfect diversification & hedging to minimize various financial risks. And also should be able to come for rescue when the indices start moving southward. The current AUM of mutual Fund industry is at more than Rs 4.68 lakh crore.
Submitted
To
UNNATI-08
School of Management Studies
University of Hyderabad
Prepared
By
Ashish Bhagat
Sasmit Kumar Sahu
(Students of MBA Finance
Christ College Institute of Management
Bangalore)
Email: ashish.bhagat1@gmail.com
sasmitksahu@gmail.com
Mobile No. – 9886820900, 9945104327
Abstract
For the sole purpose of the study, the Indian Market has been subdivided into four segments - Capital Market, Forex Market, Debt Market & Financial Services market. The paper tries to highlight the need for stability, security & sustainability in the context of Indian market. The study also shows the reasons that have made the Indian market vulnerable to various external & internal risk factors. It deals with some of the contemporary issues vis-à-vis the global market scenario. It specially focuses on some of the regulatory norms pertaining to these markets, which questions the role of the regulatory bodies. The coupling of the Indian indices with various global indices has changed the face of the capital market due to increased foreign investments. The Insurance & Mutual Fund Industry is not mature enough to provide a potential investment alternative. The recent crash of bond prices shows that even the most secure Bond market is also not free from the epidemic of volatility. The volatile exchange rate due to unpredictable capital flow has exposed some major sectors to a higher exchange rate risk. It also shows the ways to use India’s huge Foreign Exchange Reserve efficiently. Also emphasis has been laid on the measures to make the markets a safe heaven for all the stakeholders.
Adam Smith once said the group does its best when each individual does his best. Incomplete - The group does its best when each individual does best for himself as well as for the group.
In parlance to this Indian Financial system will perform better if all the financial sectors do good for themselves as well as contribute together to build a secure, stable & sustainable Indian Market. A market is a place where risk can be shared by many people. For the sole purpose of our study the market has been divided into four segments, discussed in the paper.
Capital Market
The roughly 3,000 firms that are traded in India have a market value of Rs 57 lakh crore. Taking corporate bonds into account, the market has a value of roughly Rs 65 lakh crore, and the total turnover exceeds Rs.1 lakh crore per day on most days. This market has become the foundation of financing for India's corporations and is thus central to India's growth prospect.
Still Capital market of India can safely be called to be in its nascent stage in comparison with global standards. India stands at number 10th with market capitalization of more than US $1,090 billion. (see exhibit 1)
Irrational Exuberance
The ups and downs of the financial markets are always in the news. There is plenty to report. Wide price fluctuations are a daily occurrence on the Indian stock markets as investors react to economic, business, psychological and political events. Of late, the markets have been showing extremely erratic movements, which are in no way tandem with the information that is fed to the markets. The reaction to negative news is many times more than the reaction to positive news, which can be observed in any stock market index. (see exhibit 2) The reversal since January 10 shaved 16 per cent off the BSE Sensex, with many stocks losing much higher value.
There are two schools of thought that have divergent views on the reasons of volatility. The economists in their fundamentalist approach argue that these market movements can be explained entirely by the information that is provided to the market.
Others have argued that these movements have nothing to do with economic or external factors. It is the investor reactions, due to psychological or speculative motive, which exert a greater influence on the markets.
But our study shows that both are major contributors to the volatility prevailing in the Indian Capital Market.
Factors responsible for Volatility
i) IPO rating
Soon SEBI will be introducing IPO rating system, where all IPOs before floating in the market has to be rated by a rating agency. Though the motive behind this decision is investor protection, but our prediction says this will increase market volatility. The investors will relatively put more money in the IPO which has been rated higher to make listing gains & for other psychological reasons. The IPO which has been rated higher that can charge a high premium price as well. Hence the sell off will be huge on the first day of listing, which will contribute to the volatility. And because of not having a good rating many good IPOs may not perform well.
ii) Foreign Flow
It has been rightly said that the Indian indices are at the mercy of FIIs. The coupling of Indian indices with global indices has made the market more volatile. (see exhibit 3 & 4)Though the volume of purchase has gone up in the last 3 months, so as the sale, keeping the net investment almost same. This gives us an indication that the major chunk of the investment is for speculation purpose which makes the market more volatile.
iii) Insider Trading
Insiders in several small and mid sized companies did manage to offload shares just before the correction struck, with insiders “sells” exceeding insider “buys” during the correction period. During the week before the crash (when stocks were at or near life-time highs in some cases) 35 such insider trades were struck, two-thirds of which were sale transactions. Insiders make the severity of volatility more. Though it cant be stopped but real time reporting of these transactions should be done to SEBI, so that the market can keep be cautious.
iv) Grey Market
There are many vibrant under the rug grey markets exist, which is a parallel unofficial stock market. They operate both in primary & secondary market. This gives a wide scope for speculation contributing to severe volatility.
v) Dematerialization
One of the major steps of SEBI, was to introduce dematerialization of stocks, which reduced the bad deliveries in the stock market. This also had the added benefit of faster share delivery, which was reduced drastically from 45 days to 21 days. This reduced the inventory period for stocks during delivery. This results in higher circulation and lead to increase in the availability of stocks for trading. Thus the coupled affect of reduced inventory period and reduced bad delivery risk lead to higher volatility.
vi) Rolling Settlement
Rolling settlement was introduced to reduce the speculative activities, which ultimately increased capacity. This might be due to the free-fall in the share prices that occurred after the introduction of rolling settlement.
vii) The information boom
It has helped to provide information on stock movement round the clock. This has resulted in markets adjusting to such information faster than before which in turn increase market volatility. The information technology & Internet boom has resulted in real time information processing which makes the process faster & the index volatile.
Measures to Make the Capital Market Stable, Secure and Sustainable
i) Concept of Tobin Tax
If stock markets had shock absorbers, they would have a system to curb speculative profits and losses. When speculative profits are restricted, volatility will come down automatically. We need a tax law, can be called the stock market shock observer that penalizes those who make unearned profits by speculation. Nobel Prize winner Professor Tobin proposed a tax to curb currency speculation in international markets.
The Tobin Tax — a levy on the fluctuations in stock prices, should be equally effective in stabilizing stock markets. Then, every one who sells high (or buys low) pays a tax. That tax will become a disincentive to push prices too high or too low. Tobin Tax has never been accepted possibly because powerful vested interests make a lot of unearned money by speculation.
It is possible that sometime in the future, some Finance Minister will put into practice Professor Tobin’s idea. We may have to wait till that time for an equivalent of Tobin Tax to be imposed on stock market speculation too. The Finance Minister can do much more to reduce financial volatility than he realizes.
ii) Transparent Money Flow
The ban on the Offshore Derivative on participatory Notes was a move taken in the right direction. The country should receive only those funds that are accounted for and is transparent about the investor. It can be observed from exhibit 4 that a major chunk of the fund is used for speculation & the real net investment is very low. Hence the speculation done by FIIs should be discouraged with the help of instruments like Tobin tax.
iii) Low value derivatives.
The mini contract will definitely add further liquidity in the market, as more number of investors can trade with low value & volume. Such more steps has to be taken by exchanges with the cooperation of the regulator that will increase liquidity in the market, which will reduce the severity of volatility, as fair price discovery will be easy.
iv) Depth & Width
In a stable & secure market no single entity should be able to influence the market. The market should have depth & width as well. No market is perfect but should strive for perfection. The reservation of 30% in an IPO for retail investors has been a right move in this direction.
The market regulators have been trying their best to curb these speculative uprising but have not been able to keep it in control so far. We believe that such bubbles cannot be curbed by imposing circuit breakers or margins but by allowing free trade, new products & market expansion. A more analytical media reporting which highlights better risk management coupled with investor learning will surely lead to more stable market.
FOREX MARKET
India maintains an official policy of a managed float with no target or preannounce path for the exchange rate. Consistent with this, there has been significant flexibility in the exchange rate, although volatility has increased over time, but now it is at a level on par with that of other large emerging markets countries.
In nominal bilateral terms vis-a-vis the dollar, the appreciation has been particularly notable, reaching successive nine-year highs as it rose about 12 percent.
Amid sharply rising capital inflows, the Reserve Bank of India has intervened with the stated aim to smooth volatility in the exchange rate. During January–October 2007, intervention amounted to about $64 billion, consisting of purchases of foreign currency. This represents a sizeable increase over 2005 and 2006, when intervention through October registered around $15 billion. During 2007, intervention has been highly variable from month to month, ranging from under $2 billion (in August) to over $12 billion (in October) but has consisted entirely of purchases:
The appreciation of the rupee appears to be largely an equilibrium phenomenon.
Consistent with this, the rupee does not appear to be out of line with medium-term macroeconomic fundamentals. Export performance has remained favorable, underpinned by structural improvements in the export sector, and more broadly by strong productivity
growth. While intervention has risen in tandem with swelling capital inflows, empirical```
evidence suggests that intervention has served to dampen the volatility in the rupee, rather than to influence the level or rate of change in the currency. Going forward, continued efforts to maintain strong productivity growth, while allowing due flexibility in the currency, would be the best way to cope with any pressures on competitiveness likely to arise from any emergent currency appreciation pressures.
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.
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.
Despite the surge in currency derivatives trading, it lags that in other major emerging economies. At end-2007, the daily gross volume of currency derivatives turnover represented less than 20 percent of all foreign exchange trades in India. (See Exhibit 5)
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).
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. Options trading remains nascent, with trading around US$400 million daily.
REGULATORY FRAMEWORK
The currency derivatives market is regulated by the RBI, which issued comprehensive guidelines on derivatives in April 2007. 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.
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. Regulatory efforts are underway to widen the domestic derivatives market, with a view to facilitating onshore currency hedging in India. The RBI recent raised hedging limits for documented exposures as the first measure in series of regulatory reforms.
Greater Hedging Flexibility
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 is not a surety. While more flexible use of options could help complete the derivatives market, it could also encourage hedging strategies that result in capital inflows.
Introduction of Currency Futures
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. OTC markets are essential for exporters and importers who need to hedge specific cash flows in a customized fashion.
Exchange-based markets may be needed for institutional investors seeking to manage wholesale positions.At the current stage of development, an exchange-traded currency derivatives market usefully complements the growing OTC market in India.
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.Existing trading platforms in the equity market could be an alternative to creating separate currency futures exchanges.
Separate currency futures exchanges would fail to harness the economies of scale and scope of India’s established stock exchanges. Market participation during the initial phase of currency futures trading might be narrow.
Currency derivatives can provide important benefits for financial systems.
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.
Currency derivatives markets are particularly important for countries like ours 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.
Debt market
It has been rightly said that the debt market in India though has width but does not have depth. More than 90% of the market is dominated by government Bonds & treasury bills. Corporate bonds account for less that 2%. Retail investor participation is restricted to 5% only. The secondary market has also not full fledged like secondary equity market. Debt market is a shock observer or safety net for institutional investors that take high financial risks. Recently the bond market has also seen volatility because of the interest rate fluctuations & the recent SLR status statement.
Recommendations
i) Time & cost of public issuance should be reduced
ii) Simplify disclosure and listing for private placement.
iii) Encourage retail investors to participate through mutual funds and exchanges if preferred.
iv) Increase transparency by ensuring all trades are reported, especially OTC trades.
v) Upgrade procedures of DVP to international standard.
vi) Widen investor base.
Banking Sector
The sector that that binds all other financial sectors is the banking sector. The stability of the entire financial market depends on how stable & sustainable the banking sector is. The recent Sub prime collapse has lead to a wakening call for all the financial institutions all round the globe and has laid emphasis on use of Basel-II norms for giving loans. Basel-II is based on the following three pillars.
The first pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk.
The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.
The third pillar
The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.
Mutual Fund & Insurance Sector
Indian indices should not move at the mercy of the foreign investments. For that the Domestic Institutional Investors have to be big enough. Mutual Fund & Insurance in India has not reached that level of maturity to dominate the indices. They should be big enough to provide healthy alternative investment opportunity to the retail investors to do passive trading. And also should be able to provide perfect diversification & hedging to minimize various financial risks. And also should be able to come for rescue when the indices start moving southward. The current AUM of mutual Fund industry is at more than Rs 4.68 lakh crore.
Reference:
1) Prof. Ajay Shah’s blog - http://ajayshahblog.blogspot.com/
2) Prasanna Chandra(2004), Financial management Theory & Practice, page 22 -36
3) http://www.rbi.org.in/statistics
4) http://www.sebi.gov.in/
5) http://www.amfiindia.com/
6) http://www.moneycontrol.com/
7) http://www.economywatch.com/
8) P.V. INDIRESAN, Shock Absorver-article appeared in Business Line on February 4th, 2008
9) http://www.imf.org/
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