By Ajay Shah, on December 2nd, 2011
q: How big is the market for the rupee?
The rupee is now a big market. Summing across both spot and derivatives, perhaps $30 billion a day of onshore trading and $40 billion of offshore trading takes place. Both these markets are tightly linked by arbitrage. In other words, for all practical purposes, it’s like NSE and BSE which are a single market unified by arbitrage. If you place a small order to buy 100 shares on either NSE or BSE, you get essentially the same price, and arbitrageurs are constantly at work equalising the price across both markets. It is a similar state of affairs between the onshore and the offshore rupee. Both markets are tightly integrated by arbitrage.
The offshore market for the rupee, and a large part of the onshore market, is OTC trading. Hence, the efficiencies of algorithmic trading and algorithmic arbitrage cannot be brought to bear on onshore/offshore arbitrage. So the arbitrage is done by manual labour. Still, it gets done. Both markets are tightly linked and show the same price. We should think of them as one market. It’s one big market, it is one of the big currencies of the world, it’s roughly $70 billion.
q: How might RBI do manipulation of this market?
If RBI wants to hit the market with orders big enough to make a difference, they have to be ready to do fairly big orders and to be able to do it on a sustained basis. As a rough thumb-rule, I might say that in order to make a material difference to a market with daily volume of $70 billion, they have to be in the market with atleast $2 to $3 billion a day.
q: What would go wrong if they tried this?
Three things would go wrong.
First, foreign exchange reserves are $275 billion. If RBI sells off $2.75 billion a day, the reserves would be quickly gone.
Second, when RBI sells dollars and buys rupees, this sucks liquidity out of the market. The side effect of selling dollars would be a sharp rise in domestic interest rates. In other words, monetary policy would get hijacked by currency policy. This would not be wise. Monetary policy should be focused on delivering low and stable inflation: it should have no ulterior motives.
Third, suppose you and I saw a fake market price of Rs.45 per dollar, which is created by RBI and not a market reality. We would know that in time, the truth will out, that the price will go back to Rs.52 a dollar. The rational trading strategy for each of us would be: To sell any domestic assets, and to shift money out of the country. This would trigger off an asset price collapse in India. We would take the money out, and wait for RBI to give up on these adventures. At that point (perhaps Rs.52 a dollar, perhaps worse) we would bring the money back to India and buy back our assets. We might make two returns here: first, on the move of the INR/USD from 45 to 52 (or worse) and on the drop in asset prices.
q: Isn’t it hard to take money out of India in this fashion?
It’s easier than we think. Remember September 2008? The mythology in our heads was: India is crouching safely behind a wall of capital controls. In truth, the wall wasn’t there.
q: But until recently, Mother RBI used to give us a pegged INR/USD exchange rate! What changed?
In late 2003, RBI ran out of bonds for sterilisation. Associated with that, there was a first structural break in the rupee exchange rate regime, with a doubling of volatility. A short while later, in March 2007, there was another doubling of volatility. From April 2009 onwards, RBI’s trading in the market has gone to roughly zero. Mother RBI stopped managing the exchange rate a while ago.
The exchange rate is the most important price of the economy. The decontrol of this exchange rate is the biggest achievement of the UPA in economic reforms. The credit for this goes to Y. V. Reddy and Rakesh Mohan (who took the first two steps of doubling exchange rate flexibility) and to Dr. Subbarao (who got out of trading on the currency market, which did remarkably little to INR/USD volatility).
q: Why did nobody tell me that something changed in the exchange rate regime?
RBI should be talking more transparently about what is going on. But they are not transparent about what they do. Even though hundreds of millions of people are affected by their trading on the currency market (or the lack thereof), the manual which governs their currency trading at any point in time (i.e., the documentation of the prevailing exchange rate regime) is not transparently disclosed to the people of India. We have to decipher what is going on by statistically analysing exchange rate data.
q: So what might happen to the rupee next? Is there a `law of gravity’ which will pull it back to erstwhile values of Rs.45 or Rs.50?
When you don’t manipulate a financial market, the price time-series comes out to something close to a random walk. In the ideal random walk, all changes are permanent. The random walk never forgets; there is no law of gravity which takes it back to recent values. Your best estimator of what it will be tomorrow is: what you see today.
In order to get a sense of what will come next, go through the following steps. First, go to INR/USD options trading at NSE, and pluck out the implied volatility for the four at-the-money options. I just did that, and the values are: 10.43, 10.32, 10.33 and 10.08. Calculate the average of these. With the above four values, the average is: 10.3. (This is a quick and dirty method; here is one which is much better).
This tells a very important thing: The options market believes that in the future, the volatility of the INR/USD rate will be 10.3 per cent per year.
In order to re-express this as uncertainty per month, we divide by sqrt(12). This gives the volatility for a month as : 3% per month.
Roughly speaking, the 95% confidence interval for what might happen over a month, then, runs from -6% to +6% (this is twice the standard deviation, which we just worked out was 3% per month).
The INR/USD is now Rs.51.62. By the above calculation, we can be 95% certain that one month from today, it will lie somewhere between 48.5 and 54.7.
These trivial calculations have been done by equity market participants for the longest time. It is a standard and trivial idea: To read the implied volatility off the Nifty options market, and to do such calculations to get a sense of what might come next with Nifty. But on the currency market, this is relatively novel. Only recently have we got a nice currency options market, and only recently have we got to a genuine market. Now these skills can be brought to bear on the currency market.
q: What changed in imports and exports which gave us the big recent move of the rupee?
The current account (goods, services, and then some) adds up to a mere buying and selling of $4 billion a day. The bulk of currency trading is about the capital account. The currency is a financial object; the exchange rate is defined by financial considerations and not by current account considerations.
q: What happens to the Indian economy when the rupee depreciates?
This has been the source of a great deal of confusion and it’s important to think straight about this. There are exactly three important effects in play:
- Some people had borrowed in dollars, and left is unhedged since they were speculating that the INR would appreciate. They have got burned. That’s okay – in a market economy, many people place bets about future fluctuations of financial prices, and half the time the speculator loses money. (If the rupee had not depreciated sharply, these speculators would have been truly joyous).
- When the rupee depreciates, imports become costlier and India’s exports become more competitive. So exports (X) gradually start going up and imports (M) gradually start going down. The net gain in X-M is increased demand in the local economy. In this fashion, INR depreciation is good for aggregate demand (and conversely INR appreciation pulls back demand). However, we have to bear in mind that these effects are small and take place with long lags.
- Many things in India are tradeable. It is important to focus on the things that are tradeable and not imported. As an example, there are many transactions between a domestic producer of steel and a domestic buyer of steel. Both buyer and seller are in India. But the price at which they transact is the world price of steel (which is quoted in dollars) multiplied by the INR/USD exchange rate. Through this, the domestic prices of tradeables go up when the rupee depreciates.
q: What is the impact of costlier tradeables for RBI?
RBI’s job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation) of four to five per cent. When tradeables become costlier, domestic CPI inflation goes up. So the rupee depreciation has made RBI’s job harder. RBI will have to respond by hiking interest rates. (Note that one impact of higher interest rates will be that more capital will come into India, which will tend to yield a rupee appreciation).
q: What is the impact of costlier tradeables for business cycle conditions in India?
As the example above about steel suggests, the price realisation of all tradeables companies goes up when the rupee depreciates. Costs change by less, and profitability goes up.
Firm profitability has dropped sharply in 2011. My prediction would be that firms producing tradeables will show better profitability in Oct-Nov-Dec 2011 when compared with the previous quarter, thanks to the rupee depreciation.
This is great news for business cycle conditions. Profitability goes up, which yields more cash for investment by financially constrained firms. And, when profitability is higher, more investment projects look viable.
q: In the bottom line, what is the link between the rupee and India’s business cycle stabilisation?
If RBI tried to peg the exchange rate, the lever of monetary policy would get used up to deliver the target exchange rate. By not trading on the currency market, the lever of monetary policy is now available. A pretty good use for this lever is to deliver low and stable CPI inflation.
But floating the exchange rate also yields stabilisation purely in and of itself. In bad times, capital leaves India, the rupee depreciates. This gives higher profitability in tradeables firms. Conversely, when times are good, more capital comes into India, the INR appreciates, which crimps profitability of tradeables firms. This is the most remarkable feature of the floating exchange rate: it exerts a stabilising influence upon the economy. Purely by doing nothing on the currency market, RBI has unleashed this new force of stabilisation which will help India.
q: What should RBI do next?
RBI should do as they have done, i.e. avoided trading on the currency market.
RBI should keep driving up the short-term interest rate until point-on-point seasonally adjusted CPI inflation shows a decline and goes into the target zone of 4-5 per cent. Once it hangs in there for a year, `headline inflation’ (y-o-y growth of CPI) will be in the target zone.
 
By Bron Suchecki, on April 26th, 2011
Quote from FOFOA’s latest post:
That’s right, gold is not at its highest and best use being spent (circulated) as a currency during a hunger crisis. Instead, if you are one with PLENTY of net worth, gold is the very best way to shuttle your wealth THROUGH a crisis to the other side. If you are forced to deploy this wealth for food during a crisis, then you apparently planned poorly.
Couldn’t agree more – gold is not meant to be used during a crisis, but after.
By Trace Mayer, on December 23rd, 2010
Regarding the regression theorem, can the grandson also be the great-grand father? Ideas can only be overcome by other ideas and words proffer the instruments to meaning. The ability to wield words concisely, accurately and orderly is essential for communication and persuasion. Much of discourse, particularly from court economists, has devolved into sophistry and incomprehensible babbling.
Can The Grandson Also Be The Great Grand Father?
FOFOA’S QUESTION
In an extremely verbose and conflated article the pseudo-anonymous FOFOA asks, “Does anyone have any evidence that silver is still money today?”
I find a few of FOFOA’s assertions fairly odd, especially for a voice in the gold niche. For example,
Money is debt, by its very nature, whether it is gold, paper, sea shells, tally sticks or lines drawn in the sand. (Another shocking statement?) Yes, even gold used as money represents debt. More on this in a moment. …
First, money. Money is always an overvalued something. Usually a commodity of some sort. But it can be as simple as an overvalued line in the sand, or a digital entry in a computer database. But the key is, it is always overvalued relative to its industrial uses! That’s what makes it money! …
Did you hear him at 6:35? “Only one metal in the world that fits the bill for money, and that’s gold!” That’s right Joe! Good job from the “Silverfuturist”. There can be only one!
Mish has chimed in on many of FOFOA’s fallacies.
There is a reason Chapter One of my book The Great Credit Contraction is titled Word Games. In that chapter, I present the two competing theories of money, market versus Chartalism, along with an example of the regression theorem and then distinguish money, money substitutes and illusions which can all function as either currency or legal tender or both. What is so odd about FOFOA’s fallacious assertions is that they contradict basic principles of monetary science.
SCALPEL PLEASE – DISTINGUISHING TERMS
The conflation of the terms money, money substitutes, illusions, currency and legal tender is one of the greatest problems in understanding monetary science. Let’s examine each.
Legal tender by government decree must be accepted if offered in payment of a debt. Currency can be examined either broadly or narrowly and in its narrow examination it is the medium of exchange most commonly used in ordinary daily transactions.
Illusions are figments of people’s imagination and for our discussion we will consider them negotiable instruments that promise nothing. Staying within this same discussion, money substitutes are negotiable instruments that promise the payment of money.
Therefore, it follows that gold cannot be debt and is obviously a form of currency that is no-one’s liability.
THE REGRESSION THEOREM
This exchange between Dr. Ron Paul and Dr. Alan Greenspan centered the issue on the definition of money.
Congressman Ron Paul: So it is hard to manage something you cannot define.
Dr. Greenspan: It is not possible to manage something you cannot define.
First, it should be noted that Greenspan implicitly admits the faulty argument behind Chartalism. Second, a fairly basic theory of monetary science is the regression theorem, one of many contributions by Ludwig von Mises, and answers the question why do illusions, money substitutes or money have purchasing power? For those unfamiliar with the regression theorem, before continuing, you may want to read Bob Murphy’s short article.
What is Mish’s response? “Like FOFOA I believe gold is money. However, unlike FOFOA I think money is whatever the free market says it is. The problem is, we do not have a free market we only have government decree mandating the use of dollars, Pounds, Yen, Renmimbi, Euros, and Francs as money.”
This answer from Mish regarding the competing theories of money is the only reasonable and rational response.
But I disagree with Mish’s assertion that a free market does not exist. Individuals are sovereign and ‘endowed by their Creator’ with rights. The free market existed first and then the State was created. This is the same reason Chartalism is philosophically flawed.
Sure, the Statetrix is extremely strong today but most individuals still have freedom of movement which allows people to vote with their feet. Until the free will of mankind is completely violated worldwide through the establishment of a new world order or one world government then a free market will exist. A new world order is not likely because of the failed fiat currency fractional reserve banking conspiracy. The Great Credit Contraction has begun and there is no stopping it.
Despite what most people think or feel; the State is dead, intellectually, morally, spiritually, financially and economically. Sure, some individuals in certain geographic areas, like North Korea or the United States of America, will face threats of collateral damage as the gigantic rotting corpses tumble to the ground causing great destruction.
But for a sovereign individual in a free market the management of political risk is just like managing any other risk; weather, contract, counter-party, performance, etc. I devote Chapter Six to Personal Practical Implementation like the five flag theory for managing political risk, geographic diversification and even second passports.
MISH’S MASSIVE MISAPPLICATION
But the regression theorem answers the question on how a medium of exchange can come into existence; it explains the origin of money.
Here Mish makes a critical misapplication of monetary theory. “While theoretically possible, in today’s world silver has one huge drawback that gold does not have: Silver is used up. Gold is not. Silver is widely use in industrial applications”
This is the exact opposite of why the market has chosen gold and silver as money. The theory is already being applied. The reason gold is money and currency, a medium of exchange, is because people first valued gold for its commodity uses because they attached increased value to gold based on its expected purchasing power and the reason they were willing to hold cash balances in gold.
Under the theory of market determined money astute traders in a barter environment settle on a particular commodity or commodities that are currently trading in the marketplace as money because of their increased degree of saleableness, saleability, liquidity or marketability.
SILVER PRICE IMPLICATIONS
 But silver is also valued for its industrial applications. The market searches for a cash balance medium with the lowest transaction and storage costs. As the silver price discovery occurs there are two large demand drivers: (1) industrial and (2) monetary.
In this case, silver is widely used in industrial applications. Many of these are essential for the current standard of living for humanity such as medical, automation, high tech and etc. while small amounts of silver are actually used in each application so this results in the inelasticity of demand being fairly low.
Additionally, because silver is valued for these reasons and is fungible, divisible, scarce, non-corrosive, portable and definable. A problem is the high ratio of about 50 ounces of silver per ounce of gold. Along with the lower density there is an increase in storage costs of silver relative to gold.
Taken in totality these properties make silver extremely efficient economically to be used as a medium of exchange.
As The Great Credit Contraction continues holders of capital will continue seeking safety and liquidity. As the monetary demand for silver increases then industrial and consumer prices will likewise have to increase or firms will face bankruptcy because they cannot sell for less than their costs and remain profitable. This can be particularly helpful in figuring out the implications between inflation or deflation.
But these individual preferences expressed through human and being revealed through the silver price does not constitute evidence of silver being overvalued as FOFOA asserts. That assertion rests on there being a proper valuation for silver. A proper valuation set by whom, the State? Chartalist! Plus, I would love for FOFOA to explain what types of industrial applications a digital entry in a computer database has.
Applying monetary science to Internet technology is not a simple task.
CURRENCY EVOLUTIONS
Being able to predict future market innovations from entrepreneurs is the work of often wrong science fiction authors. Could anyone predict a Ferrari in 1880? No, they thought about ‘horseless carriages’. Could anyone have predicted the Internet fifty years ago? Fifteen years ago Google did not exist. YouTube and Facebook are barely over five years old.
The fiat currency fractional reserve banking system that has evolved out of a five hundred year old money substitute system is fundamentally unstable and everyone knows it. The lifeblood of the State is dead and decaying through failing quantitative easing. The 2008 financial crisis shook the financial community and worldwide population to the core. The search for a viable replacement is on like Donkey Kong.
Applying monetary science to Internet technology is not a simple task. The first ‘horseless carriages’, like GoldMoney, have begun to develop. Remember, what the telegraph company and IBM told Alexander Graham Bell and Bill Gates. GoldMoney allows gold, silver, platinum and palladium to circulate as currency in ordinary daily transactions while immunizing the holder of capital from both counter-party risk and illusion risk, the risk that the illusion currency unit will become worthless because of loss of confidence by market participants (hyperinflation).
CONCLUSION
Just like it is logically inconsistent for the grandson to also be the great grandfather so likewise it is logically consistent for gold or silver to be money only because the FRN$ currently has purchasing power. The only reason the FRN$ has purchasing power is because when you apply the regression theorem it reveals that silver and gold were valued as commodities in the state of barter as a result of sovereign individuals making choices based on human action.
Therefore, it follows that gold cannot be debt and is obviously a form of currency that is no-one’s liability. Sure, a money substitute like a gold certificate is debt but a money substitute is not money anymore than the GLD ETF is gold just like a FRN$ is not a US$ and a dollar is defined as 371.25 grains of fine silver. Silver and gold already possess currency market share though far inferior to the FRN$, Yen or Euro.
Evolutions in currency like the FRN$, credit cards, GoldMoney, frequent flyer points, gift cards, Yen, bitcoin, etc. will continue and hasten as we further transition to the Information Age. To stimulate innovation and increase the standard of living through a more efficient currency market we should support Dr. Ron Paul’s H.R. 4248 – Free Competititon In Currency Act of 2009.
The Internet is a relentless process of decentralization and like a rising sun the inefficiencies in the worldwide free market are being dispelled with the collapse of massive currencies like the broken Euro or FRN$ which speaks to the currency market opportunity for entrepreneurs. There will no more be one currency to settle them all than there will be one world government to rule them all.
DISCLOSURES: Long physical gold, silver and platinum.
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By Bron Suchecki, on October 7th, 2010
In a recent High Court of Australia judgement on the Goods and Services Tax treatment of foreign currency transactions, I note with amusement Justice Dyson Heydon’s statement that:
“Apart from those rights [as legal tender], the pieces of paper had little value. They might have been used to stop an uneven table wobbling, or to jam shut a loose door, or to amuse small children, or to light a cigar. If the currency included coins, the coins might have been used to turn stiff screws or to lay on railway lines for the purpose of being flattened. But uses of that kind, which are very remote from their real purpose, would not prevent both the pieces of paper and the coins from being almost worthless.”
Before you rush to burn your money or flatten your coins, the judgement notes that “because the tokens are currency, the holder of the tokens can use them as a medium of exchange and as a store of economic value. Currency has value only because of the rights that attach to it.”
So relax, your paper money does have value. However, if you are concerned about what high inflation may do to the value of cash, you may wish to consider storing your surplus “economic value” in the form of legal tender bullion coins – sorry, tokens.
Of course, I can’t guarantee that precious metal prices will not fall, but at least you will always be able to use the coins to turn a stiff screw or two! 
By Ajay Shah, on October 6th, 2010
There is a lot of talk about capital inflows, rupee appreciation, concerns about export competitiveness, etc. It made me pull up the data to look at what is going on. The graph shows the nominal and real effective exchange rate of the rupee. The source is the BIS: the best computation of these indexes presently available.
 |
| Real and Nominal effective exchange rate of the Indian Rupee |
There is one constraint of this data: it ends in August. The picture shown there is rather benign. Over the five year period shown in the graph, modest REER fluctuations are visible. Over the recent period of roughly a year, where RBI intervention has subsided, it isn’t clear that something dramatic shifted.
And, I like to always remind everyone that the REER is a rather weak way to think about export competitiveness, so even if there was a sharp rise in the REER, we’d have to be cautious in rushing to conclusions about what it is saying.
The people making the case for currency trading by RBI have to cross four hurdles:
- Is there a crisis on export competitiveness that is rooted in exchange rate misalignment?
- How can controlling nominal things (the exchange rate) influence real things (the real rate)?
- Given a choice of using the tool of monetary policy for the purpose of delivering low and stable inflation (which benefits every citizen of India), versus the purpose of delivering some modification of the nominal exchange rate (which benefits a sectarian interest at best), what is the best choice?
- How can RBI be held accountable to maximise the interests of the people of India, if it is to do active trading on the currency market? What checks and balances, and what accountability mechanisms, need to be put into place in order to run a trading room in the government sector?
It is not so long ago (until early 2007) that RBI was actively trading in the currency market, championing the cause of India’s exporters, and we saw how much trouble it got them in. In some ways, our inflation crisis today is the legacy of the unprecedented credit boom of the Y V Reddy years. Today’s India is only more open than the India where Y V Reddy’s regime tripped up on currency trading, so the challenges in embarking on that path today are even more daunting.
By Rok Spruk, on June 4th, 2010
In the WSJ, Vaclav Klaus, the president of Czech Republic, draw important conclusions from the long-term economic sustainability of the Eurozone (link), arguing that the Eurozone is not an optimum currency area as suggested by the famous four criteria from economic theory. In a puzzling essay, Mr. Klaus demarks the Eurozone as a monetary union of particular economic viability and, based on the assessment of growth dynamics in Europe, suggests that the Eurozone will face a deepening problem in the future.
By Bron Suchecki, on June 4th, 2010
Two news stories in my inbox this morning from Sharelynx:
Demand Up: Gold a ‘Good Choice’ for Boosting Global Use of Yuan
“China’s trade in yuan-denominated gold investment products moves the currency closer toward global acceptance and the country should develop more of them, a central bank official said.”
Supply Down: South African gold output falls hard
“In an all too familiar announcement in recent years, the South African Chamber of Mines reported the country’s first quarter gold production fell 15% quarter-on-quarter, extending the downward slide in output.”
By Ajay Shah, on April 23rd, 2010
Exchange-traded derivatives originally only did commodity underlyings. The world’s first financial underlying was : currencies. On 16 May 1972, the Chicago Mercantile Exchange started trading in currency futures. To any finance person, nothing is simpler than a currency futures, but unfortunately in India a mixture of ignorance, ideology and turf considerations has hindered progress.
In 1996, when NSE had just got started talking about equity derivatives, I happened to be session chairman in a conference organised by Invest India titled The future of India’s stock exchanges and I remember asking Ravi Narain something like “Have you thought about other underlyings? Would you trade currency futures?”. Ravi leaned into the mic and said “We’d love to.”.
Most people in India were blinded by the notion of `RBI turf’ and did not think seriously about this problem. When I look in my media archive I see a bit on currency futures in Extracting information from finance, August 2006, and in a few pieces before that, but this was not seriously on the policy radar. When any discussion about this took place, various RBI personnel would claim that futures trading would somehow make Mother India unsafe.
In the Indian discourse, the committee report on Mumbai as an International Financial Centre, chaired by Percy Mistry (April 2007), had the first clear text on currency derivatives.
In April 2007, a column titled Currency futures now, emphasised the links between a well functioning currency derivatives market and the ability of the economy to absorb exchange rate fluctuations. (This remains the best response to Shankar Acharya’s column in Business Standard today, where he bemoans the shift away from administered exchange rates. The price of steel and crude oil and the dollar fluctuates: get used to it and get the right derivatives going).
It took 36 years from the date of the innovation (currency futures at CME) to get started with trading in India. On 2 September 2008, I was complaining about a crash in productivity. On 3 September 2008, I got a first detailed look at the liquidity of the currency futures market.
In a year, on 23 September 2009, one could cautiously suggest that currency futures liquidity was ahead of that on the OTC market. This was clearly visible in the article by Gurnain Kaur Pasricha on 25 November 2009. Here, we were on new terrain: nobody else in the world had done this other than Brazil. The global first-mover, the CME, envies the NSE currency futures contract.
And finally, on 21 April and 22 April of this year, we see signs that the currency futures are more liquid than the Nifty futures.
There is nothing innovative about launching currency futures. There is nothing more commoditised and better understood than an exchange-traded clearing-corporation-settled cash-settled contract on a currency. But the mixture of ignorance, ideology and turf battles that impedes progress in India is alive and well. Currency forwards (and the NDF market) are the only choice for FIIs, who are banned from using the exchange-traded currency derivatives.
RBI believes that with interest rate underlyings, cash settlement is somehow dangerous and that derivatives trading on short-dated interest rates will interfere with the conduct of monetary policy. I wonder how that is reconciled with OTC interest rate swaps involving MIBOR, and with the fact that all good central banks in the world are doing monetary policy without banning either cash-settled interest rate underlyings or short-maturity underlyings.
In short, this is a good story and a bad story. It is a good story in that in the end, we are one of the best countries of the world in terms of getting exchange-traded currency derivatives to work. It’s a bad story in that it took a lot longer than it should have, and the problems that impeded progress continue to be with us.
By Ajay Shah, on November 27th, 2009
In recent months, a sense has emerged that the exchange-traded currency futures market in India is more liquid than the corresponding contract traded OTC (i.e. the forward market). As an example, we examine a dataset from NSE of 28,797 observations of data – one observation per second – from 3 November 2009, for the November expiry. The effective spread for a transaction of $1 million (i.e. 1000 contracts) is calculated, in the units of paisa. This dataset has the following summary statistics:
| 5% |
25% |
50% |
75% |
95% |
| 0.519 |
0.763 |
1.000 |
1.380 |
2.344 |
In other words, 95% of the time, the spread on NSE for a $1 million rupee-dollar futures transaction was below 2.344 paisa. The median spread, for a $1 million transaction, was 1 paisa. This spread dropped below 0.5 paisa with only a 5% probability.
These numbers are significantly superior to those found on the OTC forward market, where, as a thumb rule, dealers feel that a $1 million transaction typically involves a spread of 2 paisa. This suggests that the liquidity at NSE is roughly 2x superior to the OTC market. The superiority of the execution at NSE is likely to be greater than 2x when we consider the opacity and execution risk of the OTC market. To the extent that order flow has shifted away from the forward market to the futures market, there could be a dynamic story here of the futures spread getting tighter at the expense of the forward spread.
This situation is unexpected. In the international experience, the currency forward markets is more liquid than its exchange-traded counterpart. This is despite the fact that futures markets has desirable features including near-zero counterparty risk, transparency, contracts standardisation and open public participation. The key reason for the domination of the OTC market appears to be historical. The OTC market came first, had entrenched liquidity, and the network externalities of liquidity hold the users in place.
In thinking about India’s currency futures market, it would be useful to compare and contrast with Brazil’s experience. Brazil is an interesting peer to India for reasons of a large GDP, democracy, rule of law, institutional quality, etc. It is also the only country of the world, prior to India, where the currency futures market became more liquid than the currency forward market.
In Brazil, currency futures trading began in 1991 – a seventeen year head start when compared with India. While Brazilian macroeconomics is now remarkably healthy, Brazil has had a turbulent history with many crises, high and volatile interest rates and inflation. The futures market, with daily marking to market, and therefore lower collateral requirements, offered a cheaper way to take positions in the currency. Nevertheless, there is reason to believe that several (sometimes unrelated) regulations contributed to tipping the balance in favor of futures contracts, so much so that today there is essentially no OTC market to speak of. The dealers on the forward market now provide OTC contracts to their customers but unwind their positions in the futures market (See Note 2). The regulatory pressures which moved liquidity from the OTC market to the futures market were:
- Access to spot markets was limited for several decades as a tool to control capital flight. Both domestic and foreign residents had easier access to futures markets than to spot markets. This led to greater number of players, and more liquidity in futures markets. Access to spot markets in Brazil is still far from free, for both domestic and foreign residents. India is in the same boat, with a futures market that is accessible to citizens but a spot market which is not.
- Until 2005, banks were subject to unremunerated reserve requirements on foreign exchange exposures exceeding pre-specified limits. These reserve ratios did not apply to futures positions, thus driving trading to futures markets.
- Until December 2007, Brazil imposed a financial transactions tax, called CPMF, on all debits on bank accounts. This levy applied to profit and loss payments on exchange traded contracts, not to their notional amounts, thus pushing activity to exchanges.
- OTC derivatives contracts are not netted, whereas contracts with the exchange or clearing house are netted by the latter. This means that the tax on cash flows, PIS-COFINS (See Note 3), de-facto taxes OTC transactions at a higher rate than exchange traded derivatives.
- Brazil has reporting requirements for OTC transactions – all transactions with domestic counterparties must be reported to regulators, in order for them to be considered enforceable. This levels the playing field in terms of the reporting burden of exchange traded versus OTC transactions. India has not yet done this.
- Pension funds are required to use only standardized derivatives contracts.
- The central bank, Banco Central Do Brasil, uses the futures market for doing currency intervention. This gives liquidity to the futures market, and also ensures that the OTC community has to look very carefully at the price on the screen so as to capture current information. India has not yet done this.
While some of these rules were removed in the 2000’s, after being in place for several years, their consequences have outlasted them. There is a path-dependence in market liquidity. These kinds of market rules matter in getting liquidity on the exchange off the ground. Once the exchange becomes liquid, the network externality of market liquidity sucks in further order flow and preserves the domination of the exchange even after these rules are removed.
Endnotes
1 The author is a senior analyst at the Bank of Canada. The views expressed here are personal. No responsibility for them should be attributed to the Bank of Canada.
2 The material in this note is a summary of information provided by Brazilian economists as well as that contained in Dodd and Griffith-Jones (2007), Brazil’s derivatives markets: hedging, central bank interevention and regulation, and Kolb and Overdahl (2006), Understanding futures markets, sixth edition, Blackwell Publishing.
3 The PIS and COFINS are federal taxes on revenues, charged on a monthly basis.
By Trace Mayer, on November 20th, 2009
If you are unfamiliar with hawala banking then I recommend reading Hawala Banking And Currency Controls Part I to become familiar with the concept before reading further. If you are familiar with how hawala banking works then you will probably know that hawala transactions are not inherently wrong and should not arouse any suspicion in the mind of a moral person.
However, there may be formal reporting to government depending on the peculiar nature of some of the assets depending on applicable rules for sale and transfer. In many countries there are legal rules which may impose civil and/or criminal penalties for each one of the transactions that I have described in earlier articles because they are considered money laundering by their governments.
HOW CURRENCY CONTROLS AFFECT HAWALA BANKING
The laws and regulations of various governments regarding financial transactions across the globe cover the entire spectrum from no regulation to very strict regulations. This is not a critique or recommendation based on any particular legal framework but only the fundamental principles surrounding the issue. Therefore, consult a local attorney before engaging in any financial transactions.
Currency controls can take many forms. Probably the most common form is the restriction, limitation or prohibition of the sale, purchase or exchange of certain goods or currencies within a country or between countries. Some of these controls include reporting requirements for financial transactions, registration of Money Service Businesses, record keeping requirements when you buy gold or sell silver, and identification requirements for transactors.
The informal nature of traditional hawala banking and the private nature of the transactions allows individuals to avoid interference with their fundamental human rights by currency controls which put a limit on transactions or demand “transparency” requirements. Even so, many nations have made hawala banking subject to these laws, but the laws suffer from these immoral fundamental flaws.
TRANSACTIONAL LIMITATIONS
The limitation, regulation or prohibition of some exchanges makes the goods or currencies like real estate in that they can no longer be freely moved from one country to the next. Things like official foreign currency exchange rates and limits to the amount of cash that can be taken into or out of a country are typical examples.
The solution to this problem, where it is not illegal to do so, is to effect the transaction using one, or a combination, of the examples in Part I. This way the transactional limitations can be lessened or even avoided completely. Nobody likes competition and therefore many vampire squid banks through the governments have made such transactions illegal. Even in the cases shown in Part I, where there is a legitimate reason or purpose behind “avoiding” the transactional limitations, most legal systems which outlaw avoidance would find these methods to be illegal as well.
TRANSPARENCY REQUIREMENTS
Transparency requirements are those laws like the ones found in the ironically named USA PATRIOT Act which require “know your customer” identification requirements, registration with the government to transmit money, record keeping requirements and mandatory Currency Transaction Reports and Suspicious Activity Reports. This framework was suggested by the IMF to governments around the world.
However, these laws are much like the Stamp Act of 1765. In both cases the requirement was unnecessary and used to fund activity which provided no benefit to the people taxed. The Stamp Act was quickly repealed after ardent opposition by the colonists in America. A young John Adams heard James Otis, Jr., a Boston attorney, vehemently speak out about these nefarious Writs of Assistance:
But Otis was a flame of fire! … American Independence was then and there born. The seeds of Patriots and Heroes, to defend the non sine Diis animosus infans;- to defend the vigorous youth were then and there sown. Every man, of an immense crowded audience, appeared to me to go away as I did, ready to take arms against writs of assistance.* Then, and there, was the first scene of the first act of opposition to the arbitrary claims of Great Britain-then and there the child Independence was born. In fifteen years, i.e. in 1776, he grew up to manhood, and declared himself free. [Annals Of The American Revolution Or A Record Of The Causes And Events, page 225]
The fundamental nature of hawala banking, an informal transaction among trusted individuals, makes all of these requirements superfluous and unnecessary for the hawaladars to operate successfully. The history of hawala banking shows that without any of the record keeping and regulation that banks are subject to, hawala banking is far more efficient, less expensive, is not subject to institutional or political risk, has been the source of vital funds for war torn and impoverished nations and is much faster than other systems of exchange. So why force people to use the Pony Express rather than the Internet?
FIGHTING CRIME: Pretending To Be Batman
The competing claims that underlie this clash are between the right to privacy and the protection of innocent people against criminal activity. The argument used to justify the regulation of the informal hawala system is that it is necessary to identify and prevent crime and terrorism. Although it is untrue based on credible and verifiable sources, we will assume it is true that terrorism and organized crime use hawala transactions as a significant source for funding. The question then becomes, how much privacy may be sacrificed to ferret out crime and terrorism?
The Stamp Act opponents relied on the English Constitution for an argument against the Stamp Act, taxation without representation. The same offenses to liberty and human rights are present with anti-hawala laws but the same constitutional argument is not necessarily applicable here. The stronger one is to look to the US constitution, the Fourth Amendment which states:
The right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures, shall not be violated, and no Warrants shall issue, but upon probable cause, supported by Oath or affirmation, and particularly describing the place to be searched, and the persons or things to be seized.
It cannot be more clear that in order to protect individuals from crime, before there is a search through private papers, there must be probable cause and a warrant issued to do so.
No transparency requirement as adopted in the USA PATRIOT Act or other financial regulation of hawala banking meets this critical test. Because the transactions are private, there should be probable cause and a proper warrant to search. In addition, the fundamental human right to freedom to contract gives the individuals and the hawaladars the freedom to agree not to maintain records of the individual transaction if they so choose. The same legal argument might not be available in all countries, but the fundamental rights of privacy and freedom of contract are the same for all people.
Thus, just like Batman does not always follow the law to ferret out crime, governments think they can ignore the law and legal principles to fight crime. But unlike Batman, costumed government officials do not actually succeed in reducing crime or terrorism by these means but they do manage to parasitically draw a paycheck from the productive members of society.
CONCLUSION
Hawala banking, where legal, provides opportunities to profit for hawaladars and significant other benefits for the parties to the transactions. Currency controls and other laws passed to regulate hawala banking are not only offensive to fundamental rights of freedom of contract and a right to privacy, but short of complete totalitarian control are impossible to effectively enforce in an informal system such as hawala. The private and informal nature of hawala banking makes detection of hawaladars extremely difficult. And it is the very currency controls that incentivize individuals to use the informal hawala banking system rather than the formal institutions which are slower, more expensive, less efficient, more intrusive and less secure.
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