The alternative venues for foreign exchange trading that once lurked in the shadows are now beginning to take centre-stage and policymakers are now beginning to realise that this threat needs to be urgently tackled. Offshore trading in few currencies has burgeoned to such an extent that it is higher than the onshore trading volume.
In a bid to contain the damage done by the offshore market for rupee, the RBI recently made two policy changes based on the recommendations of a task force headed by Usha Thorat. One, it has now allowed domestic banks to freely share foreign exchange rates with non-residents and, two, trading in rupee derivatives has now been allowed on International Financial Services Centres.
It is, however, doubtful if the RBI’s measures will have any immediate impact. The crux of the problem is that central banks cannot restrain offshore trading in their currencies, unlike stocks and bonds issued by domestic entities. As the chief of an offshore currency exchange explained, the central banks have control only on the currency. But since currencies are traded in pairs, for instance dollar-rupee, euro-rupee, yen-rupee, etc., these trades are beyond regulatory purview if conducted on foreign soil.
That said, the central bank can make rupee trading volumes migrate to onshore markets by improving the trading conditions onshore and increasing the acceptability of the rupee in global markets.
The offshore market
The report of the task force explains the growth, issues and solutions for these offshore markets for currencies in a comprehensive manner, which can act as guideposts for future policy actions. The growth in offshore trading in rupee was prompted by a variety of reasons, including restrictions in participation of non-residents in domestic markets, non-convertibility in the capital account, limited time of operations of domestic exchanges and a booming underlying economy.
As the number of foreign investors in the economy grew, their need to hedge their exposure has led to growth in these offshore centres, given the issues in the domestic markets. Growing speculative interest in the rupee, due to the fast-paced growth of the economy, is another reason behind the thriving trading in rupee overseas.
The NDF market for the rupee is located in IFSCs such as Singapore, Hong Kong, London, Dubai and New York. According to the numbers disseminated by the Bank of International Settlement and London FEC, the daily average rupee trades in the offshore NDF market in 2013 was $17.2 billion, while turnover of rupee forwards in the domestic market was only $3.2 billion.
While trading in the domestic forwards market grew to $21.4 billion by October 2018, trading in the NDF market too moved higher to $23 billion. In other words, trading in rupee forwards is higher in offshore markets compared to the domestic market. The rupee currently is the most traded currency in the NDF market after Korean Won.
The exchange traded currency derivatives (ETCD) market for the rupee is in comparison much smaller, about 10-15 per cent of the forwards market. But the onshore market for rupee ETCD also accounts for only around 50 per cent of the total volume. Around 50 per cent of the total rupee ETCD volumes are traded on offshore exchanges in Dubai, Singapore and Chicago.
Problems with offshore trading
A large offshore market, on which the RBI has no control, is clearly not desirable as the central bank’s attempts to manage the currency in volatile times are likely to be thwarted by traders overseas. This was evident in 2013, when despite the RBI’s valiant attempts to rescue the domestic currency by selling dollars in the domestic market, the rupee continued to spiral lower.
Analysis done by the task force revealed that in normal times, when volatility is lower, both the offshore and onshore markets for the rupee influence each other. But in periods of heightened volatility, as witnessed in 2013 and 2018, the offshore market tends to wield larger influence on the onshore market. This is because there are many large traders who take positional call on a country’s currency through these offshore markets. Once they sense that the vulnerability of a country has increased due to threat of a sustained fund outflow, they tend to increase their short positions, thus weakening the onshore rupee as well.
Also, there is a revenue loss to the economy through this trading volume migration as all transactions in the OTC market and exchanges generate revenue for the intermediaries.
Are RBI’s measures enough?
Against this background, are RBI’s recent policy changes sufficient to address the situation? The move to make Indian banks share rupee prices with non-residents will ensure that the offshore prices are more aligned with domestic prices. But the fact that onshore OTC and exchange traded currency market are not operating 24 hours of the day will still result in price distortion in opening prices in the domestic market. This can perhaps be partially addressed by introducing exchange traded rupee contracts in the GIFT IFSC. Since the trading hours of the GIFT exchanges are longer, up to 15 hours, and can be extended if required, the traders who wish to trade alongside other markets can use the GIFT exchanges.
But it would have helped if the RBI had not dragged its feet in giving permission for rupee derivative trading on GIFT IFSC as offshore rupee traders have already converged on other exchanges. While the GIFT IFSC is competitive as far as cost of transacting is considered, it may not be very easy to attract traders from other offshore exchanges such as DGCX, SGX or CME. Traders prefer exchanges with higher liquidity, where spreads are lower and price discovery is better.
A better way to curtail overseas trading in rupee would be to address the problems in rupee trading on domestic platforms. Some of the recommendations of the task force such as increasing the position limits allowed to users on onshore markets, without an underlying, can help towards this end.
Other recommendations such as setting up a central clearing and settlement mechanism for non-residents’ deals in the onshore market and wider access to FX-Retail trading platform to non-residents can also help boost non-resident participation in the domestic market.
The policymakers should also continue focusing on internationalising the rupee. China was able to move offshore trades to domestic market by increasing the internationalisation of the Chinese yuan. While the usage of the rupee is quite low in global trades, it can be increased if the sovereign bond issuances overseas take off. This can help India find a place in the popular bond indices such as JP Morgan Emerging Market Bond Index, thus helping fund flows into the country as well.