India’s fledgling capital markets hope derivatives will boost the nation’s economic prospects.

By Nina Mehta

Fifty years ago, around the time India became independent, men in Bombay gambled on the price of cotton in New York. They bet on the last one or two digits of the closing price on the New York Cotton Exchange. If they guessed the last number, they got seven rupees for every rupee laid out. If they matched the last two digits, they got 72 rupees. Gamblers preferred using the New York cotton price because the cotton market at home was less liquid and could easily be manipulated.

Now India is about to acquire its own market for risk. The country, emerging from a long history of stock market and foreign exchange controls, is one of the last major economies in Asia to refashion its capital markets to attract Western investments. In the next half-dozen years, new equity, foreign exchange and interest rate products are likely to be listed on India’s exchanges. A hybrid over-the-counter derivatives market is expected to develop alongside.

To date, India hasn’t attracted the investors that Singapore and other nations on the Asian rim have managed to court, largely because of its history of restrictions on transactions involving foreign currency and the high rate at which foreign investors’ profits were taxed. Investing in India’s stock markets has also, until recently, involved Sisyphean levels of paperwork and trading and settlement nightmares.

Over the last couple of years, derivatives trading has been pushed before the Securities and Exchange Board of India, the nation’s regulatory apparatus, by the National Stock Exchange, a fully automated, screen-based exchange established by India’s leading institutional investors in 1994 in the wake of numerous financial and stock market scandals. Government approval of derivatives trading is expected in the next few months—although this has been the case for the last half-year.

Trading will begin with index futures, since “payoffs are linear and people can understand them more easily than options,” says Nitish Idnani, formerly an officer in the derivatives department of the Securities Exchange Board of India and now a consultant at PricewaterhouseCoopers in Mumbai. Index options will be next on the menu, with options on individual stocks offered after that. The time frame for this roll-out could run from a few months to a year, with more complex structured products becoming available as markets and investors’ needs mature.

Derivatives trading, many predict, will spur growth in the underlying markets by offering a hedging facility and enticing more risk-averse investors into the system. India’s stock markets currently operate on an account-period settlement system of a week, which makes them “a curious mixture of spot and futures markets,” says Ashishkumar Chauhan, vice president of the National Stock Exchange. “The introduction of derivatives trading will separate leveraged positions from the spot markets and make it easier for exchanges to implement rolling settlement. This should reduce volatility in the existing markets, and make risk containment and regulation easier by making markets more safe.”

“If you said the rupee depreciated against the dollar by about 8 percent per year on average for the last 10 years, you wouldn’t be far off. But year to year, you couldn’t tell what the rate of depreciation would be.” —Nachiket Mor

SEBI knows it needs to get the framework as well as the details of derivatives trading right the first time around. Exchanges that trade derivatives products will therefore function as self-regulatory organizations, under the overall supervision of SEBI. Dealers must also be certified for derivatives trading, something not required in the cash markets. The agency, moreover, is bent on avoiding the deficiencies that plague the cash markets. “Positions are marked-to-market in the cash markets, for instance, and losses are collected from brokers—but gains are not paid out [immediately],” notes Idnani. “In the futures market, gains will be paid out as well.”

For their part, the two leading exchanges—the NSE and the Bombay Stock Exchange, the country’s older and more established market (and, for a time, a foe of derivatives trading)—are ready to trade index futures. The NSE will trade futures contracts on the Standard & Poor’s CNX Nifty, a 50-company index that since 1998 has been linked with Standard & Poor’s. The BSE, meanwhile, will work off its popular 30-company Sensex index. “The NSE has been the frontrunner in getting its systems in place,” points out Kiran Shah, head of settlements at Jardine Fleming India Broking, a prime brokerage. “But BSE brokers have been trading what is essentially a transaction-carry forward product, called badla locally. Consequently, those brokers are primed to cater to the derivatives segment of the market.” The Sensex, he adds, is more popular than the NSE’s Nifty “at both the investor level and mentally.”

OTC forges ahead

Although government foot-dragging and politicking have so far kept derivatives trading at arm’s length, the imperatives of globalization are nudging policy-makers toward reform. Cross-currency swaps such as the dollar/Deutsche mark and dollar/yen have been available since 1987 to manage corporate balance sheets, and currency and interest rate swaps were introduced in 1997. There’s now a burgeoning rupee/dollar swaps market as well.

Currency forwards, of course, have existed for decades to hedge forex risk. Nonetheless, the interbank forward market “has little depth beyond a year or year-and-a-half, and in times of extreme volatility the time frame comes down to six or eight months,” says Jagdish Chhabria, deputy manager in the treasury department at ICICI Ltd., a commercial private-sector bank and India’s leading player in the rupee/dollar swaps market.

At issue is the temper of India’s exchange rate. “If you said the rupee depreciated against the dollar by about 8 percent per year on average over the last eight or 10 years, you wouldn’t be far off,” says Nachiket Mor, general manager of ICICI’s treasury department. “But year to year, you couldn’t tell what the rate of depreciation would be. It could be zero or it could be 25 percent.”

As a consequence, when the dollar moves up, everybody ends up on one side of the market, since few investors are willing to take the other side. Speculation on the rupee is also not allowed—and capital account convertibility, tentatively planned for mid-2000, now looks like it will take longer to materialize.

“The introduction of derivatives trading will separate leveraged positions from the spot markets and make it easier for exchanges to implement rolling settlement.” —Ashishkumar Chauhan

Another hurdle for local corporates is that a firm’s foreign currency exposures have to be documented for derivatives trading, since hedging anticipated exposures isn’t permitted. Indeed, until 1996 government approval was required for any hedging deal. “If a customer does a U.S. dollar interest rate hedge with a bank in India, the bank still has to close out the residual risk with an overseas counterparty,” notes Amit Gupta, head of treasury marketing at HSBC Markets, a subsidiary of the Hongkong and Shanghai Banking Corp. “But now, a bank in India can give a price to the customer after looking at the underlying instrument. Earlier, you had to go to the Finance Ministry or the Reserve Bank of India for every deal.” The time frame has also improved for transactions. It now takes five minutes to close a deal, vs. a month or so in the past. Currency futures, when they are finally allowed, will have to address a number of limits on hedging, but they will have clear advantages over forwards: no default risk, more liquidity in times of uncertainty or crisis, and price transparency, since margin is not calculated based on spot values.

Erratic rates

Interest rates on the subcontinent have also proven to be somewhat skittish. In January 1998, overnight rates soared to 140 percent, compared with around 8 percent under more normal conditions. As a result of such volatility and pressure on short-term rates, interest rate swaps beyond one year are considered long-term. Another problem is that the country lacks a term benchmark curve. Currently, the risk-free sovereign benchmarks that exist are thinly traded, in part because banks hold on to government securities and Treasury bills for statutory liquidity reserve requirements. Capital adequacy requirements also make it difficult for a secondary debt market to take root. And because the secondary market is so weak, an investor who buys a bond has almost no ability to exit the position.

“Exchange-based equities trading will begin with index futures, since payoffs are linear and people can understand them more easily than options. Index options will be next, and then options on individual stocks.” —Nitish Idnani

The NSE has been publishing daily overnight, 14-day, 30-day and 90-day rates for risk-free government securities since 1998, based on a pool of quotes, but there is no basis for realistic pricing further out along the curve. Other benchmarks that have recently been considered are the bank rate, an administered rate set by the Reserve Bank of India, and the prime lending rate of large nationalized banks. ICICI, says Mor, has also decided to help synthesize a more complete yield curve by offering a two-way bond market on its own longer-term debt issues. It now trades on both sides of the curve in an effort to add depth to the markets and provide greater price transparency. On the corporate side, HSBC’s Gupta notes that he is beginning to see an increase in demand for interest rate caps.

ICICI has been innovative in other areas of the financial market as well. In April 1997, the investment bank floated a $208 million, 12-year bond linked to BSE’s Sensex index. The equity-linked issue was a novel idea at the time, but didn’t catch on with investors. ICICI and other banks have begun exploring credit derivatives and structured products to manage counterparty credit risk, but the bank’s most progressive and successful ventures have been in revamping project financing, where the risk of default is notoriously immense.

India’s dilemma as it approaches the millennium is that it has now ventured as far away from a quasi-socialist economy as it can get without losing sight of its recent history of successful capital controls. After the Asian crisis of the last two years, the policy imperatives at the central bank are clearly not to abandon market controls, which many credit with preserving the country from economic blight. Like Malaysia and unlike most other East Asian countries, India’s short-term foreign debt is relatively small in proportion to its overall foreign debt. The Reserve Bank has also kept the rupee/dollar rate reasonably steady during the recent turbulence, and—despite its capital controls—has lately kept interest rates in the single digits.

Still, there remains an inevitable conflict between the government’s prudential concerns and the desire to continue opening up the country’s capital markets. There is the further worry that if India continues its recent sluggish pace toward derivatives trading and globalization, offshore markets will develop for foreign institutional investors that want to take on Indian exposures or hedge their rupee risk. And that is a scenario the Indian government probably would not wish to confront.

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