In December 1996, US Federal Reserve Chairman Alan Greenspan raised the concern that stock prices had been unduly lifted by “irrational exuberance”. The US government acted swiftly, banning stock market trading until speculation had been eliminated.
Of course, that response never happened. Nor did the US regulators ban programme trading and stock index futures after the Black Monday crash of October 1987, nor hedge funds after the collapse of Long Term Capital Management in 1998. The presumption behind regulatory responses in such cases is the correct one—namely, that markets generally improve information flows, and allow more efficient decision-making, including better risk management. When markets or market participants behave badly, specific problems are identified and addressed, whether they pertain to individual market participants, the mechanisms of trading and general rules of the game, or the manner of regulatory oversight.
In India, we often have a hard time even getting started. The official excuse for not permitting many kinds of markets is that they will behave badly, and permit exploitation and manipulation. This attitude, of course, is completely as odds with the stated policy aims of developing the Indian financial sector into a world-class competitor. In many cases, there is enough international and domestic experience with market design to proceed quickly with setting up and running the requisite markets.
Rupee currency futures are a good example of tardiness on the part of policymakers. The RBI responded to the June 2007 start of trading of rupee futures on the Dubai Gold and Commodities Exchange by setting up a committee on the matter. There is really nothing much to mull over in terms of market design, since the technology and institutional rules are off-the-shelf products. There are two possible objections to consider, however. The first comes from current dealers, who might see their profits from a non-transparent market with entry barriers squeezed by an open exchange. This concern is often disguised as one about volatility or market stability. In fact, competition from places such as Dubai is going to affect these incumbents anyway, and market-making rewards are going to migrate overseas. The second concern has to do with currency management. The RBI has followed a policy of managing the level and volatility of the exchange rate, especially with respect to the US dollar. Would currency futures make the RBI’s job harder?
The real answer is probably that the RBI needs to adjust its objectives, allowing greater flexibility in the exchange rate, while reserving the option of intervening to maintain some degree of market order and predictability. At various times, regulators do place minimal limits on markets—the US SEC introduced circuit breakers after Black Monday to avoid trading mechanisms from being overwhelmed in extreme circumstances. This does not mean that the RBI is the appropriate regulator for currency futures. Indeed, it has no expertise in running an exchange, and as a market participant, it should definitely not be the regulator. It is obvious that Sebi should regulate currency futures trading, and that existing exchanges can add on these new products.
It is easy to confirm these intuitions by examining what’s happening on the DGCX. One can get real time data on current trades, and historical data on prices and volumes. After an initial rush, volume has settled down at about $3-4 million per day. Given the RBI’s position as market leader, futures prices have tracked the spot rupee-dollar exchange rate quite closely, and also given insight into expectations, or risk management needs of participants. For example, for the period June 11 to July 15, the closing price of July 16 futures was above the spot rate on 20 of 25 trading days. The maximum deviation was about 0.4%. The corresponding figures for August 20 futures were 19 days and 0.57%. August 20 futures were above July 16 futures for the first seven days of this period, and then below for 15 of the next 18 days. One can do more substantive analysis of the numbers, but the lessons are clear: the market is orderly, it provides information to all, and it allows participants to manage their risks as they see fit. But the rewards are accruing to Dubai, and not to anyone in India.
Setting up and running new financial markets is no longer a difficult proposition, if trading institutions and experienced regulators are already in place. There is no need for India’s policymakers to delay in this respect. In fact, some research by Bharat Ramaswami and Jatinder Bir Singh on the soya oil exchange suggests that commodity futures markets can function well even in the absence of integrated, frictionless spot markets. With respect to currency and debt markets, including derivative products, the RBI should quickly hand over the charge to Sebi, which should work with exchanges to introduce as many markets as possible in a sequenced, orderly fashion. The RBI’s proper role is macroeconomic management, not microeconomic details of running markets. This does not mean lack of monitoring or failure to manage crises. The key point is that macroeconomic management is unlikely to be compromised by enriching the set of financial markets in India. The latter, in turn, is crucial if India is serious about financial sector development.
—Nirvikar Singh is professor of Economics at the University of California, Santa Cruz