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Trading at the forex margins
May, 24th 2007

A plethora of small steps have been taken towards fuller Capital Account Convertibility, by easing further the restrictions on capital outflows. A bold move towards a liberalised remittance scheme allows remittances up to $100,000 per financial year for any permissible or capital account transactions or a combination of both. Resident individuals are free to acquire and hold immovable property or shares or any other asset outside India without prior approval.

Residents can also open, maintain and hold foreign currency accounts with a bank outside India for making remittances without prior approval. Many of these steps are primarily aimed at easing outflow of capital from the economy, thus pre-empting somewhat the need for the central bank to sterilise the appreciative bias on the currency arising out of strong capital inflows

Now the resident has a range of products to trade and hedge his exposure. He can trade in offshore equities, commodities, currency-rates, stocks and indices, treasury products, including margin trading, structured products, immovable property, and a wide array of investment products.

While residents can now do freely forex margin trading and structured products overseas, does the country offer margin trading in forex and structured products? The answer is no.

So, what value addition and advantages will the market participants get by margin trading?

Advantages of margin trading and structured products:

Highly customised: To fit the unique requirements of particular investor. They create risk-return profiles and easily available in many currency pairs.

Enhanced yield: By expressing a view on an underlying currency, investors can achieve higher returns on their investments than on traditional products.

Denomination: Available in minimum lot size of $10,000or equivalent for margin trading. For structured products it is $50,000 or more.

Overcome regulatory issues: Packaged products allow for easy access to markets and products otherwise prohibited to certain investors

Clients may benefit from hedging and arbitrage opportunities.

Asymmetric volatility

The cascading effect when anything happens in the forex market is carried over to the call money and stock markets, and it is 46 per cent and 55 per cent, respectively. Whereas in the case of equity to call money it is 140 per cent. The effect of stock market to forex is 325 per cent, whereas that of the reverse of forex to stock market is only 55 per cent.

By studying the asymmetric relationships, the customer will switch from one product to another depending on the market conditions.

Marketing Strategy and cost benefit analysis

Allows all residents and NRIs to benefit from price movements in international markets for major currencies and allows them to initiate a trade in any permitted currency.

Lets banks decide on the margin money and the leverage that should be allowed.

Allows all forex and money market brokers in India under pressure to close down due to number of direct deals taking place among the banks through the trading platforms and give them brokerage.

If the trade is carried overnight, then it will have a financing cost. If the position is long then the a financing cost is payable to the bank.

The trading platform will be web based, with live prices and deals will be done at current market prices.

Offers a variety of orders to choose from such as stop-loss, take profit, one cancels the other.

Clients can view their positions on line, past trades, pending orders.

Brokers may be able to put in trades through Internet on behalf of their clients.

As MTM is done on a daily basis market risk is mitigated and there will only be the counterparty risk.

The Government is making all efforts to promote retailing of G-Secs to retailers and banks are promoting the business. The same brokers and staff can be used to cross-selling the product which will save a lot of money for the banks.

The Flipside

When the market picks up, it will find itself pitched into direct competition with each other and there will be emerging trading platforms. This will force banks to go in for e-Treasury and web-based technology trading platforms. This threat, compounded by increasingly demanding customers, will prompt service providers to showcase their technology qualifications. Some will go further and commit themselves to big investments in systems to address particular requirements of the directive, the speed and resilience of their trading systems or the demand for cross-asset trading.

RBI's clarification circular

Residents cannot remit margin money under the LMS for doing FX margin trading with any overseas counter-party, and they cannot remit margin calls for doing any kind of trading with any exchange house for Interest Rate Futures or Currency Futures.

Though the RBI circular is silent about structured products, market participants feel that the residents should not be allowed to remit money outside India for structured products, as the product will have a derivative instrument built into it and its final value is not a predetermined one, but is liable for market risk and its return is liable for change which tantamounts for speculation by the investor.

Situation Overview

Can the resident trade in FX margin trading and structured products either in India or outside? The answer is no. Though it is understandable that the RBI would not like to open the doors to full convertibility for residents in one go and would like to move slow on the liberalisation process, let us analyse as to what are the value addition and advantages that the market participants will get by allowing to trade in India.

Margin trading: By investing a certain amount of margin money, say 1 per cent, you can initiate a trade in any currency pair up to 100 per cent. Leverage is possible. Mark to Market (MTM) will be done on a daily basis to mitigate the market risk and margin money will be recovered or paid as per the closing price.

Structured product transactions are innovative financing techniques creating customised financing and investment products to suit the financial needs of customers. Being customised, they are often unique, illiquid and difficult to price. When used appropriately, they can add positive contributions to the efficiency of markets, risk management, and to the welfare of customers and overall financial and economic development. They may diversify risks, allocate cash flows, or reduce costs.

Interest in these investments has been growing in recent years and high-net-worth investors use structured products as way of portfolio diversification. It is also available at the mass retail level, particularly in Europe and Asia where national post offices and even super markets, sell investments on these to their customers

Types of Structured Products

Equity Structures Liability Product (objective to reduce the cost): Different kinds of convertibles, variants to convertibles, convertible equity, warrants.

Asset products (objective to enhance the returns): Investment structures with payoff linked to the equity.

Interest Rate Structures Liability: Floaters, Inverse Floaters, Caps, Floors, Collars, Range Notes, Step up/down instruments.

Asset products: Treasury Inflation Protection Securities (TIPS). Separately Traded Interest and Principal Securities (STRIPS), Principal protection bonds,

Forex Structures: Choice of currency and interest rate to reduce the liability costs. Currency swaps, currency options, etc.

Asset products: Investment structures with payoff linked to the forex.

Eroding Prices, Margin

Future pricing of Treasury is likely to be skewed by the on-demand phenomenon, but it may not be as out-of-whack as other products. Margins are likely to erode and will be offset by a more predictable recurring revenue stream once the critical mass is achieved.

Differentiating factors

Those who offer the various products under one trading platform will be biggest beneficiary and the dealers and trading systems are fully geared to meet the growing demand.

Technology is potentially a crucial differentiator and can help banks engage with corporates across the length of the supply chain, rather than just at the settlement end of the transaction.

Banks should analyse and compare returns on the various products current and for other maturities up to one year, which will be a powerful tool for the individuals and portfolio manager to churn and see the impact when the markets are turning upside down.

The Way Forward

When residents can now do margin trading overseas, it begs the question why cannot banks in India tap the local market.

It is high time the RBI accorded the permission quickly. As it is a non-funded business all banks will offer the product to all its customers and it will be well received by the residents.

S. Ravi
(The author is a Senior Consultant with Tata Consultancy Services, Kochi. The views are personal.)

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