Original Source: https://boringmoney.in/p/rbi-wants-traders-out-of-currency
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The most vanilla reason to use a derivative is to hedge your position. Say you’ve bought the stock of Timbuktu, Inc. because you think it will go up. But Timbuktu’s stock performance isn’t just a function of the quality of Timbuktu, its business prospects, etc. It’s also a function of the general market sentiment. But you don’t care about the general market sentiment! You just want to bet on Timbuktu the company! So what you could do is buy a put option on the broad market index. That way, if the general market goes down and takes Timbuktu down with it, you might lose money on the stock but you’ll make money on the option. So it’ll even out.
Derivatives like options are great for hedging because they give the buyer a way to bet on the underlying thing (could be a stock, bond, commodity, whatever) without actually buying or borrowing it. So, of course, people don’t buy and sell options just for vanilla hedging anymore. They buy and sell options because they’re okay spending a small bit of money to bet on the price of the underlying product going up or down.
I mean… I don’t recommend anyone trade options, but yes, you can do that and that’s what people do. But the trades are risky and SEBI even has a slightly annoying warning pop up every time people login to their brokerage accounts. But weird people trading options in the hope of making a lot of money while risking their entire capital is somewhat acceptable for stock stuff, so that’s as far as SEBI might want to go.
On the other hand, the RBI regulates currency stuff, and risky options trading seems to be less acceptable for currency derivatives. From Bloomberg earlier this month:
The RBI had issued a circular%20Recognized%20Stock%20Exchanges%20may%20offer%20foreign%20exchange%20derivative%20contracts%20involving%20INR%20to%20users%20for%20the%20purpose%20of%20hedging%20contracted%20exposure.) back in January which said that if anyone wanted to trade currency derivatives involving the Indian Rupee, they could only do so for the vanilla reason of hedging. RBI is apparently sensitive and doesn’t like it when people bet on the direction of the value of the Rupee.
RBI’s new policy was to come into force on April 5 this year, but because of some panic, it decided to defer its implementation by a month. Here’s a glimpse into some of that panic:
Also,
If you’re a company that imports, say, marbles from the US to India and buys a USD/INR call option, the RBI is perfectly fine with it. You’re against the Rupee falling against the Dollar between the time you strike a deal and actually pay for your order. But whom do you buy the call option from?
The obvious answer is from someone who takes the other side of the trade. If you’re worried about the INR going down against the Dollar, there might be someone else worried about the opposite. But it’s not realistic to expect this company to turn up on the exchange at the exact same time as you. So, instead, you’d actually be buying this option from a middleman, whose business it is to constantly buy and sell those derivatives (or stocks, or anything) for a living.
Of course, these middlemen, the market makers, aren’t out there to be middlemen. They’re the hedge funds and quant funds, the traders with high-speed computing power running algorithms and strategies with expectations of making a lot of money. [1] They just end up accidentally providing an important service of providing liquidity for other people in the market.
Some figures say that at least 80% [2] of the current turnover of the currency derivatives market comprises prop traders and individual traders. These are the folks just betting on the price going up or down. The ones that aren’t importing marbles from the US. The ones that the RBI wants out. But if they go out, whom are the hedgers going to buy their options from?
Okay, so RBI’s new policy is going to reduce liquidity in the currency derivatives market. It already has! I checked the numbers and the turnover is already obliterated to less than 2% of what it was two months back. But let’s hold this thought.
One day before its new policy was to come into force, the RBI put out this press release whose gist goes something like this—“umm, actuallyyyy, there is no change in our policy. The recent circular is just a consolidation of previous directions.”
People’s reaction to RBI’s new circular was panic but RBI is saying they changed nothing? Here’s an angry tweet thread by Deepak Shenoy where he says the RBI’s decision is unruly and it’s essentially lying when it says that there is no change in policy.
I get it! This is what Shenoy points out was in RBI’s old policy:
And in RBI’s new policy:
That “or otherwise” in the older policy gave a lot of leeway which the new policy clearly does not. So… what does the RBI want here exactly? It could’ve just said so then? Did it want to change the policy but not look bad while it did it? No success there, for sure.
I’d like to think that this whole thing was a mistake. That someone at RBI forgot to slip in that “or otherwise” in the new policy and then the org was too embarrassed to admit it. “Hey bros, bros. Chill down. This really was our policy all along. Continue as you would,” RBI seems to say. [3]
For now, the currency derivatives market is dead. But that’s right now! The new policy is fresh. Is the market going to remain dead after, say, 6 months?
RBI is ultimately relying on brokers [4] to ensure that their customers are hedging and not just betting on the price if they trade a currency derivative. But traders don’t need to show proof and hedging and brokers don’t need to ask for it.
The currency derivatives market is already illiquid in comparison to two months ago. In general, any illiquid market is going to see more price fluctuations. [5] And price fluctuations are going to make it lucrative for traders to come in and make a quick buck. [6] The only thing in their way? Brokers who don’t have to check for proof anyway.
I’m not saying that the traders will come back, I don’t know. But the RBI is definitely making it more lucrative for them to come back. I’m marking my calendar at 6 months to check.
Footnotes
[1] Overall, that is. And with high volumes. Market making is a low margin, high volume business.
[2] Considering the drop in the currency derivative trading volume already, I’d say the real number is much higher than these estimates. Probably 90–95%.
[3] An obvious question that crops up here is—if there is no change in policy, what exactly did RBI defer until May 3?
[4] Well, sort of. The RBI’s actually relying on the stock exchange, which ultimately relies on brokers. But sure, if the stock exchange feels that a certain broker’s customers may not be hedging and just trading, it can always ask the broker to check.
[5] The guest experts story from last month is a good example of how there can be sharp fluctuations in less liquid options.
[6] This can be a double-edged sword though. If the price goes up and down more, traders can make more money out of each trade. But they can also lose more money.
Original Source: https://boringmoney.in/p/rbi-wants-traders-out-of-currency
(my newsletter Boring Money -- if you like what you read, do visit the original link to subscribe and receive similar future posts directly in your inbox)
--
The most vanilla reason to use a derivative is to hedge your position. Say you’ve bought the stock of Timbuktu, Inc. because you think it will go up. But Timbuktu’s stock performance isn’t just a function of the quality of Timbuktu, its business prospects, etc. It’s also a function of the general market sentiment. But you don’t care about the general market sentiment! You just want to bet on Timbuktu the company! So what you could do is buy a put option on the broad market index. That way, if the general market goes down and takes Timbuktu down with it, you might lose money on the stock but you’ll make money on the option. So it’ll even out.
Derivatives like options are great for hedging because they give the buyer a way to bet on the underlying thing (could be a stock, bond, commodity, whatever) without actually buying or borrowing it. So, of course, people don’t buy and sell options just for vanilla hedging anymore. They buy and sell options because they’re okay spending a small bit of money to bet on the price of the underlying product going up or down.
I mean… I don’t recommend anyone trade options, but yes, you can do that and that’s what people do. But the trades are risky and SEBI even has a slightly annoying warning pop up every time people login to their brokerage accounts. But weird people trading options in the hope of making a lot of money while risking their entire capital is somewhat acceptable for stock stuff, so that’s as far as SEBI might want to go.
On the other hand, the RBI regulates currency stuff, and risky options trading seems to be less acceptable for currency derivatives. From Bloomberg earlier this month:
The RBI had issued a circular%20Recognized%20Stock%20Exchanges%20may%20offer%20foreign%20exchange%20derivative%20contracts%20involving%20INR%20to%20users%20for%20the%20purpose%20of%20hedging%20contracted%20exposure.) back in January which said that if anyone wanted to trade currency derivatives involving the Indian Rupee, they could only do so for the vanilla reason of hedging. RBI is apparently sensitive and doesn’t like it when people bet on the direction of the value of the Rupee.
In the panic room
RBI’s new policy was to come into force on April 5 this year, but because of some panic, it decided to defer its implementation by a month. Here’s a glimpse into some of that panic:
Also,
If you’re a company that imports, say, marbles from the US to India and buys a USD/INR call option, the RBI is perfectly fine with it. You’re against the Rupee falling against the Dollar between the time you strike a deal and actually pay for your order. But whom do you buy the call option from?
The obvious answer is from someone who takes the other side of the trade. If you’re worried about the INR going down against the Dollar, there might be someone else worried about the opposite. But it’s not realistic to expect this company to turn up on the exchange at the exact same time as you. So, instead, you’d actually be buying this option from a middleman, whose business it is to constantly buy and sell those derivatives (or stocks, or anything) for a living.
Of course, these middlemen, the market makers, aren’t out there to be middlemen. They’re the hedge funds and quant funds, the traders with high-speed computing power running algorithms and strategies with expectations of making a lot of money. [1] They just end up accidentally providing an important service of providing liquidity for other people in the market.
Some figures say that at least 80% [2] of the current turnover of the currency derivatives market comprises prop traders and individual traders. These are the folks just betting on the price going up or down. The ones that aren’t importing marbles from the US. The ones that the RBI wants out. But if they go out, whom are the hedgers going to buy their options from?
What honey is for flies
Okay, so RBI’s new policy is going to reduce liquidity in the currency derivatives market. It already has! I checked the numbers and the turnover is already obliterated to less than 2% of what it was two months back. But let’s hold this thought.
One day before its new policy was to come into force, the RBI put out this press release whose gist goes something like this—“umm, actuallyyyy, there is no change in our policy. The recent circular is just a consolidation of previous directions.”
People’s reaction to RBI’s new circular was panic but RBI is saying they changed nothing? Here’s an angry tweet thread by Deepak Shenoy where he says the RBI’s decision is unruly and it’s essentially lying when it says that there is no change in policy.
I get it! This is what Shenoy points out was in RBI’s old policy:
And in RBI’s new policy:
That “or otherwise” in the older policy gave a lot of leeway which the new policy clearly does not. So… what does the RBI want here exactly? It could’ve just said so then? Did it want to change the policy but not look bad while it did it? No success there, for sure.
I’d like to think that this whole thing was a mistake. That someone at RBI forgot to slip in that “or otherwise” in the new policy and then the org was too embarrassed to admit it. “Hey bros, bros. Chill down. This really was our policy all along. Continue as you would,” RBI seems to say. [3]
For now, the currency derivatives market is dead. But that’s right now! The new policy is fresh. Is the market going to remain dead after, say, 6 months?
RBI is ultimately relying on brokers [4] to ensure that their customers are hedging and not just betting on the price if they trade a currency derivative. But traders don’t need to show proof and hedging and brokers don’t need to ask for it.
The currency derivatives market is already illiquid in comparison to two months ago. In general, any illiquid market is going to see more price fluctuations. [5] And price fluctuations are going to make it lucrative for traders to come in and make a quick buck. [6] The only thing in their way? Brokers who don’t have to check for proof anyway.
I’m not saying that the traders will come back, I don’t know. But the RBI is definitely making it more lucrative for them to come back. I’m marking my calendar at 6 months to check.
Footnotes
[1] Overall, that is. And with high volumes. Market making is a low margin, high volume business.
[2] Considering the drop in the currency derivative trading volume already, I’d say the real number is much higher than these estimates. Probably 90–95%.
[3] An obvious question that crops up here is—if there is no change in policy, what exactly did RBI defer until May 3?
[4] Well, sort of. The RBI’s actually relying on the stock exchange, which ultimately relies on brokers. But sure, if the stock exchange feels that a certain broker’s customers may not be hedging and just trading, it can always ask the broker to check.
[5] The guest experts story from last month is a good example of how there can be sharp fluctuations in less liquid options.
[6] This can be a double-edged sword though. If the price goes up and down more, traders can make more money out of each trade. But they can also lose more money.
Original Source: https://boringmoney.in/p/rbi-wants-traders-out-of-currency