History of Foreign Exchange Market in India

The foreign exchange market in India started in earnest less than three
decades ago when in 1978 the government allowed banks to trade foreign
exchange with one another. Today over 70% of the trading in foreign exchange
continues to take place in the inter-bank market. The market consists of over
90 Authorized Dealers (mostly banks) who transact currency among
themselves and come out “square” or without exposure at the end of the
trading day. Trading is regulated by the Foreign Exchange Dealers Association
of India (FEDAI), a self regulatory association of dealers. Since 2001, clearing
and settlement functions in the foreign exchange market are largely carried
out by the Clearing Corporation of India Limited (CCIL) that handles
transactions of approximately 3.5 billion US dollars a day, about 80% of the
total transactions. The liberalization process has significantly boosted the
foreign exchange market in the country by allowing both banks and
corporations greater flexibility in holding and trading foreign currencies. The
Sodhani Committee set up in 1994 recommended greater freedom to
participating banks, allowing them to fix their own trading limits, interest
rates on FCNR deposits and the use of derivative products. The growth of the
foreign exchange market in the last few years has been nothingless than
momentous. In the last 5 years, from 2000-01 to 2005-06, trading volume in
the foreign exchange market (including swaps, forwards and forward
cancellations) has more than tripled, growing at a compounded annual rate
exceeding 25%. . The inter-bank forex trading volume has continued to
account for the dominant share (over 77%) of total trading over this period,
though there is an unmistakable downward trend in that proportion.This is in
keeping with global patterns.
Introduction

The foreign exchange market, also known as the forex, FX, or currency market,
involves the trading of one currency for another. Prior to 1996 the market was
confined to large corporate banks and international corporations. However it has
since opened up to include all traders and speculators. Today, the average daily
turnover in forex markets is US$1.9 trillion, according to the Bank of International
Settlement’s Triennial Survey. The market is growing rapidly as investors gain more
information and develop more interest.

In trading foreign exchange, investors bet that one currency will appreciate over
another; they profit when they bet correctly and collect the profit in the form of an
interest rate spread when they return to the original currency. The profit margins are
low compared with other fixed-income markets. Large trading volumes can, however
result, in very high profits. Most forex trading takes place in London, New York, and
Tokyo, with most trading activity in London, which dominates the market at 30% of
all transactions. New York’s market share is 16%, and Tokyo’s has fallen to 10% due
to the growing prominence of Singapore and Hong Kong. Singapore has become the
fourth largest exchange market globally, and Hong Kong is the fifth, having
overtaken Switzerland. The various players in the foreign exchange market include
bank dealers, 16% of which are international investors and speculators. Banks
account for almost two-thirds of forex transactions; of the rest, about 20% is mainly
attributable to securities firms that operate in the international debt and equity
markets.

One type of very short-term transaction is the spot transaction between two
currencies, delivering over two days and using cash as opposed to a contract.

In a forward transaction, the money is not exchanged until an arranged date and an
exchange rate is agreed in advance. The time period ranges from days to years.
Currency swaps are a popular type of forward transaction; these involve the exchange
of currency by two parties for an agreed length of time and an arrangement to swap
currencies at an agreed later date. Another type is a foreign currency future, which is
 inclusive of interest. A standard contract is drawn up and a maturity date arranged.
The time schedule is about three months.

In a foreign exchange option (FX option), the most liquid and biggest options market
in the world, the owner may elect to exchange money in a designated currency for
another currency at an agreed date in the future. This type of transaction depends on
the availability of option contracts on an organized exchange. Otherwise, such forex
deals may be carried out using an over-the-counter (OTC) contract.

Advantages

 The forex market is extremely liquid, hence its rapidly growing popularity.
Currencies may be converted when bought or sold without causing too much
movement in the price and keeping losses to a minimum.

 As there is no central bank, trading can take place anywhere in the world and
operates on a 24-hour basis apart from weekends.

 An investor needs only small amounts of capital compared with other

investments. Forex trading is outstanding in this regard.

 It is an unregulated market, meaning that there is no trade commission

overseeing transactions and there are no restrictions on trade.

 In common with futures, forex is traded using a “good faith deposit” rather
than a loan. The interest rate spread is an attractive advantage.

Disadvantages

 The major risk is that one counterparty fails to deliver the currency involved
in a very large transaction. In theory at least, such a failure could bring ruin to the
forex market as a whole.

 Investors need a lot of capital to make good profits because the profit margins
on small-scale trades are very low.
Parties Involved in Transaction :

Unlike a stock market, the foreign exchange market is divided into levels of access. At
the top is the inter-bank market, which is made up of the largest commercial banks
and securities dealers. Within the inter-bank market, spreads, which are the
difference between the bid and ask prices, are razor sharp and not known to players
outside the inner circle. The levels of access that make up the foreign exchange
market are determined by the size of the "line" (the amount of money with which
they are trading). The top-tier interbank market accounts for 53% of all transactions.
After that there are usually smaller banks, followed by large multi-national
corporations (which need to hedge risk and pay employees in different countries),
large hedge funds, and even some of the retail FX market makers. Central banks also
participate in the foreign exchange market to align currencies to their economic
needs.

Banks
The interbank market caters for both the majority of commercial turnover and large
amounts of speculative trading every day. A large bank may trade billions of dollars
daily. Some of this trading is undertaken on behalf of customers, but much is
conducted by proprietary desks, trading for the bank's own account. Until recently,
foreign exchange brokers did large amounts of business, facilitating interbank
trading and matching anonymous counterparts for large fees. Today, however, much
of this business has moved on to more efficient electronic systems. The broker
squawk box lets traders listen in on ongoing interbank trading and is heard in most
trading rooms, but turnover is noticeably smaller than just a few years ago

Commercial companies
An important part of this market comes from the financial activities of companies
seeking foreign exchange to pay for goods or services. Commercial companies often
trade fairly small amounts compared to those of banks or speculators, and their
trades often have little short term impact on market rates. Nevertheless, trade flows
are an important factor in the long-term direction of a currency's exchange rate.
Some multinational companies can have an unpredictable impact when very large
positions are covered due to exposures that are not widely known by other market
participants.

Central banks
National central banks play an important role in the foreign exchange markets. They
try to control the money supply, inflation, and/or interest rates and often have
official or unofficial target rates for their currencies. They can use their often
substantial foreign exchange reserves to stabilize the market. Nevertheless, the
effectiveness of central bank "stabilizing speculation" is doubtful because central
banks do not go bankrupt if they make large losses, like other traders would, and
there is no convincing evidence that they do make a profit trading.

Investment management firms

Investment management firms (who typically manage large accounts on behalf of

customers such as pension funds and endowments) use the foreign exchange market
to facilitate transactions in foreign securities. For example, an investment manager
bearing an international equity portfolio needs to purchase and sell several pairs of
foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialist currency
overlay operations, which manage clients' currency exposures with the aim of
generating profits as well as limiting risk. Whilst the number of this type of specialist
firms is quite small, many have a large value of assets under management (AUM),
and hence can generate large trades.

Retail foreign exchange brokers

Retail traders (individuals) constitute a growing segment of this market, both in size
and importance. Currently, they participate indirectly through brokers or banks.
Retail brokers, while largely controlled and regulated in the USA by the CFTC and
NFA have in the past been subjected to periodic foreign exchange scams. To deal
with the issue, the NFA and CFTC began (as of 2009) imposing stricter
requirements, particularly in relation to the amount of Net Capitalization required of
its members. As a result many of the smaller, and perhaps questionable brokers are
now gone.

There are two main types of retail FX brokers offering the opportunity for speculative
currency trading: brokers and dealers or market makers. Brokers serve as an agent of
the customer in the broader FX market, by seeking the best price in the market for a
retail order and dealing on behalf of the retail customer. They charge a commission
or mark-up in addition to the price obtained in the market. Dealers or market
makers, by contrast, typically act as principal in the transaction versus the retail
customer, and quote a price they are willing to deal at—the customer has the choice
whether or not to trade at that price.

In assessing the suitability of an FX trading service, the customer should consider the
ramifications of whether the service provider is acting as principal or agent. When
the service provider acts as agent, the customer is generally assured of a known cost
above the best inter-dealer FX rate. When the service provider acts as principal, no
commission is paid, but the price offered may not be the best available in the market
—since the service provider is taking the other side of the transaction, a conflict of
interest may occur.

Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international
payments to private individuals and companies. These are also known as foreign
exchange brokers but are distinct in that they do not offer speculative trading but
rather currency exchange with payments (i.e., there is usually a physical delivery of
currency to a bank account).

It is estimated that in the UK, 14% of currency transfers/payments are made via
Foreign Exchange Companies.These companies' selling point is usually that they will
offer better exchange rates or cheaper payments than the customer's bank. These
companies differ from Money Transfer/Remittance Companies in that they generally
offer higher-value services.
Money transfer/remittance companies
Money transfer companies/remittance companies perform high-volume low-value
transfers generally by economic migrants back to their home country. In 2007, the
Aite Group estimated that there were $369 billion of remittances (an increase of 8%
on the previous year). The four largest markets (India, China, Mexico and the
Philippines) receive $95 billion. The largest and best known provider is Western
Union with 345,000 agents globally followed by UAE Exchange.

CAC (Capital Account Convertibility) for Indian Economy refers to the abolition of

all limitations with respect to the movement of capital from India to different

countries across the globe. In fact, the authorities officially involved with CAC

(Capital Account Convertibility) for Indian Economy encourage all companies,

commercial entities and individual countrymen for investments, divestments, and

real estate transactions in India as well as abroad. It also allows the people and

companies not only to convert one currency to the other, but also free cross-border

movement of those currencies, without the interventions of the law of the country

concerned.