Indian Foreign Exchange Market

A Foreign exchange market is a market in which currencies are bought and sold. It is to be
distinguished from a financial market where currencies are borrowed and lent.

Foreign exchange market is described as an OTC (Over the counter) market as there is no physical
place where the participants meet to execute their deals. It is more an informal arrangement among
the banks and brokers operating in a financing centre purchasing and selling currencies, connected
to each other by tele communications like telex, telephone and a satellite communication network,
SWIFT. The term foreign exchange market is used to refer to the wholesale a segment of the market,
where the dealings take place among the banks. The retail segment refers to the dealings take place
between banks and their customers. The retail segment refers to the dealings take place between
banks and their customers. The retail segment is situated at a large number of places. They can be
considered not as foreign exchange markets, but as the counters of such markets. The leading
foreign exchange market in India is Mumbai, Calcutta, Chennai and Delhi is other centers accounting
for bulk of the exchange dealings in India. The policy of Reserve Bank has been to decentralize
exchanges operations and develop broader based exchange markets. As a result of the efforts of
Reserve Bank Cochin, Bangalore, Ahmadabad and Goa have emerged as new centre of foreign
exchange market.

The markets are situated throughout the different time zones of the globe in such a way that when
one market is closing the other is beginning its operations. Thus at any point of time one market or
the other is open. Therefore, it is stated that foreign exchange market is functioning throughout 24
hours of the day.

Players

The participants in the foreign exchange market comprise;

(i) Corporates (ii) Commercial banks (iii) Exchange brokers (iv) Central banks

Structure

The three actors mentioned above play different roles in the trade. Traders are generally all
individuals in the public who are also corporate customers of the banks. These customers use the
banks as authorized dealers to access the forex market. There are traders of different kinds but all of
them are able to access the market only through dealers. This is much like elsewhere in the world
where brokers are the intermediaries between the forex and ordinary traders.
The banks, on the other hand, are the legally authorized institutions to handle currency. In India,
banks exist in different tiers and there are clear laws that determine which institution is categorized
as a financial institution. From these legal institutions, all those who want to trade can create
accounts, access the market and choose products that they would like to trade in. The trading
landscape has changed a lot over the years especially since the 1990's when the Indian regulatory
authorities liberalized this market.
Lastly, the Reserve Bank of India (RBI) is the central financial institution which is responsible for the
monetary policy in India. This institution has been instrumental in shaping the trading landscape in
India. Before 1993, the Indian Rupee had a fixed value which was determined by the RBI. This meant
that the currency only attracted a certain exchange rate even though the market dynamics were
changing. In 1993, though, the RBI repealed the prevailing law at the time to allow for an exchange
rate determined by the market itself. Since then, the Rupee's value has changed a lot in relation to
different currencies.
The markets in these exchanges have several listed brokers and authorized institutions. There are
several non-bank financial institutions that are legally authorized to facilitate trade in the Indian
market. These institutions are regulated by the FEDAI and they use the USP for better rates of
exchange. The market is open 24 hours every day and it is linked to the rest of the world markets.
Regulatory Aspects
The foreign exchange regulations have been liberalised over the years to facilitate the remittance of
funds both in and out of India. The changes have been introduced on a continuous basis in line with
the government policy of economic liberalisation. Still, in few cases, specific approvals are required
from the regulatory authorities for foreign exchange transactions/remittances.
 
The foreign exchange regulations in India are governed by the Foreign Exchange Management Act,
1999 (“FEMA”). The apex foreign exchange regulatory authority in India is the Reserve Bank of India
(“RBI”) which regulates the law and is responsible for all key approvals.

Challenges
 
Under the Bretton Woods system of fixed exchange rates, interventions were used frequently
to maintain the exchange rate within the prescribed margins. When the Bretton Woods
system broke down in 1971, major industrial countries discontinued pegging their currencies
to the US dollar, bringing in an era of floating exchange rates. In principle, freely floating
exchange rates would rule out intervention by central banks. The central banks have,
however, often intervened for a variety of reasons: (i) to influence trend movements in the
exchange rates because they perceive long-run equilibrium values to be different from actual
values; (ii) to maintain export competitiveness; (iii) to manage volatility to reduce risks in
financial markets; and (iv) to protect the currency from speculative attack and crisis.
Intervention by most central banks in foreign exchange markets has become necessary is
primarily because of the importance of capital flows in determining exchange rate
movements as against trade balances and economic growth, which were important in the
earlier days. In recent times, there has been a large increase in international capital
movements. In emerging market economies, particularly, these capital flows are very volatile,
and largely sentiment driven exposing financial markets to large risks. In order to reduce the
risks, authorities intervene to curb volatility. Secondly, unlike trade flows, capital flows in
“gross” terms, which affect exchange rate can be several times higher than “net” flows on any
day. Therefore, herding becomes unavoidable (Jalan, 2003).
In 1977, the IMF Executive Board laid down some guiding principles for intervention policy
by central banks of member countries. In essence, these principles stated that countries
should not manipulate their exchange rates to gain unfair competitive advantage over others,
or to prevent balance of payment adjustment, but they should intervene to counter ‘disorderly
market conditions’. It is difficult to define ‘disorderly market conditions’ but they are
generally taken to refer to management of exchange rate volatility. While intervention by
central banks in the foreign exchange market has come to be accepted as being consistent
with a fully flexible exchange rate system, there is still no consensus on the effectiveness of
central bank intervention
In the coming years, the challenge for the Reserve Bank would be to further build up on the strength
of the foreign exchange market and carry forward the reform initiatives, while simultaneously 257
FOREIGN EXCHANGE MARKET ensuring that orderly conditions prevail in the foreign exchange
market. Besides, with the Indian economy moving towards further capital account liberalisation, the
development of a well-integrated foreign exchange market also becomes important as it is through
this market that cross-border financial inflows and outflows are channelled to other markets.
Development of the foreign exchange market also need to be co-ordinated with the capital account
liberalisation. Reforms in the financial markets is a dynamic process and need to be harmonised with
the evolving macroeconomic developments and the level of maturity of participating financial
institutions and other segments of the financial market. In the coming years, the challenge for the
Reserve Bank would be to further build up on the strength of the foreign exchange market and carry
forward the reform initiatives, while simultaneously 257 FOREIGN EXCHANGE MARKET ensuring that
orderly conditions prevail in the foreign exchange market. Besides, with the Indian economy moving
towards further capital account liberalisation, the development of a well-integrated foreign
exchange market also becomes important as it is through this market that cross-border financial
inflows and outflows are channelled to other markets. Development of the foreign exchange market
also need to be co-ordinated with the capital account liberalisation. Reforms in the financial markets
is a dynamic process and need to be harmonised with the evolving macroeconomic developments
and the level of maturity of participating financial institutions and other segments of the financial
market.