On December 15, 2020, the Reserve Bank of India placed on its website a Working Paper titled ‘Price Discrimination in Over-the-Counter Currency Derivatives’ under the Reserve Bank of India Working Paper Series. The paper is authored by Abhishek Kumar and Vidya Kamate, both, its brilliant staff members. As the name indicates the study deals with the following discussion related to derivatives.

“This paper provides empirical evidence on the presence of considerable price discrimination in the Indian over-the-counter (OTC) currency derivatives market. Clients transacting with a single dealer counterparty paid an average markup of 18 paise, which falls to 9 paise for clients transacting with two dealers, and close to zero for clients transacting with ten or more dealers. This alludes to the role of bargaining power in pricing, possibly on account of dealer access.”

Let me reproduce the study from the RBI website as under.


Let us learn from the research paper.


Let me introduce you to some basic facts about foreign exchange, particularly, some of the instruments used to transact the business.

All of us are aware of currency being used to undertake cross border trade like exports/imports, offering IT or other technical services among the nations. To the obvious statement of the study that cross-border trade in goods, services, and assets (or capital) necessitates the exchange of one currency into another which is the primary reason for the existence of currency markets and participants trade in spot (including cash and tom) market to meet their immediate requirement of an asset (currency), while the derivative contracts are used to hedge against possible adverse fluctuations in exchange rates (currency risk), let me give you an example for better understanding.

I just want to buy a draft in US Dollars of 250 to pay for my membership in a foreign organization related to finance, legal, or other technical institutions. My bank immediately offers the currency, a dollar at a price, and offers a draft drawn on any beneficiary of my choice. How does the transaction take place? My financial institution immediately buys and sells the currency to square its foreign exchange position over the counter transaction with other authorized dealers who got their permission from RBI. Almost all scheduled commercial banks, leading exporters/importers, and other market makers align with this category. The quotes are obtained from inter-dealer or inter-bank dealings by their traders who deal with buying or selling transactions every day.

However, what happens if an exporter wants a quote in US Dollars for a transaction to take place in 45 days or so. The bank, a foreign exchange dealer offers a price but covers its position with derivatives for future transactions to deal with regulatory and risk management positions. But do you know that for the same transaction of say, U S Dollars 10,000 price offered by the bank will be different for various clients like the client segment which witnesses participation from a diverse investor set; from sophisticated foreign portfolio investors (FPIs) and large corporates to individuals and small and medium enterprises (SMEs)?

 Now, the studies have shown that OTC markets with diverse investor base are prone to discriminatory pricing based on the sophistication or activity of investors.

Why so?

Currency contracts are traded at exchanges or over-the-counter (OTC). Exchanges offer superior risk management and anonymity; the OTC segment provides a choice of counterparty and customization of contract. The currency market is largely OTC with an average daily turnover of USD 6.6 trillion while India which is one of the most active trading nations on daily basis trails other leading nations with a current average daily turnover in OTC and exchange-traded currency derivative (ETCD) segments at about USD 40 billion and 8 billion, respectively.

Let us get back into the research study.

The authors have quoted that limited transparency in activities in OTC derivative markets had often been cited among the primary reasons for the 2008 financial crisis (Stulz, 2010, and Stanton and Wallace, 2011, studies by leading researchers).

They have stated that the G20 and Financial Stability Board (FSB) have shown a commitment to reform the OTC derivatives market and to improve transparency in these markets. Is it not interesting to know that clients transacting with a single dealer counterparty (unsophisticated clients) paid, on an average, a markup of around 18 paise while the same for clients transacting with two dealer counterparties was about 9 paise? The average markup incurred by highly sophisticated clients, with access to ten or more dealers, was close to zero.

An anomaly, you may say. But the research paper studies this problem and leads us with its array of startling results.

 The rest of the paper is structured as follows:

Section 1, an introduction, has already been used to explain the previous paras.

 A brief summary of related literature is provided in section 2.

 Section 3 describes the transaction process in the currency forward market.

Section 4 provides details of the hypothesis, data, and variable construction used in the study.

 Section 5 presents the empirical methodology and results of the paper followed by robustness checks in section 6.

 Section 7 concludes the study.

While quoting “This study is closely related to the strand of theoretical and empirical literature that seeks to understand the impact on asset prices of search, liquidity, bargaining and informational frictions in decentralized over the counter markets.”, the authors have mentioned 20 research papers to buttress their findings.

What is the hypothesis, this study wants to prove?

“Hypothesis: The markup, in the Indian currency forward market, depends on the sophistication of clients, with less sophisticated clients incurring higher markup for booking currency contracts.”

How about the data for this study?

Let me introduce you to its transaction data.

“Transaction level data on OTC currency derivative transactions executed during a one-year period from September 1, 2018, to August 31, 2019, retrieved from CCIL TR, was used for this analysis. Transactions that were active during the month of September 2019 or had been settled till then were retrieved. Refintiv Eikon’s (Eikon) USD/INR spot and interdealer outright forward prices were obtained for calculation of markup.”

The countenance to the research bears the following charts and tables. Anyone interested in serious analysis of these statistical marvels can indulge at leisure and understand. I thought it is sufficient to have them narrated to have a basic feeling of the importance of the study. Unlike my days in youth, the current Indian researchers rank among the best in the world and explain the facets of their study with Indian statistics and the latest research techniques. What an amazing achievement!

Table 1: Filtering of Data

Table 2 – Descriptive statistics

Table 3: Client Categorization (For just information, this table contains the client list of 8713, out of which 3773 unlisted companies, 742 listed companies, and 3586 retail clients are included. Sufficient to arrive at definite conclusions.)

Table 4: Regression Results: Markup on Client Sophistication

Table 5: Regression Results: Markup on Client Categories

Table 6 – Regression Results: Markup on Client Sophistication (A list of observations for retail was 35431, unlisted 125743, and listed 90865). The regression results indicate the depth of the study.

Table 7 – Breakup of Notional Amount and Markup Paid

Table 8 – Category Wise Share in Clients, Notional Amount and Markup Paid

To a pointed query “What about the charts”, let me give the breakup.

Chart 1 – USD/INR Spot and Outright Forwards (rupee on the Y-axis with details for spot, 1 month, 3 months, and one year on the X-axis. Period covered September 18 – August 19. Values of US Dollar vis a vis Indian currency varied between 68 and 74.)

Chart 2: Frequency Distribution of Transactions by Tenor

Chart 3: Average Markup vs Number of Dealer Counterparties (Can you imagine mark up in price went up to 18 paise for 82.8% of clients with one dealer while it was 0 paise for clients dealing with 10 dealers? This confirms the hypothesis of the study, in my conclusion0

Chart 4 – Average Markup and Percentage of Clients with Two or More Dealer Counterparties (page 18)

Chart 4 – Three months realized Volatility appearing on page 23 contains a plot of movement of daily rolling three months realized volatility from Jan. 1, 2015, to Oct. 31, 2019, for USD/INR spot, obtained from Eikon. Source: Refinitiv Eikon Termina)

Some of the conclusion arrived at the study is summarized as under:

  • The paper analyzed the pricing behavior in India’s foreign exchange market with a focus on the OTC currency (USD/INR) derivatives market.
  • “The findings of the paper suggest that search frictions prevail in the Indian OTC currency derivatives market and the market is characterized by discriminatory pricing.”
  • More specifically, less sophisticated clients (i.e., clients with access to fewer dealer counterparties) were found to be paying higher markup while transacting in this market.
  • Further, retail clients (individuals, proprietorship firms, and small firms) and unlisted firms contributed to less than one-third of the gross notional value of transactions but their share in total markup was about two-third.

My observations based on practical considerations

Hardly an individual deals with foreign exchange transactions but the recent liberalization of rules in respect of remittance or receipt of funds has increased the chance of this happening bright. The arrival of new banks with the most creative ideas in all speres of banking, with a real emphasis on startups will brighten up the financial sector, shake up the market and the availability of foreign currency at the most competitive rate is not far off.

Who would have visualized that the remittance of funds, payment of instant cash in means other than banking, or usage of the latest IT products in funds management in India would attract the attention of the world?

But I do agree with the conclusion that there is a case for improving market access which can be achieved through increased usage of electronic trading platforms and that for each client category, increased access to dealers will lead to the improved negotiating power of clients and, therefore, lower transaction cost.

I expect newer players in foreign exchange enabled by a bigger economy would see this happening as visualized by G 20 leaders in Pittsburgh Summit.


Privacy statement: The above ideas collated by me as a student of banking/foreign exchange for the past 5 decades are from the RBI website which has been quoted above. Obviously, neither myself, RBI nor taxguru.in intend giving legal advice. One seriously intended to do business or consultation needs the help of experts. We are not responsible for otherwise consequences.

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Qualification: Post Graduate
Company: subramanian natarajan cpa firm
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Member Since: 09 May 2017 | Total Posts: 190
A banker with 27 years of experience, a CPA from USA with specialization in US taxation, individual, partnership, S corporation or LLC taxation etc View Full Profile

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