Currency futures: The best is yet to come: Economic Times: 21st January 2009

The growth in traded volumes in currency futures
has increased substantially in the last month, with the total volumes traded on the two exchanges around Rs 2,500 crore (around $0.5 billion) a day. There is talk of two or maybe three more exchanges joining the fray and the question is whether or not there is room for more players. Currency futures today are offered only for rupee-dollar contracts for longer periods (12 contracts) than the existing forward contracts (3 contracts). The futures markets were to get in the speculators and investors who would help to deepen the market. It was also assumed that there would be little cannibalisation of the markets given that the main players, i.e. the banks, would be in both of them. Given that volumes have sort of stabilised in the futures market, one can firm up an initial opinion. The first is on the forwards market involving merchant and inter-bank transactions. Overall volumes traded were lower at around $4.6 billion a day in December and January relative to around $6 billion in September and October, though higher than the volumes of around $4.3-4.9 billion a day in June-August. But, it is difficult to say whether there has been any substitution considering that the volumes in the futures markets are only $0.5 billion a day. Given that the forex market has been volatile in the past three months — it was around 18% in December — one would have expected a higher number. On the other hand, lower volumes of foreign trade would have lowered the merchant transactions. The inter-bank transactions have been roughly steady along these periods. The second is that the forward market in dollars (merchant and inter-bank) is a very small part of the overall foreign exchange market today. The forward market in dollars would prima facie have a counterpart in the futures market. The other segment in 'other foreign currency' would technically not have a counterpart. With an average daily turnover of $50 billion, the transactions in forwards in USD accounts for around 21% while inter-bank forwards in dollars account for another 4%.
Hence, the current currency futures actually maps around 25% of transactions in the forwards market. The inter-bank market on the other hand is more in spot and swaps, which account for around 30% each of the overall market. The balance is accounted for by the spot and forward cancellations on the merchant account. The third aspect, the participants on the futures exchanges are quite different from those in the forward market. This can be conjectured based on the implicit futures rates based on the data presented by RBI and NSE. The forward rates appear to be much higher than the futures rates for the same tenure with the difference being almost 200 bps. For example, on January 1, 2009, the one-month forward rate was annualised at 4.43% while the futures market had a rate of 2%. The three-month forward rate was 3.28% as against 2.2% on the futures exchange (only a small part of the difference could be attributed for by the differences in the days involved). In fact, at times, the futures rate was trading at a discount to the RBI reference price. It is likely that it is the speculative money that has been coming into the futures market as against the merchant transactions in the forward market which would be based on physical transactions. Two conclusions can now be drawn form this data. First: the two markets are not integrated and there is scope for arbitrage which will bring about convergence in the markets, as we cannot have two prices in two markets for the same product — one is notional and the other is based on real transactions. Second: given the size of the forward market of around $50 billion and the current size of $0.5 billion in futures, there is enormous scope and opportunity for the existence of more exchanges in the country which will enable back-to-back hedging opportunities for all market participants.