Trading in currency futures has gotten off to a decent start, going by volumes in the first six days of its history. Daily turnover in the near-month contract has averaged $38 million (about Rs168 crore today). A trade of up to 100 contracts can be easily executed at a spread of less than 2 paise, compared with the best available quote in the market.
Often, including the time of writing this article, the spread for this order size is around 1 paisa, which is fairly competitive considering the product is still in a nascent stage.
Note that a trade of 100 contracts amounts to a contract size of $100,000, which is fairly high from a retail investor’s perspective. Like all exchange-traded products, the retail segment and high networth individuals (HNIs) are expected to provide initial liquidity in the currency futures market. There’s ample liquidity already to attract increased participation from retail and HNI investors. Brokers are doing their bit as well. Geojit Financial Services Ltd, for instance, has announced it won’t charge brokerage on currency futures trades till the end of this month.
At the current stage, liquidity is minuscule compared with the inter-bank forward market, which clocks daily volumes of about $34 billion. The spreads in this market are also much lower. But what’s important is that the forward market is closed to retail and HNI traders, who are most active in the currency futures market.
The minimum trade size there is $500,000, making it inaccessible even for small-size companies. The Reserve Bank of India also mandates that one can participate in the forward market only if there is an underlying exposure in the foreign currency.
All those who want to take a view on currency movement, but can’t do so in the forward market, will be natural users of the currency futures market to begin with. As J.R. Varmaof the Indian Institute of Management, Ahmedabad, alludes to in his blog, the better liquidity of the forward market will have no appeal for this group of new entrants.
They start trading based on the other characteristics the new market offers; in time building liquidity to an extent where users of the old market are also attracted to it.
For current users of the forward market to consider the new market, there should be an ability to do trades of about $1 million at relatively low spreads. Client-level position limits will also have to be raised from the current level of $5 million. As pointed out earlier, the new entrants to currency derivatives trading wouldn’t be bothered about these limitations.
Varma says that we’re currently in phase I of the development of the currency futures market, where retail participants are bringing in the initial liquidity. Phase II would involve the entry of small and mid-size companies, which can’t access the inter-bank market and were so far buying currency derivatives from banks by paying high fees. Of course, this set of players would have to get accustomed to paying daily mark-to-market margins, but, on the other hand, they’d get some of their credit line with banks freed up. Phase III is when institutional investors such as foreign institutional investors (FIIs), banks and mutual funds (MFs) start participating actively and enable trades of large sizes. For now, many institutional investors aren’t permitted. Hopefully, by the time the market is ready for phase III (about 12-18 months, according to Varma), the market will be open for all participants.
Competition to spur growth
One distinctive feature of the currency futures market is that it will be highly competitive. The National Stock Exchange (NSE) and the Multi Commodity Exchange of India (MCX) enjoy near monopoly in the majority of the assets traded on their exchanges. The currency futures segment will perhaps be the first time they’d face serious competition for a major market.
NSE may have got the lead start, but that doesn’t matter much since trade sizes currently are still small. It hasn’t got a runaway lead. Instead, MCX starts with an advantage, thanks to its popularity with brokers and traders punting on gold and crude oil. These commodities have a strong linkage with foreign exchange movements and hence their traders can be expected to have a natural interest in currency trading as well. MCX also has the advantage of being popular with the broking community, while NSE is perceived by brokers to be more rigid in its dealings with them.
On the other hand, NSE has the advantage of a much wider audience, which is already using its equity platform. Apart from retail and HNI investors, which are common to both exchanges, it has the added advantage of already dealing with banks, FIIs and MFs. These institutional investors are not permitted to trade on commodity exchanges. For now, this segment doesn’t matter, but when they’re permitted to trade currency futures, NSE could gain from the experience of already dealing with them.
From the market’s point of view, the strong competition is certainly good, as it would not only lead to better service and lower costs, but also spur growth. Already, NSE is offering trading in currency futures from 9am till 5pm, longer than the 10am-3.30pm session its mainstay equity segment is open.
The Bombay Stock Exchange, the third exchange to have gotten approval for currency futures, offered members discounts for early enrolment.
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