What is the size of India’s dollar-rupee futures market? Last week, the combined turnover of the MCX Stock Exchange (MCX-SX) and the National Stock Exchange (NSE) in the near-month dollar-rupee futures market averaged $6 billion per day. After United Stock Exchange of India’s (USE) currency futures launch on Monday, the size of the market has risen by three times to $18 billion. USE reported volumes of $9.7 billion in the September dollar-rupee contract, 15% higher than the combined volumes on MCX-SX and NSE. It’s not even that it captured share from the incumbents—MCX-SX and NSE improved on their volumes compared with last week.
This is unnatural, to say the least. The Reserve Bank of India (RBI) data suggests that turnover in the dollar-rupee pair in the over-the-counter (OTC) market would at best be around $20 billion per day. Has the size of the currency futures market come close to the size of the OTC market overnight? USE’s high volumes also go against the principle that “liquidity breeds liquidity”, and that traders are attracted to venues that are already fairly liquid. Because of this, in most markets, new trading venues find it difficult to capture market share from established entities. In cases where they manage to do so, it is a gradual process.
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Some bankers and financial market experts say that one should ignore the volumes on the first day of an exchange’s launch, since they are often artificial in nature, propped up by friendly brokers to give an impression that the newly introduced contract is liquid. This view is supported by the fresh open interest created in the market, or rather the lack thereof. Last Friday, the cumulative open interest on MCX-SX and NSE in the September dollar-rupee contract stood at $1.13 billion. Even though volumes in this contract on Monday trebled compared with last week, the cumulative open interest position on the three exchanges dropped marginally to $1.09 billion. USE added just $57 million in open interest.
Cumulatively, the three exchanges’ open interest amounts to less than 2% of the traded volumes on Monday. In contrast, in the case of the near-month Nifty futures contract, the open interest position is about 1.5 times the daily volumes. There seems to be something structurally wrong about the currency futures market, which is generating high volumes but precious little in terms of genuine positions.
Some months ago, after a Delhi government notification that proprietary trades will attract stamp duty, volumes in the market had fallen considerably. Turnover in the currency futures market had peaked at around $10 billion in May 2010 and averaged around $8 billion in the three months between April and June 2010. In July, after the notification came into force, average daily turnover fell sharply to $5.2 billion.
Market experts say that volumes in this market don’t convey an accurate picture of the size of the market. There’s an outsized proportion of speculative and arbitrage trades led by proprietary desks, thanks to the minimal costs involved in trading currency futures contracts. Unlike equity derivatives, currency futures trades don’t attract securities transaction tax. Besides, exchanges haven’t yet begun charging fees in this segment. To add to that, volatility is relatively low and traders need to take relatively larger positions compared with the equity market to make reasonable profit. This is because the contract is priced till the fourth decimal, and unless traders take large positions in terms of notional value, they won’t make decent profits. For this reason, it doesn’t make sense to compare turnover in this market with that of the equity derivatives market.
Of course, there’s nothing unlawful about speculative activity. But the market regulator, the Securities and Exchange Board of India (Sebi), needs to be on the watch for circular trading. Market chatter suggests that because of the lack of transaction taxes, circular trading activity is relatively easier and cheaper for this segment. This would give a false impression of liquidity, which goes against Sebi’s intent of having fair and transparent markets.
The perceived success of the currency futures market is no doubt a matter of pride for Sebi and RBI which jointly launched this product, and there may be a temptation to ignore rumours about artificial volumes in the market. But if these rumours are true and are not dealt with, it will work against the long-term health of the market and affect the integrity of the market and its regulators.
Thus far, Sebi has relied on a surveillance model where there is considerable onus on exchanges to first report misdoings such as circular trades, after which Sebi does follow-up investigations. But such a model leaves out the possibility that an exchange itself may have incentive to create artificial volumes, to attract liquidity. For this, Sebi needs to have its own sophisticated surveillance system, which can capture such activity. This column has argued before that there are a number of reasons why Sebi should take over the surveillance function from exchanges. The time seems to be ripe for such a move.
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