It’s about two months since the United Stock Exchange of India (USE) launched its currency futures platform with record volumes. In the first two weeks since the new exchange’s launch in mid-September, turnover in dollar-rupee futures contracts averaged more than $15 billion daily. Before USE’s launch, average daily volumes stood at around $6 billion between the Multi Commodity Stock Exchange (MCX) and the National Stock Exchange (NSE).
But now there has been a reversion to the mean—average daily volumes now stand at around $6.5 billion between the three exchanges that offer currency futures trading (see chart). Volumes on the USE have fallen to under $1 billion and average daily volumes on the two larger exchanges amount to $5.6 billion. Needless to say, currency futures volumes look relatively reliable now.
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Back then, some bankers and financial market experts had said that one should ignore the volumes in the first few days of an exchange’s launch, since they are artificial in nature, and propped up by friendly brokers to give an impression that a newly introduced contract is liquid. About two months later, this is almost exactly how the script has played out. While volumes haven’t exactly dried up, they have fallen to a fraction of the initial levels.
But USE had reported such high volumes that it was difficult to ignore the amount of currency futures trading. Average daily volumes of $15 billion suggested that the relatively nascent exchange-traded product was challenging the established over-the-counter market in terms of size. Perhaps volumes were yanked up to such an extent that it caught unnecessary attention from regulators. Besides, there is a cost to generating volumes, even if there are no trading fees or transaction taxes. At some point, this would begin to pinch.
Based on USE’s trading history, the exchange sustained unusually high volumes for the first three weeks, when daily volumes in the dollar-rupee pair averaged $5 billion. After that volumes fell gradually to $2.5 billion a day, eventually reaching current levels of under $1 billion. In the currency options segment, which was launched in late October, USE has managed average daily turnover of less than $1 million, while NSE has reported average turnover of around $150 million.
Evidently, USE’s strategy to attract the market’s attention through unusually high volumes in the initial days of trading hasn’t worked. One may argue that without the initial blitzkrieg, volumes may not even have settled at current levels of around $1 billion. Even so, with USE’s volumes now less than half compared with the second largest venue, NSE, the exchange may find it difficult to attract liquidity. After all, traders flock to the most liquid venues.
USE’s model is unique in some sense because it is mainly owned by users of its currency derivatives products; i.e. banks and a few big traders. These players are expected to route their orders to the new exchange for obvious reasons. But while this arrangement looks neat on paper, large traders and banks are ultimately looking for liquidity, and won’t think much before shifting their business to the more liquid venues if USE isn’t able to match up on the liquidity front soon. As pointed out earlier in this column, the dividend income or capital appreciation expected from their minimal investments in USE will pale in comparison to the cost of putting trades in a less liquid exchange.
The problem for USE or any new competitor for that matter is that there don’t seem to be any options in capturing market share from competitors. It can’t differentiate on product design since this is defined by regulators; and it can’t effectively compete on price since the incumbent exchanges are already charging zero fees. These are some policy issues that need to be addressed to ensure there is effective competition in exchange-traded markets.
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