The growth of the currency futures markets has taken almost everyone by surprise. Around 18 months since its launch, currency futures turnover on the National Stock Exchange (NSE) and MCX Stock Exchange is nearly double that of Nifty futures turnover and around four-fifths of Nifty options turnover.
One of the important factors that have aided the growth of the segment is that it has relatively low transaction costs. Securities transaction tax (STT) has been waived for the segment, resulting in substantial savings for traders. Besides, exchanges have continued to waive trading fees for members. And given the fact that currencies are far less volatile than equities, the margins involved are far lower, resulting in lower capital requirements. All of these put together mean that transaction costs for currency futures are far less vis-à-vis equity derivatives.
Also Read | Mobis Philipose’s earlier columns
There are other factors as well. Currency futures contracts are priced to the fourth decimal place and given the relatively low level of volatility in prices, traders need to bet a relatively large sum to make a decent profit. The average trade size on NSE’s near-month USD/INR (US dollar/Indian Re) futures contract stood at Rs29 lakh on Monday. In contrast, average trade size in the exchange’s equity cash segment stood at Rs22,000. Of course, the larger difference also has to do with a much higher level of retail participation in the equity market.
Before getting into other factors that have supported the growth of the market, it’s important to note the positive effect of lower transaction costs on liquidity. One of the reasons traders have preferred Nifty options over Nifty futures in the past two years is the relatively low transaction cost. Options contracts entail relatively lower STT since the tax is now calculated only on the premium, instead of the earlier practice (about two years ago) of applying it on the notional value of the contract. Besides, capital outlay is also lower, at least as far as options buyers go since their downside is limited to the option premium.
With the Budget approaching, the ministry of finance would do well to note the positive effect of liquidity when STT is lowered or is waived. One could always argue that the equity market’s turnover has grown manifold since 2004 when STT was first introduced. While that is true, it also needs to be noted that pricing efficiency through arbitrage activity is not entirely possible due to the fixed STT cost. Besides, given the differential treatment across asset classes such as equities, bonds, currencies and commodities, there is the possibility that traders would shift to assets where STT is not payable. Many traders are neutral about the assets they trade and would well prefer trading assets that have lower transaction costs.
Coming back to the currency futures market, with daily turnover at around $3 billion (Rs14,040 crore) on each exchange, the segment will attract even more participants. Indian companies can use this market to hedge their forex exposure at a much more reasonable cost compared with hedging through a bank. While this is already happening, the increase in turnover just makes it possible on a larger scale. And banks, which have a monopoly in arbitraging between the futures and over-the-counter forward market, can deploy larger sums in this market. Currency options, which are expected to be introduced soon, should accelerate growth of the currency derivatives market.
Graphic: Ahmed Raza Khan / Mint
At this rate, it won’t be long before currency derivatives become the largest product among exchange-traded derivatives in India. This would be quite a departure from developed markets where equity and interest-rate derivatives head the list of most-traded contracts. It’s interesting to note, however, that despite the success of the currency futures product, exchanges are yet to account for any income from this business, since the product is still offered free.
In The Money runs every other Tuesday. We welcome your comments at firstname.lastname@example.org