The exchange-traded currency derivatives segment has impressed with a steady growth in volumes ever since it was launched in August 2008. So far this month, the three exchanges that have been permitted trading in currency derivatives have averaged volumes of $11.8 billion. This compares well with the average daily volumes of around $7 billion in January and February this year.
Growing volumes are always a healthy sign, since they attract even more market participants, and further enhance the depth and liquidity of the market. Lately there has been another heartening sign coming from the currency derivatives segment. Open interest or outstanding positions in the segment have risen manifold in the past few months. Six months ago, the outstanding positions across the three exchanges stood at close to $4 billion. They have now risen to as high as $10.7 billion.
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Regulations put forth by the Securities and Exchange Board of India (Sebi) and the Reserve Bank of India limit the exposure users of the currency derivatives market can take to a fixed percentage of the total open interest in the market. Trading members and banks can take a position of up to 15% of the total open interest on an exchange. Other market participants can take a position of up to 6% of the total open interest.
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Thanks to the sharp rise in total open interest levels, market participants with genuine hedging needs can take meaningful positions in the market. Small- and mid-sized companies have already been using the currency futures segment to hedge some of their forex exposures because of the superior transparency compared with the over-the-counter market for forex derivatives. Now, increasingly, even large companies would be able to take advantage of the opportunities in exchange-traded market.
It’s interesting to note that a large part of the jump in open interest has been in the currency options segment, which were launched only last year. In the past six months, open interest in the options segment has risen from $1 billion to $5 billion. In the currency futures segment, open interest has risen from $3 billion to $5.6 billion. It must be noted here that a significant portion of these positions are short-term speculative positions and get wound up on expiry day at the end of the month.
In end-June, for instance, outstanding positions had risen to $9.1 billion just before expiry, but dropped by over 40% to $5.3 billion on expiry day. Market participants, generally, keep this in mind while taking positions. Otherwise, they would have to forcibly cut positions in line with the drop in open interest on expiry day. Still, even if one were to build positions based on open interest on expiry day, it would still amount to meaningful position. Based on the outstanding positions in end-June, market participants can easily build positions of around $300 million across the three exchanges.
The surge in the open interest in the options segment suggests there is a fair amount of genuine hedging activity going on. Options would naturally suit companies, since a long options position would relieve them from the need to post daily mark-to-market margins. In fact, even with a short options position, it’s relatively easy to meet daily mark-to-market margins, since they can be met using non-cash resources such as fixed deposit receipts. With futures, however, mark-to-market margins have to be paid or received in cash, which can be cumbersome for some companies.
There seems to be a large amount of speculative activity, too, based on the sharper drop in open interest positions in the options segment on expiry dates. Options trading has picked up sharply in the equity derivatives segment in recent years, and this seems to be working to the advantage of the currency options segment as well. Not that anyone should complain, since speculators and market makers help build liquidity, which genuine users can take advantage of.
In sum, the exchange-traded currency derivatives market seems to progressing well, with the rise in volumes now resulting in increased open interest positions. The open interest to volumes ratio in the segment has risen to almost 1 from only around 0.4 times six months ago. The National Stock Exchange has always led the race with respect to open interest; it recorded an open interest to volume ratio of 1 on Monday, and 3.5 in the currency options segment. MCX Stock Exchange’s open interest on Monday was 0.5 times its volumes. (It hasn’t been permitted to launch currency options by Sebi.) United Stock Exchange has done well on the volumes front in currency futures this year, but open interest is abysmally low at 0.16 times volumes.
It’s well established that liquidity begets liquidity in markets. While this is true for the currency derivatives market as well, rising open interest also augurs well, since it will attract an increasing number of genuine users.
Graphic by Yogesh Kumar/Mint
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