If the outstanding success story of 2009 in global listed derivatives was the Steel Rebar Futures at Shanghai Futures Exchange, this year’s wunderkind has been in India. And there are two of them.
The US dollar/Indian rupee futures at Multi Commodity Exchange Stock Exchange and the National Stock Exchange of India have soared to become the two most actively traded currency derivatives on any exchange in the world, by number of contracts.
The NSE’s US Dollar Future traded 68.3m times in June and MCX-SX’s contract 79.4m times. The only listed derivative in the world that was traded more times was Korea Exchange’s Kospi 200 Option, with 286m bargains made.
The Indian FX contracts’ prominence is exaggerated by their small sizes – each future is for $1,000. That means MCX-SX’s volume in June was $79.4bn.
This is not nearly as large as the CME Group’s EUR/USD Future, which had volume in June of 7.9m contracts. Each is worth €125,000, giving cash volume of €988bn. BM&F Bovespa’s US Dollar Future, which tracks the dollar-Brazilian real exchange rate, had turnover of $375bn in the same month. But then, CME has been offering that contract since 1998, while BM&F launched its in 1987.
And even on a notional cash basis the Indian contracts still outstrip most other FX futures.
Like China’s success with its metal futures, India’s dizzying growth in currency derivatives has been achieved despite substantial barriers to foreign participation, and other tight regulatory controls.
Ajay Shah, professor at the National Institute for Public Finance and Policy in New Delhi, and a former consultant to the finance ministry, explains: “Foreign institutional investors are banned from trading in India’s currency futures market, while there is also a position limit imposed, depending on what institution and their exchange membership, so big companies find that their hedging needs can’t be met.”
Trading members of exchanges are not allowed to hold positions exceeding 15% of total open interest or $50m, whichever is higher. For trading members that are banks, the cap is the higher of 15% of total open interest or $100m.
Client members of exchanges are capped at 6% of open interest or $10m, whichever is higher.
Opening the floodgates
The market began in August 2008 when the Securities and Exchange Board of India approved the listing of dollar/rupee futures. All contracts must be financially settled and for $1,000, it said.
Quick out of the traps was the National Stock Exchange of India, followed two months later by the then newly launched MCX Stock Exchange, daughter of Multi Commodity Exchange of India.
The Bombay Stock Exchange also joined the fray, but it recently delisted its currency futures, putting its weight instead behind its new partner, the United Stock Exchange.
With a slight head start, NSE established a lead in trading but MCX-SX soon began to chip away at it, capturing about 30% of market activity as volumes across the two exchanges amounted to $6bn a month.
This was just the start, however, as trading continued to grow month-on-month. Just a year after launch, the market was already turning over about $1bn a day.
The trend of success continued through the second half of 2009 and slowly MCX-SX began to eat into the NSE’s lead. In the first quarter of 2010 MCX-SX went ahead, with about $62bn of trading in March, to NSE’s $58bn. Since then, MCX-SX has cemented its lead.
Meeting a need
Despite the restrictions, the contracts’ introduction has given market participants who had never been able to use over-the-counter currency derivatives a way to hedge their currency risk.
“Every Indian is exposed to currency risk in one way or another,” says DK Aggarwal, chairman of SMC Wealth Management, one of India’s largest brokers. This need goes far beyond those who export goods or import dollar-priced commodities. “Suppose I have a child going to study overseas, I know that I need to hedge,” Aggarwal says.
India’s financial laws put barriers in the way of over-the-counter hedging. Any Indian firm, institution or resident that wishes to hedge currency risk using OTC forwards, swaps or options, must first demonstrate an exposure to the underlying risk, a requirement not stipulated for exchange-traded derivatives.
Small wonder that market participants have rushed to use the futures. According to SEBI’s latest report on India’s currency derivatives market, published in August 2009: “The Indian currency futures market has grown since its commencement in August 2008. The currency futures turnover as a percentage of OTC currency forward turnover has increased from 7.19% in November 2008 to 59.60% in August 2009.”
Day traders flock to the market
While there may a be a significant demand to hedge currency risk, Jamal Mecklai of Mecklai Financial, an Indian consulting company that specialises in treasury risk management, says the currency futures market is dominated by day trading.
“India’s currency market is a highly speculative one,” Mecklai says. “There are a number of people that look at the currency futures market and see that the leverage is good, costs are low. Currently, about 60% to 70% of the market is day traders. There is very little corporate hedging and it is hard to see corporate hedging increase until delivery is permitted.”
Aggarwal disagrees on corporate participation. He says firms have become increasingly drawn to FX futures. They are often quoted with tighter bid/offer spreads than OTC instruments, reducing the costs to companies, which he says are becoming more and more open to exchange trading.
The high level of day trading can be explained by the low cost of trading. Transaction fees and margin requirements are low – and crucially, the government has waived the securities transaction tax for currency futures. That means it is often cheaper to trade FX contracts than equities or equity derivatives.
While specialised trading firms are becoming more active, there is also a growing number of banks in the market. So far they have stuck mainly to the OTC market, partly because of the position limits in futures.
But one executive at a bank in Mumbai says the banks are now spotting an opportunity. Since they can access both markets, there are arbitrages to be had. He expects these to proliferate as the listed sector grows.
No love lost
Despite the soaring volumes in FX futures, the two exchanges do not seem to feel there is room for both of them in the market. Rivalry between them has been intense since day one, and each is trying aggressively to win market share.
MCX-SX was particularly upset when the NSE waived its fees for FX futures trading. It complained to the Competition Commission of India, which ordered an investigation into MCX-SX’s allegation that NSE was misusing its dominant position by waiving fees, a practice that MCX-SX said it could not afford to emulate.
MCX-SX said NSE’s pricing was designed to drive the weaker MCX-SX out of business. NSE is denying the accusation, telling the Commission that “the fee waiver in the new currency derivative segment... is in the nature of introductory pricing with no intention to eliminate competition”.
The watchdog has yet to rule, and the animosity between the two exchanges persists. On July 17, MCX-SX took an advertisement in Indian newspapers, hitting out at the delay in being granted approval to offer equities, equity derivatives and interest rate derivatives.
It also complained about its competitors, hinting at NSE. “There have been attempts by some elements to spread misinformation to create doubt among our shareholders and undermine our reputation and business for their benefit,” the advertisement read.
While the NSE and MCX-SX are focused on each other, new competition is set to emerge. The United Stock Exchange is now just weeks away from introducing its own dollar/rupee futures contract, though as yet it has not confirmed a launch date.
The new exchange has 21 Indian banks as equity backers, including the Bank of India, United Bank of India and the Central Bank of India. It also has seven Indian private sector banking shareholders, including HDFC Bank and Jaypee Capital.
“While the USE is entering the currency futures market later than the two leading exchanges, the commitment from some of India’s largest banks – which have previously stayed away from the exchange-traded market, may be significant,” says the bank source in Mumbai – implying that their backing could help USE win business.
The tip of the iceberg
As India continues its path of market liberalisation derivatives specialists are particularly optimistic about the prospects for exchange-traded currency instruments.
SEBI has already committed to allowing the introduction of currency options – some market participants believe approval may come any day, bringing a new product that would complement the futures.
One possible roadblock, however, may be the actions of Indian local governments. On July 12 the government of New Delhi said proprietary futures trades would be subject to a stamp duty of Rp1,000 for every Rp1 crore (Rp10m) in the case of delivery-based transactions and Rp200 per Rp1 crore for squared-off transactions.
These duties are tiny – 1 basis point and 0.2bp – but some market participants still believe they could dampen volume from traders in New Delhi.
Most, however, remain excited about the prospects. “I believe the currency futures market will continue to experience strong growth,” says Mecklai.
Aggarwal, too, is bullish, predicting: “I believe currency derivatives exchanges will be even bigger than commodity derivatives exchanges.”
(Picture by zadeus)