Individuals in currency trading

On an international landscape, speculative price discovery is dominated by `institutional investors', particularly hedge funds. India is unusual in two respects. First, we have speculative price discovery in only two areas: equity and commodity futures. In all other areas, the government is either a major market manipulator or has simply banned speculative trading.

The second unusual thing about India is that in these two markets, price discovery is dominated by individuals. Institutional participants - whether domestic or foreign - are but minor participants on the equity market and the commodity futures market. At every stage of financial innovation in India, my experience has been that individuals pick up new instruments and new trading mechanisms first, they build the liquidity, and then (much later) the institutions might join in the party. As an example, see the miniscule numbers for institutional trading with equity spot and equity derivatives trading in the most-recent Economic Survey or the most-recent NSE Derivatives Update, which shows that in March 2006, institutional investors made up a princely 7% of trading on the equity derivatives market.

The currency market is arguably the world's biggest market. It has been dominated by institutional trades on OTC markets. Basically, the big boys talk to each other. Leo Melamed tells the story of currency futures as originating from an opinion piece in a newspaper by Milton Friedman, who wanted to short the GBP but was told by the big banks that they wouldn't deal with him because he was just Milton Friedman, a mere individual and not a big OTC market participant. This thought process led to a great innovation - financial futures - which makes possible safe trading between strangers, and permits a gigantic scale of entry into speculative trading. While exchange-traded derivatives worked out very well, currency futures didn't really click all these years, until some very recent signs of growth.

In this context, I found a fascinating article in The Economist which talks about the rise of individuals in currency trading in Japan. It makes me wonder how currency trading in India will shape up, once we get out of the present control raj. Some excerpts:

... Japanese savers have sought greater risk - notably in foreign exchange. They started with foreign-currency bank deposits, then moved on to investment trusts denominated in foreign currencies. In the past year or so, they have taken a further step, by piling into high-risk, high-return margin trading of currencies. So keen have they been that collectively they have become important actors in the yen foreign-exchange market.

Retail currency trading on margin was largely unmeasured until last year, when many intermediaries joined the Financial Futures Association of Japan (FFAJ), the industry watchdog. For the first time, the FFAJ, which does not allow members to solicit business, has been able to release figures on individuals' margin trading. In the three months to December, over-the-counter trading involving its members came to $280 billion. Experts believe that a new trading system called click365, run by the Tokyo Futures Exchange, and trades through non-members could bring the total near to Y40 trillion.

The size of Japan's foreign-currency market is hard to gauge, but experts put it at Y130 trillion-200 trillion, making individuals' share 20-30%. Retail investors have, in effect, acted like mini-hedge funds, using carry trades to buy American, Australian and New Zealand dollars, euros and sterling that give them yields of up to 7%, by leveraging their principal. Gaitame.com, the top foreign-currency retail intermediary, says that on some days its retail business beats its parent broker's wholesale transactions. Gaitame.com's retail accounts have grown two-and-a-half times over the past year (see chart), a trend reflected across the industry.

Analysts are used to believing that Japan's currency is moved by banks and brokers. Yet individuals are becoming more powerful. According to the FFAJ, they held a net long position in foreign currency of Y15 trillion at the end of 2005 - almost as big as Japan's current-account surplus and more than foreigners have in Japanese stocks.