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Monday, October 13, 2008

Outlook for the currency futures

I have been very interested in the evolution of exchange-traded currency derivatives in India. Some prominent people in the field do not share this sense of possibility and importance. As an example, on 19 September, Jamal Mecklai wrote in Business Standard on this subject:

Indeed, the volume of trading in the first few days -- although quite impressive as compared to start-up futures contracts anywhere in the world -- has barely crossed $50 million on a single day, a drop in the ocean compared to even our own OTC market. Of course, futures volumes are unlikely to ever be much more than a bucket in the ocean in the global market, for instance, currency futures trades constitute just about 2-3 per cent of the OTC market. So, while I applaud the move, it is important that we don't get carried away with great expectations -- we need to understand what is the real role that currency futures can play in an economy, and as a step towards greater deregulation of financial markets.

First of all, for the economy at large, the impact will likely be relatively minor and at a second order. Contrary to the belief apparently held by the regulators, the government and the ever-eager exchanges, I can't see currency futures having any value as a hedging tool. They are not used as such anywhere in the world and there are several reasons for this.

I disagree with this pessimism. First, let's get a numerical grip of the OTC INR/USD forward market. The latest RBI WSS shows FCY/INR merchant forward business as being roughly $2 billion a day, and the interbank as being another $1 billion a day. (They show these numbers twice, once as `purchase' and once as `sales', and I suspect the correct turnover number is to only count it once). Putting these together, we're probably talking OTC business on INR/USD forwards of roughly $3 billion a day. 3% of this would be $90 million a day or Rs.400 crore a day.

I have an article titled Where are we on the currency futures in Financial Express today where I take stock of what has been happening on the currency futures market. The picture you see there is much unlike what Jamal is painting. But that article used data till 7th October, and I'm already running behind the events! Here's the full daily time-series of turnover and open interest:

Date Open interest Turnover
(Contracts) (Rs. crore)
29/08 16387 291
01/09 24078 107
02/09 33667 187
04/09 30268 178
05/09 30311 168
08/09 30632 240
09/09 28744 244
10/09 41570 198
11/09 51050 235
12/09 55733 186
15/09 60272 232
16/09 86559 456
17/09 90731 338
18/09 86494 378
19/09 78973 307
22/09 71156 259
23/09 78025 363
24/09 89343 377
25/09 92526 223
26/09 74470 200
29/09 69005 290
30/09 88426 297
01/10 96958 418
03/10 122942 429
06/10 132866 406
07/10 148552 590
08/10 151484 614
10/10 143526 936

As we see, the turnover on the currency futures market has exceeded 3% of the OTC forward market (i.e. a threshold of Rs.400 crore) from October 1 onwards. On Friday the 10th, the turnover at Rs.936 crore was more than double of this threshold. Looking into the future, I think the story has only begun; it would not be prudent to bet that at the latest level of Rs.936 crore a day, growth will cease. So I think we have to start questioning the pessimistic view that exchange-traded currency futures can't exceed 2-3% of the OTC forward business.

In parallel, also note that there is some international evidence that private players are shifting away from OTC contracting to the safety of the exchange. So it's time to question our pessimistic assumptions about what can be done on exchange.

I also disagree with the claims about hedging. Cash settled derivatives as a risk management overlay on top of a physical position is a standard technique taught in the textbooks. There is absolutely no reason why the currency futures cannot be used for hedging - except when RBI's limit that no one person can hold over 6% of the market wide open interest comes in the way.

There also, things are getting better with the growing open interest of the market. On Friday, with open interest of 143,526 contracts, the limit of 6% gives a per-client limit of 8611 contracts or $8.6 million or Rs.40 crore.

There are tens of thousands of firms in India who have currency hedging needs (owing to economic exposure) which can be adequately met within this position limit. NSE members have their work cut out for them, scouting the countryside, identifying firms with currency exposure where the position limit is not a show stopper, and getting them going on doing hedging using currency futures.


  1. What makes you forget that there are two more exchanges in India which are offering Currency futures. And yet two more are in the offing.

  2. Hi, you have a nice blog. Can you tell me from where can I get information on how forex deals are accounted in banks? Is there any standard accounting method followed? Please help

  3. It was pleasure going through your Blog. I request you to update the outlook for the currency futures as a lot have changed since October. Especially the challanges faced by the broking community.

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