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Wednesday, September 23, 2009

Currency futures liquidity ahead of the forward market?

At NSE, currency futures did $1.8 billion yesterday. With this, India is starting to look like a rare country where the turnover of the currency futures market is big when compared with the currency forward market. (Gurnain pointed out, in the comments to this post, that this is the case in Brazil. I'm not aware of any other country where this is the case).

Turnover is, of course, not liquidity. An exchange can fake liquidity by doing round-trip transactions which boost trading turnover.  Liquidity is about the transactions cost faced when transacting. Liquidity comparisons between the OTC market and the futures need to take into account the fact that the OTC market trades bigger contracts. So, let's see what impact cost is visible in the information present on the web, pertaining to closing time (5 PM) on the 22nd. The quantities available at the best five prices are visible on the web. There is surely more available beyond the top five in the book, but you probably don't want to trade at those adverse prices.

Let's focus on 1000 contracts, or $1 million. Based on conversations, I get the sense that the forward market would have impact cost of 0.01% to 0.02% for this transaction size. The graph shows that the NSE contract had smaller numbers than this for both buying and selling.

(Click on the graph to see it more clearly). The futures market seems to be able to serve upto $6 million to a buyer and $2 million to a seller, while suffering reasonable values of impact cost, within the top five prices.

This is admittedly one data point. Late in the day, I noticed a big number for turnover and wondered what was happening to liquidity, so I looked at the `market by price' display visible on the web. But for a currency futures market to beat a currency forward market on liquidity is unusual by world standards, even if it is for one data point.This is particularly remarkable given the tiny window of operation that RBI has permitted for the futures market: all products other than INR/USD futures are banned, and participation by FIIs and NRIs is banne.


  1. I might be missing something but why is this unusual? I would have thought impact cost for futures market will be always be lower than forward market since forward markets are less liquid. This is what happens here.

  2. The international experience has generally found that fixed income and currency markets primarily happen OTC. I have my own views on why this happened in other countries, and why we might do different. But if you ask a practitioner on the currency markets, he would generally assume that the futures market is small and the forward market is big.

    India is now shaping up as a pioneer, by international standards, with this scale of success of the currency futures market.

  3. There are sometimes advantages (albeit rare) of of an obdurate and may I say illogical, regulator. RBI in our case. By keeping the debt markets and especially the Currency markets closed, they kept the OTC markets too very small or exported the market to Singapore, Dubai, etc. they also ensured non banks and some other entities are kept out of the OTC market too.

    This has lead to the large mass of traders flocking to the Exchange (Futures market).

    Bless RBI for the development of a transparent exchange traded Currency (and hopefully Fixed Income soon) in india.

  4. Hi Ajay
    The futures market for brazilian real has long been far bigger than the forward market.

  5. Gurnain,

    I did not know that. Thanks, and I have gone back and modified the post.

    Do you know something about how and why Brazil has these things happening on exchange?

  6. may be this story from WSJ could explain some bits....

    90% of small traders purportedly lose money. They are now flocking to the leverage-filled currency market.

  7. Hi Ajay,

    I asked a couple of Brazilian economist friends about this and they said the reasons may be historical as well as regulatory. Brazil has a long history of futures contracts, starting with commodity futures. BMF stood 6th in the world in 2008 in terms of number of total futures and options traded, and the currency futures there were introduced in 1991.( and NSE is 8th). A well established futures markets with clear procedures that are familiar to participants means higher volumes. Also, central clearing means lower counterparty risk.

    The regulatory reasons are that some of the tax rules end up discriminating against OTC transactions – for example, the transactions tax on bank debits and payments applies only to profit and loss from exchange transactions, not to notional amounts. Most forex dealers (Banco Central do Brasil only gives clearance to a few banks to trade in forex) provide OTC forward contracts to their customers but unwind their positions in the futures market. There is no significant inter dealer OTC market in forex.

    Also, the BCB intervenes in the futures market to influence the exchange rate – which again means higher volumes (though it decided to withdraw from futures market on 13th august this year, for the moment).

  8. Can it be that FIIs (through subsidaries/dummies)make use of the futures market and could the high volume transcend because of net foreign inflows into indian markets being witnessed currently)...same the case with Brazil as well.....

  9. I lack detail knowledge on capital requirements for forex exposures but could it also be that capital requirements for banks holding exposure in currency futures market is less than that of the OTC market due to lower risk of counterparty defaults ??


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