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Thursday, April 22, 2010

Currency futures: An example of how India changes

Exchange-traded derivatives originally only did commodity underlyings. The world's first financial underlying was : currencies. On 16 May 1972, the Chicago Mercantile Exchange started trading in currency futures. To any finance person, nothing is simpler than a currency futures, but unfortunately in India a mixture of ignorance, ideology and turf considerations has hindered progress.

In 1996, when NSE had just got started talking about equity derivatives, I happened to be session chairman in a conference organised by Invest India titled The future of India's stock exchanges and I remember asking Ravi Narain something like "Have you thought about other underlyings? Would you trade currency futures?". Ravi leaned into the mic and said "We'd love to.".

Most people in India were blinded by the notion of `RBI turf' and did not think seriously about this problem. When I look in my media archive I see a bit on currency futures in Extracting information from finance, August 2006, and in a few pieces before that, but these were just isolated little things. Unbanning currency futures trading was not seriously on the policy radar. When any discussion about this took place, various RBI personnel would claim that futures trading would somehow make Mother India unsafe.

In the Indian discourse, the committee report on Mumbai as an International Financial Centre, chaired by Percy Mistry (April 2007), had the first clear text on currency derivatives.

In April 2007, a column titled Currency futures now, emphasised the links between a well functioning currency derivatives market and the ability of the economy to absorb exchange rate fluctuations. (This old piece is a good response to Shankar Acharya's column in Business Standard today, where he bemoans the shift away from administered exchange rates. The price of steel and crude oil and the dollar will fluctuate: get used to it and get the right derivatives going).

It took 36 years from the date of the innovation (currency futures at CME) to get started with trading in India. For a comparison, with other innovations, India goes much faster. As an example of a technical innovation which also requires government capability, GSM telephony started up in Europe on the late 1980s and in India in the late 1990s - a gap of 10 years. So if we judge arms of the Indian state by the extent to which they impede progress, the governance quality in DOT in the 1990s was better than that seen with finance in the last decade.

On 2 September 2008, I was complaining about a crash in productivity. On 3 September 2008, I got a first detailed look at the liquidity of the currency futures market.

In a year, on 23 September 2009, one could cautiously suggest that currency futures liquidity was ahead of that on the OTC market. This was clearly visible in the article by Gurnain Kaur Pasricha on 25 November 2009. Here, we were on new terrain: nobody else in the world had done this other than Brazil. The global first-mover, the CME, would envy the liquidity of the NSE currency futures contract.

And finally, on 21 April and 22 April of this year, we see signs that the currency futures are more liquid than the Nifty futures.

How could this have been done better? There is nothing innovative about launching currency futures. There is nothing more commoditised and better understood than an exchange-traded clearing-corporation-settled cash-settled contract on a currency. But the mixture of ignorance, ideology and turf battles that impedes progress in India is alive and well.

With currencies: Currency forwards (and the NDF market) are the only choice for FIIs, who are banned from using the exchange-traded currency derivatives. Corporate users are still pushed by the existing rules to go to the OTC market. Currency options trading will now commence - but only for the INR/USD and not for other currency pairs. And futures trading on all currency pairs other than INR/USD, INR/EUR, INR/JPY and INR/GBP is banned.

With interest rates: RBI believes that with interest rate underlyings, cash settlement is somehow dangerous and that derivatives trading on short-dated interest rates will interfere with the conduct of monetary policy. I wonder how that is reconciled with OTC interest rate swaps involving MIBOR, and with the fact that all good central banks in the world are doing monetary policy without banning either cash-settled interest rate underlyings or short-maturity underlyings.

In short, currency futures is a good story and a bad story. It is a good story in that in the end, we are one of the best countries of the world in terms of getting exchange-traded currency derivatives to work. It's a bad story in that it took a lot longer than it should have, and the problems that impeded progress continue to be with us.


  1. Ajay,

    There are many weird things about currency futures that you should discuss.

    1. Customers of the OTC market have to demonstrate exposure, customers of the exchange do not.

    2. But the rules are stacked against corporate customers of the exchange because of the tiny position limit.

    3. Exchange members have an incentive to do more on currency instead of Nifty because of zero STT and zero transactions charge.

    4. One exchange is doing circular trading to show that it has high volume and sucker the investors.

    5. The banks of south Bombay are mostly sitting tight and ignoring this market.

    6. A major player - USE - will now come into the game and that will change things.

    So while something remarkable has happened (currency impact cost better than nifty impact cost) it has come about under weird circumstances. For example, it does not teach us how to make the interest rate futures market work. And in the future, when some of the six weird aspects change, the relative ranking by liquidity of nifty and currency could change.

  2. Can you please help me in figuring out how a retail investor can buy 10 year G secs in a simple way.


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