## Wednesday, April 21, 2010

### Liquidity on the currency futures vs. the Nifty futures

India is the second country of the world, after Brazil, where the currency futures are more liquid than the currency forwards. Today when I glanced at the order book of the near month rupee-dollar futures, I was struck by the big numbers that are visible:

The tick size of this market is 0.25 paisa, so the top five prices cover 1.25 paisa on each side. So there's nothing interesting about the prices: I focus on the quantities. I'm used to generally seeing quantities at each prices running all the way to 1000 to 2000 contracts which is $1m to$2m. Today I was surprised to see two quantities with much bigger values: $6m and$11.3m. This is huge. [NSE currency futures page] I was also impressed at the fact that $32.6m and$42.4m of orders are sitting on this order book. These are big numbers.

For a comparison, I popped over to look at the near month Nifty futures, which is the biggest financial product in India. This order book shows:

In your mind you have to divide the quantities by 10 to make them comparable. Hence, the spreads and the quantities in the top five are not as impressive as those of the currency. But the total orders present on the book here are staggeringly large when compared with the currency.

Theory tells us that liquidity should vary with asymmetric information and volatility. Both Nifty and the currency are macroeconomic underlyings with relatively little asymmetric information. But Nifty is more volatile. So if both markets worked well, we would expect Nifty to be less liquid. Some key differences are obviously visible: foreigners trade on the Nifty futures but are banned from the currency futures, and Nifty options are available while currency options are not yet available (though without foreigners). When these differences go away, the picture will change further.

A paper idea: When a central bank shifts to a more transparent framework on currency trading, or when a central bank steps away from currency trading altogether, asymmetric information on the currency market goes down so currency impact cost should go down. I wonder if one can find some natural experiment of this fashion. Matters are complicated because the date on which a float commences if often not the date on which the float is announced. This can be dealt with by identifying the date on which the exchange rate regime actually changed, as opposed to what is claimed by the central bank.

1. But do we know what could be the possible reasons for this? (also, if Brazil has the same reasons?)

2. See: When a currency futures market dominates a currency forward market by Gurnain Kaur Pasricha, 25 November 2009.

3. One obvious reason for the huge difference in this deviation is that Nifty is more tightly tied to macroeconomic factors and market is allowed to vary from 21000 to 8000 and again towards 18000, but the currency variation have grass root effect. There is no direct formula where you can just divide Nifty by ten and expect that to be at par with currency variations. Just assume the effect of a dollar being available for 25 rupee.
I believe even with FIIs, there won't be a major increase in currency variation.

4. Just to clarify: in my text when I say "divide by five" I'm only talking about correcting for differences in contract size.

For the rest Nifty is its own underlying, with only weak links to the INR/USD rate. And, it's more volatile.

5. One shouldn't ignore that there's no STT applicable for currency futures trades and that has caused a lot of speculative activity to shift to these contracts. Also, there are rumours of circular trading by one exchange to drive up their valuations and the other to keep up.

6. I think this is matter of concern whether more liquidity is beneficial in Indian market.

7. I think reason of more liquidity is so some weaknesses in the financial system.

8. Ajay: Aren't these a function of margin as well? Nifty futures have a margin of 10%, Currency futures 2-4%. if you divide the number of nifty contracts by 10 you get a one side with 2-4% margin, and the other with 100% margin.

Imagine I put an order for 1000 nifty. I need to put a margin of around 5 lakhs for it. By dividing by 10, my 5 lakhs is worth 100 Nifty.

In comparison if I have a 100 USD INR contracts I put in only 2 lakhs as margin.

The correct division should be 4? Around 400 Nifty will need 2 lakhs which is about the same as 100 USD-INR.

Plus Nifty's order book is really deep (we see only the top 5) and the trading frequency is greater, so order books are fleeting snapshots (compared to USD-INR which is fairly stable?) If you compare the total buy and sell quantities (and remembering that margin needs to be provided for any new order) Nifty's still got an edge?

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