August 29, 2008

life in financial markets: currency derivatives on an exchange platform

Exchange-traded currency derivatives went live today on the National Stock Exchange.

Its is a big thing for the Indian financial markets. I wrote something on it for the magazine I work for and I share it below. As I write this post (2.10 pm), the trading volume on the dollar futures contract was already a decent Rs 135 crore or US$31.54 million. Check here for more real-time price and trading info -->

My write-up:

Better for all
Exchange-traded currency futures takes off amid expectations of benefits from increased transparency and competitiveness
After much labour pangs the exchange-traded futures market has taken birth on the National Stock Exchange (NSE) on 29 August in its new currency derivatives segment with around 500 broker-members. The interesting bit is that this new baby appears to have many uncles and aunties wanting to play with it for joy and profit. The NSE had been preparing for the launch since the past few weeks since a RBI-Sebi (Reserve Bank of India-Securities and Exchange Board of India) Standing Technical Committee on exchange traded currency futures gave the green signal in its report released on 29 May this year after 13 months of deliberations.

Day traders and speculators from the existing derivatives markets in equities and commodities would be looking for volatility-based profit opportunities. The minimum contract size of $1000 (about Rs 43,000 at current rates) in Dollar futures is even smaller than the equity derivatives contracts where the minimum is above Rs 2 lakh. That makes it attractive even for small speculators.

Exporters, importers, banks and even domestic companies reliant on commodities such as crude oil, gold and copper whose prices swing as per international markets' prices are expected to either switch from—or split existing exposure from—over-the-counter (OTC) currency forward market to the new exchange-traded currency futures market. For the first time, seen in currency derivatives, banks have been permitted to have direct membership of a financial exchange unlike in the equities and commodity derivatives space where they enter through their 100 per cent subsidiaries.

Another exchange, a subsidiary company of commodity derivatives exchange, Multi Commodity Exchange, is likely to join the NSE in a month in the race for launching currency futures that also sees the Bombay Stock Exchange and National Multi Commodity Exchange following later on.

Transparency in foreign exchange dealings is expected to increase as exchange-traded currency futures will do away with all the limitations of an OTC forward market like carterlisation by banks' treasuries and forex dealers, phone-based deals, front running, pricing reporting inefficiencies and narrow participation. “Even in the spot market when companies and others go for conversion of rupees into dollars or vice versa, the exchange-traded Dollar futures will bring about transparency and competition among banks,” says Satish Menon, director of operations in Geojit Financial, an equities (cash and derivatives) member of NSE and BSE that has now also taken currency derivatives membership on the NSE. “One issue is that whichever exchange first attracts the most trading volume the most might be the only one surviving in this space.”

Certain restrictions imposed by the RBI-Sebi committee report are likely to plague the functioning of the exchange-traded contracts. First is limiting the futures contract to only dollar currency. The ones who need it the most for hedging, the exporters and importers, are increasingly exposed to non-dollar currencies such as the Euro, Yen, Yuan and Pound. “Exposures are all over the place and it's best to offer a comprehensive bouquet of products,” says Ajay Shah, senior fellow at National Institute of Public Finance and Policy. Secondly, options contracts would enable more efficient hedging and arbitraging but is not allowed at present. Participation of foreign institutional investors and non-resident Indians is not permitted.

These could hinder the success of exchange-traded currency futures market. “The right way to launch a market is to put all your kindling into the fire right at the outset,” says Ajay Shah, senior fellow at the Indian Institute of Finance. “If the launch fails, you're holding nothing and all your remaining kindling (permission for FIIs, options, Rupee/Euro etc.) is worthless.” We second that.

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