More on currency futures

I received some offline comments on my earlier blog post on currency futures in India and would therefore like to elaborate on my views.

I see this market evolving in three phases:

1. In phase one, the market is largely retail. Retail traders simply did not have access to the forward market and assuming that they would like to use currency derivatives, the futures market is the only option for them. Some of the retail participation would be purely speculative, but there would be substantial hedging demand as well. The fact is that you can have an exposure to exchange rates even if all your economic transactions are with domestic participants and are denominated in Indian rupees. For example, a small pepper farmer who sells produce in the local market in Indian rupees is exposed to currency risk to the extent to which domestic pepper prices are linked to global prices denominated in dollars or other foreign currency. I believe that retail demand alone would be sufficient to take the market to the point where it has sufficient liquidity and depth for amounts of $50,000 to $200,000.
2. This would bring the market to phase two where the liquidity and depth is enough to attract small and medium enterprises (SMEs). SMEs do not trade in the interbank market – they do forward contracts with their regular bank and face quite significant transaction costs. It is easy for the futures market to be competitive for this segment in terms of liquidity and depth. The futures market have the advantage of not tying up credit limits, but have the disadvantage of daily mark to market cash flows. Assuming that the broking business in India is more price competitive than the banking business, I expect brokers to find ways of meeting SME hedging demand at a lower all-in-cost than the banks do. Large SME participation would provide the market with good liquidity at a depth of around a million dollars.
3. At this stage, the market is ready for phase three, where the market starts competing with the inter bank market for the smaller lots traded there. It is at this point (probably a year or more from today) that the restrictions on the futures market in terms of FII participation and client level position limits will start to bite. Assuming that these restrictions are lifted by then, the futures market could provide stiff competition to the inter bank market if the exchanges provide strong support for direct market access (DMA) and algorthmic trading and persuade agencies like Reuters and Bloomberg to give enough visibility to futures market quotes.

Posted at 1:23 pm IST on Mon, 8 Sep 2008         permanent link

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