Concerns about currency futures unfounded

Shiva Iyer

Developing the currency futures market in India will be an important step in the evolution of financial markets here. Some questions that need to be answered to aid this process are: What will the futures add to the already vibrant forwards market?

What tenor and maturity the futures should be positioned? What should be the ideal size of the contract? How should the futures market be organised? What are implications from a developed currency futures market for exchange rate management? We discuss the above issues keeping in mind the recommendations made in the draft report of the RBI’s internal working group on currency futures.

Futures could serve as a hedging tool for long tenors

The Indian forwards market in currencies is well organised and very liquid for up to one year tenor. The prices are transparent, the bid-offer spreads are competitive and the execution of transactions is efficient through Reuters deal stations and other electronic booking systems.

As much as the draft report is in favour of introducing the futures in the shorter tenors it is unlikely that futures in these tenors will add significant value.

The traders will veer towards familiar forwards and be hesitant to trade in futures, if it hedges the same risk. The futures will also find it a challenge to compete with a very efficient and transparent forwards market.

Even in the international markets currency futures contracts are miniscule in comparison to the OTC contracts. As per the BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives activity, in 2004 the average daily turnover in exchange traded contracts was at $23 billion in the total foreign exchange turnover of $1880 billion.

The question then is what tenors and maturity should futures therefore be positioned? The long tenor forward markets world over are not liquid due to the fact that OTC counterparties are hesitant to undertake transactions with high potential credit risk over long tenors.

At the same time, cross currency swaps and forwards used by the hedgers in the OTC market require significant credit limits for the counterparties in the transaction.

A typical long tenor cross currency swap or a forward requires any where from 30% to 40% of the notional size as credit limit. Introducing the long tenor futures contract beyond one year will serve a meaningful purpose by offering an alternative for hedgers who cannot obtain counter party credit limits for their long tenor transactions.

The ideal size of the contract - taking cues from the forward markets
In deciding the size of the contract one needs to bear in mind that futures have a round trip transaction cost apart from the bid-offer spread.

There is per contract transaction cost while initiating a futures position and also while closing out a futures position. Smaller size contracts will result in higher average transaction cost. But at the same time these contracts have the benefit of making the market accessible to small players or individuals.

In the Indian market, for a typical hedger in the forwards market, the trade size is about $500,000 to $1 million. The report recommends a much smaller size of $1000 in comparison. A broad survey of the market will help in deciding a meaningful size of the futures contract.

A contract with a notional size of $100,000 to 250,000 will possibly make more sense for our markets. Mini futures (akin to S&P mini futures concept) for a smaller size with execution in electronic only traded platform could be introduced if there is a perceived demand. The naming convention of the futures contract should also follow the standard conventions as in the international markets.

Trading hours for futures contracts — after hours trading could be introduced gradually
The report recommends 10 am - 4 pm IST and no after hour trading has been recommended. Since foreign exchange trades are more active after the US & European markets are open, some form of after hours electronic trading is essential for the market to be successful.

One mechanism would be to tie up with regional futures exchanges to be able to provide the after hours trading platform. For eg. CME futures contract trade on the SIMEX after SIMEX opens. Indian futures contracts could trade on the DTB, LIFFE and CME. This could, however, be timed with the ongoing liberalisation of capital account.

Options on futures will also be needed
The active hedgers in the Indian markets are serious users of option and option strategies to hedge their exposure. For the futures market to develop in a significant way, options on the futures contract will also have to be introduced.

A dedicated exchange for trading only currency futures may not be commercially viable
The report prefers a dedicated exchange to trade futures contract to ensure a clean regulatory and supervisory structure. Futures exchanges are business enterprises that need to generate adequate revenues to be sustainable.

A single product exchange may not be viable as the currency futures will be competing with established OTC market. One suggestion would be to form a subsidiary in a successful futures exchange like NSE with appropriate regulatory framework to make it viable.

Currency futures - some unfounded concerns
Two major concerns expressed in the report are the risk of dollarisation and the possible increased volatility in the exchange rate. Dollarisation occurs when residents of a country use foreign currency in parallel to or instead of the domestic currency. This should not be a concern for an economy of India’s size and strength.

Some of the countries that the report cites are small tourist economies or economies with low economic activity serving as satellites of strong neighboring econo-mies.

India does not fall into either of these categories and is an unlikely candidate for dollarisation. Recent currency trends indicate that there is a shift towards non dollar assets in world economies. All hoarders of dollars world over have possibly been in a hurry to unwind their positions!

Also the futures market may not lead to more currency volatility. In fact it may provide another tool to the central bank to manage exchange rate and signal policies.

The RBI has been effective in laying out the checks and balances and plays a significant role in evolution of our markets. A serious consideration of the issues discussed will help develop the currency futures markets in India.

(The author is senior vice-president and head of financial institution sales, ABN Amro Securities. Views expressed herein are personal. shiva.iyer@in.abnamro.com)