CURRENCY FUTURES-STATUS CHECK AFTER ONE YEAR-VRK100-27102009

Currency Futures - Status Check After One Year - VRK100 - 27Oct2009

It is more than a year since the introduction of currency futures under the currency derivatives segment of Indian stock exchanges. The volumes have increased tremendously on NSE and its arch rival MCX-SX, the two dominant exchanges of trading in currency futures; while on BSE practically there have been no volumes in the last six months or so. Trading in currency futures had started by NSE on August 29, 2008. This article examines the volumes traded on these and explains the basics of the currency futures from a layman’s point of view.

RBI’s decision to introduce more currency pairs for currency futures trading is welcomed by the industry:

In its second quarter review of Annual Policy (Monetary Policy) released on October 27^th, 2009; Reserve Bank of India has proposed to permit the three recognized stock exchanges to trade currency futures in three more currency pairs namely, Euro-INR, Japanese Yen-INR and Pound Sterling-INR; in addition to US Dollar-INR which has already been permitted since the introduction of currency futures in August 2008.

As of now, the combined average daily turnover of the currency futures contracts in all the three exchanges increased from USD 1.1 billion in March 2009 to 2.5 billion in September 2009 – which means a growth of more than 125 per cent in just six months period.

These developments are very good from the market point of view. More volumes result in better price discovery and more opportunities for traders, investors, genuine hedgers, speculators and arbitrageurs.

The introduction of these new currency pairs has been anticipated for some time by the industry. Now, that the RBI at last is permitting more currency pairs in currency futures, this is good news for the industry.

Reserve Bank of India will be coming out shortly with the necessary amendments to Currency Futures (Reserve Bank) Directions 2008 separately.

Further, RBI has decided to amend their Guidelines on Forex Derivatives as per a review conducted by their internal group. Accordingly, RBI will place on its website the draft guidelines on Forex Derivatives by the end of November 2009 for wider dissemination and comments/views from banks, market participants, industry associations and others.

STATUS CHECK ON CURRENCY FUTURES IN INDIA:

Let me first walk you through some number crunching:

(It may be noted that the volumes on these exchanges refer to only currency futures as relate to USD-INR currency pair. Till now, only trading of currency futures between the US Dollar and Indian Rupee on three recognized stock exchanges are allowed by Reserve Bank of India.)

TRADED VOLUMES OF ALL EXCHANGES

Table 1: Traded volumes on all exchanges (Data: SEBI)

As can be seen from the above table, the trading volumes on these exchange-traded currency futures have risen tremendously in the last one year. Let us take note of the volume increase between December 2008 and July 2009. The volumes have surged by four times during that period from Rs 0.46 lakh crore to about Rs 1.85 lakh crore. The cumulative volume between August 2008 and July 2009 works out to Rs 8.50 lakh crore (Latest data available is up to July 2009). During FY 2008-09, total traded volume was only Rs 869 crore on BSE; practically this exchange is out of the currency futures market. In the last six months of the current financial year, there are practically no volumes on BSE.

NUMBER OF CONTRACTS TRADED ON ALL EXCHANGES

                                                                                                

            Table 2: Number of contracts traded (Data: SEBI)

Total number of contracts have grown from 94 lakh in December 2008 to 380 lakh in July 2009, a dramatic increase of four times in just seven months. All these trading volumes are happening in just two exchanges, NSE and MCX-SX. The cumulative number of contracts works out to 1,720 lakh between August 2008 and July 2009. Some more exchanges are waiting in the wings to introduce currency futures. Trading may start in the next few months in another new stock exchange, namely United Stock Exchange of India.

MONTH-END OPEN INTEREST

            Table 3: Month-end open interest (Data: SEBI)

The month-end interest used was in the order of Rs 2,300 crore at the end of March 2009. By July 2009, it has reached Rs 3,200 crore. Compared to the traded volumes on the exchange, there has been no dramatic increase in the open interest at month-ends.

Now, the rupee has suddenly started appreciating dramatically in the first week of October 2009, it would be interesting to watch how things are being panned out in the currency futures market. Obviously, volumes will grow up by several folds during the current month as more speculators and players may be attracted towards the currency futures. In the last two weeks itself, Indian rupee has appreciated by 150 paise or about three per cent against the US dollar. Such a large movement in the exchange rate is quite unusual.

THE SPAT BETWEEN NSE AND MCX-SX

                                                         

            Table 3: Market Share between NSE and MCX-SX (Data: SEBI)

Both the NSE and MCX-SX are snapping at each other heels since the beginning of trading in currency futures last year. Trading in currency derivatives started on August 29, 2008 at NSE; on October 1, 2008 at BSE and on October 7, 2008 at MCX-SX. Last year, MCX-SX's total traded volumes were higher than that of NSE during the months of December 2008, January 2009 and February 2009. Except in these three months, NSE has a slight edge in terms of total traded volumes.

During the financial year 2008-09, NSE's market share was 52%, whereas MCX-SX's market share was 48%. The same situation continued during the first four months of the current financial year.

It would be interesting to watch who will be the ultimate winner in the race for the number one position. As more stock exchanges are likely to enter the fray, the battle would keep these exchanges on their tenterhooks. And the competition may prove to be good for the market participants.

SUCCESS RATE OF THE CURRENCY FUTURES

If one goes by the spectacular rise in volumes traded on the stock exchanges, one can argue that the introduction of currency futures has been a success. However, volumes alone will not be sufficient to judge the success of this new derivative product in India. Other criteria could be the depth of the markets, participation from the various kinds of investors, corporates, and other stakeholders of the market.

Still there are some creases to be ironed out with regard to Currency Futures. FIIs and NRIs are still not allowed; even after the new product has been introduced more than a year back. As stated in the first page of this document, RBI has now proposed to permit more currency pairs – Euro-INR, Japanese Yen-INR and Pound Sterling-INR also, in addition to US Dollar-INR which is already permitted. Once these new currency pairs are introduced, may be, the product will attain better success.

If one compares the daily volume of more than USD 40 billion on the OTC market, the daily volume of less than USD 2.50 billion on the exchange-traded currency futures is small. But, over a period of time, with increased participation and more currencies, the currency futures may become a force to reckon with on their own – the dominance of exchange-traded derivatives is the norm in international markets.  

SEBI REPORT FOR JANUARY-MARCH 2009 QUARTER:

Ø      The average share of the top ten members in terms of turnover was 56% for NSE & 63% for MCX-SX for the quarter ended March 2009

Ø      There were 353 members at NSE and 327 members at MCX-SX who did Rs.10 crore or more of turnover during January- March 2009

Ø      The percentage share of Retail Participants in turnover was 41% at NSE, and 29% at MCX-SX during January-March 2009

Ø      Under proprietary trading, the share of banks was about 14 per cent on NSE and 10 per cent on MCX-SX and the share of non-banks was 45 per cent on NSE and 61 per cent on MCX-SX

Ø      One the client side, banks, insurance companies, mutual funds and other institutions have not got any transactions on behalf of the clients.

Till now, we have analysed the practical working of currency futures market in India in the last one year. The following pages will explain the readers about the background to the introduction of this new derivative product, their basic aspects, mechanism involved and the benefits of currency futures to market participants. Let me start with the background to the new instrument which  tasted some success in the last one year.   (Basics given below are aimed at the general reader)

PREAMBLE

Both RBI and SEBI had jointly constituted a standing technical committee to evolve a framework for the introduction of exchange-traded currency derivatives market in India. The committee submitted its report on May 29, 2008. In a long-awaited move, RBI and SEBI had on August 6^th, 2008, disclosed a roadmap for introducing exchange-traded currency derivatives trading in India. As part of the continuing economic reforms in India, both regulators have set out guidelines for stock exchanges as well as banks.

Further, RBI and SEBI came out with their final guidelines on August 6, 2008 for launching exchange-traded currency futures. In addition to NSE, other exchanges, like, BSE and MCX, have also introduced trading in currency futures. A new stock exchange, United Stock Exchange of India, is also expected to start trading in the next few months.

As per the roadmap, SEBI will give permission to recognized stock exchanges for starting trading in currency derivatives. After obtaining SEBI approval, the recognized stock exchange will have to approach RBI to obtain permission under FEMA (Foreign Exchange Management Act) for trading, clearing and settlement of Currency Derivatives.

           

DEFNITION

Currency futures means a standardized foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price on the date of contract, but does not include a forward contract.

BASIC ASPECTS OF CURRENCY FUTURES

ü  Only USD-INR (US Dollar-Indian Rupee) contracts are allowed to be traded for the time being (On October 27^th, 2009, RBI proposed to permit three more currency futures, namely, Euro-INR, JPY-INR and GBP-INR)

ü  The size of each contract shall be USD 1,000

ü  The contracts shall be quoted and settled in Indian Rupees

ü  The maturity of the contracts shall not exceed 12 months

ü  All monthly maturities from one to 12 months would be made available

ü  The settlement price shall be RBI’s Reference Rate on the last trading day

ü  The currency futures contract would expire on the last working day (excluding Saturdays) of the month

RBI’s ELIGIBILITY CRITERIA FOR BANKS

Banks authorized by RBI as ‘Category-I Authorized Dealers’ are permitted to become trading and clearing members subject to the following minimum prudential requirements:

Ø      Minimum net worth of Rs 500 crore

Ø      Minimum Capital Adequacy Ratio (CRAR) of 10 per cent

Ø      Net NPA (non-performing assets) should not exceed three per cent

Ø      Made net profit for the last three years

Such banks can resort to proprietary dealings or do trades on behalf of their clients in the currency derivatives segment of the exchange as per the rules of RBI and SEBI.

OLD versus NEW MARKET

Till August 2008, Resident Indians had the following over-the-counter (OTC) products: 1. Currency forwards and 2. Swaps and options. These are used by companies, institutions and residents to hedge their risks.

With the introduction of currency futures by SEBI and RBI and the inauguration of trading of currency futures on NSE in August 2008, only persons resident in India will have the option of trading in currency futures on recognized stock exchanges. The differences between OTC products and currency futures are given below:

CURRENCY FUTURES		OTC MARKET (forwards)
Standardized product dealt on a recognized stock exchange		Customized product to suit the individual requirements of the clients, but not traded on a stock exchange
Contract size (amount) is uniform/fixed		Contract size depends on the needs of the clients
Persons resident in India can trade on any recognized stock exchange without having any underlying in the foreign currency		Underlying exposure to foreign currency is required before entering in to a forward contract
Counterparty risk is eliminated by a stock exchange		Counterparty risk exists in a forward contract
Mark-to-market (MTM) obligations are settled on a daily basis		No such MTM obligations
Multi-party contracts		Bi-lateral contract

ELIGIBILITY CRITERIA FOR DEALING IN CURRENCY FUTURES

Only persons resident in India are allowed to purchase or sell currency futures to hedge an exposure to foreign exchange rate risk or otherwise. This means persons resident in India can trade in currency futures without any underlying exposure to the currency in question.

However, persons resident outside India, for example, like, Foreign Institutional Investors (FIIs) and Non-Resident Indians (NRI) can not participate in the currency futures market. FIIs usually speculate on the Indian currency in the non-deliverable forward (NDF) market in Singapore.

MECHANISM INVOLVED

As per the guidelines, the size of each currency futures contract is USD 1,000 and the tick size is 0.25 paise. Let us assume a person resident in India wants to pay for his child’s education abroad after three months. The person is not sure about the future movement of the US dollar against Indian rupee. So, this person can buy, depending on the cost of overseas education, five currency futures contracts (each fixed at USD 1,000), of three months expiry at say Rs 44 per dollar; amounting to a notional value of Rs 2,20,000 (5 x 1000 x 44). He need not pay full contract value of Rs 2,20,000; but only 2.75 to three per cent of total amounting to Rs 6,050 or Rs 6,600. Now, at the end of three months if dollar goes up to Rs 45, he would have a gain of Rs 5,000 (5000 x 45-44). And in case the dollar is down to Rs 42, he would incur a loss of Rs 10,000 (5000 x 44-42). This transaction involves costs, like, margining, brokerage, cost of carry, etc.

MARGIN REQUIREMENTS: Basically there are two types of margins - Initial Margin (Also called the SPAN Margin) and the Extreme Loss Margin. The Initial Margin is 1.75 per cent MINIMUM on the first day of the contract (that means the first day of introduction of a contract – the margin is higher on first day because there is no historical price trend available for the contract) and one per cent MINIMUM thereafter. The word 'Minimum' is very important here. Practically it is never at the minimum levels. We find that it is around 1.75% - 2% now (whether first day or other days). During peak volatility in USD/INR, this has gone up to 3% also. This margin can be changed up to six times a day depending on the volatility of the market. Extreme Loss margin is always 1% flat. So, the total margin now is approximately 2.75% to 3% in all. The above calculation is only for one sided position. If any client takes a calendar spread position (long in one contract and short in another), the initial margin is only Rs.250/- per contract and the extreme loss margin is 1/3 of 1% of only the longer maturity contract. The client can avail the benefit of calendar spread till the maturity of the nearer leg contract.

THE TRADE TIMINGS: On stock exchanges they would be from 9 a.m. to 5 p.m.

BENEFITS OF CURRENCY FUTURES

1.      Act as a better risk management tool for companies and individuals

2.      Facilitate efficient price discovery

3.      Enable better counterparty credit risk management

4.      Wider participation is ensured

5.      Trading of standardized products enable higher transparency, efficiency and accessibility and simplicity

6.      Reduction of transaction costs

As the market lot is small (USD 1,000) in currency futures market, small companies and individual investors can access this market with low transaction costs.

LIMITATIONS

At present, only currency futures (that too in the USD-INR pair) are permitted by RBI. Moreover, RBI has not allowed currency options.

Persons resident outside India are not eligible to participate in the currency futures market. This effectively means that FIIs and NRIs cannot participate. Their presence would have created tremendous depth and liquidity to this new market, market participants feel. Client Level position is restricted to USD 5 million.

Currency futures involve some costs, like, margin, brokerage, etc. RBI’s possible intervention in foreign exchange markets to keep the rupee stable may some times impact the participants who have taken exposure to currency futures.

SEBI’s RULE ON OPEN POSITION LIMIT

1. Trading Member Level: The gross open position of a trading member shall not exceed 15 per cent of the total open interest or USD 50 million (raised from 25 million to 50 million on 24.03.2009), whichever is higher. However, if the trading member is a bank, the gross open position shall not exceed 15 per cent of the total open interest or USD 100 million, whichever is higher.

2. Client Level: The gross open positions of the client should not exceed 6% of the total open interest or USD 10 million (raised from 5 million to 10 million on24.03.2009), whichever is higher.

RECOGNIZED STOCK EXCHANGES: National Stock Exchange (NSE) is the first exchange to have received an in-principle approval from SEBI for setting up currency derivative segment. NSE is the first to start trading in currency futures trading in India.

NSE had started trading on August 29, 2008. Bombay Stock Exchange started Currency Futures trading on BSE on October 1^st, 2008. MCX Stock Exchange, an arm of MCX Limited, launched currency futures on October 6, 2008. The live trading started on October 7, 2008.

REGULATORY AUTHORITIES: Both RBI and SEBI

IMPACT OF CURRENCY FUTURES

In India, there is an active OTC (over-the-counter) market for forwards with an average daily turnover of more than USD 40 billion. For the first time in India, it was made possible to trade on the currency futures on an exchange platform since August 2008.

Some experts believe that the introduction of currency futures is an important step on the road to capital account convertibility. This will help corporates to hedge their currency risks in a better manner. Students who have taken educational loans for their overseas education, Indians getting inward remittances from abroad and outbound travelers also can take advantage of this new instrument.

Individual investors are attracted to participate in currency futures as the contract size is quite small at USD 1,000 (roughly, Rs 47,000 now). The question that arises here is why do individuals need to take such a currency position. India has witnessed many takeovers and amalgamations in the past decade thanks to the liberalization of economic policies. As a result, many Indian companies carry high exposure to currency risks as their export and import content has gone up substantially due to increased trade and services. Indirectly, equity investors in such Indian companies are also exposed to currency risks.

Small companies also may find the currency futures more attractive compared to OTC market due to lower transaction costs in currency futures. As the client level open position limit is pegged at USD 10 million, the currency futures may be more conducive to small companies as compared to big companies. However, the OTC market is very big; hence, it remains to be seen how the currency futures market pans out even though volumes have been robust in the last one year.  

The introduction of currency futures market is expected to strengthen the bond-currency-derivatives (BCD) nexus. BCD nexus is a process whereby bond, currency and derivate markets are influenced by one another.

This new instrument is providing banks, exchanges and brokers with a new avenue for revenues. Till last year, banks had been doing currency dealings through the OTC market. Since last year, banks are offering currency futures by becoming trading members of the recognized stock exchanges. Banks need not go to brokers for dealing in currency futures once they become trading members of the stock exchanges permitted to undertake currency futures trading.

Speculators may also find some arbitrage opportunities between the OTC market and the exchange-traded currency futures market.

CERTIFICATION FROM NISM COMPULSORY FOR DEALERS OR BROKERS:

SEBI has mandated that all the existing approved users/sales personnel of the trading member in the currency derivative segment shall obtain certification from NISM (established by SEBI). Accordingly, all the users and personnel connected with the product have to complete this NISM certification, which enables users to have prior knowledge of all the important aspects of this new product, before the stipulated date as prescribed by SEBI in this regard.

Abbreviations used:

NSE                : National Stock Exchange

BSE                 : Bombay Stock Exchange

MCX-SX         : MCX Stock Exchange

RBI                  : Reserve Bank of India

SEBI                : Securities and Exchange Board of India

NCFM             : NSE’s Certification in Financial Makets

FII                    : Foreign Institutional Investor

NRI                  : Non Resident Indian

NISM               : National Institute of Securities Market

           

References:

1. Standing Technical Committee Report on Currency Futures-Final Report-Jointly by RBI and SEBI released on May 29, 2008

2. Inputs from Sri Janakiraman R, a veteran currency dealer from a leading private sector bank in India

3. SEBI Guidelines on Currency Futures-dated Aug. 6, 2008

4. SEBI amendment dated March 24, 2009

5. Websites of NSE, BSE and MCX-SX

6. SEBI monthly bulletins

7. NCFM Exam Module by National Stock Exchange Limited

8. RBI Guidelines on Currency Futures-dated Aug. 6, 2008

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