Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Indian Currency Futures

Ajay Shah’s blog
post yesterday
provides a lot of interesting data about liquidity
and trading in India’s nascent currency futures market. The
contract is doing quite well for a newly introduced product, but
clearly it is miniscule compared to the OTC market. What are the
prospects of this market really becoming mainstream?

How does an illiquid market grow and take liquidity away from an
established market? One important factor based on lessons from the
well known battle for bund futures (see for example Cantillon and
) is the ability of the market to attract a different group of
traders into the new market. New markets get their initial momentum
from new entrants and not from switchers from old markets. This group
of new entrants who value the liquidity of the old market less than
the other characteristics that the new market offers start trading and
gradually build up liquidity in the new market to the point where it
can start attracting switchers.

For currency futures in India, there are several such groups

  • Those who do not have the underlying exposure that the RBI
    requires for trading in the OTC market but are allowed to trade in the
    cash settled futures.
  • Those who trade in lots smaller than the million dollar (or
    half-million dollar) lot required in the OTC market.
  • Those who prefer the anonymity of the futures market as opposed to
    the bilateral trade that takes place in the OTC market.
  • Those who prefer depositing margins or collateral in the futures
    exchange to tying up credit lines in the OTC market.

The restrictions in the currency futures market (position limit and
absence of FIIs) do not bite at this stage because they do not by and
large affect this group of new entrants.

The real battle for market share would begin when the market builds
up reasonable depth and liquidity to attract participants from the
inter-bank market (as opposed to the customer market from which the
initial traders would come).

Globally, we know that the currency futures have a role in price
discovery that is disproportinate to its share in trading (Rosenberg
and Traub
) though improved transparency in the OTC market has
reduced this role quite sharply between 1996 and 2006. In India, the
price discovery role of currency futures is potentially greater
because of regulatory restrictions on the OTC market. An additional
complication is that since covered interest parity does not yet hold
in India, there is information content in the forward/futures market
distinct from what is there in the spot market. Globally, one assumes
that the information in futures and spot markets is the same.


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