While the Indian exchanges can be justifiably proud of the way the currency futures market has evolved — daily volumes crossing $4 billion in just over a year since launch — it is time for them to reconcile to the fact that the current volumes are not appropriately distributed and efforts should focus on attracting a larger number of actual hedgers.
The vast bulk of volume traded — probably in excess of 70 per cent — comes from jobbers and day traders. Another 12-15 per cent comes from banks and other players who can, and do, arbitrage the OTC market. This leaves just about 12-15 per cent of hedgers and medium-term position-takers, which, in fact, reflects the open interest (OI) on the market. In contrast, on the CME, where total volumes traded (of all currencies) average about $100 billion a day, the ratio of OI to daily volume (for all currencies) averages nearly 95 per cent; for currencies like the Mexican peso, the hedging volume is much, much higher, with the ratio of OI to volume as high as 300 per cent.
Clearly, our market has still to mature quite a bit, and it is important, from both business and regulatory standpoints, to work to develop good growth in OI rather than simply in volumes, since only then will the market genuinely provide value to the broader economy.
Higher OI will parallel increasing volumes in longer tenors. Hedgers typically need to lock in prices at tenors of three to six months, matching their business cycles. The good news is that we are beginning to see a little movement up the time curve. Over the past six or eight months, there has been a noticeable increase in the second month, which currently averages 15-20 per cent of total volumes. Doing one or two million dollars at two months is quite easy, but clearly, this needs to go up several times to be meaningful.
Banks arbitrating between the OTC and futures markets play a key role in creating volume up the time curve. Already, the arbitrage at one month has been thinning. As a result, the quicker players have started shifting their positions out to the second month. In time, as that arbitrage thins out, the interest will shift to the third month, and so on.
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This is, of course, a slow process, and it is important that the exchanges do what they can — reducing trading costs in the further months, for instance — to make this shift more attractive.
While these technical factors may increase the attractiveness of the futures markets to hedgers over time, the biggest hurdle remains the genuine lack of understanding of risk management in most companies, small or large.
If you plan to use a market — whether futures or OTC — to hedge, you need to understand that the goal is to fix your cost (or your realisation), and that opportunity losses are part of the price you pay. Unfortunately, companies find it very difficult to live with this reality. Part of this is because everybody has 20/20 hindsight; and part is because accounting norms reflect opportunity losses directly in the accounts (unlike opportunity losses in other aspects of business), confirming the intuitive sense that forex risk management cannot possibly be fully process-driven.
What is worse in the case of futures markets is that hedging involves replacing forex risk with cash flow risk, and this is also something that could dissuade some hedgers, particularly small companies that are struggling with bank limits.
Notwithstanding these difficulties, global experience shows that futures markets can provide a good window for hedging. For instance, the OI on Mexican peso futures on the CME is about $7-8 billion — even if much of this is speculative, that’s still a lot of hedging.
The key, in my view, is educating potential users about risk management, which takes a lot of time. We have been advising companies for decades now, and we still find a relatively small number of companies that are comfortable with accepting the limitations of risk management.
Thus, I believe that the continuing efforts of Indian exchanges at user education need to be given a different focus. Rather than simply showing how futures markets work and the benefits the user can get, the programmes need to provide a fair-minded exposition of the risks (opportunity loss, cash flow risk, etc.), which will increase the credibility and slowly increase buy-in.
The unrelated good news, of course, is that high rupee volatility is attracting more and more companies to the futures market — perhaps, we will see OI at 50 per cent of total volumes by the end of 2010.