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Forex futures more efficient
November, 30th 2009

Markets regulator SEBI has said that the exchange-traded currency futures market is more efficient than the over-the-counter (OTC) interbank forex market as far as the cost of entering or exiting a trade is concerned.

SEBIs statement made in an internal memorandum to its board has come as a surprise to many analysts since internationally, the forward market is much more liquid than its exchange-traded counterpart.

The market regulator has studied trends in currency futures and the OTC market and concluded that the former has been operating at a bid-ask spread narrower than that of the OTC spot market. Now, analysts are seeing this as a prelude to the regulator introducing futures contracts in currencies other than the dollar-rupee.

Volumes in listed currency futures have grown phenomenally well since August when they were first introduced with contracts of over $3 billion being traded daily in November 2009. SEBI says this rise that has allowed almost all of the FX futures transactions at NSE amid MCX-SX to take place at a spread less than or equal to half a paisa. The corresponding figure for the OTC market is 6.53%, SEBI said.

The bid-ask spread gives an indication of the cost and ease with which a contract can be traded, essentially a proxy for a markets liquidity. In a recent research paper, Gurnain Kaur Pasricha, a senior analyst at bank of Canada said Brazil is the only country in the world, prior to India, where the currency futures market has become more liquid than the forward market.

Once the exchange (traded market) becomes liquid, the network externality of market liquidity sucks in further order flow and preserves the domination of the exchange, even after these rules (helping the segment) are removed, she concluded in the paper.

The SEBI study also says the share of merchant (corporates) transactions in the OTC market has fallen from 63% in November 2008 to 30% in November 2008.

This could mean that as a hedging tool, merchants are probably moving to the futures market, the memorandum said. U Venkatraman, executive director, MCX Stock Exchange attributes this to banks offering the product to customers encouraging participation from exporters, importers and other small and medium enterprises.

Entities other than banks and retail investors made up around 65% of daily volumes in August 2009 for FX futures. While the futures and forward rate diverged initially, they have appeared to converge recently, was another of SEBIs observation. This underscores the gradual disappearance of arbitrage opportunity between the two markets.

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