There is an ongoing debate in financial circles about the relative efficacy of futures and forwards. While both are derivative instruments, forwards are generally understood to be customisable and traded over the counter; futures are standardised contracts traded on recognised exchanges similar to stock futures trading through brokers.To put things in perspective, we shall touch upon some of the key issues to throw light on the reasons why currency futures are a logical mode of trade and hedge product for those with currency exposure.
One reason which immediately goes against bank-dominated OTC currency forwards is the opacity of the whole deal. Prices quoted by banks to clients frequently depend on the amount involved with the smaller importers and exporters taking a bigger hit. And it was this opacity which ultimately led to huge losses being booked by corporates with accusations of deals in exotic derivatives which were too complicated to understand for anyone other than the banks themselves. This unfortunate saga still continues with many large companies suing major banks for misleading them. Whatever the truth, the fact is that currency futures, being highly regulated exchange-traded standardised products, would have certainly assured transparency to the process. Associated with this is the talk about mark-to-market (MTM) ie, how forwards are preferred because there is no MTM. In fact, MTM acts as an alarm and I can say with some assurance that this issue would not have come to pass if the client corporates were aware of the increasing losses on a daily basis which they would have had to cover with cash immediately. In fact, several corporates globally have shifted to hedging through futures. The other issue raised has been that forwards do not require margins; well, margins are very low in futures and there are reports that banks too have started charging margins before accepting client trades on OTC deals.
Currency futures have excellent liquidity and a fair market price is assured irrespective of whether you are a big player or a small one, with minimum exposure of only $1,000. In the OTC markets, banks are unlikely to talk to smaller customers. In terms of cost too, the currency futures markets are going to be much cheaper to use compared to OTC markets due to market forces. Exposure in multiples of $1,000 ensures that all types of market participants like exporters, importers, commodity traders, Indians investing abroad as well as those receiving remittances from overseas are able to hedge their currency risk efficiently in currency futures markets. The small lot size also makes currency futures customisable to every client?s volume requirement.
That apart, there are other advantages of trading in regulated exchanges. The product has been designed to be similar to stock and commodity futures and that makes it easy to understand for everybody in our financial ecosystem. Exchanges also provide novation by guaranteeing each leg of the trade; therefore there is no counter-party risk. This means that you always have an exit route. The above benefits also ensure another important fact?that a whole range of investors can now add currency to diversify their portfolio just like their counterparts in the most developed countries in the world.
Today, currency futures markets are open from 9 to 5 in accordance with banks? OTC currency markets. With clarity that the commodity market players need currency futures markets to hedge their risk almost till midnight, it is imminent that the timings will be changed soon. That itself will set the cat among the pigeons. Besides, client exposure limits have already been doubled and more currency pairs are being readied to trade in. The other advantage of deliverable currency is actually not required in a system where the futures clearing price will match the spot market price giving full benefit to hedgers.
All said, currency futures markets are set to be a huge success with wide participation from users and traders of all hues due to the string of advantages that accrue to participants due to strong regulation and efficient infrastructure leading to fair price discovery and an excellent platform for risk mitigation.
The author is head of Religare Commodities. These are his personal views