For a demonstration of the dynamism of India’s financial sector, there can be few better examples than the country’s foreign exchange derivatives.

In 2010, the boom in trading at Multi Commodity Exchange Stock Exchange and the National Stock Exchange of India made their US dollar/Indian rupee futures the two most actively traded currency derivatives on any exchange in the world, by number of contracts.

While the contracts are small – each future is for $1,000 – the level of activity is still remarkable. It’s even more astonishing, since this is a purely domestic market. Foreign investors are banned from trading India’s currency futures. Even large domestic companies struggle to meet their hedging needs in the market because of position limits.

This market’s potential for rapid change and growth is institutional as well as commercial. The landscape of exchanges in India is changing at a much faster rate than in most other countries, developed or emerging.

On September 20, a third currency exchange, the United Stock Exchange of India, opened for trading with a suite of currency futures. It reported a staggering 9.9m trades on its first day of operations, surpassing the previous market leaders, MCX SX and the NSE.

“Last year was very eventful for us. We went live in September, which was a milestone for us and the Indian market, as it was the first time that all the local banks came together on the same platform,” says Saurav ‘Sunny’ Arora, president of business development and marketing at the USE in Mumbai.

India’s FX futures market offers something rare in futures – genuine, direct competition between three exchanges, all offering identical products.

But the economic energy that drives such rapid change is dangerous. Financial markets everywhere are prone to booms and busts, investment bubbles and speculative manias. When these burst, they can do untold damage to an economy.

India’s government and regulators are well aware of this – indeed, India is renowned in Asia for the tight restrictions that guard its markets, both from foreign hot money and from domestic excesses.

Step by step, the authorities are relaxing their grip, letting new products develop and increasing access to markets. But can they let the car accelerate, while keeping control of it?

FX in overdrive

In the derivatives market, the sector with its foot hardest on the pedal is FX futures. Supplementing the existing dollar/rupee futures, on February 1 regulators permitted the introduction of euro, sterling and yen pairs with the rupee. These have contributed to the FX futures market’s threefold growth over 2009.

By the end of September USE had emerged as a strong challenger to the market leaders, with 46.8m contracts traded, to MCX-SX’s 78.8m and NSE’s 61.6m. The pattern continued in October as the whole market again set volume records, but since then USE’s volume has died down, to only 6.61m contracts in December.

Membership is strong, however. In late September, the exchange had 225 trading members and 32 clearing members, with nine banks acting as clearing and settlement bankers for the exchange.

By mid-December, according to Arora, the membership roll had reached 310, “of which 19 were banks and many corporate investors and the remaining were broker-dealers”.

Arora sees the diversity of USE’s participants as one of its main strengths. “We are backed by 27 banks as shareholders,” he says, “which means we have a higher sustainable advantage compared to other Indian exchanges.”

Asked about USE’s plans for the future, Arora replied: “For the moment, our main focus is to increase liquidity and get more members on board. In fact, two large international banks are currently in the process of joining us.”

The USE’s entry to the Indian FX love triangle complicated an already bitter relationship between the established players, MCX-SX and NSE.

The pair are locked in a battle for market share which has led to legal skirmishes – and which reveals the uncomfortable truth about the FX boom. None of the exchanges are charging any fees for the trading.

Legal battles

MCX-SX is so upset about the NSE waiving its fees, forcing MCX-SX to do the same, that it complained to the Competition Commission of India.

The Commission ordered an investigation into MCX-SX’s allegation that NSE was misusing its dominant position in Indian financial futures trading. MCX-SX says it cannot afford to emulate NSE because FX futures are its only product, whereas NSE has revenues from equity and index derivatives to live on.

A further piquancy to the story is that MCX-SX is also suing the Securities and Exchange Board of India. Sebi denied the exchange permission to branch out into other kinds of derivative such as currency options and interest rate futures – a decision MCX-SX wants overturned.

The regulator’s reason for refusal was that MCX-SX’s promoters, Multi Commodity Exchange of India and the Financial Technologies group, seemed to be secretly trying to circumvent the cap on firms owning more than 5% of any exchange.

USE has joined in the zero-fees dance. “At the moment, to attract more business and deepen liquidity, we have waived off trading fees or membership fees,” says Arora. “In the next quarter, we’ll examine how we will continue down that road and whether we’ll introduce fees to recoup costs. Once that is achieved, we will look at other activities.”

BSE’s eclipse

Remarkably, to many foreign derivatives experts, the exchange that springs to mind when they think of India is not one of the three already mentioned, but the Bombay Stock Exchange, which used to be a big player.

However, its volumes, which chiefly comprised Sensex Futures on India’s leading blue chip equity index, collapsed to virtually nothing in early 2008. BSE made a brief stab at currency futures later that year, before giving up.

“The NSE was the first to introduce futures and enjoys the first mover advantage. The NSE’s growth in futures has cannibalised the BSE,” explains Damodar Krishan Aggarwal, chairman of Indian private wealth management firm SMC Wealth Management Services in New Delhi. “To make up for that loss, the BSE is cooperating with international exchanges such as Euronext in terms of index products, but it is slow to catch up and make the necessary changes, such as incentivising trading Sensex products and introducing market-maker schemes,” he suggests.

The NSE’s Nifty 50 Index Futures and Options are instead the means by which investors hedge Indian equity risk.

BSE is not only looking overseas for partners. “We are in a strategic tie-up with the Bombay Stock Exchange, and current members of BSE can access USE easily without any additional cost,” says Arora at USE.

Asked which his favourite exchange was, Aggarwal said: “We are members of all the exchanges in India. The NSE especially has done a very good job – it offers excellent products for trading and is regulated very well.”

Options to catch up

Gaurav Arora (Sunny’s father) is founder and managing director of Jaypee Capital Services, the largest Indian broker for exchange-traded derivatives. He predicts very strong growth in currency, energy and gold products.

“Currency futures this year have been the most active product in terms of contracts traded,” he says. “The front month is the most active.” Most trading is short term, with month-end open interest running at about 1% of monthly trading volume.

While growth in currency futures has been enormous, FX options have only recently become available. The NSE listed rupee-dollar options on October 29, after winning clearance from the regulator.

“Once it is successful we will see options being introduced in other rupee contracts like rupee-yen, rupee-euro, and rupee-sterling,” projects Aggarwal.

The growth of the market is still largely driven by domestic speculators and hedgers. For example, Aggarwal says, hedge funds want to use equity options to protect their positions.

Gaurav Arora says a lot of volume has been shifting from futures to options, partly because “a lot of FIIs (Foreign Institutional Investors) have become active in the market”. With colocation being permitted, many foreign and domestic institutions are using various automated strategies, which Arora says “has been a major reason for volume growth”.

India is a tightly controlled market, where exchanges’ freedom to launch new products is limited. But they are on the lookout for good ideas. “New activities might include new product launches,” says Sunny Arora at USE. “All currency derivatives would be interesting, as they affect everybody’s lives. We are also studying other products like the corporate debt market.”

Gaurav Arora knows where he sees the most potential. “Developing the interest rate futures and the corporate debt market seems the most challenging and where the most opportunity is,” he believes. “Also, the commodity markets are poised for good growth in the coming year.”

When it comes to stock options, another change is imminent. So far, India has had American-style options on shares. However, on January 1 it switched to European-style options, with fixed maturation dates.

Market participants are bullish about the change. “This is a big development and I think this will make the market very liquid,” says Aggarwal at SMC Wealth.

Tax cuts sought

Traders are also looking forward to a reduction in India’s Securities Transaction Tax. Since it is paid on the total value of a transaction, it adds significantly to the cost of trading. To cut this cost, many market participants invest in index and stock options rather than futures and equities.

“At the moment, over 60% of our Nifty Index volume is coming from Nifty Options,” Aggarwal explains. “STT on options is paid on the premium and not on the strike price and therefore, the cost of trading in options is less than the cost of trading in futures and equities,” explains Aggarwal.

Asked by how much the tax might be cut, he said: “I think the STT will be reduced significantly, as representatives of the financial industry are pushing for this.”

The authorities are working on a second round of reforms to open up the capital markets. In December, the minister of state for agriculture, KV Thomas, introduced a proposal to permit commodity options to the Lok Sabha, the lower chamber of parliament.

The Forward Contracts (Regulation) Amendment Bill will, if passed, allow commodity options for the first time, supplementing India’s agricultural futures market, and would increase the powers of the Forward Markets Commission.

Market participants expect the bill to be passed in February. “This act will empower the regulator to permit foreign investors to invest in commodities. I expect a qualitative jump in the commodities space when that happens,” estimates Aggarwal.

Some are optimistic that regulators might open the doors wider to foreign investors. “India attracts a lot of interest from foreign investors, and we think that regulators will eventually broaden the range of products that are available to them, and maybe even open up currency futures for them,” says Saurav Arora.

Further changes might be afoot in the interest rate futures market, where the regulator is mulling shorter term maturities. “So far, we only have 10 year bonds, but we expect shorter maturities to be allowed, such as three or one year and six months bonds,” says Aggarwal. “As an emerging economy, we need a highly liquid bond market, and this will lead to the bond market becoming very liquid. That way, the bond market can become as vibrant and attractive as the equity markets currently are.”

Untapped potential

The stimulus of zero fees makes the early success of India’s FX futures rather misleading. But demand for this form of trading is such that, when modest fees are imposed, one might expect a vibrant market to continue.

When India gets the formula right, this shows, trading volume can soar. Whether that is a good thing, and whether the authorities will permit it in the case of each different asset class, is another matter.

But there is reason to believe that each of the main categories of market user has the potential to increase its trading of futures and options.

Foreign investors are particularly eager to get exposure to India’s fast-growing economy, and many prefer India to China, which, while it has higher GDP growth, is generally seen as less transparent. In 2010, some $35bn of foreign money flowed into the Indian capital markets.

In the derivatives sector foreign institutions, at present, are active only in equities, though they also participate in the OTC foreign exchange market.

How much more derivatives trading these institutions will be able to do depends on how far they are admitted to the market by regulators.

Sunny Arora at USE believes there is still a large untapped client base in the Indian corporate sector. “Indian corporations and other natural hedgers need to come more on exchange to hedge their risks,” he argues. “So far, they don’t participate as much as would be needed. We think this is because many corporations don’t know how to use derivatives and we need to impart education and training to bring them on board.”

Reaching the people

But the biggest source of future growth may well be India’s institutional investors and its large population discovering trading.

“Domestic institutions are strong across asset classes,” says Dr Ranjan Chakravarty, head of research at MCX-SX. “The large public sector banks are very active government securities traders, and to a lesser extent the privately held domestic banks. Domestic institutional investors are also multi-asset, typically of the nature of mutual funds. Retail participates mainly through the mutual fund route.”

Yet Indian pension funds are not allowed to invest in derivatives, and can only invest 5%-10% of their capital in equities. The potential is, therefore, much larger than at present, and Aggarwal believes the second round of financial reforms will ease these restrictions.

As Aggarwal points out, direct market access is now also allowed for institutional investors. High frequency trading is happening – he estimates about 20%-30% of volumes in India come from algo trading, and there are a lot of arbitrage opportunities that hedge funds and brokers can profit from.

“All the major tech providers are in India,” Aggarwal adds. “With its technical infrastructure that includes real time risk management, the NSE definitely numbers among the top exchanges in the world.”

The government is also keen to grow the retail sector. “Around 1.5% of the population invests in equity markets at present,” says Aggarwal. “The government is working to increase that number and exchanges are increasing awareness of trading, for example, by offering a 5% discount on equities in PSU disinvestment [privatisations]. That way, they are slowly growing the retail base, which we believe will grow to more than 6% of the total population in the next five to 10 years.”

Chakravarty at MCX-SX agrees: “Financial inclusion is a reality and as an example, retail participants from around 500 cities and towns across India are already connected to MCX-SX.”

The financial sector’s targets are India’s growing middle class, such as people returning to India with MBAs and those working in outsourcing for financial institutions. Their savings should fuel growth in equities, which will then spill over into derivatives.

And the way these people trade might be radically different, potentially even leapfrogging the west. “Another big thing is mobile trading in the retail space,” Aggarwal says. “India has 600m people with mobile devices. Mobile trading is especially attractive to cater to the rural area of India. The sheer amount of people with mobiles gives India a dynamic that is rarely found anywhere else. I think mobile trading can gain momentum and could be enormous.”

Hopes and wishes

Still, with all the potential, the list of products desired by the market is long.

“We would like to see commodity options. We need a more vibrant commodities market and for foreign investors to invest in commodities,” says Aggarwal. “The same goes for the bond markets, and we’d like to see Vix futures introduced in Indian stock exchanges. At the moment the Indian equity market enjoys the major share of the total financial market, whereas in US or Europe, it constitutes only about 13%-15%. Thus, our commodity futures, currency and bond markets have a long way to go and need to be made more vibrant and liquid.”

Regulation is not only hindering inbound investing, Aggrawal points out. “Indian residents currently can only invest up to $200,000 outside India under the automatic route in a financial year, and cannot do margin-based trading outside. This limit might be eased or increased. What we need is to further free the economy and remove such limits.”

Summing up his expectations for the future, MCX-SX’s Chakravarty says: “In terms of product and market development, we are as ready, in terms of capability, as are the exchanges of the developed world. As an industry we’re focused on bringing optimal products to the table, on a highly technologically advanced base, and delivering them to a huge population with a high savings rate and an appetite and desire for wealth creation. And we will do what we have to do to achieve this.”