When a Currency Futures Market Dominates a Currency Forward Market

By Ajay Shah, on November 27th, 2009

In recent months, a sense has emerged that the exchange-traded currency futures market in India is more liquid than the corresponding contract traded OTC (i.e. the forward market). As an example, we examine a dataset from NSE of 28,797 observations of data – one observation per second – from 3 November 2009, for the November expiry. The effective spread for a transaction of $1 million (i.e. 1000 contracts) is calculated, in the units of paisa. This dataset has the following summary statistics:

5% 25% 50% 75% 95%
0.519 0.763 1.000 1.380 2.344

In other words, 95% of the time, the spread on NSE for a $1 million rupee-dollar futures transaction was below 2.344 paisa. The median spread, for a $1 million transaction, was 1 paisa. This spread dropped below 0.5 paisa with only a 5% probability.

These numbers are significantly superior to those found on the OTC forward market, where, as a thumb rule, dealers feel that a $1 million transaction typically involves a spread of 2 paisa. This suggests that the liquidity at NSE is roughly 2x superior to the OTC market. The superiority of the execution at NSE is likely to be greater than 2x when we consider the opacity and execution risk of the OTC market. To the extent that order flow has shifted away from the forward market to the futures market, there could be a dynamic story here of the futures spread getting tighter at the expense of the forward spread.

This situation is unexpected. In the international experience, the currency forward markets is more liquid than its exchange-traded counterpart. This is despite the fact that futures markets has desirable features including near-zero counterparty risk, transparency, contracts standardisation and open public participation. The key reason for the domination of the OTC market appears to be historical. The OTC market came first, had entrenched liquidity, and the network externalities of liquidity hold the users in place.

In thinking about India’s currency futures market, it would be useful to compare and contrast with Brazil’s experience. Brazil is an interesting peer to India for reasons of a large GDP, democracy, rule of law, institutional quality, etc. It is also the only country of the world, prior to India, where the currency futures market became more liquid than the currency forward market.

In Brazil, currency futures trading began in 1991 – a seventeen year head start when compared with India. While Brazilian macroeconomics is now remarkably healthy, Brazil has had a turbulent history with many crises, high and volatile interest rates and inflation. The futures market, with daily marking to market, and therefore lower collateral requirements, offered a cheaper way to take positions in the currency. Nevertheless, there is reason to believe that several (sometimes unrelated) regulations contributed to tipping the balance in favor of futures contracts, so much so that today there is essentially no OTC market to speak of. The dealers on the forward market now provide OTC contracts to their customers but unwind their positions in the futures market (See Note 2). The regulatory pressures which moved liquidity from the OTC market to the futures market were:

  1. Access to spot markets was limited for several decades as a tool to control capital flight. Both domestic and foreign residents had easier access to futures markets than to spot markets. This led to greater number of players, and more liquidity in futures markets. Access to spot markets in Brazil is still far from free, for both domestic and foreign residents. India is in the same boat, with a futures market that is accessible to citizens but a spot market which is not.
  2. Until 2005, banks were subject to unremunerated reserve requirements on foreign exchange exposures exceeding pre-specified limits. These reserve ratios did not apply to futures positions, thus driving trading to futures markets.
  3. Until December 2007, Brazil imposed a financial transactions tax, called CPMF, on all debits on bank accounts. This levy applied to profit and loss payments on exchange traded contracts, not to their notional amounts, thus pushing activity to exchanges.
  4. OTC derivatives contracts are not netted, whereas contracts with the exchange or clearing house are netted by the latter. This means that the tax on cash flows, PIS-COFINS (See Note 3), de-facto taxes OTC transactions at a higher rate than exchange traded derivatives.
  5. Brazil has reporting requirements for OTC transactions – all transactions with domestic counterparties must be reported to regulators, in order for them to be considered enforceable. This levels the playing field in terms of the reporting burden of exchange traded versus OTC transactions. India has not yet done this.
  6. Pension funds are required to use only standardized derivatives contracts.
  7. The central bank, Banco Central Do Brasil, uses the futures market for doing currency intervention. This gives liquidity to the futures market, and also ensures that the OTC community has to look very carefully at the price on the screen so as to capture current information. India has not yet done this.

While some of these rules were removed in the 2000’s, after being in place for several years, their consequences have outlasted them. There is a path-dependence in market liquidity. These kinds of market rules matter in getting liquidity on the exchange off the ground. Once the exchange becomes liquid, the network externality of market liquidity sucks in further order flow and preserves the domination of the exchange even after these rules are removed.

Endnotes

1 The author is a senior analyst at the Bank of Canada. The views expressed here are personal. No responsibility for them should be attributed to the Bank of Canada.
2 The material in this note is a summary of information provided by Brazilian economists as well as that contained in Dodd and Griffith-Jones (2007), Brazil’s derivatives markets: hedging, central bank interevention and regulation, and Kolb and Overdahl (2006), Understanding futures markets, sixth edition, Blackwell Publishing.
3 The PIS and COFINS are federal taxes on revenues, charged on a monthly basis.



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Futures COT

By Bron Suchecki, on October 12th, 2009
Adam Hamilton of Zeal LLC is one commentator I have been following for many years. His latest one on the Commitments of Traders Report is essential reading:

“The bottom line is gold futures activity as chronicled in the CFTC’s Commitments of Traders Report is often misunderstood. A minority of analysts choose to interpret facts about week-to-week developments out of the illuminating context of bull-to-date behavior in similar situations. Thus their interpretations of this complex report are often misleading. And sadly many newer traders are swayed by this shoddy analysis.

It is critical to remember gold futures are a zero-sum game. For every short, there is an offsetting long. So if the feared commercial hedgers’ net-short position is surging and hitting records, then so too are speculators’ net-long positions.”

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Currency Futures Liquidity Ahead of the Forward Market?

By Ajay Shah, on September 23rd, 2009

At NSE, currency futures did $1.8 billion yesterday. With this, India is starting to look like the first country where the turnover of the currency futures market is big when compared with the currency forward market.

Turnover is, of course, not liquidity. Liquidity is about the transactions cost faced when transacting. Liquidity comparisons between the OTC market and the futures need to take into account the fact that the OTC market trades bigger contracts. So, let’s see what impact cost is visible in the information present on the web, pertaining to closing time (5 PM) on the 22nd. The quantities available at the best five prices are visible on the web. There is surely more available beyond, but you probably don’t want to trade at those adverse prices.

Let’s focus on 1000 contracts, or $1 million. Based on conversations, I get the sense that the forward market would have impact cost of 0.01% to 0.02% for this transaction size. The graph shows that the NSE contract has smaller numbers than this for both buying and selling.

(Click on the graph to see it more clearly). The futures market seems to be able to serve upto $6 million to a buyer and $2 million to a seller, while suffering reasonable values of impact cost, within the top five prices.

This is admittedly one data point. Late in the day, I noticed a big number for turnover and wondered what was happening to liquidity, so I looked at the `market by price’ display visible on the web. But for a currency futures market to beat a currency forward market on liquidity is unusual, even if it is for one data point.



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Massive Institutional Gold Market Change

By Trace Mayer, on September 2nd, 2009

There is a massive change in the institutional gold market.  The CME Group has announced, “In response to market needs, CME Group will offer a clearing service for the OTC London gold forward market beginning September 20, 2009 for trade date September 21, 2009.”

After an analysis of the governing terms, policies, procedures and methods I think this scheme will allow for gold demand to be shunted into gold substitute products and keep the price of gold in fiat currencies low while entangling the gold substitutes with increased risks.

COUNTER-PARTY RISK

While similar there are differences between future and forward contracts.  For example, future contracts are traded on exchanges, use margin and are marked to market daily.  In contrast, forward contracts are generally privately traded over-the-counter (OTC derivatives) between two parties and are not marked to market.  Therefore, forward contracts are subject to greater counter-party risk than future contracts.  This may be a reason why there was nine weeks of silver backwardation in early 2009 with the LBMA forwards while not with the futures.

Based on the following new press release and the FAQs for Cleared OTC London Gold Fowards there are a few key features investors should be cognizant of and while I will not address all of them for brevity sake I will hone in on some of the most important.

Contracts remain as forwards in clearing and are not converted to futures contracts.  Every trade establishes a new open position.  There is no liquidation.  Upon reaching delivery, positions are netted down and CME Clearing remains in the delivery process.  Delivery occurs at London Precious Metals Clearing (LPMCL) member banks using “London Good Delivery Gold. … Clearing coverage for all good forward maturities that are physically deliverable into unallocated “London Good Delivery” gold extends 10 years out. [emphasis added]

This is interesting given the standard industry practice to ‘net’ purchases and sales.  The London Precious Metal Clearing Limited states:

The bullion market has generally advocated the netting of same day value trades by counterparty, as a means to reduce the number of settlements, but also and more importantly, in order to reduce the amount of credit risk both while the trades are live but not yet due for settlement, as well as at the actual point of settlement.

Note:  Netting is particularly important given that the vast majority of bullion trades are against US dollars, when the metal leg is settled in London by 4.00pm, but party due to receive the dollar counter-value in New York will not normally know whether or not the dollars have been received in their account, until the US dollar clearing closes at the end of the New York business day.

Why would the CME want to provide for no liquidation and wait until delivery to net down positions and thus increase the amount of counter-party and credit risk in the transactions?

GUARANTEE

Question 22 asks:

How are the contracts guaranteed?

CME Clearing provides two forms of guarantee:  a counterparty guarantee and a delivery guarantee.

When OTC forward trades are substituted in the clearing system, CME Clearing becomes the counterparty to every buyer and seller.  Once these trades are accepted for clearing, the counterparties look to CME Clearing for financial performance during the life of the transaction.

The second guarantee occurs at settlement.  With Cleared OTC London Gold Fowards, the clearing house remains in the delivery chain and provides each party the full comfort that the clearing house will effectively make delivery of dollars and gold.

These two guarantees add convenience for the parties involved and is a primary reason for exchanges.  But the failure of an exchange, like the COMEX failing to deliver, is possible and almost happened with Deutsche Bank according to securities attorney Avery Goodman.  Those parties availing themselves of acquiring bullion through these cleared forwards should take adequate precautions to minimize their risk and I will mention these later.

DELIVERY

Question 23 asks:

How will delivery be made?

For delivery, all participants will establish an unallocated gold bullion account at a London Precious Metal Clearing Ltd. bank.  Standing settlement instructions will need to be provided to CME Clearing for each clearing position account.  CME Clearing will become counterparty in the delivery process by opening accounts at LPMCL banks to facilitate this process. CME Clearing will not become a clearing bank itself or manage vault facilities which hold precious metals in storage.

WHAT IS THE LPMCL?

In April 2001 the six LBMA members that offer clearing services formed a not-for-profit company called London Precious Metal Clearing Limited.  These six members include Barclays Bank PLC, The Bank of Nova Scotia-ScotiaMocatta, Deutsche Bank AG – London Branch, HSBC Bank USA National Association – London Branch, JPMorgan Chase Bank and UBS AG.

The LPMCL website is, inconveniently, in javascript which keeps the text out of major search engines like Google and makes it difficult to provide hyperlinks to the relevant citations.  Under the Introduction in the Physical section clear at the bottom they assert that “Unallocated accounts do not entail specific bars being set aside and the customer has a general entitlement to fungible metal.  Unallocated accounts are the most convenient and commonly used method of holding gold and silver.  The owner is an unsecured creditor of the clearing member.”

Under the LPMCL Unallocated User Agreement an

‘Unallocated Account’ means, in relation to a Precious Metal, the account(s) maintained by us in your name recording the amount of that Precious Metal which we have a contractual obligation to transfer to you (or, in the case of a negative balance, if so permitted by us, which you have a contractual obligation to transfer to us).

An unallocated gold account does not have the same risk profile as physical gold bullion held either personally or through a trusted third party vaulting service like GoldMoney in bailment.  An unsecured debtor is extremely different from an absconding bailee.

GOVERNING RULES

Question 13 asks:

What Exchange rules will govern this service?

All disputes are governed by the COMEX and CME rules and regulations.  Once the trade is substituted into clearing, any prior legal agreements will fall away and both parties will come under the rules and regulations of the COMEX and CME.

COMEX Rulebook

CME Rulebook

This is particularly interesting that there would be a merger and integration clause to supplant prior contracts with COMEX rules.

CFTC SANCTION

Under a 22 February 2005 notice from Nancy Minett, Vice President of the Compliance Department at the Commodities Futures Trading Commission, provides that:

The New York Mercantile Exchange, Inc. (”NYMEX” or the “Exchange”) hereby notifies the Commodity Futures Trading Commission (”CFTC”) that, as set forth in the attached rule interpretation, it will accept gold-backed ETF shares as the physical commodity component for EFP transactions involving COMEX gold futures contracts

GLD ETF PROBLEMS

Why the CFTC would allow supposedly gold-backed ETF shares to satisfy the physical commodity component in an exchange of futures for physical transaction baffles me.  In December I wrote A Problem With The GLD ETF which reads:

See “Risk Factors” starting on page 6.”  Page 11 states “Neither the Trustee nor the Custodian independently confirms the fineness of the gold allocated to the Trust in connection wtih the creation of a Basket [issuances].”  Page 12 “In issuing Baskets, the Trustee relies on certain information received from the Custodian which is subject to confirmation after the Trustee has relied on the information.  If such information turns out to be incorrect, Baskets may be issued in exchange for an amount of gold which is more or less than the amount of gold which is required to be deposited with the Trust.”  There is no assurance that the ‘gold’ held in the ETFs is actually the same gold as defined under the periodic table.

I then followed up that article with Another Problem With The GLD ETF which reveals,

The latest 10-K (Commission File Number 000-32356) on pages 26 and 18 respectively: ” Gold held by the Custodian’s currently selected subcustodians and by subcustodians of subcustodians may be held in vaults located in England or in other locations.” and “In addition, the Trustee has no right to visit the premises of any subcustodian for the purposes of examining the Trust’s gold or any records maintained by the subcustodian, and no subcustodian is obligated to cooperate in any review the Trustee may wish to conduct of the facilities, procedures, records or creditworthiness of such subcustodian.”

Not only does the GLD ETF not have to store physical gold bullion as defined under the periodic table but any gold it may hold the Trustee has no right to examine even for the purpose of an audit of the physical gold bullion.  Anyone who is willing to accept supposedly gold-backed ETF shares instead of physical gold as defined under the periodic table may be brain dead.

GREENLIGHT CAPITAL FLEES GLD

For example, in a 13 July 2009 letter to investors David Einhorn of Greenlight Capital, a multi-billion dollar hedge fund with the largest holding in GLD, wrote:

We made a couple of modest changes to our macro hedges.  First, after extensive investigation we switched our entire GLD exchange traded fund position into physical gold.  At a minimum this will provide some savings as the costs of storing gold are less than the fees on GLD.  It also gives David’s desk a lot more “bling” (actually it is being held at a professional storage facility) [emphasis added].

In addition to needing to send David a bill for my articles about the GLD ETF it also makes me wonder whether the CFTC is in denial or complicit?

PHYSICAL GOLD IS GETTING SCARCE

This further consolidation of the gold price determinant via the OTC forwards with the COMEX will make the central bank gold price suppression scheme easier to manage because gold demand that was previously satisfied with physical bullion through forward contracts between private parties can now be satisfied with unallocated gold accounts or, in other words, paper substitutes for physical bullion.  But the increased convenience and lower transaction costs come with the latent cost of increased counter-party risk which may later prove lethal to one’s financial condition.

And as Norman R. Nelson, Executive Vice President and General Counsel of The Clearing House Association LLC declared on behalf of the Federal Reserve in Bloomberg v. Federal Reserve, the revelation of such trade secrets would be “information virtually everyone would consider potentially disastrous.”

I hypothesize that the reason for this move is that physical gold bullion is getting increasingly scarce.  After all, annual worldwide production is only about 70 million ounces or $65B compared to the quantitative easing by the Federal Reserve, Bank of England, etc.

Gold is cash and the risk-free asset because at all times and in all circumstances gold and silver are money and also essential checks and balances in the political machinery.  While the fiat currencies represent the common stock of nations and their evaporation of the FRN$ portends difficult circumstances.  Now is the time to start implementing provident living principles, preparing for survivalism in the suburbs and learning how to protect your personal and financial privacy.

CONCLUSION

The green shoots are but illusions because the administration is intentionally exacerbating the greater depression.  There is another market crash coming.  Currency controls are being heightened.

Do not mistake this brief reprieve and added ammunition for the gold cartel as a recovery.  Attempting to suppress interest rates by manipulating the gold price through paper instruments, like settling either COMEX futures contracts or OTC forwards with GLD ETF shares, is a policy destined for failure and is ‘potentially disastrous’ on a massive scale.

I titled my book The Great Credit Contraction and it has only begun.  Like David Einhorn’s example shows capital is moving into the safest and most liquid assets with physical gold bullion, either a coin in your hand or stored with a trusted professional storage facility like GoldMoney and not the GLD ETF or COMEX futures contract, is the safest and most liquid of them all.

Disclosure:  Long physical gold, silver and platinum with no position in GLD or SLV.



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Potential COMEX Gold Fail

By Trace Mayer, on June 19th, 2009

FUTURES AND FORWARD CONTRACTS

Many commodities trade via forward or futures contracts.  A forward contract is is an agreement between two parties to buy or sell an asset at a specified point of time in the future.  A futures contract is a standardized contract to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price (the futures price).

REGULATION AND COUNTER-PARTY RISK

Both futures and forward contracts introduce counter-party risk which depends on the financial ability of the counter-party to perform and may result in a failure to deliver.  The calculated counter-party risk of futures contracts are assumed to be lower than forward contracts because they are traded on commodity exchanges.  This is because generally governments must provide a common insurance or regulatory standard, such as the Commodity Futures Trading Commission (CFTC), and some release of liability, or at least a backing of the insurers, before a commodity market can begin trading.

COMMODITY MARKET SIZE

As a result of this increased confidence the size of futures contracts has grown tremendously.  The major commodities exchanges in the United States were the COMEX and NYMEX which merged under the New York Mercantile Exchange and Commodity Exchange, Inc. (NYMEX) name on 3 August 1994.

The notional value outstanding of OTC commodity derivatives contracts increased 27% in 2007 to $9.0 trillion. OTC trading accounts for the majority of trading in gold and silver. Overall, precious metals accounted for 8% of OTC commodities derivatives trading in 2007, down from their 55% share a decade earlier as trading in energy derivatives rose.

BACKWARDATION

Because of the large aboveground stockpiles of the monetary metals threfore gold and silver should never enter backwardation.  Backwardation would be evidence of the market’s increased apprehension of counter-party risk and the increased probability of a failure to deliver.  The brief gold backwardation or the recent black swan of nine weeks of silver backwardation in the London Bullion Market Association (LBMA) forward markets revealed the extreme fragility of the worldwide financial and monetary system.

Mr. Avery Goodman, a securities attorney and a member of the roster of neutral arbitrators of the National Futures Association (NFA) and the Financial Industry Regulatory Authority (FINRA), has also written extensively about whether the COMEX will default on gold and silver, how the NYSE ran out of gold bars, the evidence that the ECB bailed out Deutsche Bank preventing a failure to deliver of gold on the COMEX and a follow up article on the ECB’s saving of the COMEX from a gold default.

Then there are other commentators like Jason Hommel, the creator of the satirical silver CFTC appreciation medallion above, who alleges regulatory culpability.  Still others like the Gold Anti-Trust Action Committee (GATA) who has met with CFTC officials bring considerable intellectual firepower to the allegation of a central bank gold price suppression scheme where Mr. Robert Landis, a Harvard trained attorney, asserts “Any rational person who continues to dispute the existence of the rig after exposure to the evidence is either in denial or is complicit.”

TOOLS OF SPECULATION

Due to the size of the derivative contracts traded on the commodity exchanges and the counter-party risk the contracts are impregnated with therefore a bankruptcy of either the counter-party, the exchange or both could happen.  Due to the increased liquidity of these exchanges many of those buying or selling the contracts for speculative purposes neither want possession of the underlying commodity nor possess the underlying commodity and have the ability to physically deliver.

While there are some some legitimate measures such as oil or gold companies that sell forward their production, and the number of gold companies has increasingly withered, in many cases when you buy these gold derivatives you are buying from a speculator who is shorting gold and that gold speculator does not actually own any physical gold.

MECHANICS OF AN EXCHANGE BANKRUPTCY

Let us assume for the sake of argument that gold prices go ballistic and you decide you want your gold by taking delivery on the contract.  What if gold prices go up dramatically in one day such as a thousand dollars an ounce.  Is it possible?  Of course.  Is it probable?  Not really.

But that means the person who shorted gold is in a very precarious position and could have possibly lost everything or more.  Perhaps they had a stop but the market is fast and gaps and as a result they cannot get out of their position.  What would happen?

Let us assume this speculator had ten thousand dollars in their commodities account and they were short a gold contract.  Suddenly, perhaps overnight, the Chinese press the issue because the International Monetary Fund failed to deliver on their gold sales and needed a line of credit, gold prices rapidly jumped and this speculator lost a hundred thousand dollars overnight.   Now the brokerage firm has to attempt to collect on this ninety thousand dollar margin call in the form of an unsecured debt.  What if they cannot collect and what if there are hundreds or thousands of speculators in similar situations?

With this failure to deliver and violation of margin requirements what if the exchange, because they do not have adequate capital or liquidity, cannot get the currency to settle the contracts?  Then the exchange goes broke unless there is a government bail out but what good would that fiat currency do in purchasing the physical gold or silver bullion?

COUNTER-PARTY RISK MATERIALIZING

This is what happened with the American Insurance Group.  The reason AIG went bankrupt is because they were the other side of many speculative contracts.  When the flock of black swans they had insured against descended AIG could not perform because they did not have the cash.  The government bailed them out at the cost of hundreds of billions if not trillions of dollars.

This means if you buy silver or gold on the COMEX via futures contracts, there is a huge move up, the COMEX goes bankrupt and the government does not bail them out then you are not going to be able to cash out your epic gains from the casino.  Like the auto maker’s bond holders you will not realize and enjoy the profits you thought you would.

This is precisely what happened with people who were short a bunch of oranges and other interesting things via hedges with Lehman Brothers and even though they ‘made’ millions of dollars on their positions they lost everything.  Why?  Because Lehman Brothers went under and did not perform on the contracts.  This is counter-party risk.

CONCLUSION

At all time and in all circumstances gold and silver remain money.  For the conservative investor the reason to own them is as insurance for when everything else fails.  These issues of counter-party risk are important when considering how to buy gold or silver through third parties.  There are third-parties, like GoldMoney, that not subject to counter-party risk because of the way ownership is titled and the ability to demand physical delivery at any time.

As I explain in my book The Great Credit Contraction capital is burrowing down the pyramid into safer and more liquid assets.  The safest and most liquid of them all are gold and silver.  Why?  Because the world reserve currency the FRN$ is merely an illusion that can become worthless while gold and silver are money and will always buy something.

Consequently, the conservative investor will determine what their gold standard is considering there are 140 ounces of paper gold for every ounce of physical gold.  Then they will take appropriate actions, such as buying gold in a vending machine, to remove the layers of risk between them and their purchasing power in an effort to preserve and safeguard their capital.

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Predicting the Gold Price

By Bron Suchecki, on May 27th, 2009

Some useful observations on the gold market in a recent Unqualified Reservations blog entry:

One trivial example of a liquid, functioning prediction market that does not, and cannot, produce accurate predictions is the gold futures market. The gold futures market is a large, active and efficient market in future gold, but in hindsight it demonstrates little or no predictive power. The cause is not at all obscure: since both gold and dollars can be stored at minimal cost, a variety of arbitrage strategies bind the gold futures market to the much larger dollar-futures market (ie, the market for loans). The price signal is real, but it is conveying much more subtle data than the market’s net opinion of whether gold will go up or down.

…

Again, the market for future gold does not function as a prediction market, because it is bound by arbitrage to the market for spot gold and the market for future dollars. At least one of these so-called markets is substantially the product of official intervention.



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