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. Last Updated: 07/27/2016

Currency Future Market Stalled

Forward exchange markets -- or futures markets -- allow currencies to be bought and sold at rates of exchange fixed today, for delivery at specified times in the future. A Russian trader expecting to acquire rubles (or make a payment in dollars) in three, six or 12 months can sell (or buy) the currency "forward," thus guarding against exchange rate shifts during the intervening period.

Getting the hang of futures is difficult, but worthwhile. The reason is that speculating with futures can generate huge returns. Say the ruble rises 20 percent. A trader who has previously bought rubles for dollars can buy back dollars and make a 20 percent "spot market" return on the original investment. But in the futures market, traders are not limited by the amount of money they originally hold. Because no payment except for a small down payment is due on a futures contract until it matures, the same currency appreciation means an almost penniless investor can make 20 percent on $100 million. All that is needed is the brains -- and guts -- to negotiate a $100 million futures contract prior to the currency upside.

The implication is that once a currency's direction is clear, currency speculators should, in theory, quit the spot market and shift to futures -- increasing speculative pressure in the market. But in Russia, the currency futures market is seriously illiquid.

In March, the Moscow Commodities Exchange collapsed. Some analysts say it accounted for almost 70 percent of futures trading volumes. But even before the exchange folded, daily futures market turnover was below $20 million. Before and after the October 1994 ruble crash, when Russia's currency futures were in their zenith, more than $100 million of currency futures were bought and sold daily.

Currency futures are of interest not only to speculators, but also to commercial hedgers. Russian importers, for instance, must pay their suppliers in dollars -- so they may buy futures contracts in case the ruble exchange rate falls. Exporters, conversely, may want to convert hard-currency proceeds into rubles; in this case, they can use the futures market to protect themselves from a ruble appreciation.

These two groups of hedgers provide, in turn, another chance for the speculators. Importers will always pay slightly more for a dollar future contract than their view of where the ruble will actually be one, three or six months down the line. They pay the premium because they are insured against the risk of a major currency movement. Exporters, meanwhile, will buy slightly below their expectations. This wedge means potential profits exist for speculators who can arbitrage between the two groups, even if the spot rate of the currency remains fixed. One-off speculations on currency movements aside, it is also possible to speculate on the futures market systematically.

Despite these profit-making possibilities, activity on the dollar futures market remains a long way below the heady days of 1994. A major problem is that currency insurance is only as good as the insurer and, especially since the commodities exchange collapse, few futures exchanges are deemed creditworthy. In fact, since the ruble corridor was introduced in July 1995, the nominal stability of the ruble has made hedgers less likely to hedge -- the ruble now seems a safer bet than the futures dealers.

Another reason the currency futures market is dormant is the emergence of another futures market in short-term treasury-bills, widely known as GKOs. Because GKOs are denominated in rubles, buying them involves two uncertainties: first, the government might default; also, even if the GKO is redeemed, an exchange rate depreciation may reduce its value in dollar terms. During 1994 and early 1995, GKO investors would hedge part of their risk using the futures market -- buying a promissory note from the bank purchasing the GKOs on their behalf and building into the note a dollar futures agreement.

During the past year, though, investors have been hedging their default and currency risk on GKOs simultaneously by buying dollar-denominated GKO futures. Daily turnover in such futures has lately reached $50 million. So once somebody invented GKO futures, the need to hedge GKOs currency-risk on the regular dollar futures market disappeared. This is a major reason why volumes in currency futures have dropped.

Another reason is that last summer the Moscow Interbank Currency Exchange, or MICEX, announced it would begin trading in dollar futures. Because the reliability of the exchange is higher than anywhere else -- in part because of its close ties with the Central Bank -- its planned entry into the futures market has deterred many other potential market-makers. But it has yet to deal in futures.

The official line is that the Central Bank cannot agree on an accounting procedure for commercial banks working in this area. In fact there is a feud going on between the State Tax Service, which wants to tax profits on futures, and the financial men, who say futures should enjoy the same tax-free status as GKOs. The MICEX's futures settlement system has been ready for some months, but the system will not emerge until this dispute has been resolved.

So what if the futures market is underdeveloped? Despite their unfavorable reputation, futures markets can play a crucial role in an emerging market such as Russia. Futures markets in commodities can allow farms and mining companies to lend on the strength of future output, channelling the money into infrastructure investment. More fundamentally, risky investments can be made more attractive not only by using currency futures but also investing in derivatives linked to future interest rates.

Even if the futures market remains solely the domain of speculators for awhile, it serves a useful purpose in gauging the market's reaction to the latest twists in Russia's politics. The GKO is at the mercy of collusive primary dealers, while equities reflect the whim of overseas investors who live off newspaper headlines. But the dollar futures market is home only to true insiders.

It is reassuring that since the first round of the elections, the futures market has shown the ruble strengthening against the dollar, particularly since President Boris Yeltsin's deal with Alexander Lebed heading into the final round.