Thursday, January 17, 2008

The Indian Derivatives Odessey

A distinctive feature of the reforms of the 1990s has been the accent on financial sector reforms. Financial sector reforms in India were brought to the front burner owing to the fixed income and stock market Scam of 1992; this luckily enabled a policy focus in India upon the financial sector well in advance of the East Asian debacle of 1997.The first three inputs in reforms on the securities markets are now well in place: a new electronic exchange (NSE), reforms to clearing (NSCC) and the depository (NSDL). NSE commenced equities trading in November 1994, the clearing corporation was started in April 1996 and the depository was inaugurated in November 1996. Of these steps, the depository was much delayed and many critics have highlighted the policy failures in these delays. Yet, from November 1994 to November 1996, India's policy makers undeniably achieved a remarkably rapid transformation of securities markets in the country.Once the basic structures of a cash market fall into place, the logical next step for market development is the commencement of exchange--traded financial derivatives. Derivatives give people the ability to manage and control risk. Today, in India, fluctuations in the stock market or in the dollar--rupee generate a political constituency which seeks government interventions into the market to prevent price fluctuations. This discomfort with price risk is a basic source of the political opposition to liberalisation, which inevitably exposes Indian citizens to greater price risk. Derivatives are hence a central part of the reforms process; by giving individuals and firms the power to make choices about what risks they are comfortable with and what risks are best hedged away, derivatives make individuals and firms more tolerant of price risk and hence liberalisation.In addition, from a purely financial sector perspective, derivatives are important insofar as they are part and parcel of market development. Derivatives trading helps improve market liquidity, raises skills and knowledge among market players, and is a vital ingredient of market reforms such as the transition to rolling settlement.Hence the commencement of derivatives trading at an exchange is of utmost important, from the perspective of financial sector development and with respect to the larger problem of creating a constituency for reforms. This step has unfortunately been plagued by delays, and is one where the policy establishment is not shown in good light. In terms of knowledge and capabilities, exchange--traded derivatives could have commenced in India in middle 1996. The story ever since has been one of delays that are reminiscent of pre--reforms India:June 1996 NSE sent a proposal to SEBI about starting exchange--traded derivatives. Time elapsed: 5 months. November 1996 SEBI announced a committee headed by L. C. Gupta to formulate policy for exchange--traded derivatives. This was one of the largest--ever committees of its nature; it had 24 members. Time elapsed: 16 months. March 1998 L. C. Gupta Committee submits report. Five months have passed by since this, with no sign of market commencement in sight. Through this two--year process, the Bombay Stock Exchange played a prominent role by trying to delay the onset of exchange--traded derivatives while (successfully) working towards rapid regulatory approvals for a new badla. In a comic twist, in recent weeks, the BSE now says that it no longer has any intellectual criticisms of exchange--traded derivatives and wishes to start trading index futures itself.Earlier, it was thought that a notification from the finance ministry would be all that was needed to enable futures trading. The budget speech, instead, has spoken of an amendment to SCRA. It is hard to see why this clarity was not obtained in 1996 itself, in which case the enabling provisions could have been well in place in advance of SEBI's processes.In the case of the depository, SEBI had completed its process prior to the legislation being approved by parliament. Hence, it should be possible for SEBI to similarly give NSE all clearances so that the market can commence functioning immediately after the SCRA amendment is passed.Coincidentally, two changes are bundled into the current amendment to SCRA: the changes which enable exchange--traded derivatives and provisions concerning plantation schemes. It is hard to imagine a greater contrast -- between the basic importance of derivatives for financial sector development and the peripheral role of plantation schemes.The crucial milestones in the future of institutional development in India's securities markets may now be summarised as:Transition to rolling settlement. SEBI should now have a policy through which stock market trading should only be allowed to take place using rolling settlement, starting with the largest stocks in the country and covering all stocks over a period of two years. This process can commence now. Onset of index futures and index options. This process can commence the moment the SCRA is amended. Under the best scenario, we can expect to see index futures trading in November 1998 and index options in December 1998. Exchange--traded derivatives on interest rates and currencies. The logical next step, once exchange--traded derivatives exist, is to trade derivatives which enable risk management on fluctuations of interest rates and the dollar--rupee. This will be an outcome of the confidence that the RBI has in the quality of NSE's derivatives exchange and SEBI's policy regime governing exchange--traded derivatives. In the aftermath of the East Asian crisis, it is common for policy makers to express a desire to put problems of financial sector development on a high priority. The policy establishment has set an extremely bad example in the context of derivatives: NSE had invested a great deal of effort and expense in being ready to trade derivatives by middle 1996 and they have been waiting ever since. This is reminiscent of industrial licensing -- through this process, policy--makers are deterring development in other areas.When an agency or an entity thinks of embarking on market development in the future, they will look at the example of NSE and put a top priority on politics rather than financial sector development. This is reminiscent of the time that Indian industrialists used to spend in Delhi in obtaining permissions, which came at the expense of the time which they should have spent on technology and product development. Policy makers should be supporting innovation and modern market development; they should not be blocking the onset of new ideas.


Derivatives trading takes place under the Securities and Exchange Board of India Act, 1992 and the framework including suggestive bye-law and its Clearing Corporation/House has been laid down by Dr. L.C. Gupta Committee, constituted by SEBI.
Some of the eligibility conditions laid down by SEBI for Derivative Exchange/Segment and its Clearing Corporation/House are as follows:
The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation. The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through atleast two information vending networks, which are easily accessible to investors across the country. The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas / regions of the country. The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading. The Derivative Segment of the Exchange would have a separate Investor Protection Fund. The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades. The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both. The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days. The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for swift movement of margin payments. In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close-out all open positions. The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. The Clearing Corporation/House shall hold the clients' margin money in trust for the client purposes only and should not allow its diversion for any other purpose. The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivative Exchange / Segment. Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O Segment of NSE.
The rights of investors in the Derivative Market are well protected by SEBI. The measures specified by SEBI are as follows:
Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor. The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives. Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member. In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/ Clearing corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled / closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges
FAQs on Derivatives
What is the lot size of a contract?Lot size refers to number of underlying securities in one contract. Addition to it, for stock specific derivative contracts SEBI has specified that the lot size of the underlying individual security should be in multiples of 100 and fractions, if any, should be rounded of to the next higher multiple of 100. This requirement of SEBI along with the requirement of minimum contract size makes the basis of arriving at the lot size of a contract.
Is there any market wide limits?For index products it is nil.For stock specific products it is of open positions.For an option and futures it is as undementioned: 30 times the average number of shares traded daily, during the previous calendar month, in the cash segment of the Exchange, OR 10% of the number of shares held by non-promoters i.e. 10% of the free float, in terms of number of shares of a company. It is also specified that when the total open interest in a contract reaches 80% of the market wide limit in that contract, the exchanges would make the price scan range and volatility scan range (specified) double. The exchanges has to continuously review the impact of measures and take further proactive risk containment measures as may be appropriate, including, further increases in the scan ranges and levying additional margins.
What are derivatives? Derivative as the name suggests are the financial contracts which derive their value from the underlying. The underlying may be the security or an index. Thus derivative instruments have no independent value. Rather their values are dependent on the price of the underlying instruments which they represent.
What are forward contracts? Forward Contracts are contracts where two parties agree to do a trade at a future date at the pre determined or agreed price and quantity. Thus the trade takes place at a future date but the terms of the trade are determined previously.
What are the problems of forward contracts?Forward Contracts are between two parties, Hence these are individual contracts which are settled between the two parties to the contracts. However these are not traded on the stock exchange. Hence they are illiquid. They also suffer from the counterparty risk as in case of default by one party, there is no settlement guarantee as they are not traded on the exchange.
What are future contracts? Future Contracts have come into existence to tide over the problems of the forward contracts. Future contracts are standardized contracts with standard conditions and terms. They are traded on the stock exchange and settlement of the contracts takes place through the clearing corporation of the stock exchange, which assumes the counterparty risk. This it acts as a buyer to the seller and a seller to the buyer and in case of default of any of the parties, the settlement is guaranteed by the clearing corporation.
What is an Index future Contract?An Index future contract is where the underlying security is not an individual share but the Index such as Sensex, Nifty, IT Index, Bank Index and so on. These contracts derive their value from the value of the underlying index

The Indian derivatives market

Traders, whether of goods or financial services, always look for two things only - larger volumes and larger commissions. But there is a problem, and had my name been Taylor I would have formulated a trite 'rule' as well, namely, that they can't have both at the same time unless they are a monopoly.So, if trading commissions can't be increased, and indeed have to be lowered because of competition, how does a trader increase volume? Simple: he looks around for more products to trade in.Until the mid-1980s, this golden rule didn't apply much to money. But since then, the ever-increasing amounts cash that the US has been pumping into the world by virtue of being the provider of the world's signature currency has resulted in a spate of new financial 'products'. They have exactly the same characteristics as physical products: unless traded, their value is zero or almost zero.One of these new products is called a derivative which, when you peel the onion down to the pip, is basically a bet on a bet. Thus, if you bet that a dollar will be worth Rs 40 in December, then you can sell that bet to some sucker who thinks he can sell it onwards and make some money at the margin. In short, you trade in bets.Around 2002, soon after the effects of the dotcom collapse ebbed away and Alan Greenspan flooded the world with cheap credit, another form of betting became possible. This was the credit derivative. You loaned money and then sold the thing off to some fund or the other and got it off your books partly - or if you were clever, entirely.The process was dignified by fancy names: slicing risk, repackaging risk, and so on. Overall, the theory went, if you distributed risk amongst lots of fellows or funds, everyone would be less at risk. It was exactly the same as one man lifting 100 kilos and 10 men lifting it.The idea was so seductive that only did money start chasing its own tail, it also started betting on itself in ways that make no sense at all because all this frenetic activity actually leads to absolutely nothing useful being produced, not even the much claimed "efficient and optimal allocation of resources".Instead, it produces a potential for systemic turbulence that can be devastating. Imagine ten pallbearers and that one of them stumbles badly. Get the picture? That's what the sub-prime crisis is all about.So what you need is some sort of crutches and in a recent speech*, Shyamala Gopinath, a Deputy Governor of the RBI, has described what sort are needed in India. It is worth reading if only to avoid complaining later about that no one knows how the RBI looks at the whole business of derivatives."While derivatives are very useful for hedging and risk transfer, and hence improve market efficiency," she said, "it is necessary to keep in view the risks of excessive leverage, lack of transparency particularly in complex products, difficulties in valuation, tail risk exposures, counterparty exposure and hidden systemic risk." In short, a pallbearer with well hidden multiple fractures."There is need for greater transparency to capture the market, credit as well as liquidity risks in off-balance sheet positions and providing capital for it. From the corporate point of view, understanding the product and inherent risks over the life of the product is extremely important."Further development of the market will also hinge on adoption of international accounting standards and disclosure practices by all market participants, including corporates."The message: look before you leap because, to quote her again, "insufficient transparency at the firm level probably undermined ex ante market discipline. These issues, which have been well-known to the regulators and the industry for some years become pressing mainly in a crisis.Lending institutions find it difficult, if not impossible, to simultaneously review in a thorough manner a large proportion of their exposures. How effectively ex post market discipline is allowed to operatewill have a significant impact on the future conduct of financial firms."