International Trade and Finance (Derivatives)

International Trade And Finance

Project Title:

Comparison Of Derivatives Market In India

And USA

Submitted By: Nikhil Chainani (13171) Priya Sharma (13206) Priyanka Bansal (13208) Priyanka Goyal ( 13209) BMS 2D

INDEX              

Introduction Participants Functions Types Instruments in India Futures Options Derivatives market in India Comparison in Indian and global market Trading volumes Regulatory framework Settlement Types of derivatives allowed in India and USA Conclusion

Need for the study

Risk is a characteristic feature of most commodity and capital markets. Variations in the prices of agricultural and non-agricultural commodities are induced, over time, by demand -supply dynamics. The last two decades have witnessed many-fold increase in the volume of international trade and business due to the wave of globalization and liberalization sweeping across the world. This has led to rapid and unpredictable variations in financial assets prices, interest rates and exchange rates, and subsequently, to exposing the corporate world to an unwieldy financial risk. In the present highly uncertain business scenario, the importance of risk management is much greater than ever before. The emergence of derivatives market is an ingenious feat of financial engineering that provides an effective and less costly solution to the problem of risk that is embedded in the price unpredictability of the underlying asset. In India, the emergence and growth of derivatives market is relatively a recent phenomenon. Since its inception in June 2000, derivatives market has exhibited exponential growth both in terms of volume and number of traded contracts. The market turn-over has grown from Rs.2365 crore in 2000-2001 to Rs. 11010482.20 crore in 2008-2009. Within a short span of eight years, derivatives trading in India has surpassed cash segment in terms of turnover and number of traded contracts. The present study encompasses in its scope an analysis of historical roots of derivative trading, types of derivative products, regulation and policy developments, trend and growth, future prospects and challenges of derivative market in India. Some space is devoted also to a brief discussion of the status of global derivatives markets especially the USA vis-a–vis the Indian derivatives market.

OBJECTIVES OF STUDY

  

Understanding the role types and functions of derivatives . To study different types of derivatives – forwards , futures, options , swaps,etc. Comparing the derivatives in india and usa based on the following – 1. Volumes 2. Regulatory framework 3. Settlement 4. Types of derivatives allowed in india and usa.

DERIVATIVES MEANING: The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be bullion, index, share, bonds, currency, interest etc. Annual turnover of the derivatives is increasing each year from 1986 onwards, Year

Annual turnover

1986

146 millions

1992

453 millions

1998 2002 & 2003

1329 millions it has reached to equivalent stage of cash market

Derivatives are used by banks, securities firms, companies and investors to hedge risks, to gain access to cheaper money and to make profits Derivatives are likely to grow even at a faster rate in future they are first of all cheaper to world have met the increasing volume of products tailored to the needs of particular customers, trading in derivatives has increased even in the over the counter markets. In Britain unit trusts allowed to invest in futures & options .The capital adequacy norms for banks in the European Economic Community demand less capital to hedge or speculate through derivatives than to carry underlying assets. Derivatives are weighted

lightly than other assets that appear on bank balance sheets. The size of these offbalance sheet assets that include derivatives is more than seven times as large as balance sheet items at some American banks causing concern to regulators DEFINITION Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines “derivative” to include1. A security derived from a debt instrument, share, and loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract, which derives its value from the prices, or index of prices, of underlying securities. Derivatives are the securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.

PARTICIPANTS IN THE DERIVATIVES MARKET The following three broad categories of participants who trade in the derivatives market: 1. Hedgers 2. Speculators and 3. Arbitrageurs Hedgers: Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. Speculators:

Speculators wish to bet on future movements in the price of an asset. Futures and Options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs: Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. For example, they see the futures price of an asset getting out of line with the cash price; they will take offsetting positions in the two markets to lock in a profit. FUNCTIONS OF THE DERIVATIVES MARKET

The derivatives market performs a number of economic functions. They are: 1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. 2. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 3. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. 4. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. 5. Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

TYPES OF DERIVATIVES

Commo dity

Financia l

Basic Instrum ent

Complex Instrum ents

Exotic, Swaptions and LEAPS etc. Forward

Futures

Options

Swa ps

The most commonly used derivatives contracts are forwards, futures and options. Here various derivatives contracts that have come to be used are given briefly:

1. Forwards 2. Futures 3. Options 4. Warrants 5. LEAPS 6. Baskets 7. Swaps 8. Swaptions 1. Forwards: A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price

2. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchangetraded contracts. 3. Options: Options are of two types – calls and puts

Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before.a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

4. Warrants: Options generally have two lives of up to one year, the majority of options traded on options exchanges having a minimum maturity of nine months. Longerdated options are called warrants and are generally traded over-the-counter. 5. Leaps: The acronym LEAPS means Long-term Equity Anticipation Securities. These are options having a maturity of up to three years. 6. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. 7. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:



Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.



Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

8. Swaptions: Swaptions are options to buy or sell that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions markets has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

1.3.6 DERIVATIVES INSTRUMENTS IN INDIA The first derivative product to be introduced in the Indian securities market is going to be "INDEX FUTURES". In the world, first index futures were traded in U.S. on Kansas City Board of Trade (KCBT) on Value Line Arithmetic Index (VLAI) in 1982. Organized exchanges began trading options on equities in 1973, where as exchange traded debt options did not appear until 1982, on the other hand fixed income futures began trading in 1975, but equity related futures did not begin until 1982.

DERIVATIVES SEGMENT IN BSE & NSE On June 9,2000 BSE & NSE became the first exchanges in India to introduce trading in exchange traded derivative product with the launch of index futures on sense and Nifty futures respectively. Index futures was follows by launch of index options in June 2001, stock options in July 2001 and stock futures in Nov 2001.Presently stock futures and options available on 41 well-capitalized and actively traded scripts mandated by SEBI. Nifty is the underlying asset of the Index Futures at the Futures & Options segment of NSE with a market lot of 200 and the BSE 30 Sensex is the underlying stock index with the market lot of 50. This difference of market lot arises due to a minimum specification

of a contract value of Rs. 2 lakhs by Securities Exchange Board of India. A contract value is contracting Index laid by its market lot. For e.g. If Sensex is 4730 then the contract value of a futures Index having Sensex as underlying asset will Be 50 x 4730 = Rs. 2,36,500. Similarly if Nifty is 1462.7, its futures contract value will be 200 x 1462.7 = Rs.2, 92,540/-. Every transaction shall be in multiple of market lot. Thus, Index futures at NSE shall be traded in multiples of 200 and at BSE in multiples of 50

CONTRACT PERIODS At any point of time there will always be available near three months contract periods. For e.g. in the month of June 2009 one can enter into either June Futures contract or July Futures contract or August Futures Contract. The last Thursday of the month specified in the contract shall be the final settlement date for that contract at both NSE as well BSE. Thus June 29, July 27 and August 31 shall be the last trading day or the final settlement date for June Futures contract, July Futures Contract and August Futures Contract respectively. When one futures contract gets expired, a new futures contract will get introduced automatically. For instance, on 30th June, June futures contract becomes invalidated and a September Futures Contract gets activated.

SETTLEMENT

Settlement of all Derivatives trades is in cash mode. There is Daily as well as Final Settlement. Outstanding positions of a contract can remain open till the last Thursday of that month. As long as the position is open, the same will be marked to Market at the Daily Settlement Price, the difference will be credited or debited accordingly and the position shall be brought forward to the next day at the daily settlement price. Any position which remains open at the end of the final settlement day (i.e., last Thursday) shall be closed out by the Exchange at the Final Settlement Price which will be the closing spot value of the underlying (Nifty or Sensex, or respective stocks as the case may be).

Regulation for Derivatives Trading SEBI set up a 24-member committee under Chairmanship of Dr.L.C. Gupta to develop the appropriate regulatory framework for derivatives trading in India. The committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures. SEBI also approved the “suggestive bye-laws” recommended by the committee for regulation and control of trading and settlement of derivatives contracts. The provisions in the SC(R) A and the regulatory framework developed there under govern trading in securities. The amendment of the SC(R) A to include derivatives within the ambit of ‘securities’ in the SC(R) A made trading in derivatives possible within the framework of the Act. 1. Any exchange fulfilling the eligibility criteria as prescribed in the L C Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC(R) a, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading / clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practices of its members and will obtain approval of SEBI before start of trading in any derivative contract 2. The exchange shall have minimum 50 members. 3. The members of an existing segment of the exchange will not automatically become the members of derivative segment. The members of the derivative segment need to fulfill the eligibility conditions as laid down by the L C Gupta committee. 4. The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation / house. Clearing corporation / houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval. 5. Derivative brokers/dealers and clearing members are required to seek registration from SEBI. 6. The minimum contract value shall not be less than Rs. 2 Lakh. Exchanges should also submit details of the futures contract they propose to introduce.

7. The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI.

While from the purely regulatory angle, a separate exchange for trading would be a better arrangement. Considering the constraints in infrastructure facilities, the existing stock (cash) exchanges may also be permitted to trade derivatives subject to the following conditions. I. Trading should take place through an on-line screen based trading system. II. An independent clearing corporation should do the clearing of the derivative market. III. The exchange must have an online surveillance capability, which monitors positions, price and volumes in real time so as to deter market manipulation price and position limits should be used for improving market quality. IV. Information about trades quantities, and quotes should be disseminated by the exchange in the real time over at least two information-vending networks, which are accessible to investors in the country. V. The exchange should have at least 50 members to start derivatives trading. VI. The derivatives trading should be done in a separate segment with separate membership; That is, all members of the cash market would not automatically become members of the derivatives market. VII. The derivatives market should have a separate governing council which should not have representation of trading by clearing members beyond whatever percentage SEBI may prescribe after reviewing the working of the present governance system of exchanges. VIII. The chairman of the governing council of the derivative division / exchange should be a member of the governing council. If the chairman is broker / dealer, then he should not carry on any broking or dealing on any exchange during his tenure. IX. No trading/clearing member should be allowed simultaneously to be on the governing council both derivatives market and cash market.

FUTURES

FUTURES Futures contract is a firm legal commitment between a buyer & seller in which they agree to exchange something at a specified price at the end of a designated period of time. The buyer agrees to take delivery of something and the seller agrees to make delivery. STOCK INDEX FUTURES Stock Index futures are the most popular financial futures, which have been used to hedge or manage the systematic risk by the investors of Stock Market. They are called hedgers who own portfolio of securities and are exposed to the systematic risk. Stock Index is the apt hedging asset since the rise or fall due to systematic risk is accurately shown in the Stock Index. Stock index futures contract is an agreement to buy or sell a specified amount of an underlying stock index traded on a regulated futures exchange for a specified price for settlement at a specified time future. Stock index futures will require lower capital adequacy and margin requirements as compared to margins on carry forward of individual scrips. The brokerage costs on index futures will be much lower. Savings in cost is possible through reduced bid-ask spreads where stocks are traded in packaged forms. The impact cost will be much lower in case of stock index futures as opposed to dealing in individual scrips. The market is conditioned to think in terms of the index and therefore would prefer to trade in stock index futures. Further, the chances of manipulation are much lesser. The Stock index futures are expected to be extremely liquid given the speculative nature of our markets and the overwhelming retail participation expected to be fairly high. In the near future, stock index futures will definitely see incredible volumes in India. It will be a blockbuster product and is pitched to become the most liquid contract in the world in terms of number of contracts traded if not in terms of notional value. The advantage to the equity or cash market is in the fact that they would become less volatile as most of the speculative activity would shift to stock index futures. The stock index futures market should ideally have more depth, volumes and act as a stabilizing factor for the cash market. However, it is too early to base any conclusions on the volume or to form any firm trend.

The difference between stock index futures and most other financial futures contracts is that settlement is made at the value of the index at maturity of the contract. FUTURES TERMINOLOGY



Contract Size The value of the contract at a specific level of Index. It is Index level * Multiplier.



Multiplier It is a pre-determined value, used to arrive at the contract size. It

is the price per index point. 

Tick Size It is the minimum price difference between two quotes of similar nature.



Contract Month The month in which the contract will expire.



Expiry Day The last day on which the contract is available for trading.



Open interest Total outstanding long or short positions in the market at any specific point in time. As total long positions for market would be equal to total short positions, for calculation of open Interest, only one side of the contracts is counted.



Volume No. Of contracts traded during a specific period of time. During a day,

during a week or during a month. 

Long position Outstanding/unsettled purchase position at any point of time.



Short position Outstanding/ unsettled sales position at any point of time.



Open position Outstanding/unsettled long or short position at any point of time.



Physical delivery Open position at the expiry of the contract is settled through delivery of

the underlying. In futures market, delivery is low. 

Cash settlement Open position at the expiry of the contract is settled in cash. These

contracts Alternative Delivery Procedure (ADP) - Open position at the expiry of the contract is settled by two parties - one buyer and one seller, at the terms other than defined by the exchange. World wide a significant portion of the energy and energy related contracts (crude oil, heating and gasoline oil) are settled through Alternative Delivery Procedure. Pay off for futures: A Pay off is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits, for the buyer and the seller of futures contracts, are unlimited.



Pay off for Buyer of futures: (Long futures) The pay offs for a person who buys a futures contract is similar to the pay

off for a person who holds an asset. He has potentially unlimited upside as well as downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits and when the index moves down it starts making losses



Pay off for seller of futures: (short futures)

The pay offs for a person who sells a futures contract is similar to the pay off for a person who shorts an asset. He has potentially unlimited upside as well as downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits and when the index moves up it starts making losses. OPTIONS

An option agreement is a contract in which the writer of the option grants the buyer of the option the right to purchase from or sell to the writer a designated instrument at a specific price within a specified period of time. Certain options are shorterm in nature and are issued by investors another group of options are long-term in nature and are issued by companies.

OPTIONS TERMINOLOGY: 

Call option: A call is an option contract giving the buyer the right to purchase the stock.



Put option: A put is an option contract giving the buyer the right to sell the stock.



Expiration date: It is the date on which the option contract expires.



Strike price: It is the price at which the buyer of a option contract can purchase or sell

the stock during the life of the option 

Premium: Is the price the buyer pays the writer for an option contract.



Writer:

The term writer is synonymous to the seller of the option contract. 

Holder: The term holder is synonymous to the buyer of the option contract.



Straddle: A straddle is combination of put and calls giving the buyer the right to either buy or sell stock at the exercise price. 

Strip: A strip is two puts and one call at the same period.



Strap: A strap is two calls and one put at the same strike price for the same period.



Spread: A spread consists of a put and a call option on the same security for the same time period at different exercise prices. The option holder will exercise his option when doing so provides him a benefit

over buying or selling the underlying asset from the market at the prevailing price. These are three possibilities. 1. In the money: An option is said to be in the money when it is advantageous to exercise it. 2. Out of the money: The option is out of money if it not advantageous to exercise it. 3. At the money: IF the option holder does not lose or gain whether he exercises his option or buys or sells the asset from the market, the option is said to be at the money. The exchanges initially created three expiration cycles for all listed options and each issue was assigned to one of these three cycles.  January, April, July, October.  February, March, August, November.  March, June, September, and December.

In India, all the F and O contracts whether on indices or individual stocks are available for one or two or three months series and they expire on the Thursday of the concerned month.

CALL OPTION: An option that grants the buyer the right to purchase a designated instrument is called a call option. A call option is a contract that gives its owner the right, but not the obligation, to buy a specified price on or before a specified date. An American call option can be exercised on or before the specified date only. European options can be exercised on the specified date only. PUT OPTION: An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares. A put becomes more valuable as the price of the underlying stock depreciates relative to the strike price. For example, if you have one Mar 09 Taser 10 put, you have the right to sell 100 shares of Taser at $10 until March 2008 (usually the third Friday of the month). If shares of Taser fall to $5 and you exercise the option, you can purchase 100 shares of Taser for $5 in the market and sell the shares to the option's writer for $10 each, which means you make $500 (100 x ($10-$5)) on the put option. Note that the maximum amount of potential proft in this example ignores the premium paid to obtain the put option. FACTORS DETERMINIG OPTION VALUE:



Stock price



Strike price



Time to expiration



Volatility



Risk free interest rate



Dividend

DIFFERENCE BETWEEN FUTURES & OPTION:

FUTURES

OPTIONS

1) Both the parties are obligated to perform.

1) Only the seller (writer) is obligated to

2) With futures premium is paid by either party. 3) The parties to futures contracts must perform at the settlement date only. They are not obligated to perform before that date. 4) The holder of the contract is exposed to the entire spectrum of downside risk and had the

potential for all upside return.

5) In futures margins to be paid. They are

perform. 2) With options, the buyer pays the seller a premium. 3) The buyer of an options contract can exercise any time prior to expiration date. 4) The buyer limits the downside risk to the option premium but retain the upside potential. 5) In options premiums to be paid. But they are very less as compared to the margins.

approximate 15-20% on the current stock price.

Advantages of option trading



Risk management: put option allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out insurance against a fall in the share price.



Time to decide: By taking a call option the purchase price for the shares is locked in. This gives the call option holder until the Expiry day to decide whether or exercised the option and buys the shares. Likewise the taker of a put option has time to decide whether

or not to sell the shares. 

Speculations: The ease of trading in and out of option position makes it possible to trade options with no intention of ever exercising them. If investor expects the market to rise, they may decide to buy call options. If expecting a fall, they may decide to buy put options. Either way the holder can sell the option prior to expiry to take a profit or limit a loss. Trading options has a lower cost than shares, as there is no stamp duty payable unless and until options are exercised.



Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly however leverage usually involves more risks than a direct investment in the underlying share. Trading in options can allow investors to benefit from a change in the price of the share without having to pay of the share.

Summary of options Call option buyer

Call option writer (seller)



Pays premium



Receives premium



Right to exercise and buy the



Obligation to sell shares if exercised

share



Profits from falling prices or remaining



Profits from rising prices



Limited losses, potentially

neutral

unlimited gain Put option buyer



Potentially unlimited losses, limited

gain Put option writer (seller)



Pays premium



Receives premium



Right to exercise and sell shares



Obligation to buy shares if exercised



Profits from falling prices



Profits from rising prices or remaining



Limited losses, potentially unlimited gain

neutral 

Potentially unlimited losses, limited gain

Derivatives Market India

Derivatives trading commenced in Indian market in 2000 with the introduction of Index futures at BSE, and subsequently, on National Stock Exchange (NSE). Since then, derivatives market in India has witnessed tremendous growth in terms of trading value and number of traded contracts. Here we may discuss the performance of derivatives products in India markets as follows. Derivatives Products Traded in Derivatives Segment of BSE The BSE created history on June 9, 2000 when it launched trading in Sensex based futures contract for the first time. It was followed by trading in index options on June 1, 2001; in stock options and single stock futures (31 stocks) on July 9, 2001 and November 9, 2002, respectively. Currently, the number of stocks under single futures and options is 1096. BSE achieved another milestone on September 13, 2004 when it launched Weekly Options, a unique product unparalleled worldwide in the derivatives markets. It permitted trading in the stocks of four leading companies namely; Satyam, State Bank of India, Reliance Industries and TISCO (renamed now Tata Steel). Chhota (mini) SENSEX 7 was launched on January 1, 2008. With a small or 'mini' market lot of 5, it allows for comparatively lower capital outlay, lower trading costs, more precise hedging and flexible trading. Currency futures were introduced on October 1, 2008 to enable participants to hedge their currency risks through trading in the U.S. dollar-rupee future platforms. Table summarily specifies the derivative products and their date of introduction on the BSE Products Traded in Derivatives Segment of the BSE S.no 1 2 3

Product Traded with underlying asset Index Futures- Sensex Index Options- Sensex Stock Option on 109 Stocks

4

Stock futures on 109 Stocks

5

Weekly Option on 4 Stocks

6

Chhota (mini) SENSEX Futures & Options on Sectoral indices namely BSE TECK, BSE FMCG, BSE Metal, BSE

7

Introduction Date June 9,2000 June 1,2001 July 9, 2001 November 9,2002 September 13,2004 January 1, 2008 N.A.

Bankex and BSE Oil & Gas. 8 Currency Futures on US Dollar Rupee Source: Complied from BSE website

October 1,2008

Derivatives Products Traded in Derivatives Segment of NSE NSE started trading in index futures, based on popular S&P CNX Index, on June 12, 2000 as its first derivatives product. Trading on index options was introduced on June 4, 2001. Futures on individual securities started on November 9, 2001. The futures contracts are available on 2338 securities stipulated by the Securities & Exchange Board of India (SEBI) . Trading in options on individual securities commenced from July 2, 2001. The options contracts are American style and cash settled and are available on 233 securities. Trading in interest rate futures was introduced on 24 June 2003 but it was closed subsequently due to pricing problem. The NSE achieved another landmark in

product introduction by launching Mini Index Futures & Options with a minimum contract size of Rs 1 lac. NSE crated history by launching currency futures contract on US Dollar-Rupee on August 29, 2008 in Indian Derivatives market. Table 3 presents a description of the types of products traded at F& O segment of NSE. Products Traded in F&O Segment of NSE S.n o Product Traded with underlying asset 1 Index Futures- S&P CNX Nifty 2 Index Options- S&P CNX Nifty 3 Stock Option on 233 Stocks 4 Stock futures on 233 Stocks 5 Interest Rate Futures- T – Bills and 10 Years Bond 6 CNX IT Futures & Options 7 Bank Nifty Futures & Options 8 CNX Nifty Junior Futures & Options 9 CNX 100 Futures & Options 10 Nifty Midcap 50 Futures & Options 11 Mini index Futures & Options - S&P CNX Nifty index 12 long Term Option contracts on S&P CNX Nifty Index 13 Currency Futures on US Dollar Rupee 14 S& P CNX Defty Futures & Options Source: Complied from NSE website

Introduction Date June 12,2000 June 4,2001 July 2, 2001 November 9,2001 June 23,2003 August 29,2003 June 13,2005 June 1,2007 June 1,2007 October 5,2007 January 1, 2008 March 3,2008 August 29,2008 December 10, 2008

Growth of Derivatives Market in India Equity derivatives market in India has registered an "explosive growth" (see Fig. 2) and is expected to continue the same in the years to come. Introduced in 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives trading in Indian markets. The introduction of derivatives has been well received by stock market players. Trading in derivatives gained popularity soon after its introduction. In due course, the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market. For example, in 2008, the value of the NSE derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE cash markets was only Rs. 3,551,038 Cr. If we compare the trading figures of NSE and BSE, performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories. Among all the products traded on NSE in F& O segment, single stock futures also known as equity futures, are most popular in terms of volumes and number of contract traded, followed by index futures with turnover shares of 52 percent and 31 percent, respectively . In case of BSE, index futures outperform stock futures. Business Growth of Derivatives at NSE from 2000-2009

Source: NSE fact book 2008 issue Product wise Turnover of F&O at NSE from 2000-2008

Source: Author’s calculation based on data complied from NSE

NSE Derivatives Segment Turnover

Year

Index Futures

Stock Futures

Index Options

Stock Options

Intere st Rate Future

Average Total

Daily Turnove

2583617.9 2558863.5 2358916.9 2008-09 2 5 0 3820667.2 7548563.2 1362110.8 2007-08 7 3 8 2006-07 2539574 3830967 791906 2005-06 1513755 2791697 338469 2004-05 772147 1484056 121943 2003-04 554446 1305939 52816 2002-03 43952 286533 9246 2001-02 21483 51515 3765 2000-01 2365 Source: Complied from NSE website

s

r 7650896.8 46938.0 0 2 13090477. 52153.3 75 0 7356242 29543 4824174 19220 2546982 10107 2130610 8388 439862 1752 101926 410 2365 11

149498.40 0.00 359136.55 0.00 193795 0 180253 0 168836 0 217207 202 100131 25163 -

NSE Cash & Derivatives Segment Turnover Year Cash Segment 2007-08 3,551,038 2006-07 1,945,285 2005-06 1,569,556 2004-05 1,140,071 2003-04 1,099,535 2002-03 617,989 2001-02 513,167 2000-01 1,339,510 Source: Complied from NSE website Table Number of contract Traded at NSE 6: Derivatives Segment Yea r

2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

Index Futures

Stock Futures

Index Options

1364767 47 1565985 79 814874 24 585378 86 216354 49 171916 68 212676 3 102558 8

14915999 7 116790708 20358795 55366038 2 10495540 25157438 1 80905493 12935116 47043066 3293558 32368842 1732414 10676843 442241 1957856 175900

Derivatives Segment 13090477.75 7356242 4824174 2546982 2130610 439862 101926 2365

Stock Optio ns 78262 31 94606 31 52833 10 52407 76 50451 12 55830 71 35230 62 10375 29

(Rs. in Cr.)

Interest Rate Futures 0 0 0 0 0 10781 -

Total 410253 683 425013 200 216883 573 157619 271 7701718 5 5688677 6 1676890 9 419687 3

2000-01 90580 Source: from NSE complied website Average Daily Transaction at NSE in Derivatives and Cash Segment

-

Derivatives Year Segment 200708 52153.30 200629543 07 200519220 06 200405 10107 2003838 04 8 2002175 03 2 200102 410 200011 01 Source: Complied from NSE website and NSE fact book 2008 Table 8:BSE Derivatives Segment Turnover Year

Index Futures

Stock Futures

Cash Segment 14,148 7,812 6,253 4,506 4,328 2,462 2,078 5,337

Index Options Call Put

200708 234660 7609 31 8 200607 55491 3515 0 0 20055 1 3 0 06 200405 13600 213 1471 827 20036572 5171 0 0 04 20021811 644 1 0 03 200102 1276 452 39 45 20001673 01 Source: Complied from BSE website & various issues of

90580

Stock Options Call Put

Total

0

0

242309

0 0

0 0

59006 9

2 174

0 157

16112 12452

21

0

2478

79 -

35 -

1922 1673

SEBI bulletins

Number of Contract Traded at BSE Derivatives Segment Year

Index

Stock

Index

Stock

Total

Futures

Futures

200708 7157078 295117 200607 1638779 142433 200506 89 12 200405 449630 6725 200304 246443 128193 200203 111324 25842 200102 79552 17951 200001 77743 Source: Complied from BSE website & SEBI bulletin

Options Call Put

Options Call Put

951

210

9

6

7453371

2

2

0

1

1545169

100 4806 5

0

2

0

03

27210

72

17

531719

1

0

4391 3230

382258

41

2

783

138037

1139

1276

3605 1500

105527

-

-

-

77743

19

-

(Rs. in Cr.)

BSE Cash & Derivatives Segment Turnover Cash Year Segment 200708 1578857 200695618 07 5 200581607 06 4 200451871 05 5 200350305 04 3 200231407 03 3 200130729 02 2 200001 1000032 Source: Complied from BSE website & SEBI bulletin

Derivatives Segment 2423 09 5900 6 9 1611 2 1245 2 2478 1922 1673

Despite of encouraging growth and developments, industry analyst feels that the derivatives market has not yet, realized its full potential in terms of growth & trading. Analysts points out that the equity derivative markets on the BSE and NSE has been limited to only four products- index futures, index options and individual stock futures and options, which in turn, are limited to certain select stocks only. Although recently NSE and BSE has added more products in their derivatives segment (Weekly Options, Currency futures, Mini Index etc.) but still it is far less than the depth and variety of products prevailing across many developed capital markets.

Status of Indian Derivatives Market vis-a vis Global Derivatives Market The derivatives segment has expanded in the recent years in a substantial way both globally as well as in the Indian capital market. The figures revealed by Futures Industry Association (FIA)9 Annual Volume Survey bring out the fact that more than 15 billion futures and options contracts were traded during 2007 on the 54 important exchanges that report to the FIA, reflecting a remarkable increase of 28% from the previous year. Looking back at the last four years, it can be worked out that these figures reflect that the growth rate was 29 % in 2006, 19% in 2006, 12% in 2005, and 9% in 2004. From the same table it also follows that of the total volume traded globally over the period 200007, the US exchanges alone constituted as much as 35 percent share. Fig. 6 presents the break down of derivatives volume by region and it is clearly evident that after North America with a share of about 40 percent, Asia-Pacific occupies the second slot with a share of 28 percent and Europe falls at the third place with its contribution of 24 percent.

Futures Industry Association (FIA) is an association of futures commission merchants, banks and trading advisers operating in the United States, European and Asian futures markets. FIA provides information and education on futures markets and trading. It also represents the interest of its members by lobbying If we compare the turnover-wise performance of the derivatives segments over the last five years, it may be noticed from an inspection of the relevant tables that the Indian segment has expanded phenomenally as compared to the global segment. The turnover of the NSE derivatives segment in 2003-04 stood at Rs. 2130610 crores. It grew to an astonishing level of Rs.13090477 crores during the year 2007-08, displaying a more than six-time increase over the fiveyear period. In marked contrast, at the global level the increase was less than even two-fold: the turnover was $ 8163 million in 2003 and $ 15187 million in 2007. Global Trend in Turnover of Derivatives Trading

Non- US Year US Exchanges Exchanges 2000 1313.65 1675.80 2001 1578.62 2768.70 2002 1844.90 4372.38 2003 2172.52 5990.22 2004 2795.21 6069.50 2005 3525.00 6448.67 2006 4616.73 7245.48 2007 6137.20 9049.47 2000-07 23983 (35.48) 43620 (64.52) Source: FI Futures Industry, March/April 2008

(in millions ) Global 2989.45 4347.32 6217.28 8162.54 8864.71 9973.67 11862.21 15186.67 67604 (100)

Figure 6: Derivatives Volume by Region Jan-Dec 2008

Latin America

Other 39.74%

4.84% Europe Asia Pacific 28.18 %

23.61%

North America 39.63%

Source: Newedge Difference on the following parameters – volume , settlement , regulatory framework and types of derivatives allowed and not allowed. 1. Types of derivatives allowed and not allowed Types of derivatives allowed in inida vs rest of the world countries Index Futures Options Stock Futures Options currency Futures Options

Australi a

China

Hong kong

india

japan

korea

Usa

yes yes

no no

yes yes

yes yes

yes yes

yes yes

yes yes

yes yes

no no

yes yes

yes yes

no yes

no yes

yes no

yes no

no no

no no

yes no

yes no

yes yes

no no

Interest rate Future Options Bonds Futures Options Commoditit ies Futures options

yes yes

no no

yes no

yes no

yes yes

yes no

yes yes

yes yes

yes no

yes no

no no

yes yes

yes yes

yes yes

yes yes

yes no

no no

yes no

yes no

yes no

yes no

2. volume Trading Volumes After recording a staggering year-on-year growth of 60.43 percent in trading volumn in 2009–2010, the NSE’s derivatives market continued its momentum in 2010–2011 by clocking a growth of 65.58 percent (Table 6-5). The NSE further strengthened its dominance in the derivatives segment in 2010–2011 with a share of 99.99 percent of the total turnover in this segment. The share of the BSE in the total derivatives market turnover fell from 0.0013 percent in 2009–2010 to 0.0005 percent in 2010–2011. The total turnover of the derivatives segment jumped by 26.56 percent during the first half of 2011–2012 compared to the turnover in the corresponding period in the previous fiscal year.

The index options segment was the clear leader in the product-wise turnover of the futures and options segment in the NSE in 2010–2011 (Table 6-6 and Chart 61). The turnover in the index options category was 62.79 percent of the total turnover in the F&O segment of the NSE, followed by the stock futures and index futures that saw a year-on-year growth of 18.79 percent and 14.90 percent, respectively. This trend continued in the first half of 2011–2012, with index options constituting around 72.89 percent of the total turnover in this segment.

The turnover of index optionszoomed by 59.93 percent during the first half of 2011–2012, compared to the turnover in the corresponding period in the previous fiscal year.

FIA Volume Report: Global Futures and Options Volume Rose 2.1% to 21.64 Billion in 2013 FIA released its annual report on global trends in the trading of futures and options. According to statistics gathered by FIA from 84 exchanges worldwide, 21.64 billion futures and options contracts were traded in 2013, an increase of 2.1% from the previous year, but still well below the number of contracts traded in 2011 and 2010. Futures trading accounted for 12.22 billion contracts, just over 56% of total industry volume. Trading of options accounted for the other 44%. By category, contracts based on equity indices and individual stocks accounted for 11.77 billion, 54% of total volume. Interest rate futures and options accounted for 3.33 billion, 15% of total volume. The trends in North America and Asia-Pacific moved in opposite directions. Exchanges in North America reported 7.9 billion contracts traded in 2013, up 9.9% from the previous year. Exchanges in Asia-Pacific reported 7.29 billion contracts, down 3.1% from the previous year.

CME Group continued to rank as the world’s largest derivatives exchange by volume, with 3.16 billion contracts traded in 2013, up 9.2% from the previous year. IntercontinentalExchange jumped to the second position following its acquisition of NYSE Euronext and its subsidiary exchanges in Europe and the U.S. On a combined basis, ICE’s volume reached 2.81 billion futures and options, up 14.7% from the previous year. This year’s report includes tables showing the top 30 derivatives exchanges ranked by volume, the top 20 contracts across six categories, and breakdowns of global volume by region and by category. This year’s report also includes a special feature showing the futures and options that have had the greatest increase in volume over the last five years. FIA collects volume and open interest statistics from 84 exchanges on a monthly basis. The statistics are provided by the exchanges on a voluntary basis and are subject to revision by the exchanges. FIA does not audit the exchanges and does not guarantee that the statistics are accurate. Volume is measured by the number of contracts traded on a round-trip basis to avoid double-counting. Some exchanges provide facilities for processing and clearing offexchange transactions. FIA statistics include these types of transactions were reported by the exchanges.

Settlement of futures contracts on index and individual securities

National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on the Derivatives (Futures & Options) segment. NSCCL acts as legal counter-party to all deals on NSE’s F&O segment and guarantees settlement. A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals executed by Trading Members (TM) on NSE, who clear and settle such deals through them. Daily Mark-to-Market Settlement The positions in the futures contracts for each member is marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. The profits/ losses are computed as the difference between the trade price or the previous day's settlement price, as the case may be, and the current day's settlement price. The CMs who have suffered a loss are required to pay the markto-market loss amount to NSCCL which is passed on to the members who have made a profit. This is known as daily mark-to-market settlement. Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is currently the price computed as per the formula detailed below: F =S * e rt where : F = theoretical futures price S = value of the underlying index r = rate of interest (MIBOR) t = time to expiration Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. After daily settlement, all the open positions are reset to the daily settlement price. CMs are responsible to collect and settle the daily mark to market profits / losses incurred by the TMs and their clients clearing and settling through them. The payin and pay-out of the mark-to-market settlement is on T+1 days (T = Trade day). The mark to market losses or profits are directly debited or credited to the CMs clearing bank account.

Option to settle Daily MTM on T+0 day Clearing members may opt to pay daily mark to market settlement on a T+0 basis. The option can be exercised once in a quarter (Jan-March, Apr-June, Jul-Sep & Oct-Dec). The option once exercised shall remain irrevocable during that quarter. Clearing members who wish to opt to pay daily mark to market settlement on T+0 basis shall intimate the Clearing Corporation as per the format specified in specified format. Clearing members who opt for payment of daily MTM settlement amount on a T+0 basis shall not be levied the scaled up margins. The pay-out of MTM settlement shall continue to be done on T+1 day basis.

Final Settlement On the expiry of the futures contracts, NSCCL marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash. The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. The final settlement profit / loss is computed as the difference between trade price or the previous day's settlement price, as the case may be, and the final settlement price of the relevant futures contract. Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account on T+1 day (T= expiry day). Open positions in futures contracts cease to exist after their expiration day Settlement Procedure Daily MTM settlement on T+0 day Clearing members who opt to pay the Daily MTM settlement on a T+0 basis would compute such settlement amounts on a daily basis and make the amount of funds available in their clearing account before the end of day on T+0 day. Failure to do so would tantamount to non payment of daily MTM settlement on a T+0 basis. Further, partial payment of daily MTM settlement would also be considered as non payment of daily MTM settlement on a T+0 basis. These would be construed as non compliance and penalties applicable for fund shortages from time to time would be levied. A penalty of 0.07 % of the margin amount at end of day on T+0 would be levied on the clearing members. Further, the benefit of scaled down margins shall not be available in case of non payment

of daily MTM settlement on a T+0 basis from the day of such default to the end of the relevant quarter. Settlement of options contracts on index and individual securities

Daily Premium Settlement Premium settlement is cash settled and settlement style is premium style. The premium payable position and premium receivable positions are netted across all option contracts for each CM at the client level to determine the net premium payable or receivable amount, at the end of each day. The CMs who have a premium payable position are required to pay the premium amount to NSCCL which is in turn passed on to the members who have a premium receivable position. This is known as daily premium settlement. CMs are responsible to collect and settle for the premium amounts from the TMs and their clients clearing and settling through them. The pay-in and pay-out of the premium settlement is on T+1 day (T = Trade day). The premium payable amount and premium receivable amount are directly debited or credited to the CMs clearing bank account.

Final Exercise Settlement Final Exercise settlement is effected for option positions at in-the-money strike prices existing at the close of trading hours, on the expiration day of an option contract. Long positions at in-the money strike prices are automatically assigned to short positions in option contracts with the same series, on a random basis. For index options contracts and options contracts on individual securities, exercise style is European style. Final Exercise is Automatic on expiry of the option contracts. Option contracts, which have been exercised, shall be assigned and allocated to Clearing Members at the client level. Exercise settlement is cash settled by debiting/ crediting of the clearing accounts of the relevant Clearing Members with the respective Clearing Bank. Final settlement loss/ profit amount for option contracts on Index is debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day). Final settlement loss/ profit amount for option contracts on Individual Securities is debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day). Open positions, in option contracts, cease to exist after their expiration day. The pay-in / pay-out of funds for a CM on a day is the net amount across settlements and all TMs/ clients, in F&O Segment.

There are four entities in the trading system of a derivative market: 1. Trading members: Trading members can trade either on their own account or on behalf of their clients including participants. They are registered as members with

NSE and are assigned an exclusive trading member ID 2. Clearing members: Clearing members are members of NSCCL. They carry out confirmation/inquiry of trades and the risk management activities through the trading system. These clearing members are also trading members and clear trade for themselves or/and other. 3. Professional clearing members: A clearing member who is not a trading member is known as a professional clearing member (PCM). Typically, banks and custodian become PCMs and clear and settle for their trading members. 4. Participants: A participant is a client of trading members like financial institutions. These clients may trade through multiple trading members, but settle their trades through a single clearing member only. The terminals of trading of futures & options segment are available in 298 cities at the end of March 2006. Besides trading terminals, it can also be accessed through the internet by investors from anywhere.

Settlement Schedule Product

Settlement

Futures Contracts on Index & Daily Mark-toIndividual Securities Market Settlement

Schedule

Pay-in : T+1 working day at or after 11.30 a.m. Payout : T+1 working day at or after 12.00 p.m.

(T is trade day) Futures Contracts on Index & Individual Securities

Final Settlement

Pay-in : T+1 working day at or after 11.30 a.m. Payout : T+1 working day at or after 12.00 p.m. (T is expiration day of contract)

Interest Rate Futures Contracts

Daily Mark-toMarket Settlement

Pay-in : T+1 working day on or after 11.30 a.m. Payout : T+1 working day on or after 12.00 p.m. (T is trading day)

Interest Rate Futures Contracts

Final Settlement

Pay-in : T+1 working day on or after 11.30 a.m. Payout : T+1 working day on or after 12.00 p.m. (T is expiration day)

Options Contracts on Index & Individual Securities

Premium Settlement Pay-in : T+1 working day at or after 11.30 a.m. Payout : T+1 working day at or after 12.00 p.m. (T is trade day)

Options Contracts on Index

Exercise & Final Settlement

Pay-in : T+1 working day at or after 11.30 a.m. Payout : T+1 working day at or after 12.00 p.m. (T is expiration day of contract)

Options Contract on Individual Securities

Interim Exercise Settlement

Pay-in : T+2 working day at or after 11.30 a.m. Payout : T+2 working day at or after 12.00 p.m. (T is exercise day)

Options Contract on Individual Securities

Exercise & Final Settlement

Pay-in : T+2 working day at or after 11.30 a.m. Payout : T+2 working day at or after 12.00 p.m. (T is expiration day)

Settlement Price Product

Settlement

Settlement Price

Futures Contracts on Index or Individual Security

Daily Settlement

Closing price of the futures contracts on the trading day. (The closing price is the last half hour weighted average price of the contract).

Un-expired illiquid futures contracts

Daily Settlement

Theoretical Price computed as per formula F=S * e rt

Futures Contracts on Index or Individual Securities

Final Settlement

Closing price of the relevant underlying index / security in the Capital Market segment of NSE, on the last trading day of the futures contracts. (The closing price of the underlying index / security is its last half an hour weighted average value / price in the Capital Market

segment of NSE).

Options Contracts on Individual Securities

Interim Exercise Settlement

Closing price of such underlying security on the day of exercise of the options contract. (The closing price of the underlying security is its last half an hour weighted average price in the Capital Market Segment of NSE).

Options Contracts on Index and Individual Securities

Final Exercise Settlement

Closing price of such underlying security (or index) on the last trading day of the options contract. (The closing price of the underlying security (or index) is its last half an hour weighted average price in the Capital Market Segment of NSE).

Major Payment, Clearing, and Settlement Systems in the United States The Federal Reserve and the private sector operate the systems that constitute the infrastructure for the processing and completion of financial transactions in the United States. Listed below are some of the major systems currently operating in the United States. Some privately-operated systems have been designated by FSOC as systemically important under Title VIII. Additional information regarding selected systems, including recent transaction volume levels, is set forth in

an Appendix to this report. In the future, new and evolving types of financial products, transactions and instruments could lead to new payment, clearing, and settlement systems and activities. FMUs Designated by the FSOC On July 18, 2012, FSOC voted unanimously to designate eight FMUs as systemically important. Each was assigned a supervisory agency on the basis of the types of activities that they perform. The eight systemically important FMUs are: • The Clearing House Payments Company, on the basis of its role as operator of the Clearing House Interbank Payments System (CHIPS).8

(Supervisory Agency—The Federal Reserve) • CLS Bank (foreign exchange) (Supervisory Agency—The Federal Reserve) • Chicago Mercantile Exchange (CME) Clearing (credit default and interest rate swaps) (Supervisory Agency—Commodity Futures Trading Commission) • Depository Trust Company (DTC) (Supervisory Agency—Securities and Exchange Commission) • Fixed Income Clearing Corporation operating the Government Securities Division (GSD) and the Mortgage-Backed Securities Division (MBSD) (Supervisory Agency—Securities and Exchange Commission)

• ICE Trust (credit default swaps) (Supervisory Agency—Commodity Futures Trading Commission) • National Securities Clearing Corporation (NSCC) (Supervisory Agency—Securities and Exchange Commission 8

The Electronic Payments Network and other subsidiaries are deemed systemically important by default for being component parts of the parent company The Clearing House Payments Company, which was designated systemically important. Supervision of U.S. Payment, Clearing, and Settlement Systems

Congressional Research Service 4 • The Options Clearing Corporation (equity derivatives) (Supervisory Agency—Securities and Exchange Commission) The Clearing House operates an interbank funds transfer system known as CHIPS and an ACH system known as EPN. DTCC operates the Depository Trust Company (DTC), the major U.S. depository, and clearing corporations for government, mortgage-backed, and corporate and municipal securities. These entities provide the primary infrastructure for the clearance, settlement, and custody of the vast majority of transactions in the United States involving equities, corporate debt, municipal bonds, money market instruments, and government securities.9

In the future, FSOC may add or remove PCS systems from the designated list, as conditions warrant.

Regulatory framework Regulatory objectives

The regulation should be designed to achieve specific, well-defined goals. It is inclined towards positive regulation designed to encourage healthy activity and behavior .Of course, the ultimate objective of regulation of financial markets has to be to promote more efficient functioning of markets on the "real" side of the economy, i.e. economic efficiency. It has been guided by the following objectives: a. Investor Protection: Attention needs to be given to the following four aspects: i.

Fairness and Transparency: The trading rules should ensure that trading is conducted in a fair and transparent manner. Experience in other countries shows that in many cases, derivatives brokers/dealers failed to disclose potential risk to the clients.

ii.

Safeguard for clients' moneys: Moneys and securities deposited by clients with the trading members should not only be kept in a separate clients' account but should also not be attachable for meeting the broker's own debts. It should be ensured that trading by dealers on own account is totally segregated from that for clients.

iii.

Competent and honest service: The eligibility criteria for trading members should be designed to encourage competent and qualified personnel so that investors/clients are served well. This makes it necessary to prescribe qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of a knowledge base.

iv.

Market integrity: The trading system should ensure that the market's integrity is safeguarded by minimising the possibility of defaults. This requires framing appropriate rules about capital adequacy, margins, clearing corporation, etc.

b. Quality of markets: The concept of "Quality of Markets" goes well beyond market integrity and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity. c. Innovation: While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology.

India 

Present system of regulation in commodity forward/future trading

At present, there are three tiers of regulations of forward/futures trading system exists in India, namely, Government of India, Forward Markets Commission and Commodity Exchanges. The FC(R) Act, 1952 prohibits options in commodities. For the purpose of forward contracts in certain commodities can be regulated by notifying those commodities u/s 15 of the Act; forward trading in certain other commodities can be prohibited by notifying these commodities u/s 17 of the Act. 

Need for regulating futures market

The need for regulation arises on account of the fact that the benefits of futures markets accrue in competitive conditions. The regulation is needed to create competitive conditions. In the absence of regulation, unscrupulous participants could use these leveraged contracts for manipulating prices. This could have undesirable influence on the spot prices, thereby affecting interests of society at large.. Regulation is also needed to ensure that the market has appropriate risk management system. In the absence of such a system, a major default could create a chain reaction. The resultant financial crisis in a futures market could create systematic risk. Regulation is also needed to ensure fairness and transparency in trading, clearing, settlement and management of the exchange so as to protect and promote the interest of various stakeholders, particularly non-member users of the market. 

Forward Markets Commission

Forward Markets Commission is a regulatory body for commodity futures/ forward trade in India. This was set up under the Forward Contracts (Regulation) Act of 1952. It is responsible for regulating and promoting futures/ forward trade in commodities. The Forward Markets Commission’s Head Quarter is located at Mumbai and Regional Office at Kolkata. Web-site:-www.fmc.gov.in 

Functions of the Forward Markets Commission

(a) FMC advises Central Government in respect of grant of recognition or withdrawal of recognition of any association. (b) It keeps forward markets under observation and takes such action in relation to them as it may consider necessary, in exercise of powers assign to it. (c) It collects and publishes information relating to trading conditions in respect of goods including information relating to demand, supply and prices and submit to the Government periodical reports on the operations of the Act and working of forward markets in commodities. (d) It makes recommendations for improving the organization and working of forward markets. (e) It undertakes inspection of books of accounts and other documents of recognized/registered associations.



Powers of the Commission?

The Commission has powers of deemed civil court for (a) Summoning and enforcing the attendance of any person and examining him on oath; (b) Requiring the discovery and production of any document; (c) Receiving evidence on affidavits, and (d) Requisitioning any public record or copy thereof from any office. The following powers are vested in the Central Government, most of which are delegated to the Commission: The powers of approving memorandum and articles of association and Bye-laws; powers to direct to make or to make articles (Rules) or Byelaws; powers to suspend governing body of recognised association, and, powers to suspend business of recognised association. 

Regulatory measures prescribed by Forward Markets Commission

Forward Markets Commission provides regulatory oversight in order to ensure financial integrity (i.e. to prevent systematic risk of default by one major operator or group of operators), market integrity (i.e. to ensure that futures prices are truly aligned with the prospective demand and supply conditions) and to protect & promote interest of customers /non-members. The Forward Markets Commission prescribes following regulatory measures: (a) Limit on net open position as on the close of an individual operator and at Member level to prevent excessive speculation (b) Circuit-filters or limit on price fluctuations to allow cooling of market in the event of abrupt upswing or downswing in prices. (c) Imposition of margins to prevent defaults by Members/clients (d) Physical delivery of contracts and penalty for default/delivery obligations (e) Daily mark to marketing of the contracts 

Legal and regulatory provisions for customer protection

The F.C(R) Act provides that client’s position cannot be appropriated by the member of the Exchange, except a written consent is taken within three days’ time. Forward Markets Commission is persuading increasing number of Exchanges to switch over to electronic trading, clearing and settlement, which is more customer-friendly. Commission has also prescribed simultaneous reporting system for the Exchanges following open out-cry system. These steps facilitate audit trail and make it difficult for the members to indulge in malpractices like, trading ahead of clients, etc. The Commission has also mandated all the Exchanges following open outcry system to display at a prominent place in Exchange premises, the name, address, telephone number of the officer of the Commission who can be contacted for any grievance. The website of the Commission also has a provision for the customers to make complaint, send comments and suggestions to the Commission.

Current status on OTC derivative products:

Product/G -20 requirem ents

Trade Standardis Repositor ation y (for both interbank and client trades)

Interest IRS Rate Derivative s

Available for both interbank and client trade

Credit CDS Derivative

Available Standardise Not for both d. available. interbank and client trades.

Forex OTC Forex Available Derivative forwar for both s d interbank and client trades (FCY -INR & FCYFCY).

Forex

Available

PartialMIBOR standardised .

Central Electronic Clearing trading (CCP) platform

NonNot No margin guaranteed available. requirement central Electronic clearing in trading place. platform CCP based under clearing considerati under on. considerati on.

Not Guarantee available as d Central majority of clearing interbank available. trades RBI has not driven by mandated customized it. client trades.

Not

Higher capital /Margin requiremen ts for noncentrally clearing OTC derivative trades

Not available

Margin requirement in place

No exclusive platform available. Can be traded on FX- SWAP.

No regulatory requirement.

Guarantee Can be

No

Swap

for both interbank and client trades (FCY -INR & FCYFCY).

Forex Available option for both interbank and client trades (FCY -INR & FCYFCY).

available as majority of interbank trades driven by customized client trades..

d Central clearing available. RBI has not mandated it.

Not Central available as clearing majority of not interbank available. trades driven by customized client trades.

traded on regulatory CCIL and requirement. Reuters’ trading platform. Majority of trades done through brokers.

Not available.

No regulatory requirement.

Curren Available Not cy for both available. Swap interbank and client trades (FCY -INR & FCYFCY).

Not available.

Not available.

No regulatory requirement.

IRS in FCY

Available Not for both available. interbank and client trades.

Not available.

Not available.

No regulatory requirement.

IRS Not Not option available available. in FCY due to negligible trading volume.

Not available.

Not available.

No regulatory requirement.

Source: http://www.rbi.org.in/Scripts/PublicationReportDetails.aspx? UrlPage=&ID=762

United States In the United States, the Securities and Exchange Commission (SEC),Commodity Futures Trading Commission (CFTC), and the Federal Reserve System (Fed), among others, are responsible for financial regulation. The SEC regulates the securities industry (stocks, bonds, and security-based derivatives) and enforces its laws. The CFTC regulates the trading of agricultural commodities and futures, but as of recently, since most futures are now based on securities, the distinction between the organizations has been blurring, especially with regards to derivatives regulation.The Commodity Exchange Act (CEA) regulates the trading of commodity futures in the United States. Passed in 1936, it has been amended several times since then. The CEA establishes the statutory framework under which the CFTC operates. The DoddFrank Wall Street Reform and Consumer Protection Act brings comprehensive reform to the regulation of swaps Analysis Major issues concerning regulatory framework There are several important issues in connection with derivatives trading, some of which have a direct bearing on the design of the regulatory framework. They are listed below: a. Should a derivatives exchange be organised as independent and separate from an existing stock exchange? b. What exactly should be the division of regulatory responsibility, including both framing and enforcing the regulations, between SEBI and the derivatives exchange?

c. How should we ensure that the derivatives exchange will effectively fulfill its regulatory responsibility. d. What criteria should SEBI adopt for granting permission for derivatives trading to an exchange?

e. What conditions should the clearing mechanism for derivatives trading satisfy in view of high leverage involved? f. What new regulations or changes in existing regulations will have to be introduced by SEBI for derivatives trading? Should derivatives trading be conducted in a separate exchange? 1. A major issue raised before the Committee for its decision was whether regulations should mandate the creation of a separate exchange for derivatives trading, or allow an existing stock exchange to conduct such trading. The Committee has examined various aspects of the problem. It has also reviewed the position prevailing in other countries. Exchange-traded financial derivatives originated in USA and were subsequently introduced in many other countries. Organisational and regulatory arrangements are not the same in all countries. Interestingly, in U.S.A., for reasons of history and regulatory structure, futures trading in financial instruments, including currency, bonds and equities, was started in early 1970s, under the auspices of commodity futures markets rather than under securities exchanges where the underlying bonds and equities were being traded. This may have happened partly because currency futures, which had nothing to do with securities markets, were the first to emerge among financial derivatives in U.S.A. and partly because derivatives were not "securities" under U.S. laws. Cash trading in securities and options on securities were under the Securities and Exchange Commission (SEC) while futures trading was under the Commodities Futures Trading Commission (CFTC). In other countries, the arrangements have varied. 2. The Committee examined the relative merits of allowing derivatives trading to be conducted by an existing stock exchange vis-a-vis a separate exchange for derivatives. The arguments for each are summarised below. Arguments for allowing existing stock exchanges to start futures trading: a. The most weighty argument in this regard is the advantage of synergies arising from the pooling of costs of expensive information technology networks and the sharing of expertise required for running a modern exchange. Setting-up a separate derivatives exchange will involve high costs and require more time. b. The recent trend in other countries seems to be towards bringing futures and cash trading under coordinated supervision. The lack of coordination was recognised as an important problem in U.S.A. in the aftermath of the October 1987 market crash. Exchange-level

supervisory coordination between futures and cash markets is greatly facilitated if both are parts of the same exchange.

Arguments for setting-up separate futures exchange: a. The trading rules and entry requirements for futures trading would have to be different from those for cash trading. b. The possibility of collusion among traders for market manipulation seems to be greater if cash and futures trading are conducted in the same exchange. c. A separate exchange will start with a clean slate and would not have to restrict the entry to the existing members only but the entry will be thrown open to all potential eligible players. Recommendation 

From the purely regulatory angle, a separate exchange for futures trading seems to be a neater arrangement. However, considering the constraints in infrastructure facilities, the existing stock exchanges having cash trading may also be permitted to trade derivatives provided they meet the minimum eligibility conditions as indicated below : 1. The trading should take place through an online screen-based trading system, which also has a disaster recovery site. The per-half-hour capacity of the computers and the network should be at least 4 to 5 times of the anticipated peak load in any half hour, or of the actual peak load seen in any half-hour during the preceding six months. This shall be reviewed from time to time on the basis of experience. 2. The clearing of the derivatives market should be done by an independent clearing corporation, which satisfies the conditions listed in a later chapter of this report. 3. The exchange must have an online surveillance capability which monitors positions, prices and volumes in realtime so as to deter market manipulation. Price and position limits should be used for improving market quality. 4. Information about trades, quantities, and quotes should be disseminated by the exchange in realtime over at least two information vending networks which are accessible to investors in the country.

5. The Exchange should have at least 50 members to start derivatives trading. 6. If derivatives trading is to take place at an existing cash market, it should be done in a separate segment with a separate membership; i.e., all members of the existing cash market would not automatically become members of the derivatives market. 7. The derivatives market should have a separate governing council which shall not have representation of trading/clearing members of the derivatives Exchange beyond whatever percentage SEBI may prescribe after reviewing the working of the present governance system of exchanges. 8. The Chairman of the Governing Council of the Derivative Division/Exchange shall be a member of the Governing Council. If the Chairman is a Broker/Dealer, then, he shall not carry on any Broking or Dealing Business on any Exchange during his tenure as Chairman. 9. The exchange should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country.

10.

The exchange should have an adequate inspection capability.

11. No trading/clearing member should be allowed simultaneously to be on the governing council of both the derivatives market and the cash market. 12. If already existing, the Exchange should have a satisfactory record of monitoring its members, handling investor complaints and preventing irregularities in trading

Summary and Concluding Remarks Innovation of derivatives have redefined and revolutionised the landscape of financial industry across the world and derivatives have earned a well deserved and extremely significant place among all the financial products. Derivatives are risk management tool that help in effective management of risk by various stakeholders. Derivatives provide an opportunity to transfer risk, from the one who wish to avoid it; to one, who wish to accept it. India’s experience with the launch of equity derivatives market has been extremely encouraging and successful. The derivatives turnover on the NSE has surpassed the equity market turnover. Significantly, its growth in the recent years has surpassed the growth of its counterpart globally. The turnover of derivatives on the NSE increased from Rs. 23,654 million (US $ 207 million) in 2000-01 to Rs. 130,904,779 million (US $ 3,275,076 million) in 2007-08. India is one of the most successful developing countries in terms of a vibrant market for exchange-traded derivatives. This reiterates the strengths of the modern development of India’s securities markets, which are based on nationwide market access, anonymous safe and secure electronic trading, and a predominantly retail market. There is an increasing sense that the equity derivatives market is playing a major role in shaping price discovery. Factors like increased volatility in financial asset prices; growing integration of national financial markets with international markets; development of more sophisticated risk management tools; wider choices of risk management strategies to economic agents and innovations in financial engineering, have been driving the growth of financial derivatives worldwide and have also fuelled the growth of derivatives here, in India. There is no better way to highlight the significance and contribution of derivatives but the comments of the longest serving Governor of Federal Reserve, Alan Greenspan: “Although the benefits and costs of derivatives remain the subject of spirited debate, the performance of the economy and the financial system in recent years suggests that those benefits have materially exceeded the costs."

Bibliography  Official sites of RBI , FMC , NASDAQ  www.cmegroup.com  Sm_ed_begn.pdf

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