(MSU) Derivatives Unit -5 Development of Derivative Markets in India

Kotla. N. Sathyanarayana Reddy 9986314840

Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the worlds largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created. In the equity markets, a system of trading called badla involving some elements of forwards trading had been in existence for decades.6 However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared securities. This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of market-determined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk. Figure 1 shows how the
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Kotla. N. Sathyanarayana Reddy 9986314840

volatility of the exchange rate between the Indian Rupee and the U.S. dollar has increased since 1991. The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk. Derivatives Instruments Traded in India In the exchange-traded market, the biggest success story has been derivatives on equity products. Index futures were introduced in June 2000, followed by index options in June 2001, and options and futures on individual securities in July 2001 and November 2001, respectively. As of 2005, the NSE trades futures and options on 118 individual stocks and 3 stock indices. All these derivative contracts are settled by cash payment and do not involve physical delivery of the underlying product (which may be costly). Derivatives on stock indexes and individual stocks have grown rapidly since inception. In particular, single stock futures have become hugely popular, accounting for about half of NSEs traded value in October 2005. In fact, NSE has the highest volume (i.e. number of contracts traded) in the single stock futures globally, enabling it to rank 16 among world exchanges in the first half of 2005. Single stock options are less popular than futures. Index futures are increasingly popular, and accounted for close to 40% of traded value in October 2005. Figure 2 illustrates the growth in volume of futures and options on the Nifty index, and shows that index futures have grown more strongly than index options. NSE launched interest rate futures in June 2003 but, in contrast to equity derivatives, there has been little trading in them. One problem with these instruments was faulty contract specifications, resulting in the underlying interest rate deviating erratically from the reference rate used by market participants. Institutional investors have preferred to trade in the OTC markets, where instruments such as interest rate swaps and forward rate agreements are thriving. As interest rates in India have fallen, companies have swapped their fixed rate borrowings into floating rates to reduce funding costs.10 Activity in OTC markets dwarfs that of the entire exchange-traded markets, with daily value of trading estimated to be Rs. 30 billion in 2004 (Fitch Ratings, 2004). Foreign exchange derivatives are less active than interest rate derivatives in India, even though they have been around for longer. OTC instruments in currency forwards and swaps are the most popular. Importers, exporters and banks use the rupee forward market to hedge
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Kotla. N. Sathyanarayana Reddy 9986314840

their foreign currency exposure. Turnover and liquidity in this market has been increasing, although trading is mainly in shorter maturity contracts of one year or less (Gambhir and Goel, 2003). In a currency swap, banks and corporations may swap its rupee denominated debt into another currency (typically the US dollar or Japanese yen), or vice versa. Trading in OTC currency options is still muted. There are no exchange-traded currency derivatives in India. Exchange-traded commodity derivatives have been trading only since 2000, and the growth in this market has been uneven. The number of commodities eligible for futures trading has increased from 8 in 2000 to 80 in 2004, while the value of trading has increased almost four times in the same period (Nair, 2004). However, many contracts barely trade and, of those that are active, trading is fragmented over multiple market venues, including central and regional exchanges, brokerages, and unregulated forwards markets. Total volume of commodity derivatives is still small, less than half the size of equity derivatives (Gorham et al, 2005). Indian Commodity Exchanges There are more than 20 recognised commodity futures exchanges in India under the purview of the Forward Markets Commission (FMC). The country's commodity futures exchanges are divided majorly into two categories: National exchanges Regional exchanges22 The four exchanges operating at the national level (as on 1st January 2010) are: a) National Commodity and Derivatives Exchange of India Ltd. (NCDEX) b) National Multi Commodity Exchange of India Ltd. (NMCE) c) Multi Commodity Exchange of India Ltd. (MCX)
d) Indian Commodity Exchange Ltd. (ICEX) which started trading operations on

November 27, 2009 The leading regional exchange is the National Board of Trade (NBOT) located at Indore. There are more than 15 regional commodity exchanges in India.

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Kotla. N. Sathyanarayana Reddy 9986314840

REGULATIONS At present, there are three tiers of regulations of forward/futures trading system in India, namely, Government of India, Forward Markets Commission (FMC) and Commodity Exchanges. Rules Governing Commodity Derivatives Exchanges /Participants 1. Limit on net open position as on the close of the trading hours. Some times limit is also imposed on intra-day net open position. The limits are imposed memberwise and client wise. 2. 3. Circuit-filters or limit on price fluctuations to allow cooling of market in the Special margin deposit to be collected on outstanding purchases or sales when event of abrupt upswing or downswing in prices. price moves up or down sharply above or below the previous day closing price. By making further purchases/sales relatively costly, the price rise or fall is sobered down. This measure is imposed by the Exchange (FMC may also issue directive). 4. Circuit breakers or minimum/maximum prices: These are prescribed to prevent futures prices from falling below as rising above not warranted by prospective supply and demand factors. This measure is also imposed on the request of the exchanges (FMC may also issue directive). 5. Stopping trading in certain derivatives of the contract, closing the market for a specified period and even closing out the contract. These extreme measures are taken only in emergency situations. Rules Governing Trading On Exchange Trading: The NCDEX provides an automated trading facility in all the commodities admitted for dealings on the derivative market. Trading on the Exchange is allowed only through approved workstation(s) located at locations for the office(s) of a trading member as approved by the exchange. The LAN or any other mode of connectivity to other workstations at any place connecting an approved workstation of a trading member shall require an approval of the exchange.

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Kotla. N. Sathyanarayana Reddy 9986314840

Trading days: The Exchange operates on all days except Sunday and on holidays declared from time to time. Trading members and users: Trading members are entitled to appoint, (subject to such terms and conditions, as may be specified by the relevant authority of the Exchange) from time to time Authorised persons (he will appoint the users) Approved users (use the trading system through username and password)

Trading hours and trading cycle: The Exchange announces the normal trading hours/ open period in advance from time to time. In case necessary, the Exchange can extend or reduce the trading hours by notifying the members. Contract expiration: Derivatives contracts expire on a pre-determined date and time up to which the contract is available for trading. Trading parameters: The Exchange from time to time specifies various trading parameters relating to the trading system. Every trading member is required to specify the buy or sell orders as either an open order or a close order for derivatives contracts. The Exchange also prescribes different order books that shall be maintained on the trading system and also specifies various conditions on the order that will make it eligible to place it in those books. Failure of trading member terminal: In the event of failure of trading member's workstation and/ or the loss of access to the trading system, the Exchange can at its discretion undertake to carry out on behalf of the trading member the necessary functions which the trading member is eligible for. Only requests made in writing in a clear and precise manner by the trading member would be considered. The trading member is accountable for the functions executed by the Exchange on its behalf and has to indemnity the Exchange against any losses or costs incurred by the Exchange. Trade operations: Trading members have to ensure that appropriate confirmed order instructions are obtained from the constituents before placement of an order on the system. They have to keep relevant records or documents concerning the order and trading system

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Kotla. N. Sathyanarayana Reddy 9986314840

order number and copies of the order confirmation slip/modification slip must be made available to the constituents. Margin requirements: Every clearing member, has to deposit a margin with the Exchange in respect of the trades to which he is party, in the manner prescribed by or under the provisions as contained in the exchange Bye-laws and Regulations as may be in force, . Unfair trading practices: No trading member shall buy, sell, deal in derivatives contracts in a fraudulent manner, or indulge in any market manipulation, unfair trade practices, Rules Governing Investor Grievances, Arbitration The Exchange has put in place a dispute resolution mechanism by way of arbitration for resolution of disputes between members or between a member and client arising out of transactions on the Exchange. The arbitration mechanism and procedure for reference of disputes to arbitrateon are detailed in the Exchange Bye-laws and Regulations. Definitions:

Arbitrator means a sole arbitrator or a panel of arbitrators. Applicant/Claimant means the person who makes the application for initiating Respondent means the person against whom the applicant/claimant lodges an

arbitral proceedings.

arbitration application, whether or not there is a claim against such person. The Exchange may provide for different seats of arbitration for different regions of the country termed as Regional Arbitration Centres (RACs). The seat of arbitration shall be Mumbai where no RAC has been notified. JURISDICTION In matters where the Exchange is a party to the dispute, the civil courts at Mumbai shall have exclusive jurisdiction and in all other matters, proper courts within the area covered under the respective RAC shall have jurisdiction in respect of the arbitration proceedings falling/ conducted in that RAC. PERIOD FOR REFERENCE OF CLAIMS/DISPUTES

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Kotla. N. Sathyanarayana Reddy 9986314840

All claims shall have to be referred within six months from the date on which such claim, dispute or difference arose. The time taken by the Exchange for administratively resolving the dispute shall be excluded for the purpose of determining the period of six months. CONTRACT SPECIFICATIONS
Index Futures 5 indices Index Options 5 indices Futures on Individual Securities 202 securities FUTSTK Symbol of Underlying Security DDMMMYYYY Options on Individual Securities 202 securities OPTSTK Symbol of Underlying Security DDMMMYYYY CA / PA Strike Price Mini Index Futures S&P CNX Nifty FUTIDX Mini Index Options S&P CNX Nifty OPTIDX Long Term Index Options S&P CNX Nifty OPTIDX

Parameter Underlyin g Instrument Underlyin g Symbol Expiry Date Option Type Strike Price Trading Cycle

Security Descriptor:
FUTIDX Symbol of Underlying Index DDMMMYYYY OPTIDX Symbol of Underlying Index DDMMMYYYY CE / PE Strike Price

MINIFTY DDMMMYYYY -

MINIFTY DDMMMYYYY CE / PE Strike Price

NIFTY DD-MMMYYYY CE / PE Strike Price Three quarterly expiries (March, June, Sept & Dec cycle) and next 8 half yearly expiries (Jun, Dec cycle)

3 month trading cycle - the near month (one), the next month (two) and the far month (three)

Expiry Day Strike Price Intervals Permitted Lot Size Price Steps Price Bands

Last Thursday of the expiry month. If the last Thursday is a trading holiday, then the expiry day is the previous trading day. Depending Depending Depending on on on Depending on underlying underlying underlying underlying price price price price Underlying specific Rs.0.05 Operating range of 10% of the base price Underlying specific Rs.0.05 A contract specific price range based on its delta value is computed and Underlying specific Rs.0.05 Operating range of 20% of the base price Underlying specific Rs.0.05 A contract specific price range based on its delta value is computed and 20 Rs.0.05 Operating range of 10% of the base price 20 Rs.0.05 A contract specific price range based on its delta value is computed and Underlying specific Rs.0.05 A contract specific price range based on its delta value is computed and updated on a daily basis

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updated on a daily basis

Kotla. N. Sathyanarayana Reddy 9986314840

updated on a daily basis updated on a daily basis