HISTORICAL PERSEPCTIVE OF EQUITY DERIVATIVES MARKET IN INDIA

Transcription

1 CHAPTER 2 HISTORICAL PERSEPCTIVE OF EQUITY DERIVATIVES MARKET IN INDIA Index : 2.1 Evolution of Global Derivatives Markets Evolution of Capital Markets in India Evolution of Derivatives Markets in India Evolution of Equity Derivatives Market Reference to Commodity and Currency Derivatives Market in India 2.4 Development of Equity Derivatives Markets in India Comparison of Equity Derivatives Indices and Stocks on NSE and BSE 2.6 Equity on BSE Equity on NSE Comparison of Equity and in various segments of Indian Stock Market 2.9 Equity Derivatives in India during the period from to Comparison of Futures of BSE and NSE Comparison of Options of BSE and NSE Product-wise Comparison of Equity Derivatives of BSE and NSE 2.13 Product-wise Comparison of Equity Derivatives across Indian Equity Derivatives

2 CHAPTER 2 HISTORICAL PERSEPCTIVE OF EQUITY DERIVATIVES MARKET IN INDIA 2.1 Evolution of Global Derivatives Markets: The history of derivatives is considered to be longer than what many people believe. Derivatives have been around in the global market for a very long time. The evidence of characteristics of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ. However, the beginning of modern day derivative contracts is ascribed to the requirement of farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or over production etc. The first recorded instance of futures trading appears to have been occurred with Yodoya rice market in Osaka, Japan around In the ancient age, merchants used to store rice in warehouses to use the same in future and to raise cash. The Warehouse holders used to sell the receipts against the stored rice. These were the earliest known form of forward contracts whereby the landlords were protected against any future economic losses due to falling prices. These were evidently standardized contracts, which made them much like today's futures. It is said that there may also have been rice futures traded in China as long as 6000 years ago. 1 The evolution of markets in commodities and financial assets may be viewed as a worldwide long-term historical process. In this process, the emergence of futures has been recognized in economic literature as a financial development of considerable significance. A vast economic literature has been built around this subject. From forward trading in commodities emerged the commodity futures. The emergence of financial futures is a more recent phenomenon and represents an extension of the idea of organized futures markets. 2 However, modern origin of futures/forwards as an exchange based industry lies in the productive fields of the grain belt of U.S. in the first half of the 19th century. This evolution was supported by the exigencies of supply and demand where price fluctuations for grain were violently volatile and 31

3 consequently had a serious and noticeable effect on the economy by causing an increase in food prices. At harvest time in the 19 th century, when farmers hauled their grain filled wagons to Chicago and with so many sellers looking for a buyer, the price went firmly down and farmers were forced to accept whatever was offered or worse, he was forced to watch it spoil or dumped in a lake. And the wise grain merchant made money in later months when the supply was short and demand was high. All this prompted a group of Chicago businessmen to do something and in 1848, 82 merchants representing every important business interest in Chicago met above a flour store on South Water Street and founded the Chicago Board of Trade (CBOT) which till today remains foremost in commodity futures trading. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. Thus, the Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848 in United States of America where forward contracts on various commodities were standardized around In 1865, the CBOT went further and listed the first exchange traded derivatives contract in the U.S. these contracts were called futures contracts. Since then, futures contracts have remained more or less in the similar form, as we know them today. 3 There were many other Exchanges that came into existence in the late 19 th Century. "The New York Coffee, Cotton and Produce Exchanges came into existence in the United States of America in 1870s and 1880s. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading and renamed as Chicago Mercantile Exchange (CME). The first stock index futures contract was traded at Kansas City Board of Trade. Today, there exist several other commodity exchanges such as the New York Mercantile Exchange, the New York Commodity Exchange, and the New York Coffee, Sugar and Cocoa Exchanges in the United States of America. 4 Development of derivative market in UK can be traced back to the arrival of a centralized commodities market, founded in 1565 by Sir Thomas Gresham and opened by Queen Elizabeth I. It was based in the Royal Exchange (which in 1982 became the first home to the London International Financial Futures Exchange, LIFFE) and was run along similar lines to the 32

4 Amsterdam Trade Centre in the Netherlands which had opened a few years earlier. Each commodity had a different part of the exchange from which to trade. These markets were using spot trading methods and it is from these origins that the more complicated forward markets arose. 5 Derivatives are intended for the purpose of facilitating the hedging of price risks of the underlying asset which may be in the form of inventory holdings or a financial/ commercial transaction over a certain period. When the asset prices are locked in, derivative products help in minimizing or neutralizing the impact of fluctuations in asset prices on the profitability and cash flow situation and serves as an important tool for risk management. Due to growing instability in the financial markets, the financial derivatives gained prominence after The pace of innovation in derivatives markets increased remarkably in the 1970s. The first major innovation occurred in February 1972, when the Chicago Mercantile Exchange (CME) began trading futures on currencies. The biggest increase in derivatives trading activity was observed subsequently in the 1970s when futures on financial instruments started trading in CME. This was the first time any futures contract was written on anything other than a physical commodity. There are now many futures trading exchanges established all over the world. Foreign currencies such as the Swiss Franc and the Japanese Yen were first. In the 1980s, futures began trading on stock market indexes such as the S&P 500. Another innovation that further uplifted the financial derivatives trading to the next platform was observed in April 1973, when the CBT formed the Chicago Board Options Exchange (CBOE) to trade options on common stocks. This was the first time an option was traded on any exchange in the world. Subsequently, in October 1975, the CBOT introduced the first futures contract on an interest rate instrument - Government National Mortgage Association futures. In January 1976, CME launched Treasury bill futures and in August 1977, the CBOT launched Treasury bond futures. In1980s, the use of cash settlement came in. In December 1981, the IMM launched cash settlement contracts, the 3-month Eurodollar futures. Cash settlement made feasible the introduction of derivatives on stock index futures. In February 1982, the Kansas City Board of Trade (KCBT) listed futures on the 33

5 Value Line Composite stock index and in April 1982, the CME listed futures on the S&P 500. These contract introductions marked the launch of futures contracts on stock indexes. In 1980s, the exchange-traded option contracts were also written on "underlying" other than individual common stocks. The CBOE and AMEX listed interest rate options in October 1982 and the Philadelphia Stock Exchange (PHLX) listed currency options in December 1982 as also options and gold futures. In January 1983, the CME and the New York Futures Exchange (NYFE) began to list options directly on stock index futures and in March 1983, the CBOE began to list options on stock indexes. Since 1970, the introductions of new products completely transformed the nature of derivatives trading activity on the exchanges. While derivatives exchanges were originally developed to help market participants manage the price risk of physical commodities, today's trading activity is focused on hedging the financial risks associated with unanticipated price movements in various underlying such as commodities, stocks, bonds, and currencies. The 1980s also saw the re-emergence of OTC derivatives trading. As derivatives on financial assets became increasingly popular, investment banks began to think of new ways to tailor contracts to meet customer needs. Some innovations were minor changes in the standard terms of exchange-traded derivatives contracts on financial instruments (e.g., modifications to the expiration date and/or the contract denomination). In 1980, the first OTC Treasury bond option was traded. Other contracts were new and seemingly different. They fall under the generic heading of "swaps". A swap contract is a contract to "swap" a series of periodic future cash flows, where the terms of the swap are usually set such that the up-front payment is zero. The first interest rate swap was in 1981, when the Student Loan Marketing Association (i.e., "Sallie Mae") swapped interest payments on intermediate-term fixed rate debt for floating-rate payments indexed to the three-month Treasury bill rate. The cash flows of the two legs of a swap can be linked to virtually any asset or index. A basis rate swap, for example, is an exchange of floating rate payments where the two floating rates are linked to, 34

6 say, a three-month Treasury bill rate and a three-month Eurodollar time deposit rate. A currency swap is an exchange of interest payments (either fixed or floating) in one currency for payments (either fixed or floating) in another. An equity swap involves the exchange of an interest rate payment and a payment based on the performance of a stock index. An equity basis swap involves an exchange of payments on two different indexes. Swap agreements may appear different from standard forward and option contracts, but they are not. Every swap can be decomposed into a portfolio of forwards and options. The benefit a swap provides is that several transactions are bundled into a single product." 6 The calendar of introduction to Derivatives Products in the Global market has been given below: Table: 2.1 Calendar of Introduction of Derivatives Products in the Global Market Year Products 1874 Commodity futures 1972 Foreign currency futures 1973 Equity options 1975 T-bonds futures 1981 Currency swaps 1982 Interest rate swaps; T notes futures; Eurodollar futures; Equity index futures; options on T-bond futures; Exchange- listed currency options 1983 Options on equity index; Options on T- notes futures; Euro-dollar futures; options on equity index futures; interest rates caps and floors 1985 Euro-dollar options; swaptions 1987 OTC compound options; OTC average options 1989 Futures on interest rate swaps; quanto options 1990 Equity index swaps 1991 Differential swaps 1993 Captions; exchange-listed FLEX options 1994 Credit default options Source: As can be seen from the above table, there have been various innovations that can be seen in the derivatives market globally. In the last four decades there have been numerous derivatives products that have been introduced globally. Since 1972, the financial futures have quickly spread to an increasing number of developed and developing countries. They are recognized as the best and most cost-efficient way of meeting the need for riskhedging felt in certain types of commercial and financial operations. In recent 35

7 years, the market for financial derivatives has grown in terms of the variety of instruments available, as well as their complexity and turnover. Countries not providing such globally accepted risk-hedging facilities are disadvantaged in today s rapidly integrating global economy Evolution of Capital Markets in India The Stock Exchanges in India has been in existence since now more than a century. Bombay Stock Exchange, commonly referred to as the BSE, is a stock exchange located in Mumbai, Maharashtra was established in 1875 as "The Native Share & Stock Brokers' Association" in BSE is Asia s first Stock Exchange and one of India s leading exchange. Over the past 137 years, BSE has facilitated the growth of the Indian corporate sector by providing it an efficient capital raising platform for a very long time. Subsequently, when the National Stock Exchange was set up in November 1992, the way markets were functioning started transforming. By 1995, all the Stock Exchanges switched over from the open outcry system to screen based online trading system. With the advent of electronic networking of stock exchanges with dealing brokers and introduction of on-line screen based trading in the Indian capital market, the capital market radically transformed during last two decades. In last two decades, the mindset of investors and all market players has changed and there has been immense confidence developed in the minds of investors in Indian Capital Market across India as well as globally. The advent of technology has also enabled the Indian Stock Exchanges to spread their operations to every nook and corner of the country and through internet to different parts of the world as well. Series of structural and functional reforms had taken place in the financial sector, bringing capital market to the global standards. Many changes have taken place in the securities/capital markets (primary/secondary markets), resulting in the total integration of the securities market, diversification of the products traded, and providing the investor a risk-free and transparent environment. Stock exchanges, in the post reform period, were freed from the direct control of the Government and placed under a professional regulatory authority, i.e. Securities & Exchange Board of India (SEBI). 36

8 The Securities and Exchange Board of India (SEBI) was established by the Government of India in 1988 through an executive resolution, and it was subsequently upgraded as a fully autonomous body (a statutory Body) in the year 1992 with the passing of the Securities and Exchange Board of India Act on January 30, In place of Government Control, a statutory and autonomous regulatory board with defined responsibilities and independent powers was set up. The basic objectives of SEBI are: to protect the interests of investors in securities; to promote the development of Securities Market; to regulate the securities market and for matters connected therewith or incidental thereto. 8 Since its inception SEBI has taken many commendable steps towards fulfilling the objectives set for it. SEBI has contributed in making the capital market a safe place to invest and be reliable by way of streamlining capitalization requirements, margining system, compulsory dematerialization, establishment of clearing corporations etc. thereby reducing market and credit risks. The Indian Capital market, further gave fillip to the Indian and global investor s confidence when the Depositories Act, 1996 was passed and National Securities Depository Limited (NSDL) and Central Depository Services Limited (CDSL) were set up. A depository is an organization, which holds the shares in the form, of electronic accounts just in the similar way as bank holds the money. This has enabled shares and securities to be held electronically instead of in the form of paper-printed documents. This has addressed many issues and provided several benefits like- it provided a safe, convenient way of holding securities; it facilitated immediate transfer of securities instead of earlier months period taken in physical deliveries; it eliminated risks associated with physical certificates such as bad delivery, fake securities, delays, thefts etc.; it helped in reducing paperwork involved in transfer of securities; it reduced transaction cost; it addressed odd lot problem as now even one share can be sold; etc. 37

9 it made process faster thereby helping the settlement cycle to today s T+2 day Another significant development in Indian capital market was launch of indexes by the Exchanges. A market Index is a convenient and effective product because of the following reasons: It acts as a barometer for market behavior; It is used to benchmark portfolio performance; It is used in derivative instruments like index futures and index options; It can be used for passive fund management as in case of Index Funds. BSE introduced Sensex index in 1986 as an indicator of the broad market. Sensex enables tracking changes of the market direction convenient to effectively gauge stock market movements. The BSE 30 Sensex was first compiled with the market capitalization weighted index of 30 Scrips. It represented 30 large well-established and financially sound companies. It was the first index to be launched by any Stock Exchange in India. BSE subsequently launched in January 1989, BSE National Index (Base: = 100). It comprised of 100 stocks listed at five major stock exchanges in India at Mumbai, Calcutta, Delhi, Ahmedabad and Madras. The BSE National Index was renamed as BSE-100 Index from October 14, 1996 and since then it is calculated taking into consideration only the prices of stocks listed at BSE. With a view to provide a better representation of the increased number of companies listed, increased market capitalisation and the new industry groups, the Exchange constructed and launched on May 27, 1994, two new indices viz., the 'BSE-200' and the 'DOLLEX-200' indices. The launch of BSE- 200 Index in 1994 was followed by the launch of BSE-500 Index and 5 sectoral indices in In 2001, BSE launched the BSE-PSU Index, DOLLEX-30 and the country's first free-float based index - the BSE TECK Index taking the family of BSE Indices to 13. NSE launched S & P CNX Nifty in April S&P CNX Nifty is a well diversified 50 stock index accounting for 23 sectors of the economy. NSE also introduced in December 1996 CNX Nifty Junior. While derivatives markets flourished in the developed world, Indian markets remained deprived of financial derivatives till beginning of 21 st century. While the rest of the world progressed by leaps and bounds on the 38

10 derivatives front, Indian market lagged behind. The exchange traded financial derivatives emerged in the global markets of the developed nations in the 1970s and their derivatives markets grew from strength to strength. The trading volumes nearly doubled in every three years making it a trillion-dollar business. The financial derivatives have become so universal that, now, one cannot think of the existence of financial markets without derivatives as its part. Indian securities markets have indeed waited for too long for derivatives trading to emerge. The development of futures trading is advancement over forward trading which has existed for centuries and grew out of the need for hedging the price risk involved in many commercial operations. Futures trading represent a more efficient way of hedging risk. Mutual Funds, FIIs and other investors who are deprived of hedging opportunities were the main beneficiaries of derivatives market. 2.3 Evolution of Derivatives Markets in India: Derivatives markets in India also have been in existence in one form or the other for a long time. The existence of characteristics of derivatives contracts is considered to be as old as epic Mahabharata. In India derivatives in the form of commodity forwards were also prevalent in 19 th century. The commodity derivative market has been functioning since the 19th century with organized trading in cotton through the establishment of Cotton Trade Association in There have been various contracts introduced on other commodities since then. But the tangible developments in this area took place only in the beginning of 20 th Century. The Bombay Securities Contract (Control) Act, 1925 was passed after the Atlay Committee recommendations to regulate activities in Stock Exchanges. It empowered the Government to grant and withdraw recognition to a stock exchange and provided that rules of a recognized stock exchange could be made or amended only after prior approval of the Government. Though the stock exchanges were in operation, there was no legislation for their regulation till this Act was enacted in This was, however, deficient in many respects. Under the constitution which came into 39

11 force on January 26, 1950, stock exchanges and forward markets came under the exclusive authority of the central government. 9 However, the commodity market activities remained unregulated. With a view to restricting speculative activity in cotton market, the Government of Bombay issued an Ordinance in September 1939 prohibiting option business. Bombay Options in Cotton Prohibition Act, 1939, later replaced the Ordinance. In 1943, the Defence of India Act was utilized on large scale for the purpose of prohibiting forward trading in some commodities and regulating such trading in others on all India basis. In the same year oilseeds forward contracts prohibition order was issued and forward contracts in oilseeds were banned. Similarly orders were issued banning forward trading in food-grains, spices, vegetable oils, sugar and cloth. These orders were retained with necessary modifications in the Essential Supplies Temporary Powers Act 1946, after the Defence of India Act had lapsed. Government with a view to evolving the unified systems of Bombay enacted the Bombay Forward Contract Control Act The Bombay Forward Contracts (Control) Act, 1947 which was applied on cotton, bullion and seeds but still the operations was not extended to stocks and shares because of BSE s objections. After Independence, the Constitution of India adopted by Parliament on 26th January, 1950 placed the subject of "Stock Exchanges and Futures Market" in the Union list and therefore the responsibility for regulation of forward contracts devolved on Government of India. The Parliament passed Forward Contracts (Regulation) Act, 1952 which presently regulated forward contracts in commodities all over India and banned cash settlement and options trading. Hence, derivatives trading subsequently shifted to informal forwards markets Evolution of Equity Derivatives Market: In 1969 government banned all forward trading in securities under the power of Section 16 of SC(R)A. Its preamble stated that it was to prevent undesirable transactions in securities by regulating business of dealings in, by prohibiting options and by providing for certain other matters connected therewith. Also Section 20 of the Act explicitly prohibited all options in securities. 10 Thus using the power of section 16, 40

12 the central government had prohibited all forwards trading in securities. In last few decades, government s policy shifted in favour of an increased role of market-based pricing. Though the Indian securities market was substantially improving day by day towards in the 90 s however it was felt that there were inadequate risk management tools. In order to provide such tools and to deepen and strengthen cash markets, a need was felt for trading of derivatives like futures and options. But introduction of futures and options was not possible in view of prohibitions in the SC(R)A and required withdrawal of these prohibitions. In line with the change in the thought process, the Government of India took its first step to opening up the derivatives market by introduction of financial derivatives trading in India by promulgating the Securities Laws (Amendment) Ordinance, It withdrew prohibition on options in securities. 11 Thus on January 25, 1995, the securities laws amendment ordinance withdrew the prohibitions by repealing section 20 of the SCRA and amending its preamble. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. Hence, SEBI set up a 24 member committee under the chairmanship of Dr L. C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 recommending among others, that the derivatives may be declared as securities under section 2(h) (iia) of the SC(R)A, so that the regulatory framework applicable to trading of securities could govern trading of derivatives also. The Dr. L.C. Gupta Committee in its report strongly favoured the introduction of financial derivatives in order to provide the facility for hedging in the most cost-efficient way against market risk. The Committee also acknowledged the fact that a soundly based derivatives market requires the presence of both hedgers and speculators. The Committee is of the opinion that there is need for equity derivatives, interest rate derivatives and currency derivatives. In the case of equity derivatives, while the Committee believes that the type of 41

13 derivatives contracts to be introduced will be determined by market forces under the general oversight of SEBI and that both futures and options will be needed, the Committee suggests that a beginning may be made with stock index futures. The Committee's recommendations on regulatory framework for derivatives trading envisaged two-level regulation, i.e. exchange-level and SEBI-level. The Committee s main emphasis is on exchange-level regulation by ensuring that the derivative exchanges operate as effective self regulatory organizations under the overall supervision of SEBI. It emphasized on a much stricter governance system is needed for the derivative exchanges in order to ensure that a derivative exchange will be a totally disciplined market place. The Committee opined that the entry requirements for brokers/dealers for derivatives market have to be more stringent than for the cash market. These include not only capital adequacy requirements but also knowledge requirements in the form of mandatory passing of a certification programme by the brokers/dealers and the sales persons. An important regulatory aspect of derivatives trading was mentioned to be strict regulation of sales practices. 12 Further, SEBI in June 1998 set up a committee under the Chairmanship of Prof. J. R. Varma to study and recommend measures for risk management in equity derivatives market in India. Prof. J. Varma Committee submitted its report in October 1998 suggesting the required risk containment measures in the form of margining system, methodology for charging initial margins, broker net-worth requirement, liquid asset definition, deposit requirement, position limits applicability, and real time monitoring requirement. The securities contracts regulation Amendment Bill, 1998 was introduced in the Lok Sabha on July 4, 1998 proposing to expand the definition of securities to include derivatives within its ambit so that trading in derivatives would be introduced and regulated under the SC(R) A. The Bill however lapsed following the dissolution of 12th Lok Sabha. 42

14 The recommendations of the Committee headed by Prof. J.R. Varma for risk containment in derivatives market were accepted by SEBI in March A fresh Bill was introduced on Oct 28, 1999 and was converted into an Act on December 16, 1999 making way for derivatives trading in India. Besides giving the definition of derivatives this act inserted subclause (ia) infection to acts to include derivatives within the ambit of securities. Since derivatives contracts are generally cash settled, these may be classified as wagers being null and void under section 30 of the Indian contracts act 1872, end it may be difficult to enforce derivatives contracts. In order to avoid such legal and Fidelity's, a new section 18 a has been inserted to provide that notwithstanding anything contained in any of the long for the time being reinforced, contracts in derivatives shall be legal and valid if such contracts are traded on a recognized stock exchange and settled on its clearing house in accordance with the rules and bylaws of such stock exchange. This means that the act prohibits OTC derivatives. Section 23 has been amended to provide that anybody who enters into a contract in contravention of section 18A shall be punishable. 14 It was well known fact that derivatives were traded in the India, as private contracts, even before introduction of exchange trades contracts in derivatives were offered. Since, these contracts were private contracts, they faced usual problems associated with such contracts such as defaults, no arbitration mechanism, no guarantee of their settlements etc. They also faced various risks associated with these private contracts such as credit risks, market risks, liquidity risks, market risks, legal risks etc. The road for stock exchange traded derivatives contracts was cleared with removal of prohibition of options on securities by way of amendment to Securities Laws through Securities Laws (Amendment) Ordinance, Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May The Dr. L.C Gupta Committee on Derivatives had also permitted existing stock exchanges having cash trading to trade in derivative 43

15 contracts through a separate segment with separate membership. However, it was required that the derivative segment of an exchange and its Clearing House/ Corporation shall be separate from the cash segment in the following areas The legal framework governing trading, clearing and settlement of the derivative segment should be separate from the cash market segment. In other words, the Regulations and / or Bye-laws of derivative segment, as the case may be for specific exchanges, shall be separate from the cash market. Trade Guarantee Fund (TGF)/Settlement Guarantee Fund (SGF) of the derivative segment shall be separate from the TGF/SGF of cash market segment. Membership of the derivative segment shall be separate from the cash market segment. The Governing Council/Clearing Council/Executive Committees of the derivative segments shall be separate from the cash market segment. The separation, if any, as regard to the functional, operational and administrative modalities were left at the discretion of the Exchange. The cash and derivative segment of an Exchange were also permitted to have common personnel, trading terminal and infrastructure. As per SEBI guidelines, the exchanges fulfilling the eligibility criteria as prescribed in Dr. L.C. Gupta Committee Report are eligible to apply to SEBI for grant of recognition under Section 4 of the Securities Contract Regulation Act, It is also required that the derivatives exchange/segment should have a separate governing council and representation of trading/clearing members should be limited to maximum of 40% of the total members of the Governing Council. The exchange is also required to regulate the sales practices of its members and need to obtain prior approval of SEBI before start of trading in any derivatives contract. 15 At that time in 2000, there were 23 stock exchanges recognized by SEBI for offering equity market trading in India. In the Capital Market, the stock exchanges need to be recognized under the Securities 44

16 Contracts (Regulation) Act, The Stock Exchanges are required to obtain the recognition/registration from SEBI to be eligible to offer trading in various segments in the Indian Market. As on March 31, 2012, there were 20 Stock Exchanges recognized/ registered by SEBI for trading in various segments such as Equity, Equity Derivatives and Currency Derivatives in India. The names of these are: Ahmedabad Stock Exchange Limited (ASE) Bangalore Stock Exchange Limited (BgSE) Bhubaneswar Stock Exchange Limited (BhSE) Bombay Stock Exchange Limited (BSE) Calcutta Stock Exchange Limited (CSE) Cochin Stock Exchange Limited (CoSE) Delhi Stock Exchange Limited (DSE) Gauhati Stock Exchange Limited (GSE) Inter-connected Stock Exchange (ISE) Jaipur Stock Exchange Limited (JSE) Ludhiana Stock Exchange Limited (LSE) MCX SX Exchange Limited (MCXSX) Madhya Pradesh Stock Exchange Limited (MPSE) Madras Stock Exchange Limited (MSE) National Stock Exchange of India Limited (NSE) OTC Exchange of India (OTCEI) Pune Stock Exchange Limited (PSE) Vadodara Stock Exchange Limited (VSE) U.P. Stock Exchange Limited (UPSE) United Stock Exchange of India Limited (USE) Out of the above Stock Exchanges, Securities and Exchange Board of India (SEBI) permitted only NSE and BSE to launch the derivative segments and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty Index and BSE-30 (Sensex) Index. In June 2000, exchange-traded equity derivatives were introduced at the two national stock exchanges, National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). This was followed by approval for trading in options based on these two 45

17 indices and options on individual securities. The trading in index options commenced in June The trading in Stock Options commenced on July 2001 & Stock Futures on November 2001, the approval for trading Interest rate Futures was given in June In India, the Index option contracts are cash settled European style options and the Stock options are also cash settled American style contracts. Interest rate derivatives are based on notional 10 year bond and 91 days T-bills. All the exchange traded equity derivatives contracts in India today are cash settled contracts. Till recent time (2012), only two exchanges in India were permitted to offer trading in equity derivatives contracts by SEBI viz. NSE and BSE. It was only on July 11, 2012, the third exchange MCX-SX has been given permission to facilitate the trading in equity derivatives contracts Reference to Commodity and Currency Derivatives Market in India: In the commodities market, by a notification issued on March 1, 2000, the government lifted the three decades old prohibitions on forward trading in securities by repealing 1969 notification. During that period, national electronic commodity exchanges were also set up. The National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform for commodities trading. In India, under the Forward Contracts (Regulation) Act, 1952, forward trading in commodities notified under section 15 of the Act can be conducted only on the Exchanges, which are granted recognition by the Central Government (Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution). All the Exchanges, which deal with forward contracts, are required to obtain certificate of Registration from the Forward Markets Commission (FMC). 16 At present 22 Exchanges are recognized / registered for forward / futures trading in commodities. 46

18 Hence, in Commodity Derivatives as of 2012 there are five national commodity exchanges recognized by Forward Market Commission (FMC) to offer trading in contracts of commodity derivatives in India. The names of these national commodity exchanges are as follows: Multi Commodity Exchange of India Ltd., Mumbai (MCX) National Commodity & Derivatives Exchange Ltd., Mumbai (NCDEX) National Multi Commodity Exchange of India Limited, Ahmedabad (NMCE) Indian Commodity Exchange Limited, New Delhi (ICEX) Ace Derivatives and Commodity Exchange Limited, Mumbai (ACE) Also there are various other regional commodity exchanges operating in India as recognized by FMC, the details of whom are as given below: Bikaner Commodity Exchange Ltd., Bikaner Bombay Commodity Exchange Ltd., Vashi Chamber Of Commerce, Hapur Central India Commercial Exchange Ltd., Gwalior Cotton Association of India, Mumbai East India Jute & Hessian Exchange Ltd., Kolkata First Commodities Exchange of India Ltd., Kochi First Commodities Exchange of India Ltd., Kochi Haryana Commodities Ltd., Sirsa India Pepper & Spice Trade Association., Kochi Meerut Agro Commodities Exchange Co. Ltd., Meerut National Board of Trade, Indore Rajkot Commodity Exchange Ltd., Rajkot Rajdhani Oils and Oilseeds Exchange Ltd., Delhi Surendranagar Cotton oil & Oilseeds Association Ltd., Surendranagar Spices and Oilseeds Exchange Ltd., Sangli Vijay Beopar Chamber Ltd., Muzaffarnagar It may be noted here that, the Government of India identified the best international systems and practices in respect of trading, clearing, settlement and governance structure and invited applications from 47

19 associations - existing and potential - to set up National Commodity Exchanges by introducing such systems and practices. The term, "National" used here for these Exchanges does not mean that other regional Exchanges are restricted from having nationwide operations. Further, National Commodity Exchanges are granted recognition in all permitted commodities by FMC whereas the other regional exchanges have to approach the FMC for grant of recognition for each futures contract separately. There are also two national spot exchanges operating in India offering spot trading in commodities. They are: NCDEX Spot Exchange Ltd (NSPOT) National Spot Exchange Limited (NSEL) There were also largely three stock exchanges namely NSE, BSE and MCX-SX permitted to offer the contracts in currency derivatives segment in India since they were permitted in India in At later date, BSE entered into arrangement with United Stock Exchange of India Ltd (USEIL) and BSE suspended its currency derivatives segment operations and USEIL started offering the same. Thus at all point of times, there were only three major stock exchanges which offered the trading in Currency Derivatives in India. 2.4 Development of Equity Derivatives Markets in India The Exchanges play a very important role in the entire system of derivatives trading in India since the exchanges are required to design contracts which are traded on the Exchanges. These contracts are not capable of being modified by any participants, i.e., these contracts are standardized. The Exchanges also provide the trading platform, which facilitates the bid and offer platform which emanate from geographically dispersed locations across India and now with electronic media across globe. The Exchanges are also required to provide facilities for clearing, settlement, risk management, arbitration mechanism and other relevant functions related to the trading activity in the derivatives contracts. The Exchanges are also required to provide financially secured environment by putting in place suitable risk management mechanism 48

20 (margining system etc.) and guaranteeing settlement performance of contract through the process of novation. In equity derivatives, NSE has a market share in the total turnover of the derivatives market in India of almost 100 percent. Hence, while giving the market structure, eligibility of stocks in derivatives market, risk management system and other relevant structures in the derivatives segment of the exchanges the reference and inferences are drawn from the derivatives segment of NSE. The derivatives trading on NSE commenced with popular benchmark S&P CNX Nifty Index futures on June 12, The trading in S&P CNX Nifty Index Options commenced on June 4, The trading on NSE in Single Stock Options and Single Stock Futures commenced on July 2, 2001 and November 9, 2001 respectively. NSE launched trading in Interest Rate Futures on June 24, The first sector specific futures and options in the form of CNX IT Futures & Options were launched in August 29, 2003 for trading. Since then, there are many other sector specific and index futures and options such as Bank Nifty Futures & Options, CNX Nifty Junior Futures & Options, CNX 100 Futures & Options, Nifty Midcap 50 Futures & Options, Mini Nifty Futures & Options on S&P CNX Nifty, Long term Options on S&P CNX Nifty, S&P CNX Defty Futures and Options etc are launched by NSE for trading. The Interest Rate Futures introduced by NSE were subsequently banned due to pricing issue. The Sensex Index Futures on BSE were introduced on June 09, Subsequently, the Index Options on Sensex were introduced on June 1, The stock options in 109 stocks and stock futures in 109 stocks were introduced by BSE on July 9, 2001 and November 9, 2002 respectively. Subsequently, BSE also introduced weekly Options on 4 Stocks on September 13, 2004 and Futures & Options on various sector specific indices such as BSE TECK, BSE FMCG, BSE Metal, BSE Bankex and BSE Oil & Gas etc. The table given below gives the chronology of events about the development of derivatives market in India: 49

21 Table: 2.2 Development of Equity Derivatives Markets in India: A Chronology of events Date Dec. 14, 1995 Nov. 18, 1996 May 11, 1998 July 07, 1999 May 24, 2000 May 25, 2000 Jun. 09, 2000 Jun. 12, 2000 Aug. 31, 2000 Sep., 2000 Jun. 01, 2001 Jun. 04, 2001 Jul. 02, 2001 Jul. 09, 2001 Nov. 09, 2001 Nov. 01, 2001 Jun. 24, 2003 Oct Aug. 29, 2003 Jan., 2004 Sep. 13, 2004 Jun. 13, 2005 Jun. 01, 2007 Jun. 01, 2007 Oct. 05, 2007 Dec. 27, 2007 Jan. 1, 2008 Jan. 1, 2008 Jan. 11, 2008 Feb. 29, 2008 Mar. 03, 2008 Aug. 29,2008 Oct. 2,2008 Oct. 08, 2008 Dec. 10, 2008 Gist of events NSE sought permission from SEBI to start trading in index futures. SEBI setup L. C. Gupta Committee to draft a policy framework for index futures. L. C. Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced on BSE. Trading of Nifty futures commenced on NSE. Trading of futures and options on Nifty to commence on Singapore International Monetary Exchange (SIMEX) SIMEX (now known as Singapore Stock Exchange -SGX) introduces Nifty Futures on its exchange Index Options launched on BSE Trading of Equity Index Options on NSE Trading of Single Stock Options on NSE Stock Options launched on BSE Trading in Single Stock Futures on NSE Trading of Single Stock futures on BSE Trading of Interest Rate Futures on NSE Trading in Interest Rate Futures withered out Trading of CNX IT Futures and Options on NSE Permitted introduction of Futures contracts on a basket of GoI securities Weekly Options on BSE Trading on Bank Nifty Futures and Options on NSE Trading CNX Nifty Junior Futures and Options on NSE Trading CNX 100 Futures and Options on NSE Trading Nifty Midcap 50 Futures and Options on NSE SEBI permitted introduction of mini derivative (Futures and Options) contract on Index -Sensex and Nifty Trading of Chhota (Mini) Sensex Futures & Options on BSE Trading of Mini Nifty Futures & Options on S&P CNX Nifty on NSE SEBI permitted Exchanges to introduce option contracts on SENSEX and Nifty with a longer tenure of up to five years BSE introduced Long Dated Options' on its index Sensex on February 29, 2008 with an expiry of up to 3 years Trading of Long term Options (upto 5 years) on S&P CNX Nifty on NSE Launch of Currency Futures contracts in USD-INR on NSE Trading of Currency Futures contracts in USD-INR on BSE Launch of Currency Futures contracts in USD-INR on MCX-SX Trading of S&P CNX Defty Futures and Options on NSE 50

22 Aug. 07, 2009 Aug. 31, 2009 Feb. 01, 2010 Apr. 27, 2010 Jul. 15, 2010 Jul. 30, 2010 Oct. 04, 2010 Sep. 11, 2011 Mar. 30, 2012 Jul. 16, 2012 Nov. 20, 2012 BSE-United Stock Exchange (USE) form alliance to develop Currency and Interest Rate Derivatives Markets Re-introduced Trading in Interest Rate Futures on NSE under Currency Derivatives Launch of currency futures on additional currency pairs such as Euro-INR, Pound Sterling-INR and Japanese Yen-INR on NSE and MCX-SX SEBI permitted Stock Exchanges to introduce derivatives contract on volatility index SEBI allowed Stock Exchanges to introduce physical settlement stock options and/or stock futures SEBI allowed introduction of options on USD-INR spot rate on currency derivatives segment of stock exchanges EUREX-SENSEX Futures launched by BSE SEBI permitted Stock Exchanges to introduce derivative contracts (Futures and Options) on foreign stock indices in the equity derivatives segment BSE launched trading in BRICMART indices derivatives SGX launches Nifty Options on its exchange SEBI banned trading in Futures & Options mini contracts on indices which came with a minimum contract size of Rs 1 lakh to protect retail investor Source: Compiled from BSE, NSE and SEBI As can be seen from the above table giving the chronology of events in the equity derivatives market in India, the equity derivatives market has been constantly seen some development or the other year after year. As can be seen from the above, it took almost four and half years for SEBI to evaluate the proposal of NSE to start equity derivatives in India. However, once the permission was granted by SEBI in May 2000, there have been many new products that have been introduced and SEBI has also granted permission for various developments in the equity derivatives market. 2.5 Comparison of Equity Derivatives Indices and Stocks on NSE and BSE The trading activity in India consistently grew over a period of time. The number of underlying indexes has also seen steady increase over the years. It was necessary to understand the growth of stocks introduced for trading in the equity derivatives on these exchanges. The table below narrates the story of the underlying indices and stocks in the equity derivatives market since their introduction on the derivatives stock exchanges: 51

23 Financial Year Table: 2.3 Equity Derivatives Indices and Stocks Traded on NSE and BSE NSE-Stocks NSE Index(es) BSE-Stocks BSE Index(es) * Source: Compiled from SEBI, BSE and NSE *For the year , the date has been taken as November 15, 2012 for the number arrived As can be seen from the above, the indices traded on both the derivatives exchanges have grown year after year. The stocks qualifying on NSE have been largely found to be more than that of BSE. However, both these exchanges have common stocks traded on them. Further, the stocks traded in the equity derivatives market on these exchanges have been inconsistent. The stocks traded on the exchanges were growing till , which started decreasing since then. Today, there almost half the number of stocks traded on the exchanges compared to the peak number of stocks traded on the Exchanges. 2.6 Equity on BSE: India has really seen exponential growth of the equity derivatives market especially at NSE. The equity derivatives trading on NSE has grown multifold and even overtaken the cash market turnover since The cash equity turnover has also seen a good growth in India in the last decade. The exchanges BSE and NSE have emerged as major equity exchanges over a period of last decade. The other exchanges have either become defunct or have started trading on these two major stock exchanges through their subsidiaries. 52

24 Year The details of Equity on BSE for the period from till have been given in the table below: Table: 2.4 Equity on BSE during the period from till No. of Compan ies Listed No. of Compan ies Traded No. of Tradin g Days No. of Trades (in Lakhs) Traded Quantity (in Lakhs) (in Rs. crores) Avg Daily Turnove r (in Rs. crores) Market Capitaliz ation (in Rs. crores) % increase in on previous year ,861 NA ,031 45, ,88,146 NA ,585 NA ,834 84, ,68, % ,702 NA ,07,248 67, ,68, % ,603 NA ,185 50, ,63, % ,832 1, ,926 1,24, ,05, % ,853 1, ,877 2,07, ,30, % ,849 2, ,29,272 3,10,750 1,279 6,19, % ,815 2, ,08,635 6,86,428 2,735 9,12, % ,869 1, ,428 2,58,511 10,00,032 3,984 5,71, % ,782 2, ,277 1,82,196 3,07,292 1,244 6,12, % ,650 2, ,413 2,21,401 3,14,073 1,251 5,72, % ,528 2, ,028 3,90,441 5,03,053 1,981 12,01, % ,731 2, ,374 4,77,171 5,18,715 2,050 16,98, % ,781 2, ,640 6,64,455 8,16,074 3,251 30,22, % ,821 2, ,462 5,60,777 9,56,185 3,840 35,45, % ,887 2, ,303 9,86,010 15,78,857 6,290 51,38, % ,929 3, ,408 7,39,600 11,00,074 4,527 30,86, % ,975 3, ,056 11,36,513 13,78,809 5,651 61,65, % ,067 2, ,285 9,90,777 11,05,027 4,333 68,39, % ,133 2, ,944 6,54,137 6,67,498 2,681 62,14, % Source: Compiled from SEBI and BSE NA Not Available or Not Applicable As can be seen from the above table, total number of companies listed in BSE had grown since till and had started falling only since till The number of companies listed since has continuously seen some increase. However, the number of companies traded on BSE has been growing somewhat constantly barring few years. In terms of turnover on the exchange, it had seen huge deep in the year over the previous year by %. Subsequently, it was steadily growing till Since, the market crash in , the market volume had been declining over the previous year except for the year