Financial Derivatives Market: An analysis for the decade

By: T. MUTHUKUMARAN Dr V.K. SOMASUNDARAM Financial Derivatives Market: An analysis for the decade Derivatives trading commenced in India in June 2000 after the Securities and Exchange Board of India (SEBI) granted the final approval in May 2001 on the recommendation of the L.C. Gupta Committee. Despite the encouraging growth and developments, industry analysts feel that the derivatives market has not yet realised its full potential. which have no independent value. Their value depends upon the underlying asset. The underlying asset may be financial or non-financial in nature. Derivative products like futures and options in the Indian stock markets have become important instruments of price discovery, portfolio diversification and risk hedging in recent times. In the last decade, many emerging and transition economies have started introducing derivatives contracts. Role of financial derivatives The global liberalisation and integration of financial markets has created new investment opportunities, which, in turn, require the development of new instruments that are more efficient to deal with the increased risks. Institutional investors who are actively engaged in industrial and emerging markets need to hedge their risks from these internal as well as cross-border transactions. The most desired instruments that allow market participants to manage risks in the modern securities trading are known as derivatives. Derivatives are instruments Derivatives may be traded for a variety of reasons. Derivatives enable a trader to hedge against risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (that is, taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular 14 FACTS FOR YOU March 2011

Date December 14, 1995 November 18, 1996 May 11, 1998 July 7, 1999 May 24, 2000 May 25, 2000 June 9, 2000 June 12, 2000 August 31, 2000 June 2001 July 2001 November 9, 2002 June 2003 September 13, 2004 January 1, 2008 January 1, 2008 August 29, 2008 October 2, 2008 November 27, 2008 March 2009 January 8, 2010 March 6, 2010 August 10, 2010 September 20, 2010 Source: BSE & NSE Table I A Trace of Derivatives in India Progress NSE asked SEBI for permission to trade index futures. SEBI set up 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 at BSE. Trading of Nifty futures commenced at NSE. Trading of futures and options on Nifty to commence at SIMEX. Trading of Equity Index Options at NSE Trading of stock options at NSE Trading of single stock futures at BSE Trading of interest rate futures at NSE Weekly options at BSE Trading of chhota (mini) Sensex at BSE Trading of mini index futures and options at NSE Trading of currency futures at NSE Trading of currency futures at BSE A clearing and settlement arrangement on a non-guaranteed basis was put in place for the OTC interest rate derivatives trades 13 members participated in the non-guaranteed settlement of OTC rupee interest-rate derivatives SEBI standardises lot size for equity derivatives SEBI for physical delivery in equity derivatives segment Currency futures opened for NBFCs USE to begin currency futures trading trade was for hedging or speculation, and active markets require participation of both the hedgers and speculators. History of derivatives market in India Derivatives market in India has been in existence in one form or the other for a long time. In commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In 1952, the Government of India banned cash settlement and options trading. Derivatives trading shifted to informal forwards markets. In recent years, the government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options in securities. The last decade, beginning the year 2000, saw the ban on futures trading being lifted in many commodities. Around the same period, national electronic commodity exchanges were also set up. Derivatives trading in India Derivatives trading commenced in India in June 2000 after the Securities and Exchange Board of India (SEBI) granted the final approval in May 2001 on the recommendation of the L.C. Gupta Committee. SEBI permitted the derivatives segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Initially, SEBI approved trading in index futures contracts based on various stock market indices such as S&P CNX, Nifty and Sensex. Subsequently, index-based trading was permitted in options as well as individual securities. Regulation of derivatives trading in India 1. The regulatory framework in India is based on the L.C. Gupta Committee Report and the J.R. Varma Committee Report. 2. It is mostly consistent with the International Organisation of Security Commission (IOSCO) principles and addresses the common concerns of investor protection, market efficiency and financial integrity. 3. The L.C. Gupta Committee report provides a perspective on the division of regulatory responsibility between the exchange and SEBI. 4. It recommends that SEBI s role should be restricted to approving rules, bye-laws and regulations of a derivatives exchange. 5. It emphasises the supervisory and advisory role of SEBI with a view to permitting desirable flexibility, maximising regulatory effectiveness and minimising regulatory cost. March 2011 FACTS FOR YOU 15

Table II Total Derivatives Contract and Turnover Since Inception (Turnover in Rs billion) Year NSE BSE Total Number of contracts Turnover Number of contracts Turnover Number of contracts Turnover 2000-01 90,580 23.65 77,743 16.73 168,323 40.38 2001-02 4,196,873 1,019.26 105,023 19.26 4,301,896 2,088.75 2002-03 46,768,909 4,398.62 138,011 24.77 46,906,920 5,803.50 2003-04 56,875,995 21,304.08 382,288 120.74 57,258,283 25,247.70 2004-05 77,017,185 25,469.82 531,719 161.13 77,548,904 30,948.14 2005-06 160,619,271 48,241.74 203 0.09 160,619,474 48,243.86 2006-07 216,883,573 73,562.42 1,781,217 590.06 218,664,790 91,964.65 2007-08 425,013,200 130,904.78 7,453,371 2,423.08 432,466,571 207,861.57 2008-09 657,390,497 107,904.82 496,502 117.75 657,886,999 112,987.59 2009-10 679,293,922 176,636.65 9,028 2.34 679,302,950 176,729.27 Source: BSE & NSE Table III Product-wise Volume and Turnover in NSE (Turnover in Rs billion) Year Index futures Stock futures Index options Stock options Number of Turnover Number of Turnover Number of Turnover Number of Turnover contracts contracts contracts contracts 2000-01 90,580 23.65 2001-02 1,025,588 214.83 1,957,856 515.15 175,900 37.65 1,037,529 251.63 2002-03 2,126,763 439.52 40,676,843 2,865.33 442,241 92.46 3,523,062 1,001.31 2003-04 17,191,668 5,544.46 32,368,842 13,059.39 1,732,414 528.16 5,583,071 2,172.07 2004-05 21,635,449 7,721.47 47,043,066 14,840.56 3,293,558 1,219.43 5,045,112 1,688.36 2005-06 58,537,886 15,137.55 80,905,493 27,916.97 12,935,116 3,384.69 8,240,776 1,802.53 2006-07 81,487,424 25,395.74 104,955,401 38,309.67 25,157,438 7,919.06 5,283,310 1,937.95 2007-08 156,598,579 38,206.67 203,587,952 75,485.63 55,366,038 13,621.11 9,460,631 3,591.37 2008-09 210,428,103 33,501.11 221,577,980 34,796.42 212,088,444 37,315.02 13,295,970 2,292.27 2009-10 178,306,889 39,343.89 145,591,240 51,952.47 341,379,523 80,279.64 14,016,270 5,060.65 Source: NSE 6. Regulatory requirements for authorisation of derivatives brokers or dealers include capital adequacy, net worth, certification requirement and initial registration with SEBI. 7. It also suggests establishment of a separate clearing corporation, maximum exposure limits, mark to market margins, margin collection from clients and segregation of clients funds, regulation of sales practice and accounting, and disclosure requirements for derivatives trading. 8. The J.R. Varma Committee suggests a methodology for risk containment measures for index-based futures and options, stock options and single stock futures. The risk containment measures include calculation of margins, position limits, exposure limits, and reporting and disclosure. Growth of derivatives market in India Equity derivatives market in India has registered an explosive growth and is expected to continue the same way 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 16 FACTS FOR YOU March 2011

Table IV Product-wise Volume and Turnover in BSE (Turnover in Rs million) Year Index futures Stock futures Index options Stock options Call Put Call Put Number of Turnover Number of Turnover Number of Turnover Number of Turnover Number of Turnover Number of Turnover contracts contracts contracts contracts contracts contracts 2000-01 77,743 16,730 2001-02 79,552 12,760 17,951 4,520 1,139 390 1,276 450 3,605 790 1,500 350 2002-03 111,324 18,110 25,842 6,440 41 10 2 0 783 210 19 0 2003-04 246,443 65,720 128,193 51,710 1 0 0 0 4,391 1,740 3,260 1,570 2004-05 449,630 136,000 6,725 2,130 48,065 14,710 27,210 8,270 72 20 17 0 2005-06 89 50 12 10 100 30 0 0 2 0 0 0 2006-07 1,638,779 554,910 142,433 35,150 2 0 2 0 0 0 1 0 2007-08 7,157,078 2,346,600 295,117 76,090 951 310 210 80 9 0 6 0 2008-09 495830 117,570 299 90 251 60 122 30 0 0 0 0 2009-10 3744 960 8 0 5,276 1,380 0 0 0 0 0 0 Source: BSE & SEBI Table V Top 5 Exchanges by Number of Stock Index Futures CME Group 373,562,635 387,676,929 3.6 EUREX 211,119,321 211,855,381 0.3 National Stock Exchange of India 79,554,314 105,431,318 24.5 Osaka Securities Exchange 71,819,297 61,849,732 16.1 NYSE Liffe Europe 49,227,075 48,120,912 2.3 per cent of the derivatives trading in Indian markets. If one compares 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. Turnover in the derivatives segment since inception is shown in Table II. During 2000-01, turnover on NSE was Rs 23.65 bllion and during 2009-10, it was Rs 176,636.65 billion. Likewise, during 2000-01 turnover on BSE was Rs 16.73 billion and during 2009-10, it was Rs 2.34 billion. Turnover on BSE increased till 2004-05 but during 2005-06 there was a noticeable decrease in turnover. The turnover on BSE started increasing since 2006-07. At NSE, during the period 2001 to 2010, turnover was the highest in 2009-10. At BSE, practically, no derivatives trading took place in the period 2005-06. However, since 2006-07 the turnover started increasing. Over the given period, the maximum turnover in NSE was Rs 176,636.65 billion, while in BSE it was Rs 2,423 billion. The index futures trading at NSE commenced on June 12, 2000 on S&P CNX Nifty Index. Index futures at NSE are currently available on indices like S&P CNX Nifty, Nifty Midcap 50, CNX IT and CNX Bank. Among the Index Futures products at NSE, the share of Nifty Futures is around 94 per cent. This shows that Nifty Futures have been the most prominent and popular product to enable wider participation of retail investors in the derivatives markets. Table III shows the journey of index futures since 2000. Over a period of time many indices have been made available for index futures trading. The index futures turnover at NSE grew from Rs 23.65 billion to Rs 39,343.89 billion in 2009-10. The trading in single stock futures started on November 9, 2001. Table III shows the business growth of stock futures at NSE in terms of number of contracts traded and turnover since inception. Stock futures at NSE grew from Rs 515.15 billion to Rs 51,952.47 billion in 2009-10. As of March 2010, there were 190 stocks available for trading at NSE and the Index options were allowed for trading on S&P CNX Nifty Index on June 4, 2001. Worldwide, options have been the most preferred product in derivatives trading. However, in India, in the beginning the preferred product of derivatives trading was futures. The growth of index options at NSE March 2011 FACTS FOR YOU 17

Table VI Top 5 Exchanges by Number of Single Stock Future NYSE Liffe Europe 198,955,076 115,450,139 72.3 EUREX 118,123,693 93,714,781 26 National Stock Exchange of India 74,154,830 80,669,667 8.1 Johannesburg SE 37,002,890 47,916,565 22.8 Korea Exchange 21,881,547 22,673,290 3.5 Table VII Top 5 Exchanges by Number of Stock Index Options Korea Exchange 1,671,466,852 1,375,065,894 21.6 National Stock Exchange of India 221,430,570 146,706,110 50.9 EUREX 173,244,615 204,870,100 15.4 Chicago Board Options Exchange 147,176,493 106,219,417 38.6 TAIFEX 48,775,481 40,839,780 19.4 in terms of turnover has been from Rs 37.65 billion to Rs 80,279.64 billion in 2009-10. The single stock options were allowed for trading on July 2, 2001. Stock options at NSE grew from Rs 251.63 billion to Rs 5,060.65 billion in 2009-10. As of March 2010, there were 190 stocks options available for trading at NSE. International markets The derivatives segment has expanded substantially in recent years both globally as well as in the Indian capital market. The exchanges of the developed markets have shown robust growth and maintained their leadership position. At the same time, developing and emerging market exchanges have gained a position of eminence with strong growth. It is evident from Table V to VIII that the Indian market has emerged stronger along with markets in Korea, Spain and Israel. Emerging trends 1. Investors are gradually becoming more market-savvy. 2. Information and communication technology (ICT) has started revolutionising financial markets. 3. Electronic trading is replacing pit-trading all over the world at an increasing rate. 4. The need for better cooperation/coordination among regulators is increasing to understand crossborder movements of funds of ambiguous origin and purpose. 5. Emergence of MNC/supranational financial institutions has brought about financial integration. Envisioning the future 1. Indian markets becoming vibrant and achieving a leading status in the global financial system with the introduction of derivatives. 2. ICT becoming all pervasive, and playing a critical role in minimising information asymmetry in the markets leading to an efficient price-discovery and investor protection. 3. Organised exchanges becoming the institutions that help in achieving efficiencies of scale, transparency in price discovery, orderly conduct of transactions and evolving as one-stop financial shopping malls of the future. 4. Organised exchanges becoming self regulatory in the true sense of word with complete shift to principle-based regulation, away from today s rule-based regulation. 5. Market participants building enough knowledge base so as to shift from compliance-based supervision to risk-based supervision. 6. Operational aspects of the business being given to the organised exchanges. 7. The regulators to play the role of enablers in a true sense, moving away from day-to-day directions to the participants and interventions in the markets. Vibrant market in India India is one of the most successful developing countries in terms of a vibrant market for exchangetraded derivatives. This reiterates the strengths of the modern development of India s securities markets which are based on nationwide market access, 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 sophis- 18 FACTS FOR YOU March 2011

Table VIII Top 5 Exchanges by Number of Stock Options Chicago Board Options Exchange 463,486,201 463,756,036 0.1 BM&FBOVESPA 424,137,525 235,338,378 80.2 International Securities Exchange 398,680,825 498,252,797 20 NASDAQ OMX PHLX 262,650,693 297,065,194 11.6 EUREX 143,320,872 161,303,588 11.1 ticated 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 also fueled the growth of derivatives in India. Despite the encouraging growth and developments, industry analysts feel that the derivatives market has not yet realised its full potential in terms of growth and trading. Analysts point out that the equity derivative markets on the BSE and NSE have 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 NSE and BSE recently added more products in their derivatives segment (weekly options, currency futures, mini index, etc), their number is still far less than the depth and variety of products prevailing across many developed capital markets. As Indian derivatives markets become more sophisticated, greater investor awareness will become essential. NSE has programmes to inform and educate brokers, dealers, traders and market personnel. In addition, institutions will need to devote more resources to develop the business processes and technology necessary for derivatives trading. T. Muthukumaran is an assistant professor at Saradha Gangadharan College, Puducherry, and Dr V.K. Somasundaram is head at the post graduate and research department of corporate secretaryship, Bharathidasan Govrnment College for Women (an autonomous institute), Puducherry March 2011 FACTS FOR YOU 19