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The Indian capital markets have metamorphosis over the last few
years. A sea changes in the stock markets have seen
dematerialized stocks, faster settlements, increased
transparency, reduced fraud and competitive costs. The
introduction of derivatives in the market required the existence of
a clean, efficient and paperless cash market, which was delivered
just in time. Introduction of exchange traded derivatives in June,
2000 was proceeded by parleys for over 5 years, involving a lot of
serious deliberations for introducing the best practices from
around the world. Before discussing the forward trading in Indian
stock market, a brief view of functioning of stock exchanges in
India is discussed in this section.
Competition amongst the two largest exchanges has brought enormous benefits to
shareholders in terms of providing better and more cost effective services. As if that
were not enough, a competing depository (established by the BSE) has brought
down prices in that industry by over 80 percent. The market for exchange traded
derivatives started in June of 2000 when the two stock exchanges almost
simultaneously started trading in futures on indices. The exchanges created
separate segments where derivatives trading would take place. These segments
would have a separate set of regulations and a separate clearing and settlement
mechanism. The guarantee fund is also separate from the stock market (also called
the cash segment). The last few months have seen a movement in the cash
segment to a T+ 5 settlement and beginning 1 April, 2002 the exchanges have
moved to a T+ 3 settlement, with daily) net settlement (i.e., a buy and a sell order
of the same person made on a day shall be set off). Reduction of fraud, easing of
costs, easing of complications and a virtual elimination of mistakes in clearing and
settlement of securities have made the Indian capital markets amongst the best in
terms of efficiency technology and costs. Unfortunately, with the recent downturn in
the economy, liquidity has dried up and exchanges are facing larger volatility in
stocks. The markets in derivatives, though they took off with I tepid start, have seen
double digit growth almost every month over the last year. The exchanges are
clamoring for a smaller contract size and, therefore, access to more investors. With
growing evidence that small investors benefit greatly from investing in stock futures
rather than from investing in mutual funds, the case of protecting smaller investors
by keeping them away from the derivatives market might not sound very noble in
the future.
• Group 'B,' has weekly settlement and is at par with group 'A'
in every respect, but carry forward is not allowed in its case.
It includes actively traded securities.
Trading Systems
Most of the exchanges carry out stock trading transactions on either 'cash basis' or
'carry over' basis, though their own clearing houses. Let us discuss herein brief the
system of trading in general which is anally followed on the stock exchanges.
The trading business in 'Group A' securities is settled through clearing houses in
addition to other methods of settlements. The year of a stock exchange is divided
periods called 'Accounts' which normally runs into a fortnight; but sometimes, it
may be of a longer durations of three to four weeks. Thus, all the transactions
performed during that period (one account period) are settled by payment and
delivery of securities by the traders on the 'notified days' of the clearing programme
of a given stock exchange.
3. He can carry over the contract to the next settlement. In other words, if an
investor has purchased some shares but has no money to pay for delivery then he
can request to his broker to cany forward his business transaction to the next
settlement account. In such situation, the broker of the investor would then find out
someone who would pay on due date, (also called as pay-in day) on the behalf of
the investor and would take delivery of the shares. The financer who finances in
such carry forward transaction will charge interest on such funds, this is also known
as 'cantango' or badla, for the fortnight till the next pay-in-day. Similarly, on the
other side, the seller, sometimes, may also have to pay the 'charge' to the buyer
when the shares are over sold and the buyer demands the delivery of the shares,
this is known as 'backwardation charges' or 'andha badla'. The badla system or
charges play a significant role in forward trading. This system has to be operated
with the approval of the concerned stock exchange which may even fix badla
charges H under exceptional circumstances.
Differences
• The price for future delivery is defined in advance in the forward
trading whereas in 'badla* it is known only at the time of final
settlement Badla charges change from time to time.
In general, a customer has to sign a stock loan consent from which allows
the broker to lend the clients' securities to others for short sales. Short
sellers provide liquidity to genuine investors. Further, badla operators also
provide finance to the members who need to meet their commitment in the
current settlement and transfer their position to the later settlement.
Ban on Badla System
• The stock exchange should record and report at the end of trading
period, transactions into those for delivery, jobbing, carry forward and
own account separately. This is known as four track trading. However,
the SEBI implemented as a thin trade system in which transaction for
delivery were separated from those for carry forward.
• A daily margin at the flat rate of 15 percent will be recorded from the
brokers for carry forward deals and on a marked-to-market basis every
week. Margin will depend upon the volatility of share prices.
Since the market operators and speculators made a lot of resentment over
the implementation of the RCFS, ultimately the SEBI set up another
committee J.R. Committee in March, 1997 to review this revised system. The
Committee submitted its report in July, 1997 and its main recommendations
(popularly known as the Modified Carry Forward System or MCFS), are as
follows:
• The new system should be introduced only when an exchange has the
necessary software for calculating margins on a daily basis.
• The scrips chosen for carry forward trade should have sufficient
floating stock.
• The financiers should be allowed to take custody of the shares with
safeguards in case of vyaj badla. The shares lent by badla financiers
will continue to be deposited with the clearing house.
Further to enhance liquidity and to shorten the carry forward cycle, the SEBI
has introduced compulsory rolling settlement on a T+ 5 basis for 119 scrips
from May 8,2000 and which are subject to compulsory dematerialized
trading. The SEBI has also instructed to the stock exchanges to complete
their settlement within seven days and to conduct the auction immediately
after the completion of relevant trading period in those cases where the
members have failed to give the delivery.
It is observed that the above said norms have created a positive impact on
carry forward trading as well as functioning of the stock exchanges in the
country. The stock exchanges have enforced the disclosures and
transparency norms on the listed companies. The surveillance systems have
improved and their boards are now broadbased. The trading cycle is made
uniformly for seven days, and there are almost 8000 electronic trading
terminals all over the country. Further, now the stock exchanges have set up
trade guarantee funds to ensure smooth trading and reduce counter-party
risk.
Derivatives Regulations in Indian Stock Market
June, 2000 saw the introduction of financial derivatives in the country for the first
time—even though carry forward of positions and weekly settlement had meant
that a quasi-forward market existed for over a century. The first trade in derivatives
was a culmination of legislative and legal efforts which had begun as early as 1995.
In 1995, SEBI appointed a committee for exploring issues in introduction and
creating a regulatory framework for a derivative market.
After the committee report was tabled, the first action taken was to wet nurse the
derivatives market adopting the entire regulatory framework of securities. This was
done simply by defining securities to include derivatives and removing certain
prohibitions on forward and options trading. Thus, the entire framework of existing
securities regulations including anti-fraud and various disclosure obligations have
become part of the regulations of derivatives in India. This is in sharp contrast to
the introduction of futures on individual stocks in US. Their introduction took 20
years, endless bickering between the two regulators Securities Exchange
Commission (SEC) and Commodity Futures Trading Commission (CFTC), anew Act
which lays down several requirements for trading which should rightfully be in the
bye-laws of the exchange/board of trade. By that standard, India managed to
leapfrog as far as not just technology but also regulations. The introduction of new
products has seen more of changes in the micro regulations like margining and
default which are discussed subsequently.
The clearing house of the Bombay Stock Exchange (BSE) is a part of the exchange
currently though it may, in the future, be spun off into an independent company.
The clearing banks are banks that have agreed to clear the trades through their
branches and transfer payments efficiently and often automata ate* order
execution. The banks work under the terms of an agreement signed with the
clearing house of exchange for terms of automatic withdrawal and payment of
funds into the accounts of the members, who must have accounts with the
designated clearing banks.
The clearing member is a member of the derivatives segment who is directly
responsible for all trades entered by trading members clearing with it. On the other
hand, trading members are responsible for being in touch with clients and placing
the trade orders through the terminals provided them. A trading member must be
clear through a clearing member. A clearing member may refuse or restrict the
trading rights of any or all its trading members clearing under it (even if legitimate
under existing rules) because a clearing member is responsible for any default of
trading members clearing under his/her tutelage. A clearing member can also be a
trading member, however, no separate membership category exists for such
persons because such persons must comply with the rights and obligations of both
independently.
Products available
The first derivative product introduced in India was Index Futures. Subsequently,
options on index, futures on single stock and option on single stocks were
introduced. 87 stocks have been permitted for individual futures/option trading
based on fairly stringent measures of the particular exchange. Till now, all products
are cash settled, however, securities settled products are intended to be inducted
into the market soon to provide better arbitrage opportunities to market players. In
the future, the markets might even play the games at the Over-the-Counter (OTC)
derivatives markets—which usually handle currency, interest rates and other
products. Currently, the financial derivatives are regulated almost exclusively by
SEBI. If currency and interest rates are introduced, the regulatory bodies may have
some overlap as to regulations.
The regulatory framework and the existing infrastructure of the markets were
suitably modified and most issues around the cash segment were resolved by the
time the derivatives contracts were introduced. Further improvements, in the
settlement of the cash segment have seen a correlated increased confidence in the
markets, resulting into better volumes and reduced arbitrage opportunity. What has
worked most in favour of the derivatives market, however, is the checks and
balances, the systematic strength of the structure of the markets and the
regulations which have translated into volumes.
Market regulations
The primary laws in relation to derivatives are not legislative. They are created by
the respected stock exchanges .In fact, the only legislative acts passed are those
that define derivatives and remove earlier bans on options and forward trading. The
Bombay Stock Exchange and the National Stock Exchange, both these two
exchanges authorized by the regulator to start trading have passed extensive
regulations for the organized trading of derivatives. Thus, the regulations at the
exchange level are discussed in substantial detail. Before that we will briefly
introduce the statutory background of the markets.
The relevant acts and statutory provisions are contained in the Securities Contract
(Regulations) Act. 1957, Securities and Exchange Board of India, 1992 (SEBI Act)
and various rules and regulations pitted under them. SEBI has passed guidelines
from time to time regulating the role of market intermediaries and Self Regulating
Organizations (SROs). Guidelines under the SEBI Act do not pass through the muster
of Parliament. In fact, some people have challenged the validity of these guidelines
—unsuccessfully
These regulations in fact provide the regulatory framework for securities regulations
by the Indian regulator (SEBI). Though the guidelines of SEBI do not pass the muster
of Parliament, the rules and bye- taw* of a stock exchange are in fact tabled in the
Indian Parliament. In fact the rules and regulations of the USE have been held to
bypass certain statutory provisions like insolvency laws and the arbitration Mute in
limited parts because to do otherwise would be to affect the risk profile of the
market.
• The clearing corporation/house will perform full novation, i.e., the clearing
corporation/house will interpose itself between both legs of every trade, becoming
the legal counterparty to both or alternatively should provide an unconditional
guarantee for settlement of ail trades.
• The clearing corporation/house will hold the clients* margin money in trust for
the client purposes only and should not allow its diversion for any other purpose.
Exposure limits
Further each member has exposure limits circumscribed by its capital/security
deposited. If for reasons of adverse price change, a member exceeds its exposure
limits beyond that afforded by its deposit, its trading terminal will not permit any
further trades which will increase its exposure. The member may be permitted to
enter trades which will reduce the exposure limit—since on a portfolio basis adding
further exposure can reduce overall exposure obligations. The member is also
obliged to immediately furnish further deposit or reduce his/her exposure to be in
compliance with margin requirements. Such compliance measures are in very large
part taken by the trading system without human intervention. Failure to settle
margins within a short span of time would attract further action for compliance by
the exchange.
If a trading member defaults, action can be taken by the clearing member and the
exchange. The clearing member has an obligation to report the exposure violation
to the exchange. Further the clearing member's algorithms added to the trading
member's trading terminals would automatically limit that trading member's ability
to transact contracts which would increase its exposure liabilities. The clearing
member can also close out contracts of its trading members to reduce such excess
exposure. Similarly, the clearing house can close out individual contracts of a
clearing member, and a trading member can close of a client who has exceeded
exposure limits.
The clearing house acts as the common agent of the members for
clearing contracts between member and for delivering securities
(if required) to and receiving securities (if required) from and for
receiving j saying any amounts payable to or payable by such
members in connection with any contracts and to d ill things
necessary or proper for carrying out the foregoing purposes. The
clearing house stands as counterparty in the trade. Therefore, in
the event of default of any member, the settlement is completed!
Hilling money out of the Trade Guarantee Fund and completing
the settlement. Subsequently the defaulting party is pursued by
the exchange which is holding the members' deposits and
margins in Iien. The extent of loss is usually limited in the event of
default because of the daily settlement and the margin deposited
by the member. A second protection is the fact that if a client or a
trading member defaults | tearing member is responsible for its
actions. The third line of defense of course is the fact that |
tearing house stands as a guarantor/counterparty to each trade.
Payment for the guarantee/counterparty is made out of a Trade
Guarantee Fund.
Regulatory Instruments
As we know that the derivatives are of different types and are managed by various
bodies like stock exchanges, trade associations, clearing houses, over-the-counter
bodies, etc. Thus, the issues relating to their implementation and regulation are also
different. A careful balancing of various considerations is necessary in deciding
these. We will discuss here the important instruments of regulation used for this
purpose by the different regulatory authorities and governing bodies from time to
time.
Margining system
Mandating a margin methodology not specific margins:
The LCGC recommended that margins in the derivatives markets would be based on
a 99 percent Value at Risk (VAR) approach. The group discussed ways of
operationalizing this recommendation keeping in mind the issues relating to
estimation of volatility discussed in 2.1. It is decided that the SEB1 should authorize
the use of a particular VAR estimation methodology but should not mandate a
specific minimum margin level. The specific recommendations of the group are as
follows:
Initial methodology: The group has evaluated and approved a particular risk
estimation methodology that is described in Clause 3.2 . The derivatives
exchange and clearing corporation should be authorized to start index
futures trading using this methodology for fixing margins.
effective and this effective date shall not be less than three months after the
date of filing with SEBI. At any time up to two weeks before the effective
date, SEBI may instruct the derivatives exchange and clearing corporation
not to implement the change, or the derivatives exchange and clearing
corporation may on its own decide not to implement the change.