DERIVATIVES IN INDIA

BY
G.VENKATACHALAM

History of Derivatives
Chicago Board of Trade (CBOT) for derivatives trading, became functional in 1848 and by 1865 futures contract in commodities started trading. In 1972 currency futures were introduced, followed by equity options in 1973. Year 1975 saw introduction to Interest Rate futures. Currency Swaps were introduced in 1981 and in 1982 Index futures, Interest Rate swaps and Currency Options were started. In 1983, Index Options and Options on futures were started.

Revival of Trading in India

Financial sector reforms have been an integral part of the liberalization process. Initially the focus was on streamlining and modernizing the cash market for securities. Various steps were therefore taken in this regard. A modern electronic exchange, the NSE was set up in 1994.

India (Cont)
The National Securities Clearing Corporation (NSCCL) was set up to clear and settle trades. Dematerialized trading was introduced with the setting up of the NSDL. The attention then shifted to derivatives, for it was felt that that investors in India needed access to risk management tools.

India (Cont)
There was however a legal barrier. The Securities Contracts Regulation Act, SCRA, prohibited trading in derivatives. Under this Act forward trading in securities was banned in 1969. Forward trading on certain agricultural commodities however was permitted, although these markets have been very thin.

India (Cont)
The first step was to repeal(cancel) this Act. The Securities Laws (Amendments) Ordinance(order) was promulgated(circulated) in 1995. This ordinance withdrew the prohibition on options on securities. The next task was to develop a regulatory framework to facilitate derivatives trading.
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India (Cont)
SEBI set up the L.C. Gupta committee in 1996 to develop such a framework. The committee submitted its report in 1998. It recommended that derivatives be declared as securities so that the regulatory framework applicable for the trading of securities could also be extended to include derivatives trading.
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India (Cont)
Trading in derivatives has its inherent risks from the standpoint of non-performance of a party with an obligation to perform. For this purpose SEBI appointed the J.R. Varma Committee to recommend a suitable risk management framework. This committee submitted its report in 1998.

India (Cont)
The SCRA was amended in December 1999 to include derivatives within the ambit of securities. The Act made it clear that trading in derivatives would be legal and valid only if such contracts were to be traded on a recognized stock exchange. Thus OTC derivatives were ruled out.

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India (Cont)
In March 2000, the notification prohibiting forward trading was withdrawn. In May 2000 SEBI permitted the NSE and the BSE to commence trading in derivatives. To begin with trading in index futures was allowed.

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India (Cont)
Thus futures on the S&P CNX Nifty and the BSE-30 (Sensex) were introduced in June 2000. Approval for index options and options on stocks was subsequently granted. Index options were launched in June 2001 and stock options in July 2001. Finally futures on stocks were launched in November 2001.
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DERIVATIVES IN INDIA: A CHRONOLOGICAL DEVELOPMENT December The NSE sought SEBI's permission to trade index futures. -14, 1995 November The LC Gupta Committee set up to draft a policy framework for index 18, 1996 futures.

1996
May-11, 1998 July-7, 1999 May-25, 2000 June-12, 2000 June 2003

The SEBI Appointed a J.R.VARMA committee to recommend Risk mgt towards derivatives The LC Gupta Committee submitted a report on the policy framework for index futures.
Reserve Bank of India gave permission for OTC forward rate agreements and interest rate swaps. SEBI allowed the NSE and the BSE to trade in index futures.

Trading of Nifty futures commenced on the NSE.

Trading on interest rate futures commenced at NSE

July 2003

Trading on FC-rupee option started

DERIVATIVES TRADING AT NSE/BSE

S.No
1 2
3 4 5 6 7 8 9 10 11 12 13 14 15

Items
Date of introduction Name of security
underlying asset Contract size Tick size/price step Minimum price fluctuations Price bands Expiration months Trading cycle Last trading/expiry day Settlement Final settlement price Daily settlement price Trading hours Margin

BSE
June 9,2000 BSE
BSE sensitive index(SENSEX) Sensex value*50 o.1 point of sensex (equivalent to Rs 5) Rs 5 NA 3 near months A maximum of 3 months: the near month (1), the next month(2) and Far month(3) Last Thursday of the month or the preceding day In cash on T+1 bas Index closing price on the last trading day(a) Closing of future contract 9.30 am to 3.30 pm Upfront margin on daily basis

NSE
June 12, 2000 N FUTIDX NIFTY
S&P CNX NIFTY 200 or multiples of 200 Rs 0.05 Not applicable NA 3 near months As in previous column As in previous column As in previous column Index closing price on the 1st trading day(s) Closing of future contract 9.30 am to 3.30 pm As in previous column

REGULATION OF DERIVATIVES TRADING IN INDIA

INSTITUTIONAL FRAMEWORK OF DERIVATIVES MARKET
Exchange- Exchange provides buyers and sellers of futures and

option contract necessary infrastructure to trade. Clearing House - Clearing house ensures solvency of the members by putting various limits Custodian / Ware House- Futures and options contracts do not generally result into delivery but there has to be smooth and standard delivery mechanism to ensure proper functioning of market. Bank for fund movements - Futures and options contracts are daily settled for which large fund movement from members to clearing house and back is necessary. This can be smoothly handled if a bank works in association with a clearing house.

REGULATORY FRAMEWORK
SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992 SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India(SEBI) with statutory powers for (a) protecting the interests of investors in securities (b) promoting the development of the securities market and (c) regulating the securities market. POWERS OF SEBI

Regulating the business in stock exchanges and any other securities markets. Registering and regulating the working of stock brokers, subbrokers etc. Promoting and regulating self-regulatory organizations. Prohibiting fraudulent and unfair trade practices. Calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, mutual funds and other persons associated with the securities market and intermediaries Performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956, as may be delegated to it by the Central Government.

REGULATION FOR DERIVATIVES TRADING

SEBI set up a 24-member committee under the Chairmanship of Dr. L. C. Gupta to develop the appropriate regulatory framework for derivatives trading in India. On May 11, 1998, SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures.

Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta committee report can apply to SEBI for grant of recognition under Section 4 of the SC(R) A, 1956 to start trading derivatives. The exchange would have to regulate the sales practices of its members and would have to obtain prior approval of SEBI before start of trading in any derivative contract.

REGULATION FOR DERIVATIVES TRADING

The Exchange should have minimum 50 members. The members of an existing segment of the exchange would not automatically become the members of derivative segment. The members of the derivative segment would need to fulfil the eligibility conditions as laid down by the L. C. Gupta committee. The clearing and settlement of derivatives trades would be through a SEBI approved clearing corporation/house. Clearing corporations/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval.

REGULATION FOR DERIVATIVES TRADING

Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges. The minimum net worth for clearing members of the derivatives clearing corporation/house shall be Rs.300 Lakh. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to submit details of the futures contract they propose to introduce. The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position will be prescribed by SEBI/Exchange from time to time.

REGULATION FOR DERIVATIVES TRADING

The L. C. Gupta committee report requires strict enforcement of Know your customer rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client. The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI.

Derivatives Products Traded in Derivatives Segment of NSE

S.no
1 2 3 4 5 6 7 8 9 10 11 12 13 14

Product Traded with underlying asset

Index Futures-S&P CNX Nifty Index Options-S&P CNX Nifty Stock Option on 233 Stocks Stock futures on 233 Stocks Interest Rate Futures- T Bills and 10 Years Bond CNX IT Futures & Options Bank Nifty Futures & Options CNX Nifty Junior Futures & Options CNX 100 Futures & Options Nifty Midcap 50 Futures & Options Mini index Futures & Options - S&P CNX Nifty index long Term Option contracts on S&P CNX Nifty Index Currency Futures on US Dollar Rupee S& P CNX Defty Futures & Options

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

COMMODITY FUTURES
Buying and selling of commodities through contract basis. These are a large number of commodities on which the futures contracts are available. They range from agricultural products, such as wheat, rice, sugar, etc., to metals such as gold, silver, to plantations such as rubber, coffee, to energy products such as oil. Furnace oil, etc.

Commodity Market Structure

Spot Market
Quality Certification Agencies Warehouses Hedger (Exporters/ Millers/ Industry) Producers (Farmers/ Co-operatives/ Institutional)

Clearing Bank

Commodities Ecosystem

MCX

Transporters/ Support Agencies

Traders (Speculators) Arbitrageurs/ Client) Consumers (Retail/ Institutional)

Global Commodities Market

Commodity Markets - Overview

Indian commodity market set for paradigm shift Four licenses recently issued by Govt. of India to set-up National Online Multi Commodity Exchanges to ensure a transparent price discovery and risk management mechanism List of commodities for futures trade increased from 11 in 1990 to over 100 in 2003

Reforms with regard to sale, storage and movement of commodities initiated

Shift from administered pricing to free market pricing WTO regime Overseas hedging has been allowed in metals Petro-products marketing companies have been allowed to hedge prices Institutionalization of agriculture

Participants in Commodity Futures

Farmers/ Producers Merchandisers/ Traders Importers Exporters Consumers/ Industry Commodity Financers Agriculture Credit providing agencies Corporate having price risk exposure in commodities

Benefits of Commodity Trading

Price discovery for commodity players
A farmer can plan his crop by looking at prices prevailing in the futures market

Hedging against price risk

A farmers can sell in futures to ensure remunerative prices

A processor/ manufacturing firm can buy in futures to hedge against volatile raw material costs
An exporter can commit to a price to his foreign clients

Easy availability of finance Based on hedged positions commodity market players (farmers, processors, manufacturers, exporters) may get easy financing from the banks Seasonal volatility: Faster dissemination of information:

Reducing cost of credit:

More efficient physical markets:

How Commodity Futures Help

Risk Management Growers Short hedge on upcoming produce Traders Short Hedge on stored quantity Manufacturers Long Hedge on input cost, Short hedge on finished products Price Discovery Futures prices can be used as indicative prices for negotiating the export prices and also upcountry sales

Contract specification: S&P CNX Nifty Futures

Underlying index

S&P CNX Nifty Exchange of trading National Stock Exchange of India Limited Contract size Permitted lot size shall be 50 (minimum value Rs.2 lakh) Price steps Re. 0.05 Price bands Not applicable Trading cycle The futures contracts will have a maximum of three month trading cycle - the near month (one), the next Month (two) and the far month (three). New contract will be introduced on the next trading day following the Expiry of near month contract
Expiry day Settlement basis Settlement price

The last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday Mark to market and final settlement will be cash Settled on T+1 basis. Daily settlement price will be the closing price of the futures contracts for the trading day and the final settlement price shall be the closing value of the Underlying index on the last trading day.

Contract specification: S&P CNX Nifty Options

Underlying index Exchange of trading Security descriptor Contract size Price steps Price bands Trading cycle S&P CNX Nifty National Stock Exchange of India Limited NOPTIDX NIFTY Permitted lot size shall be 50 (minimum value Rs.2 lakh) Re. 0.05 Not applicable The options contracts will have a maximum of three month trading cycle - the near month (one), the next month (two) and the far month (three). New contract will be introduced on the next trading day following the expiry of near month contract. The last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday.

Expiry day

Settlement basis Cash settlement on T+1 basis. Daily settlement price N.A Final settlement price Closing value of the index on the last trading day of the options contract

Contract specification: stock futures

Underlying Exchange of trading Security Contract size Price steps Price bands Trading cycle Individual securities National Stock Exchange of India Limited N FUTSTK As specified by the exchange (minimum value of Rs.2 lakh) Re. 0.05 Not applicable The futures contracts will have a maximum of three month trading cycle - the near month (one), the next month (two) and the far month (three). New contract will be introduced on the next trading day following the expiry of near month contract. The last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday. In Cash on T+1 Basis Daily settlement price will be the closing price of the futures contracts on the trading day and the the final settlement price will be the closing price of the the underlying on the last trading day of the options contract.

Expiry day Settlement basis Settlement price

Contract specification: stock options

Underlying Exchange of trading Security descriptor. Individual securities available for trading in cash market National Stock Exchange of India Limited NOPTSTK.

Style of option
Strike price interval Contract size Price steps Price bands Trading cycle

American.
As specified by the exchange As specified by the exchange (minimum value of Rs.2 lakh) Re. 0.05 Not applicable The options contracts will have a maximum of three month trading cycle - The near month (one), the next month (two) and the far month (three). New contract will be introduced on the next trading day following the expiry of near month contract.

Expiry day Settlement basis Daily settlement price Final settlement price Settlement day

The last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday. T+1 Basis Closing price of underlying on the day of exercise Closing price of underlying on the last trading day of the options contract Last trading day