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Indian Derivative Market Inception

Indias tryst with derivatives began in 2000 when both the NSE and the BSE commenced trading in equity derivatives. But, Derivatives markets have been

in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the worlds largest futures industries. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets.
In June 2000, index futures became the first type of derivate instruments to be launched in the Indian markets, followed by index options in June 2001, options in individual stocks in July 2001, and futures in single stock derivatives in November 2001. Since then, equity derivatives have come a long way. New products, an expanding list of eligible investors, rising volumes, and the best risk management framework for exchange-traded derivatives have been the hallmark of the journey of equity derivatives in India so far. Indias experience with the equity derivatives market has been extremely positive. India is one of the most successful developing countries in terms of a vibrant market for exchange-traded derivatives. This reiterates the strengths of the modern development in Indias securities markets, which are based on nationwide market access, anonymous electronic trading, and a predominant retail market. There is an increasing sense that the equity derivatives market plays a major role in shaping price discovery. The Market

Today, equity and commodity derivative markets are rapidly gaining in size in India. In terms of popularity too, these markets are catching on like a forest fire. Derivatives markets broadly can be classified into two categories, those that are traded on the exchange and the those traded one to one or 'over the counter'. They are hence known as:

Exchange Traded Derivatives OTC Derivatives (Over The Counter) OTC Equity Derivatives

The Reserve Bank of India has permitted options, interest rate swaps, currency swaps and other risk reductions OTC derivative products. Besides the Forward market in currencies has been a vibrant market in India for several decades. Derivative trading in India takes can place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a SelfRegulatory Organisation and Sebi acts as the oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House, which is independent in governance and membership from the Derivative Exchange/Segment.

With the amendment in the definition of 'securities' under SC(R)A (to include derivative contracts in the definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992.
Participants of this market can broadly be classified into two functional categories, namely, marketmakers and users. A user participates in the derivatives market to manage an underlying risk. A market-maker provides continuous bid and offer prices to users and other market-makers. A market-maker need not have an underlying risk. At least one party to a derivative transaction is required to be a market-maker. Purpose- Users can undertake derivative transactions to hedge - specifically reduce or extinguish an existing identified risk on an ongoing basis during the life of the derivative transaction - or for transformation of risk exposure, as specifically permitted by RBI. Market-makers can undertake derivative transactions to act as counterparties in derivative transactions with users and also amongst themselves. At present, the following types of derivative instruments are permitted, subject to certain conditions: Interest rate derivatives Interest Rate Swap (IRS), Forward Rate Agreement (FRA), and Interest Rate Future (IRF). Foreign Currency derivatives Foreign Currency Forward, Currency Swap and Currency Option.

The derivatives turnover on the NSE has surpassed the equity market turnover. The turnover of derivatives on the NSE increased from Rs 23,654 million in 20002001 to Rs 292,482,211 million in 20102011, and reached Rs157,585,925 million in the first half of 20112012. The average daily turnover in these market segment on the NSE was Rs 1,151,505 million in 20102011 compared to Rs 723,921 in 20092010. India is one of the most successful developing countries in terms of a vibrant market for exchange-traded derivatives. This reiterates the strengths of the modern development in Indias securities markets, which are based on nationwide market access, anonymous electronic trading, and a predominant retail market. There is an increasing sense that the equity derivatives market plays a major role in shaping price discovery. In 2010, the growth story was driven mainly by financial contracts, foreign exchange contracts in particular. The dollar-rupee contract traded on the MCX-SX had a volume of 821.3 million contracts, making it the second most actively traded contract across all derivatives exchanges in the world. In terms of the number of single stock futures contracts traded in 2010, the NSE held the second position. It was second in terms of the number of stock index options contracts traded and third in terms of the number of stock index futures contracts traded in 2010. The NSE improved its ranking in 2010 in terms of traded volumes in futures and options taken together, improving its worldwide ranking from 15th in 2006 to eighth position in 2008, seventh in 2009, and fifth in 2010. The traded volumes in the derivatives segment of the NSE saw an increase of 75.92 percent in 2010, compared to the volumes in 2009.

In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in havala or forwards markets.
Rules and Regulations

The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line with the suggestive Bye-laws. Sebi has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The first type of regulation required for any derivatives market falls under the rubric of orderly market provisions. These measures, which have been tested over time in securities markets around the world, are designed to facilitate a liquid, efficient market with a minimum of disruptions. Registration and reporting requirements, transparency and creation of a level playing field for all investors alike, a system of mitigation of payments risks and safeguarding investors moneys, are essential requirements. The first type of regulation required for any derivatives market falls under the rubric of orderly market provisions. These measures, which have been tested over time in securities markets around the world, are designed to facilitate a liquid, efficient market with a minimum of disruptions. Registration and reporting requirements, transparency and creation of a level playing field for all investors alike, a system of mitigation of payments risks and safeguarding investors moneys, are essential requirements. Certification requirements exist for all Members. Members are required to do business according to the code of conduct specified under the SEBI Broker Sub-Broker regulations. Members are required to extend know-your-customer (KYC) rules to all their clients in order to have all relevant information on their operations. The Clearing Corporation has to build a sophisticated risk containment system in order to function seamlessly. The key element of risk containment is the margining system, which involves taking collateral from traders in such a way as to greatly diminish the incentives for traders to default. Capital and collateral requirements need to be updated for all derivatives dealers, so that capital is held in an amount that is commensurate with not only the exposure to credit loss, but also potential future exposure and value at risk.
SEBI decided to standardize the lot size for derivative contracts on individual securities. The stock exchanges shall ensure that the lot size is the same for an underlying traded across exchanges.

In continuation to the SEBI circular dated January 15, 2008 regarding the introduction of the volatility index, the capital market regulator, vide its circular dated April 27, 2010, decided to permit stock exchanges to introduce derivatives contracts on volatility index. The introduction of derivatives contracts on volatility index is subject to the condition that the underlying volatility index has a track record of at least one year. SEBI decided to permit the stock exchanges to introduce option contracts on the SENSEX and the Nifty with a tenure up to five years. The introduction of such five-year option contracts will be subject to the condition that there are eight semi-annual contracts of the cycle June/December together with three serial monthly contracts, and three quarterly contracts of the cycle March/June/September/December. Certain position limits have also been prescribed for FIIs and mutual funds. They are as follows: Index Options- Rs. 500 crore or 15 percent of the total open interest of the market in index options, whichever is higher. This limit would be applicable on open positions in all options contracts on a particular underlying index. Index Futures- Rs. 500 crore or 15 percent of the total open interest of the market in index futures, whichever is higher. This limit would be applicable on open positions in all futures contracts on a particular underlying index. Stock Options and futures- For stocks having applicable market wide position limit (MWPL) of ` 500 crore or more, the combined futures and options position limit is 20 percent of the applicable MWPL or Rs. 300 crore, whichever is lower, within which stock futures position cannot exceed 10 percent of the applicable MWPL or Rs.150 crore, whichever is lower. Conclusion

In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian market has equaled or exceeded many other regional markets.13 While the growth is being spearheaded mainly by retail investors, private sector institutions and large corporations, smaller companies and state-owned institutions are gradually getting into the act. The variety of derivatives instruments available for trading is also expanding. A proper framework to account for derivatives with liquidity and transparency needs to be developed. Further regulatory reform will help the markets grow faster. Similarly, credit derivatives, the fastest growing segment of the market globally, are absent in India and require regulatory action if they are to develop. Hopefully we will find effective ways to channelize the power of financial innovation in a more constructive manner.