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Workshop on Banking

Part I - Banking
Introduction

WHAT IS A BANK AND WHAT IS BANKING?

The present day banking has its origin in U.K. Their early role was to safe keep the money
deposited by the local citizens and charge them a small fee for the same. Slowly the
bankers started realising that they could use this money by lending it to those who
needed it. That was the beginning of "deposit" and "loan". Thus "financial intermediary"
was born - "financial intermediary" simply meaning that money flows through them from
the "money-surplus" units to "money-needed" units.

The depositors would be paid certain amount and the borrowers of this money would be
charged certain amount, called "interest". There would obviously be difference between
the amount of interest paid to depositors and the amount of interest recovered from the
borrowers. This would be the profit for the financial intermediary, which is a bank. This is
the foundation for today's "retail banking".

With the growth in commerce, first within a country and then globally, banking started
transcending first the regional boundaries and then the national boundaries. That is how
"international banking" started. Even today, international banking caters to "international
trade" to a major extent.

While primarily the banking function revolved around acceptance of deposits and granting
of loans, the customers started feeling the need for other services. These services were:
remittance of funds from one place to another place, purchase of securities on behalf of
its customers, safe custody of important documents, safe deposit vault services etc.
Thus slowly the services extended by banks went on expanding. Today in India, any
medium sized or large commercial bank extends the following services:

♦ Acceptance of deposits of various kinds – deposits that can be withdrawn on demand


like Savings/Current Accounts or those deposits that have a fixed maturity date, like,
Fixed Deposit Accounts, Recurring Deposit Accounts etc.
♦ Extending loans to borrowers in the form of Loans and Overdraft (This overdraft
facility in India is called "Cash Credit" facility in the case of business enterprises)
♦ Extending financial assistance to exports on soft terms
♦ Remittance of funds from one place to another place by various modes like Mail
Transfer (M.T.), Telegraphic Transfer (T.T.), Demand Drafts (D.D.), Electronic Fund
Transfer (E.F.T.) etc.
♦ Collection of bills for commercial transactions tendered by its customers facilitating
commerce within the country as well as outside the country.

♦ Safe custody services for safe keeping of important documents


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♦ Safe Deposit Vault services (SDV) for personal safe keeping of documents, cash,
jewellery etc.
♦ Foreign exchange transactions involving import/export of goods and remittance of
foreign exchange (both outward and inward)
♦ Issuing letters of undertaking to suppliers of goods and/or services through their
bankers which are called “Letters of Credit” (L/C)
♦ Issuing Bank Guarantees on behalf of its customers in favour of various beneficiaries
including Government Agencies (B/G)
♦ Obtaining credit reports from other Banks and specialised Credit Agencies on
customers (both within India and outside India) as well as providing Credit Information
about its customers to other Credit Agencies.
♦ Doing Government business, like payment of pension, collection of direct tax (like
income tax) and indirect taxes (like excise duty).
♦ Extending Counselling Services to its customers on International Trade, Loan
Arrangements (Syndication), when to come out with public issue of equity shares etc.
♦ Extending cash withdrawal facilities through Automated Teller Machines/Any Time
Money (ATMs).
♦ Carrying out standing instructions of customers for receipt of payments (amount
credited to customers’ accounts) and making of payments (amount debited to the
customers’ accounts).
♦ Issue of International Money Orders (IMO), Travellers’ Cheques (TC), both in Indian
Rupee and Foreign Currency to travellers, exchanging Indian Rupee for Foreign
Currency Travellers cheques from foreign tourists/visitors, issue of Foreign Currency
to those who travel abroad/exchanging foreign currency for Indian Rupee, payment to
International Credit Card Agencies, issue of Credit Cards to domestic customers etc.
♦ Acceptance of deposits from non-resident Indians
♦ Arrangement of international finance to its customers as well as managing issue of
Global Depository Receipts (GDR)/American Depository Receipts (ADR)/ Euro-Bonds
etc.
♦ Investment in Govt. securities, shares of blue chip companies etc. for its own portfolio.
♦ Extending custodial services (please refer to chapter on banking terms)

DIFFERENCE BETWEEN RETAIL BANKING AND WHOLESALE BANKING

Wholesale banking typically involves a small number of very large customers such as big
corporations and governments, whereas retail banking consists of a large number of small
customers who consume personal banking and small business services. Wholesale banking
is largely inter-bank; banks use the inter-bank markets to borrow from or lend to other
banks/large customers, to participate in large bond issues and to engage in syndicated
lending. Retail banking is largely intra-bank; the bank itself makes many small loans.

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Most of the Indian public sector banks practise retail banking; they are slowly practising
the concept of “wholesale banking”. On the other hand, most of the well-established
foreign banks in India and the recent private sector banks practise wholesale banking
alongside retail banking.

As a result of this difference, the composition of income for a public sector bank and a
well-established private sector bank is different. While a major portion of the income for
large public sector banks is from lending operations, in the case of any private sector bank
in India, the amount of non-operating income (other than interest income) is substantially
higher. The composition of other income is - commission on bills/guarantees/letters of
credit, counselling fees, syndication fees (arrangement for loans), credit report fees, loan
processing fees, correspondent bank charges (please see next chapter for the meaning of
correspondent bank) etc. Internationally also, in the case of any bank, the non-interest
income is substantially more than interest income. This is considered as a healthy sign, as
the investment required for earning non-interest income is negligible. Non-interest
income is from activities, which are not fund based but fee-based. Hence very little
capital is required to carry on such activities.

Note: The significance of important banking terms used in the course material is
explained in the next chapter. "Global banking" activities are an extension of various
activities listed above into the international market. Global banking primarily consists of
trade in international banking services and establishment of branches and subsidiaries in
foreign countries.

WHAT IS A SCHEDULED BANK IN INDIA?

In India, the Central Banking Authority is the Reserve Bank of India (RBI); it is also
referred to as the "Apex Bank". It functions under an act called The Reserve Bank of
India Act, 1934. All the banks and other financial institutions operating in India come
under the monitoring and control of RBI. RBI controls the banking sector in India through
an act called "The Banking Regulations Act". In the past, when there were very few banks,
RBI used to include all the "scheduled" banks in its Schedule. Nowadays, when the number
of banks has gone up substantially, RBI has to change the schedule every now and then.
Hence irrespective of whether a bank finds its name in the schedule to the RBI Act or
not, its "schedule status" can be found out from its banking licence. A bank that is not a
scheduled bank is referred to as "non-scheduled" bank even in its banking licence.

The difference lies in the type of banking activities that a bank can carry out in India. In
the case of a scheduled bank, it is licensed by the RBI to carry on extensive banking
operations including foreign exchange operations, whereas, a non-scheduled bank can carry
out only limited operations. There are a number of factors considered by RBI to declare a
bank as a "scheduled bank", like the amount of share capital, type of banking activities

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that the bank is permitted to carry out etc. An example of difference between a
scheduled and non-scheduled bank is dealing in "Foreign Exchange".
WHAT IS THE DIFFERENCE BETWEEN A COMMERCIAL BANK AND A CO-OPERATIVE
BANK?

A commercial bank is run on commercial lines, for profits of the organisation. A co-
operative bank on the other hand is run for the benefit of a group of members of the co-
operative body. A co-operative bank distributes only a very small portion of its profit as
dividend, retaining a major portion of it in business.

All the nationalised banks in India and almost all the private sector banks are commercial
scheduled banks. There are a large number of private sector co-operative banks and most
of them are non-scheduled banks. In the public sector also, within a state, starting from
the State Capital, there are State Co-operative Banks (example: in Karnataka, we have
Karnataka State Co-operative Bank) and District Central Co-operative Banks at the
district level. Under the District Central Co-operative Bank, there are Co-operative
Societies. At present, in India, the banks can be bifurcated into following categories.

Category 1 – Public Sector banks (also referred to as "nationalised banks"), which are
commercial and scheduled. Examples: State Bank of India, Bank of India etc.

Category 2 – Private Sector banks, which are commercial and scheduled. These could be
foreign banks as well as Indian Banks. Examples: Foreign Bank - CITI Bank, Standard
Chartered Bank etc. Indian Bank - Bank of Rajasthan Limited, VYSYA Bank Limited etc.

Category 3 – Private Sector banks, which are co-operative and scheduled. These are large
co-operative sector banks but which are scheduled banks. Examples: Saraswat Co-
operative Bank Limited, Shamrao Vithal Co-operative Bank Limited, Cosmos Co-operative
Bank Limited etc.

Category 4 – Private Sector banks, which are co-operative and non-scheduled. These are
small co-operative banks but which are non-scheduled. Examples: Local co-operative banks
which operate within a town or a city, like Mahesh Sahakari Bank Limited etc.

Category 5 – Public Sector banks, which are co-operative and non-scheduled. These are
state owned banks like the Maharashtra State Co-operative Bank (State level), Pune
District Central Co-operative Bank (District level) and Junnar Co-operative Society etc
(primary level).

Category 6 – Regional Rural Banks that are state owned and have different roles assigned
to them. They are outside the purview of our discussions

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Category 7 – Gramin Banks that are also state owned and have different roles assigned to
them. They are also outside the purview of our discussions.

1.2 Different Bank Accounts - Bank Facilities – Banking Terms -


Determination of interest on deposits and advances

DIFFERENT BANK ACCOUNTS - DEPOSITS

1. Deposit account offering withdrawal facility – Savings Bank Account as well as Current
Account. The nomenclature of the Savings Bank Account is different in different
countries. For example, Savings Bank Account with withdrawal facility through Cheques
is referred to as "Check Accounts" in the USA. In India, while the balances in the
Savings Bank Accounts get interest, the balances in the Current Accounts do not get
interest.

2. Deposit account without withdrawal facility – different categories –


♦ Lump sum investment for specific periods, after which the principal amount is paid
back together with interest for the entire deposit period. This is on a cumulative basis
or reinvestment basis.
♦ Lump sum investment for specific periods and interest is paid on a periodic basis. The
principal amount is paid back on maturity/due date.
♦ Lump sum investment for specific periods and interest together with a part of the
principal amount is paid periodically with last instalment payable on due date/maturity
date.
♦ Periodic investment, mostly on a monthly basis and repayment on a cumulative basis,
both principal and interest amounts – example, recurring deposit accounts
♦ Periodic investment, less frequent than the previous one but investment is usually
substantial and repayment on a cumulative basis together with interest. Periodic
investments may not be of the same size.

DIFFERENT BANK ACCOUNTS – ADVANCES AND LOANS

Overdraft – An extension of current account in which the customer is allowed to withdraw


more than the credit balance lying in the account. This may be a temporary
accommodation to tide over temporary cash crunch or on a regular basis. If permitted
on a regular basis, withdrawals are allowed up to a ceiling (called "a limit"), subject to
availability of sufficient security with the bank. For "security" please refer to the
following section on "banking terms". It is a facility in which the customer can cancel
the previous debit balance (amount withdrawn) by subsequent credits (amount
deposited) and draw afresh as and when required, subject to a limit. In case the
overdraft is given to business enterprises, it is for day-to-day operations, which is
otherwise known as “working capital”.

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Cash Credit – A credit facility under which a customer draws up to a pre-set limit, subject
to availability of sufficient security with the bank. The difference between an
Overdraft and a Cash Credit account is that while the former is extended more to
individuals and less for business, the latter is extended only to business bodies. The
Cash Credit facility is unique to India, as in most of the countries it is called
"Overdraft". Further, the cash credit facility is more or less on a permanent basis so
long as the business is going on. Internationally, at the end of a specific period, the
overdraft facility is withdrawn and the customer is required to pay back the amount
lent by the bank. The purpose of cash credit is for working capital. The operations are
similar to Overdraft.

Loan – A lump sum amount given to the customer, either in one "tranche" or in two or
three "tranches" and repayment over a period of time in monthly or quarterly or half-
yearly or annual (very rarely) instalments. Interest may be recovered separately from
the customer who is called "borrower" or combined with the instalment. In case it is
combined with the instalment, it is known as “equated” instalment. If interest is
recovered separately, it is usually on a quarterly basis, while instalment can be as
mentioned above. Loan is very common abroad and given against specific assets like
consumer durable, white goods, house property etc. Given to individuals as well as
business bodies. Loans against property and for the purpose of owning
flats/apartments/houses are known as "mortgage" loans.

Repayment period: Anywhere between 2 years to 5 years for other than housing loan.
For housing loan, in India, between 10-15 years and abroad, it can be even up to 30
years. Withdrawal facility by cheque is not available unlike Overdraft or Cash Credit.

BANKING TERMS OFTEN USED/ COMMON BANKING PRACTICES

1. Bill – usually mistaken for a commercial invoice. Actually bill in the banking parlance
means a Bill of Exchange drawn by a seller on the buyer whenever he sells goods or
services on "payment later" basis. Such a transaction is referred to as a "credit"
transaction. The bill is routed through the bank for collection of amount from the
buyer. Commercial invoice is a part of the documents submitted to a bank by the seller.

A Bill of Exchange is an order made to the buyer by the seller that in exchange for
the goods or services sold by him on credit, the buyer is required to pay on a specific
date, a certain amount with or without interest to him or to any other directed
party (mostly a bank).

2. Discount – less than face value. If the value of the bill is Rs.100/- and in case the
bank gives finance against the same, the amount of finance will be less than Rs.100/-,
say Rs.98/-. Rs. 98/- is the discounted value of the bill for Rs. 100/-, while the
difference of Rs. 2/-, is known as “discount”. Discount is the interest recovered up
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front, especially in the case of those bills for which payment will be forthcoming after
a specific or expected period.

3. Remittance – A facility, by which its customer at one place makes funds available to
the bank and the bank in exchange, makes the funds available to the customer or any
other specified party at the required place, within the same country or abroad.

There is more than one mode of remittance. It can be by Demand Draft (DD), Mail
Transfer (MT), Telegraphic Transfer (TT), Electronic Mail Transfer (EMT) through
computer networking (or through satellite channel), International Money Order (IMO)
etc.

4. Letter of credit – Seller “A” enters into contract with Buyer “B”. One of the terms of
supply is that buyer will establish a letter of credit in favour of the seller through his
bank. The Buyer approaches his bank, which, on certain conditions, agrees to extend
this facility. Under this facility, the buyer’s bank gives commitment of payment to the
seller through his bank. The commitment is dependent upon the seller fulfilling specific
conditions as per the L/C. The conditions are:

 The seller should furnish proof of despatch of goods or services and


 Submit all the documents required under the L/C.
Then, the buyer’s bank will pay the amount of the bill drawn by the seller on the buyer
under this arrangement. International letters of credit are by and large, “irrevocable”
(cannot be cancelled by the buyer without the consent from the seller)

Advantage – This facilitates global commerce through the banking channel which acts
as the financial intermediary and based on the letter of credit established by the
buyer’s bank, the seller’s bank will extend financial assistance to the seller till he gets
the payment from the buyer’s bank.

5. Bank guarantee – Could be a finance guarantee or a performance guarantee. Under


finance guarantee, the bank guarantees the beneficiary (the person named in the
guarantee to receive the guaranteed sum under stated circumstances), certain amount
on behalf of its customer who has commercial relationship with the beneficiary. Under
performance guarantee, the bank guarantees performance of a contract or
goods/services supplied under a contract by its customer. However, even in the latter
case, if its customer fails to deliver, it settles the claim of the beneficiary in money
terms only; the bank does not fulfil the contract obligation of its customer.

Example of Finance guarantee - Two parties enter into a contract. One is the supplier
and the other is the buyer. The terms of supply include 25% of advance to be given by
the buyer. The buyer wants assurance of supply as per the contract with the seller.
Hence he insists on a bank guarantee by the seller’s bank. The seller’s bank gives the
same against some security given by the seller. In case the seller does not fulfil the
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contract, the beneficiary of the guarantee lodges a claim with the guarantee-issuing
bank. The bank then pays the buyer the assured sum.

Example of Performance guarantee


Similarly, in the case of an export contract, the foreign buyer, who is the importer,
may insist upon the seller’s bank issuing a performance guarantee to ensure that the
seller sticks to the delivery schedule. The buyer will establish a letter of credit in
favour of the seller through his bank only upon the buyer’s bank receiving the required
performance guarantee from the seller’s bank.

Lodging a claim under a guarantee with the guarantee-issuing bank by the beneficiary
is known as "invocation" of a guarantee.
Cancellation of a guarantee is known as "revocation" of a guarantee.
Letters of credit and bank guarantees play a very important role in international
banking.

6. Negotiation – the term refers to the act of a bank extending finance to the seller
against a letter of credit in his favour, once he furnishes proof of despatch and fulfils
all conditions of the letter of credit, as laid down by the buyer. The conditions relate
only to documents and not goods.

7. Cash Reserve Ratio – Called in short, CRR. It is in operation in India. Usually, in


developed countries, CRR and SLR (refer to the next point) are not separately levied.
They are together known as "statutory reserve". Suppose a bank has total deposits of
Rs. 100 Bn. and is required to maintain a CRR of say 5%. This means that the bank
should maintain in current accounts with the Central Bank or any other approved bank
balances, not less than Rs. 5 Bn. This much amount is impounded and kept in the free
form and the bank cannot lend this money. This acts as a buffer to the bank. In
India, RBI decides from time to time and at present it is 8.5% of the deposits held by
the bank.

8. Statutory Reserve Ratio – Called in short, SLR. In the above example, suppose the
bank is supposed to maintain SLR of 25%. This means that over and above CRR, the
bank is expected to keep aside an amount of Rs. 15 Bn. This will be kept in easy-to-
encash securities like treasury bills of the Government of USA and any other approved
securities. Here again, the Central Banking Authority in USA, i.e., the Federal Bank,
decides the ratio. In India, at present it is 25%. This again acts as buffer to the
bank and prevents the bank from lending the entire amount of deposits kept with it by
various customers.

Note pertaining to Reserve Ratio – the investment decision is taken not at the branch
level. It is taken at the Head Office of the bank. In India, the department handling
this is known as "Treasury" department at the Head Office. This is natural, as this
outfit is in touch with the market constantly. Further, compliance with SLR is to be
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done on the basis of deposits of the bank with all its branches and hence the Head
Office is suitable for this purpose. The Head Office reports the position of deposits
as well as investment under CRR/SLR to the Central Banking Authority once in a
fortnight.

9. Clearing operation – Suppose Customer “A” has his Savings Account with chequebook
facilities with Bank of India, Pune Branch. He issues a cheque in favour of “B” who is a
customer of Bank of Maharashtra, Pune. “B” deposits the cheque in his account with
Bank of Maharashtra, which presents the cheque to Bank of India, Pune Branch,
through a platform known as “clearing house”. The Central banking authority, namely
the Reserve Bank of India or its authorised bank in all the major centres mostly
conducts this across India.

10. Daily product basis – This is the basis on which interest is usually determined on credit
facilities, like loan, overdraft, cash credit etc. For this, the basis is 365 days in a
year. Some banks do take 360 days in a year also. There is no hard and fast rule in
this behalf. For example Barclays Bank has given a customer an overdraft facility to
the extent of Rs. 10000/- for 45 days at 6% p.a. On a daily product basis, the interest
is determined as under:

Step No. 1 – 10000 x 45 days = known as product = 450,000

Step No. 2 – determination of annual average as rate of interest is on annual basis, i.e.,
450,000/365 = Rs. 1233/-. This means that on a 365 days per year basis, drawing
Rs.10000/- for 45 days is equivalent to drawing Rs.1233/- through out the year, i.e., on
annual basis.

Step No. 3 – calculation of interest at 6% p.a. = 1233 x 0.06 = Rs.73.98

This means that by adopting daily product basis we are converting the amount drawn
for a period less than a year to its annual equivalent so that the rate of interest, which
is universally on annual basis, can be applied to determine the quantum of interest.

One may ask, why this indirect method when all the above three steps can be combined
into one? The answer is yes. The utility of daily product basis lies in determining the
annual equivalent in cases wherein the amount drawn is likely to differ every now and
then, like in the case of overdraft or cash credit. Refer to Specimen 1 for detailed
calculation of interest on daily product basis in an overdraft account, in which balances
differ every now and then.

Besides credit facilities, this is the method adopted by most of the US Banks for
giving interest on current account balances also. For other deposit accounts, which are
fixed in nature, yearly interest is straight away applied.

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11. Monthly product basis – Suppose as in the case of India, in the savings account, the
product is taken on a monthly basis. In India, the rule is interest is paid on the
minimum balance in the account between the 10th and the last day of every month. This
means that any credit to the account after the 10th of the month is ignored for the
particular month, while debit is taken into account. Accordingly let us say for example
the following minimum credit balances existed in a savings account earning 4% p.a.
interest in India.

January 02 – Rs. 1000/-


February 02 – Rs.800/-
March 02 – Rs.150/-
April 02 – Rs.250/-
May 02 – Rs. 300/-
June 02 – Rs.300/-

Suppose the interest is payable every half-year and accordingly this customer will be
entitled to 2% for the half-year ending June 2002. In order to determine the correct
half-yearly interest, you need to find out annual equivalent of the deposit that the
customer has kept in his savings account. Then divide the sum of the monthly products
by 12. The annual equivalent amount is Rs.233.33 and the interest at 4% p.a. for the
half-year on this works out to Rs. 9.33. This is the way interest is found out on a
monthly product basis.

12. Repayment holiday – Whenever a loan is taken especially for acquiring fixed assets, the
repayment does not start immediately. It starts after the fixed asset starts giving a
return especially in the case of business enterprises. This is not so in the case of
personal loans. The period during which there is no repayment is known as “repayment
holiday period”. This is also known as “Moratorium period”. This period is longer in the
case of industrial loans and minimum or absent in the case of personal loans. It should
be noted that during this period, interest is charged and there is no period for non-
levy of interest, although there may be a period of non-recovery of interest, i.e.,
interest, although levied not recovered for a specific period. Again if this is the case,
interest on interest is recovered.

13. Credit instruments – Any instrument that is drawn on a bank, against surrender of
which the concerned bank will pay us the amount mentioned in the instrument.
Examples – checks, drafts, mail transfers, travellers’ checks, international money
orders etc.

14. Negotiable instruments – All the credit instruments that are transferable from one
person to another by a process known as “endorsement” are called “negotiable”
instruments. Suppose “A” is receiving payment by means of check from “C”. “A” owes
money to “B”. The check is a negotiable instrument as it enables “A” to settle his dues
to “B” by endorsing the same in favour of “B”. This renders the check a negotiable
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instrument. There may be some restriction on some of the above instruments, not
allowing free transferability either by the banks or by the issuers of the instruments
themselves.

15. Acceptance – We have seen what a bill of exchange is. The buyer who has already
received goods or services from the seller is required to acknowledge his debt to the
seller by signing on the bill of exchange. This act of acknowledgement is called
“acceptance”. At times in this, banks are also involved just to enhance the credibility
of a bill of exchange. This is called banker's acceptance for which the bank charges
commission. It is similar to giving bank guarantee.

16. Credit Report – It is called by different names. At times, it is referred to as “Credit


Information Report”. At other times, it is also called “Customer’s confidential report”.
Banker’s report also means the same. With the growth of commerce within a country
and abroad, most of the times, trade is done with organisations, about which you are in
the dark. The banker provides good platform for knowing something about the
business enterprise with which you are likely to deal. There are accepted
abbreviations internationally for denoting the soundness or the lack of it of a business
enterprise. These abbreviations are commonly used in such reports. You can seek
confidential information about your prospective customers about whom you do not have
sufficient knowledge. The banker provides this information for a fee, which includes
the fees that they have to remit to International Credit Agencies.

17. Syndication – Making arrangement for loans for borrowers. Should not be confused
with granting of loans. The bank may or may not participate in the loan process, but
would assume responsibility for getting “in principle” sanction from all the participating
banks and financial institutions. It is more common internationally and syndication
fees are quite substantial abroad. Syndication fees are part of non-interest income as
no funds are involved in the activity. For example an Indian company wants a Foreign
Currency Loan of 100 M. Rs. Making arrangement for this is called syndication. Even
if the arranging bank participates in the loan by granting a portion of it, syndication is
different from it. It gets paid separately for this activity.

18. Custodial services - As per instructions of the customers, accepting dividend and
interest warrants on shares and bonds/debentures respectively and credit the
proceeds of the same to the customer’s account. For this also separately fees are
charged, which is a non-interest income.

19. Security - Fixed assets like land, building, plant and machinery etc. as well as working
capital assets like inventory or bills receivable are offered as security to a lender by a
borrower for assurance of repayment of the loan taken by him. Suppose it is a housing
loan. The value of the apartment is Rs. 1,000,000/-. This is the value of security for
the mortgage loan. The bank would give loan to the extent of certain prescribed % of
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the value of the security. Security can be paper security like shares, debentures,
fixed deposit receipts, life insurance policies etc.

20. Margin – This is expressed in % of the value of security. In the above example,
suppose the margin is 25%, it means that the housing loan would be to the extent of
Rs. 250,000/-. At times the margin is also expressed as the amount of loan in % terms
to the value of security. Accordingly the margin would work out to be 75% in this
case. This should be borne in mind while preparing the programme for a bank.

21. Foreign exchange – It is one of the most important aspects of international banking, as
a result of the different currency systems in the two countries involved. For example
an American company imports from France and the bill is in French Francs. It is
obvious that the exporter wants French Francs in France. Where does the American
importer get the French Francs? He gets it from the banking system. He exchanges
US Rs. for French Francs. In fact the importer need not possess French Francs at all.
It is enough he surrenders US Rs. to his bank in the US and in exchange for the same,
the US bank will give equivalent French Francs to the French exporter in France. This
transaction will be through its NOSTRO Account as seen earlier, maintained with a
correspondent bank in France.

22. Securitisation
This is the process whereby traditional bank assets, namely, mortgages are sold by the
bank to a trust or a corporation, which in turn sells the assets as securities. This is
very reliable way of raising resources for the banks and this concept is catching up
well internationally.

International Banking

As mentioned in the introduction, international banking revolves around the following:


♦ International trade
♦ Tourism,
♦ Remittance of funds from one place to another place,
♦ Syndication of loans globally for large business houses and multinationals,
♦ Accessing international markets for equity/borrowing in the form of bonds etc. for
corporate houses/multinationals
♦ Foreign exchange management etc.

The above give rise to the following transactions:

INTERNATIONAL TRADE

♦ Letters of Credit,

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♦ International Guarantees like performance guarantee, advance


♦ Money guarantee etc.
♦ Deferred Payment Credit backed by bank guarantee
♦ Bills for collection
♦ Foreign exchange involved in remittance of proceeds from the
Importing country to the exporting country

TOURISM -

♦ International Travellers’ checks


♦ International Money Orders
♦ Foreign exchange involved in encashment of travellers’ checks
and International Money Orders/Demand Drafts/Telegraphic Transfer/SWIFT
remittance etc.
♦ Credit card business and international bills settlement under credit cards

REMITTANCE OF FUNDS FROM ONE PLACE TO ANOTHER PLACE BESIDES


TOURISM/INTERNATIONAL TRADE

♦ Routine transfer from persons employed abroad


♦ Donations/charity remittances
♦ Remittances for disbursement of loans (inward for the borrowing country)
♦ Remittances for repayment of loans (outward for the borrowing country)
♦ Remittance for payment of interest (outward for the borrowing country)
♦ Remittance of royalty, dividend (outward for remitting country)

SYNDICATION OF LOANS GLOBALLY FOR CORPORATE HOUSES

♦ This does not involve any funds and it is a non-fund based activity earning non-interest
income

ACCESSING INTERNATIONAL MARKET FOR EQUITY/BORROWING IN THE FORM OF


ADR/GDR AND EURO BONDS ETC.

♦ This again does not involve any funds and it is a non-fund based activity earning non-
interest income

FOREIGN EXCHANGE MANAGEMENT

♦ This is common to all the activities listed above, which involve funds. Such activities
are called fund-based activities of the bank, unlike syndication and/or accessing

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international markets for GDR/ADR, Euro bonds etc., which are non-fund-based
activities.

Note: A discussion about international banking is not complete without mention of


electronic cash on the Internet or “E-cash”. This could easily become global currency,
issued by Governments and private firms alike. The explosive growth of this phenomenon
will tremendously influence globally the banking industry and hence everybody in the
banking industry is watching this development with interest, awe and fear, all at the same
time.

Profile of a bank

DIFFERENT LAYERS OF BANKING OPERATIONS IN INDIA IN GENERAL

Branch banking – This is the operating unit of a bank - a place wherein all the operations
of a branch take place, both retail and wholesale. This is the place for operations and not
for bank administration, although branch administration is a part of branch operations. A
branch is responsible to itself and does not control another branch.

Bank administrative units which control branches within its territory/jurisdiction – These
are at different levels, the first level being a Regional Office or a Divisional Office or an
Area Office, the second level being a Zonal Office and the third and apex level being the
Head Office. These administrative units do not carry on any banking operations like
branches but monitor and control all the branches within its jurisdiction to ensure that
the functioning is smooth and as per the guidelines of the Bank as a whole and the Reserve
Bank of India (the country’s Central Banking Authority). Further in respect of decision
making, starting from the branch to Head Office, there are different levels with each
successive higher level having higher delegated powers than the previous level.

At the same time, we can easily visualise that among the operating units, i.e., branches, all
the branches may not be at the same level in terms of delegated powers. The extent of
powers enjoyed by a branch will depend upon its size, i.e., mix of deposits and advances at
its command etc. Small branches will enjoy less authority; medium sized branches enjoy
more authority, while large branches will enjoy maximum authority. The authority relates
to the extent of finance that they can give at their level without any reference to the
next higher level of authority (Regional Office or Zonal Office) or the highest level of
authority (Head Office).

The designation of the controlling offices differs from bank to bank and no uniform
practice is seen in India. The level of authority or extent of authority to be wielded by a
particular layer is decided by the Board of Directors who meets in the respective Head
Offices. The Board of Directors is headed by a Chairman and is assisted, most of the
times by an Executive Director. In turn, the Executive Director is assisted by General

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Managers (some banks have additional posts called Chief General Manager, Deputy Chief
General Manager etc.), Deputy General Managers, Assistant General Managers, Zonal
Managers, Regional Managers, Branch Managers (at the branch level) etc. This is just to
give an overall view of the possible hierarchical structure within a bank in India and not
meant for giving the reader the organisation chart of a bank.

Most of the large size banks have an international banking department.

WHAT ARE THE DUTIES OF AN INTERNATIONAL BANKING DEPARTMENT?

1. Exchange operations
2. Opening of documentary credits of importation as well as providing notices and
confirmation of export documentary credits.
3. Remittance to correspondents of documents for collection and handling of collection
received from them.
4. Issuing bond guarantees on foreign countries or issuing bonds or guaranties for the
account of foreign banks or firms in favour of local firms.
5. Handling foreign currency assets of the bank.
6. Granting lines of credit to banks or firms abroad and securing and handling lines of
credit granted to the bank by its correspondents.

7. Maintaining public relation to assure permanent contact, directly or indirectly, with


customers within the country or abroad.
8. Maintaining close supervision of relations with correspondent banks worldwide, which,
aside from credit and service aspects, also means permanent control over reciprocity
received or given.
9. Compiling statistical data to evaluate the evolution of bank operations in the
international sector.

1.5 ADMINISTRATIVE FUNCTIONS IN A BANK

Different administrative units in a Bank

There is distinction between banking operations at a branch level and at administrative


levels. The names of the administrative offices differ from one banking institution to
another. Please refer to Section 2.4 – page no. 37 also in this behalf. To illustrate the
same, let us study the following structure.

Tier No. 1 – Branches of various business mix and sizes of business, small, medium, large
and very large.
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Tier No. 2 – Regional Offices or Area Offices

Tier No. 3 – Zonal Offices or Divisional Offices

Tier No. 4 – Head Office

Tier No. 1 functions already seen.

Tier Nos. 2, 3 and 4 constitute the administrative units of the bank. It does not mean
that at the branch level there is no administration. What the branch does is called
“branch administration” as opposed to the function of these 3 tiers, known as “bank
administration”.

Typical functions of different administrative units of a bank:

To ensure conformity with the rules and regulations of Head Office by the branches and
other smaller administrative units under its control.
To ensure conformity with the Central Banking Rules and Regulations as applicable from
time to time by all the branches and other smaller administrative units under control.
(In India, the central banking agency is the Reserve Bank of India.)
To grant loans and other credit facilities to branch borrowers whose requirements fall
outside the delegated authority of the proposal referring branches/smaller
administrative units, but within its own delegated authority.
To co-ordinate the activities of all the branches/smaller administrative units within its
jurisdiction.
To administer the branches/smaller administrative units under its control in matters
relating to leave of the managers of the branches, branch premises, other bank assets
at the branch level, transfer of bank officers within the area of jurisdiction as per its
delegated authority.
To recommend any proposal to the higher administrative unit of the bank for sanction of
loans and other credit facilities whenever the requirements fall beyond the purview of
its delegated authority.
To ensure periodic audit of the branches and other smaller administrative units of the
bank by duly appointed teams of auditors, who are officers from the bank itself.
To maintain liaison with other banks in the same geographical location at a corresponding
level – Area Office of one bank with similar administrative units of other banks
operating in the same area etc.
At the Head Office level –

♦ To maintain liaison with top administrative units of other banks.


♦ To maintain liaison with the Central Banking Authority
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♦ To evolve policy every year relating to the bank in the areas of business
development, branch expansion, opening of branches abroad etc.
♦ To maintain vigilance cell for detecting frauds within the bank, dealing with errant
bank officials, conducting personnel enquiries against bank employees etc.
♦ To look after international wing of the bank, like opening of branches abroad, types of
business to be undertaken there, where to open bank accounts, which banks abroad
should be correspondent banks of the bank etc.
♦ To hold negotiations with other banking institutions (globally) for establishing
Lines of credit for utilisation within the country.
♦ To evolve policy and administer the same relating to personnel within the bank, like
promotion, transfer, recruitment, service rules and regulations, dismissals,
superannuation benefits etc.
♦ To decide about the delegated authority at various levels of the banks, like branches,
administrative offices etc.
♦ To co-ordinate in preparation of final accounts of the bank on an annual basis.
♦ To facilitate audit of the bank by the Central Banking Authority.
♦ To ensure co-operation with all Govt. Agencies within the country.
♦ To evolve on an on-going basis, suitable systems for smooth bank administration.
♦ To do investment banking by investing funds set aside by way of CRR, SLR etc. for the
bank as a whole in suitable securities.
♦ To take decisions relating to raising resources by way of equity, preference share
capital, bonds (domestic as well as global), debentures (domestic as well as global),
loans (domestic as well as global) etc.
♦ To take decisions relating to lending resources to other financial institutions (domestic
mostly).

Banking Business vs. Other Business

To conclude this course material, it is necessary for us to understand how banking


business is different from other business. The following points indicate broadly the areas
of difference between a banking business and other types of business, namely,
manufacturing, services, trading etc.

1. Bank deals in money/finance unlike others and hence is required to evolve all checks
and balances to ensure that the trust and confidence of the depositors and other
customers is kept up. For this, suitable control measures like dual control (control in
the same banking unit at two different levels with two different types of personnel)
need to be evolved to prevent frauds in the bank.

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2. Banking operations need to be automated much more than other business due to the
need for control and the routine/repetitive nature of business. This will not only
ensure better operating efficiency but also compliance with the control system.
3. In other business, profit and loss accounts are prepared may be once in a month,
whereas a bank prepares the same every day. At the end of each day, the position
relating to deposits, advances, profit or loss as the case may be will be known to the
banking business unit, namely the branch.
4. In other business, the entire resources can be used excepting for a small portion kept
in the form of cash, while in banking business, a substantial portion of resources gets
locked up in investment as required by CRR/SLR.
5. In other business, cash flow statement is prepared usually for a period of a month,
whereas in the banking business, every day it is required if not in great details, at
least on a summary basis.
6. The Regulatory Authorities like the Central Banking Authority control a bank, whereas
other business is not directly controlled by any statutory authority.
7. Bank’s contribution to growth of an economy is manifold as compared to the
contribution to an economy even by the largest corporate conglomerate.

What are Derivatives ?

Derivative is an instrument that derives its value from an underlying asset. The asset
could be "commodity", "share/debenture" or "currency". For example, we enter into a
contract for purchasing US Dollar from a prospective seller, in exchange for Indian
Rupees, at Rs.48.00 on 20/03/2001 - 1000 US Dollars. This is called a "derivative".

The derivative used in Finance and Banking is called a "financial derivative". Financial
derivative is based on a "financial asset". Financial asset is different from any fixed
asset like building etc. A financial asset is money receivable by the asset holder due to
any one or more of the following:
Receivable due to sale of service
Receivable due to sale of goods
Receivable due to lending

What could be the objective of a derivative in general?

To minimise cost of borrowing by locking into a suitable interest rate, especially when
the market is going through increase in interest rates - Example - Fixed rate
borrowing for more than one year, when the market rates are expected to go up.
Floating rate of borrowing for more than one year, when the market rates are
expected to come down. A switch from fixed rate into floating rate, in case the
market conditions change. This is called "interest rate swap".
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To minimise risk associated with acquiring an asset in terms of availability and cost in
future - You want to buy ACC shares 2 months later, say, at 1000/- per share. The
present market rate is Rs.950/-. You expect the rate to go up to Rs.1100/- two
months hence. You are on the look out for a prospective seller who would sell to you at
a price less than this amount. You get a seller who is prepared to sell to you at say,
Rs.1050/-. This price is acceptable to you. Both of you enter into a contract and this
contract is called "futures contract". How does it happen that somebody is prepared
to sell it at Rs.1050/- when you expect it to go up. This is exactly what the market is
about. Perceptions about future rate movements would differ from person to
person. In the instant case, you perceive it to go up, whereas the seller
perceives it to come down. Further he may require the money very urgently and
badly.

To be in a better position to manage liability of loan, especially if the borrowing is in


foreign currency by managing foreign exchange risk - Example - You want US Dollars
1000 three months hence. The present Exchange Rate is 1 US Dollar = Rs.46.50. The
market is "bullish" on US Dollar. You expect the Exchange Rate to go up substantially.
Hence you are exposed to Exchange Risk three hence months hence. You expect the
US Dollar to go up to Rs.49/-. The Bank with whom you are dealing is prepared to sell
three months later (known as "forward sale") 1 US Dollar @ Rs.48.50. You want to fix
the Exchange Rate just now and accordingly enter into a contract with the bank. This
is known as "forward sale contract".

There is one more product besides the above, called "option". This is an improvement
on "futures". In case, one of the parties to any of the contracts as above wants to
cancel the contract, he has to compensate the other party to the contract. In the
case of an "option contract", for payment of a small premium, known as "option
premium", the purchaser of the option contract acquires the "Right" but not the
"obligation" to go through the contract. The writer of the contract is the seller and
the holder of the contract is the purchaser. The writer receives the premium from
the purchaser. This is quite often used in "bonds" issued by Corporations, Companies
etc. We will see more of it later.

Now let us examine futures, swaps and options in detail.

Future Contracts

A future contract is an agreement between a seller and a buyer that calls for the
seller (called the short) to deliver to the buyer a specified quantity and the grade of
an identified commodity/financial value, at a fixed time in future, and at a price
agreed into when the contract is entered into. These are contracts are traded
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through an Exchange, standardized by the Exchange and guaranteed by a Clearing


Corporation. Sometimes the contract is settled in cash value of the underlying.
The principal features of futures contract are:

• Futures contracts are traded on organised exchanges , so sellers and buyers


are not directly known to each other.
• Future contracts have standardised contract terms and periods. Generally
future contracts are traded with expiration/ settlement period of one month ,
two months up till an year. Each month's contract is considered as a separate
series and mostly maturity is in last week of the month. A open contract can
also be closed before expiry by squaring off the position in the same series.
• Futures segment has two-tier structure. A futures exchange where trading is
done and a clearing house which undertakes clearing and settlement of all the
executed trades on the exchange and also guarantees the fulfilment of the
futures contracts by way of margins and trade guarantee funds..
• Both exchange and clearing house have separate membership requirement. Thus
a Trading Member, who is a member of the exchange, can choose to be member
of the clearing house or else associate with a clearing member, who is member
of clearing house, for the settlement of trading members trades.
• Futures trading require margin payment by clearing members, i.e., the share
brokers, who in turn can collect the same from their clients and settlement of
trade takes place on a daily basis.
• Mark-to-market: At the end of each trading session, all outstanding contracts
are repriced at the settlement price of that trading session. This would mean
that some participants would make a loss while others would stand to gain. The
exchange adjusts this by debiting the margin accounts of losers and crediting
margin accounts of gainers. In effect, it’s a zero sum market where some
participants gain at the cost of losers.
• Actual delivery is rare as most of the futures contract are offset by equally
opposite contracts.

Index Futures:
The index futures are the most popular futures contracts as they can be used in a
variety of ways by various participants in the market. They offer different users
different opportunities like hedging , speculation etc. Index futures derive its value
from the underlying basket of index of securities. Generally popular indices, such as
Sensex, Nifty etc. can be traded as they are reflective of market sentiments and
mirror the movement of any fund's portfolio.

To explain it simply, suppose one wants to trade in futures contracts, say Nifty Index
Futures. One can place orders through his broker to buy or sell Nifty contract (min
contract size for Nifty is 200, so orders should be in multiple of 200) for any
particular month (series). Before placing the order one has to place some amount as

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initial margin, which can be a percentage of the value of his position. In exchange,
different prices shall quoted for all the series of one two or three months of
maturity. Suppose July, Aug and September series are traded at 1500, 1505 and 1515
respectively. An investor decides to buy 200 Nifty of August series at Rs. 1505 on
July 07. This contract will remain a long (open) till the maturity of August series on
31-Aug-2000. This open position can be squared off by selling similar 200 Aug series
on any day before maturity. Suppose on July 12, the quoted price of Aug series is
1550 and the investor chooses to close his position by selling 200 Nifty, then his cash
flow or profit will be Rs 9000/- {( 1550-1505 ) * 200}. This cash flow shall be received
in form of every day marked-to-market profit or loss. Each day his open contract will
be marked at that day's closing price of the series. So next day his carried forward
price will be taken as previous days closing.

E.g. cash flow for 200 buy Aug. series is:


Date Buy/CF price closing /Sell MTM
07-JUL 1505 1525 +4000
10-JUL 1525 1535 +2000
11-JUL 1535 1530 - 1000
12-JUL 1530 1550 +4000

NET MTM : +9000

After the investor has squared off his position he will receive a profit of Rs 9000/-
as well as the initial margin deposited earlier with his broker. Initial margin could be
10% of the value of his position i.e. Rs 30000/- approximately. ( 0.1 * 200 * 1505)
Options

Options are similar to futures contract but it gives its holder the right (but not the
obligation) to buy (known as "call option") or sell (known as "put option") securities at
a pre-determined price (known as "strike price" or "exercise price"), within or at the
end of a specified period (known as "expiration period"). So an "Option holder" may or
may not exercise his rights depending on the prevailing market conditions in future. In
order to acquire the right of option, the option buyer pays to the option seller (known
as "option writer") an Option Premium, which is the price paid for this right. The
buyer of an option can lose no more than the option premium paid but his possible gain
in unlimited. On the other hand, the option writer's possible loss is unlimited but his
maximum gain is limited to the "option premium" charged by him to the holder.
Therefore payoff in options is asymmetric. The most critical aspect of options
contracts is the evaluation of the fairness of option premium, i.e. option pricing. Most
often, options go unexercised.

American options are exercisable at any time prior to expiration date while European
options can be exercised only at the expiration date. Expiration can be similar to that
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of futures i.e. one month, two-month and three-month. For the call option holder, it is
worthwhile to exercise the right only if the price of the underlying securities/asset
rises above the exercise price. For the put option holder, it is worthwhile to exercise
the right only if the price falls below the exercise price. There can be options on
commodities, currencies, securities, Stock Index, individual stocks and even on
futures. Options strategies can be highly complicated.

Swaps

Financial swaps are a funding technique, which allows the flexibility of exchanging the
mode of cash flow pay off on a notional predetermined asset. E.g., "Exchange" of

"Fixed interest" pay off for a "Floating interest" pay-off on a fixed notional
principal amount. It permits a borrower to access one market and then exchange the
liability for another type of liability. The global financial markets present borrowers
and investors with a wide variety of financing and investment vehicles in terms of
currency and type of coupon - fixed or floating. Floating rates are tied to an index,
which could be the London Inter-Bank borrowing rate (LIBOR), US treasury bill rate
etc. This helps the investors exchange one type of asset for another for a preferred
stream of cash flows. Swaps by themselves are not a funding instrument; they are a
device to obtain the desired form of financing indirectly. The borrower might
otherwise have found this too expensive or even inaccessible.

All swaps involve exchange of a series of periodic payments between two parties. A
swap transaction usually involves an intermediary who is a large international financial
institution. The two payment streams are estimated to have identical present values
at the outset when discounted at the respective cost of funds in the relevant
markets.

Types of Swaps
The two most widely prevalent types of swaps are interest rate swaps and currency
swaps. A third is a combination of the two to result in cross-currency interest rate
swaps. Of course, a number of variations are possible under each of these major types
of swaps.

Interest Rate Swaps


An interest rate swap as the name suggests involving an exchange of different
payment streams, which fixed and floating in nature. Such an exchange is referred to
as an exchange of borrowings or a coupon swap. In this, one party, B, agrees to pay to
the other party, A, cash flows equal to interest at a predetermined fixed rate on a
notional principal for a number of years. At the same time, party A agrees to pay
party B cash flows equal to interest at a floating rate on the same notional principal
for the same period of time. The currencies of the two sets of interest cash flows
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are the same. The life of the swap can range from two years to over 15 years. This
type of a standard fixed to floating rate swap is also called a "plain vanilla swap" in
the market jargon.

Currency Swaps
Currency swaps involves exchanging principal and fixed rate interest payments on a
loan in one currency for principal and fixed rate interest payments on an
approximately equivalent loan in another currency. Suppose that a company A and
company B are offered the fixed five-year rates of interest in U.S. dollars and
sterling. Also suppose that sterling rates are generally higher than the dollar rates.
Also, company A enjoys a better credit worthiness than company B as it is offered
better rates on both dollar and sterling. What is important to the trader who

structures the swap deal is that difference in the rates offered to the companies on
both currencies is not the same. Therefore, though company A has a better deal in
both the currency markets, company B does enjoy a comparatively lower disadvantage
in one of the markets. This creates an ideal situation for a currency swap. The deal
could be structured such that company B borrows in the market in which it has a lower
disadvantage and company A in which it has a higher advantage. They swap to achieve
the desired currency to the benefit of all concerned.

A point to note is that the principal must be specified at the outset for each of the
currencies. The principal amounts are usually exchanged at the beginning and the end
of the life of the swap. They are chosen such that they are equal at the exchange
rate at the beginning of the life of the swap.

Market Participants

Exchanges: Derivatives are traded on Exchanges , which perform two functions : 1)


provide and maintain market place to enter into a contract 2) Police and enforce
ethical and financial standards applicable on exchange.

Trading Member (T.M): Trading Member performs functions similar to a brokerage


house in the securities industry. All trades has to routed through a TM and they
collect margins from their clients for their positions .

Clearing member (C.M): It acts as an intermediary between clearing house and the
clients or non-clearing member TM's.

Clearing Corporation: They perform the vital function of clearing the transactions on
the exchanges. Unlike clearing houses in security market , they guarantee the trades
by acting as a counter party to the trade. For precaution , a margin is maintained on a
mark-to-market basis everyday besides the initial margin.
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Regulatory Authorities : Future Markets have self-regulatory and central regulatory


authorities. They perform the function of market surveillance and keep a vigil on
market manipulations.

Traders/Clients : They are the users of derivative market and take specific positions
depending on their purpose viz . Hedging , Speculation etc.

*** End of Document ***

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