Topic 1: Overview of the Derivatives Market 1 What are Derivatives? ‘The word derivatives conjures up many different images for people who are not involved in the finance industry. Perhaps the most common view is that derivatives, such as futures and options, are new products and that investing in them is little more than gambling. However, as this first section will show, derivatives are not new, nor is speculation for profit their primary purpose. 1.1. Definition Derivatives are financial instruments whose value is derived from an underlying physical commodity or financial instrument. As such, their price is derived from the price of the instrument on which they are based — crude palm oil futures are based on the price of palm oil traded in the commodities market, while stock index options are based on the Kuala Lumpur Composite index. Derivative products have a very long history. The earliest derivatives were based on commodities — there are records of forward contracts on olive presses in Greece in the sixth century BC, and of forward contracts on rice crops in 18th century Japan. Options on equity stocks were available on the London Stock Exchange more than a century ago. However, the most exciting growth period for derivatives has been the last 30 years. The use of derivatives to control financial risk exploded in the early 1970s in response to the increased risk in financial markets resulting from rising inflation, increased interest rate volatility, the floating of exchange rates, and the oil price shocks. The first financial derivatives contract offered by an exchange was a currency futures contract, offered on the Chicago Mercantile Exchange in 1972. The first interest rate futures contract was offered on the Chicago Board of Trade in 1975. The world’s first formatised options exchange, the Chicago Board Options Exchange, was opened in 1973. Financial derivatives based on the prices of securities, currency values and interest rates are now widely available in many countries, including Malaysia where stock index futures and interest rate futures are now well established. 1.2. Purpose of Derivatives The main reason for the evolution and existence of derivatives is the fact that prices of commodities and financial instruments fluctuate, often rapidly and over wide ranges. Producers and users of those commodities and financial instruments, wish to avoid the uncertainty that this price fluctuation brings. The derivatives market brings buyers and sellers together in one place, where, through their brokers, they agree on a price at which 12 secu oman, Malan Scat tite Eaton ataTopic 1: Overview of the Derivatives Market those commodities and financial instruments will change hands at given future dates, thereby limiting their exposure to price change. Thus, the primary purpose of derivatives is to manage price risk. Derivatives provide a useful risk management tool for those who wish to minimise their exposure to fluctuations in the price of physical commodities or financial instruments. Corporations, government entities, financial institutions and investors, are all concerned about managing price risk. Futures, options, and other derivatives, provide these financial market participants with a tool to manage (i.e. hedge) this risk. In addition, derivatives are used by professional traders, known as speculators, who endeavour to make profits by correctly anticipating price changes. Though often maligned and misunderstood, the involvement of speculators is crucial to the operation of the market as they allow risk to be transferred from those seeking to avoid it, to those wilting to accept it in the hope of making a profit. 1.3 Types of Derivatives Derivatives are artificially constructed from existing debt and equity instruments, commodities and even foreign currencies. The range of derivatives that can be constructed is very wide, but essentially they fall into just a few categories — futures, forwards, swaps and options. In the following modules, however, we confine ourselves to futures and options and we do not cover other types of derivative products. Futures Futures are contracts, legally binding agreements, made on the trading floor of a futures exchange or via an electronic screen dealing system, to buy or sell something in the future. That ‘something’ could be gold or tin, cocoa or palm oil, a foreign currency, shares or interest rates. Each contract specifies the commodity, the quantity, quality and time of delivery or cash settlement. The buyer and seller of a futures contract agree on a price today for a product to be delivered and paid for in the future. That is why it is called a futures contract. In most cases, actual delivery of the underlying security does not take place. Instead, the contracts are closed out by opposite deals before the delivery date is reached. A trader who has bought a futures contract will close out by selling the same number and type of contract he originally bought. In some cases, delivery is not even possible, with the contracts written in terms of a notional (i.e. hypothetical) rather than an actual security. For these contracts, the profit or loss on the contract is calculated when the contract matures, as the difference between the price of the underlying instrument agreed in the Contract and the price on the delivery date. This difference is then settled in cash between the parties, (secre Commision, ans aneurin Eaton Ata, 199Topic 1: Overview of the Derivatives Market Options ‘An option is a contract between two parties in which one party (the buyer) has the right but not the obligation to buy or sell a specified asset at a specified price, at or before a specified date, from the other party (the seller). The seller of the option therefore has a contingent liability, or an obligation, which is activated if the buyer exercises that right. Options provide a means of obtaining insurance against risk in the underlying markets, while still allowing the option buyer to take advantage of favourable price changes. They are quite different from futures contracts, which can be thought of as a price-setting mechanism, as opposed to options, which are a facility for price insurance that can be abandoned at a comparatively low cost if they are not needed. 1.4 Exchange-Traded vs Over-the-Counter Derivatives Derivatives’ can be classified according to the type of market in which they are traded. There are two types of markets: + Exchange-traded markets — which are based on a formalised exchange + Over-the-counter markets — which are outside a formalised exchange Exchange-Traded Derivatives ‘An exchange is a specific market place where derivatives are originated and traded. The exchange provides the trading environment. They serve as communication centres, centralising orders from various buyers and sellers and disseminating relevant information on price. The types of derivatives most commonly traded on an exchange are futures and options. The features of exchange-traded derivatives are detailed below. + Trading Method: The trading of derivatives on certain exchanges fs based on the system of open outcry on a physical trading floor, where traders transact deals through a combination of hand signals and speech. However, with the advent of computerised trading, most exchanges no longer have open outcry trading and all transactions are performed electronically, using the computer. Bursa Malaysia Derivatives Berhad uses a screen-based dealing system for all of its products, namely the KLCI Futures, KLCI Options, Crude Palm Oil Futures, Crude Palm Kernel Oil Futures, KLIBOR Futures, 3-Year MGS Futures, 5-Year MGS Futures, 10-Year MGS Futures and Single Stock Futures. + Contracts Have Standard Features: Contracts listed on exchanges are highly standardised as to the type and maturity of the ‘underlying’ instrument, i.e. the commodity or security on which the contract is based. This standardisation makes it easy for market participants to deal in these instruments because there is no need for 14 <2 ScuiesCnmion, alyiand Secs ete avation ata, 1+ Little Secondary Tra Topic 1: Overview of the Derivatives Market discussions or negotiations to determine the contract specifications — the only thing left to negotiate is the price. This in turn promotes greater liquidity because there is a large number of only a limited range of contracts being traded at any one time. Liquidity in the derivatives market refers to the capacity of a contract to be bought or sold quickly and easily with little or no impact on price. + Secondary Trading: Standardisation also means that deals can be readily unwound prior to the maturity date — participants simply do a reverse transaction. For exaiiplé, if a trader has sold a number of crude palm oil futures contracts, this position can be closed out by buying the equivalent number of the same contracts. This ease of entering and exiting positiohs further promotes liquidity. + Clearing House: Transactions are settled through a dedicated clearing house associated with (although not necessarily owned by) the exchange. The clearing house tracks the positions outstanding and registers contracts. It centralises and nets out the collection and disbursement of margins and variation gains/losses. It also supervises the close out of contracts, either through physical delivery or payment of settlement amounts. Over-the-Counter Derivatives The instruments most commonly traded over-the-counter (OTC) are swaps, forward rate agreements, and options on physical instruments. Compare the features of exchange- traded derivatives described above with those of the OTC markets below. + Trading Method: OTC instruments are not traded at a centralised marketplace or through a formalised trading system. Instead, participants arrange deals through face- to-face meetings or through the telephone or other means of communication. + Tailor-Made Contracts: Contracts are not standardised in terms of quantity, delivery date or term to maturity. The details of each transaction are negotiated by the ‘counterparties. This lack of standardisation has benefits in that the specifications can more exactly meet the needs of the parties. ig: The lack of standardisation means there is much less secondary trading of contracts, and much lower liquidity, because each contract tends to be unique. It is also more difficult to manage positions, since contracts usually cannot be onsold to third parties. Contracts can be unwound prior to maturity, only if the original counterparty agrees to a reverse transaction — in this case, the two offsetting gross contracts may be netted out. Failing this, an offsetting transaction can be done with another counterparty, but in most cases, these two offsetting transactions will not be able to be netted. (eSects Comms, aaa and Secu ste Eaton sala, 999Topic 1: Overview of the Derivatives Market + No Clearing House: There is no centralised clearing house for OTC derivatives. As a consequence, OTC transactions involve higher credit risk because exposure is directly to the counterparty and there is no system of deposits or margins, and no guarantee fund. Traders control this risk through credit assessments of counterparties and the setting of exposure limits. 1.5 Derivatives Markets in Malaysia ‘The derivatives market in Malaysia commenced with the establishment of the Kuala Lumpur Commodity Exchange (KLCE) in July 1980. The initial futures contract traded on KLCE was Crude Paim Oil Futures. This contract is still traded until today. The KLCE had the infrastructures and capacity to allow for the trading of financial futures, however, setting up a subsidiary was necessary because trading in the financial futures fell under different jurisdictions. Therefore on 19 August 1992, the KLCE, with the support of the government authorities, incorporated a wholly owned subsidiary called the Kuala Lumpur Futures Market Sdn Bhd (KLFM) which was later renamed Malaysia Monetary Exchange Bhd (MME) in mid-1995. On 7 May 1996, the Minister of Finance approved the establishment and operation of MME as a futures and options exchange company and the three-month KLIBOR futures contract was launched on 28 May 1996. (On 9 November 1998, the KLCE was renamed the Commodity and Monetary Exchange of ‘Malaysia (COMMEX) in preparation for the merger with the Malaysian Monetary Exchange. The merger took place on 7 December 1998. A visibility study by the International Monetary Fund for Bank Negara Malaysia in 1990 ‘identified the need for some form of financial risk management tool in the face of increasing volatility in the financial markets. This study led to a series of regulatory infrastructure reforms to introduce financial derivatives. As a result of these reforms, Malaysia’s first financial derivatives exchange was established - The Kuala Lumpur Options and Financial Futures Exchange (KLOFFE). KLOFFE was licensed as a futures and options exchange on 11 December 1995 and the stock index futures and stock index options were first traded on 15 December 1995 and 1 December 2000 respectively, In tine with the Capital Market Masterplan of the Securities Commission, KLOFFE and COMMEX merged on 11 June 2001 and formed a new derivatives exchange called the Malaysia Derivatives Exchange Berhad (MDEX).On 20 April 2004, MDEX was renamed Bursa Malaysia Derivatives Berhad. 1-6 sect Comin, asa and Scars tute Eden Aura, 199Topic 1: Overview of the Derivatives Market Figure 1 below illustrates the structure of the Malaysian derivatives market. Figure 1: Structure of the Malaysian Derivatives Market ‘Minister of Finance ‘Bursa Malaysia Derivatives Berhad Bursa Malaysia * KLIBOR Futures Derivatives. + Crude Palm Ol Futures Cheating Berhad * Crude Paim Kernel Oil Futures Stock Index Futures + Stock Index Options + 3-Yeor MGS Futures 5-Year MGS Fulures to-Year MGS Futures SSF Futures, Relevance of Futures and Options to the Capital Market ‘The Malaysian Goverhment is committed to fostering the growth of an effective capital market to support the financial system required for the country’s economic development, Indeed, the government’s goal of achieving the status of a developed country by the year 2020, means that a rapidly expanding capital market is essential. The capital market assists the process of economic devetopment by mobilising long-term funds from the investing public to finance public development programs and private investments. It also promotes private enterprise by providing a convenient means of raising capital for corporate investment and expansion, Integral to the growth of Malaysia's capital market is the development of the futures and options market. Futures and options provide hedging and asset allocation facilities which allow investors to hold larger debt and equity positions and, as a result, enhance the Liquidity of these underlying markets. Liquidity in the capital markets is essential, given the government's privatisation plans which will necessitate a large scale mobilisation of funds. An active derivatives market that complements the capital market will enable investors to hedge or adjust their positions and thus make them more willing to take larger holdings, thereby fuelling Malaysia's economic development. (secre Commi, iy rdSnties tte Eton asta, 188 17Topic 1: Overview of the Derivatives Market Participants in the Malaysian Futures and Options Market ‘The Malaysian futures and options market is made up of a diverse range of participants. They include: + the regulator ~ which authorises the existence of the market + the futures exchange ~ which provides the trading facilities + the clearing house — which clears and processes trades and assumes counterparty risk + intermediaries such as holders of a Capital Markets Services Licence (CMSL) who carry on the business of trading in futures contracts, holders of a CMSL who carry on the business of fund management, and holders of a CMSL who carry on the business of investment advice — who advise and/or trade in the market + the users, or clients of the intermediaries — who may be hedgers, speculators or arbitrageurs. 18 secures Connon, Masa and Secession Aue, 19Topic 1: Overview of the Derivatives Market These are illustrated in Figure 2 below. Figure 2: Participants in the Malaysian Futures and Options Market Regulator + Securities Commission Exchange + Bursa Clearing House Bursa Malaysia Malaysia Futures and Derivatives Derivatives Options Market Clearing Berhad Berhad Intermediaries Users/cltents (Holders of a CMSL) + Hedgers + Speculators » Arbitrageurs The remainder of this topic examines each of these participants with a view to illustrating their role in the Malaysian futures and options market. sears Commi, saayra ane secu nte Eaton sista, 189Topic 1: Overview of the Derivatives Market 2 The Futures Exchange We begin our examination of the Malaysian futures and options market with a close look at the exchange, the Bursa Malaysia Derivatives Berhad 2.1 The Bursa Malaysia Derivatives Berhad The first futures exchange in Malaysia, the Kuala Lumpur Commodity Exchange (KLCE) was established in July 1980 with just one contract, crude palm ofl futures. Futures contracts on other commodities soon followed with a rubber futures contract in 1983 (known as “RSS 1 Rubber futures”) and a second rubber futures contract in 1986 (known as “SMR 20 Rubber futures”). Tin futures were launched in 1987, cocoa futures in 1988, palm olien futures in 1990 and crude palm kernel futures in 1992. Currently the active contract is the crude palm oil futures. ‘The KLCE had the infrastructure and capacity to allow for the trading of financial futures, however, setting up a subsidiary was necessary because trading in the financial futures fell under different jurisdictions. Therefore on 19 August 1992, the KLCE with the support of the government authorities, incorporated a wholly owned subsidiary called the Kuala Lumpur Futures Market Sdn Bhd (KLFM) which was later renamed Malaysia Monetary Exchange (MME) in mifd 1995. On 7 May 1996, the Minister of Finance approved the establishment and operation of MME as a futures and options exchange company and the three-month KLIBOR Futures was launched on 28 May 1996. On 9 November, the KLCE was renamed as the Commodity and Monetary Exchange (CONMEX) of Malaysia in preparation for the merger with the Malaysian Monetary Exchange (MME). The merger took place on 7 December 1998. ‘The Kuala Lumpur Options and Financial Futures Exchange (KLOFFE), Malaysia’s first financial derivatives exchange was established in December 1995. Stock index futures and stock index options were first traded on KLOFFE on 15 December 1995 and 1 December 2000 respectively. In line with the Capital Market Masterplan of the Securities Commission, KLOFFE and COMMEX merged on 11 June 2001 and formed a new derivatives exchange called the ‘Malaysia Derivatives Exchange Berhad (MDEX). On 5 January 2004, Kuala Lumpur Stock Exchange Berhad (KLSE Berhad) became the holding company of MDEX. This was one of the effects of the demutualisation exercise, secret Cone Ana nd Sets ate Econ ra, 299 iiTopic 1: Overview of the Derivatives Market which also resulted in the Kuala Lumpur Stock Exchange (KLSE) being converted from a company limited by guarantee to a public company limited by shares. Subsequently, on 20 April 2004, KLSE Berhad and MDEX had their names changed to Bursa Malaysia Berhad and Bursa Malaysia Derivatives Berhad respectively. Participantship of the Futures Exchange Bursa Malaysia Derivatives Exchange Berhad participantship is made up of the following classes: (a) Trading Participants which comprise: (i) Equity Financial Participants (ii) Non-Equity Financiat Participants (iit) Commodity Participants () Local Participants (©) Associate Participants (4) Such other class of participantship as many from time to time created by The futures exchange (@) Trading Participants ‘Trading Participantship shall be companies incorporated under the Companies Act 1965 and are set specifically to carry out a futures broking business and must be licensed under the Capital Markets and Services Act 2007 (CMSA). The minimum issued and paid-up capital of a Trading Participant is currently RMS million and this amount, is determined by Bursa Malaysia Derivatives Berhad in consultation with the Securities Commission. The minimum financial requirements may change from time to time. Trading Participants may be Clearing Participants or Non-Clearing Participants. The following are descriptions of Trading Participants: (i) Equity Financial Participants ‘Companies that hold Preference Share “A” and are allowed to trade on equity related products such as KLCI Futures and KLCI Options. 112 (Sees Coemse, ly ad Sess wate Extn Aus, 19! Topic 1: Overview of the Derivatives Market Gi) Non-Equity Financial Participants Companies that hold Preference Share “B” and are allowed to trade on non- equity financial related products that are three-month Kuala Lumpur Interbank Offered Rate (KLIBOR) Futures, 3-Year MGS Futures, 5-Year MGS Futures and 10- Year MGS Futures. Commodity Participants ‘Companies that hold Preference Share “C” and are allowed to trade on ‘commodity product such as Crude Palm Oil (CPO) Futures and Crude Palm Kernel Oil (PKO) Futures. . (iv) General Participants Companies that hold Preference Share “A”, “B” and “C” and are allowed to trade all Bursa Malaysia Derivatives Berhad products. (b) Local Participants Local Participant is offered to individuals who wish to trade on their own behalf. These individuals are not permitted to trade on behalf of clients. Local Participants are not required to be licensed under the CMSA as they are not considered to be intermediaries in the industry. They are however required to be registered with the futures exchange. Local Participants have access to the trading facility of Bursa Malaysia Derivatives Berhad for the purpose of executing their own trades of which matched trades will then be cleared through any of the Clearing Participants. (c) Associate Participants Associate Participants must be corporations that do not carry the business of futures broking within Malaysia and do not own any Preference Shares. However, these companies have been granted the option to be a Clearing Participant. Associate Participants are required to nominate a Trading Participant who will execute trades on their behalf. Types of Orders The following types of orders may be entered into the electronically into the Bursa Trade trading system Sects Caner, aly Sse aie Econ al, 199 1-13Topic 1: Overview of the Derivatives Market Market Orders Matched at the best available prices to the fullest extent possible of the quantity of the market order entered immediately upon its entry into the trading system. Any remaining unexecuted quantity of the market order is cancelled. A market order which cannot be executed immediately upon it entry into the trading system shall also be cancelled, Market orders may be entered during the pre-opening, pre-closing and the main trading phases. Limit Orders ’ Stipulates a maximum buy price or a minimum sell price. These orders are matched at the price stipulated price or at a price better than the stipulated price. Limit orders may be entered during the pre-opening, pre-closing and the main trading phases. Stop Orders A buy or sell order that specifies a trigger price (ie, the traded price at which the stop order shall be converted into a market order or a limit order). There are 2 types of stop orders, namely stop-loss order and stop-limit order. During the main trading phase, where the trigger price specified in the stop order is reached: a stop-loss order is converted into a market order in the chronological order of time of the placement of the stop-loss order. The market order shall then be considered for matching in accordance with the principles for matching of orders; or a stop-limit order is converted into a limit order in the chronological order of time of the placement of the stop-limit order. The stop-limit order shall then be considered for matching in accordance with the principles of matching Stop orders may be entered during the pre-opening, pre-closing and the main trading phases. ‘Market-On-Opening Orders/Market-On-Closing Orders An order with no price stipulation and may be entered into the trading system during the pre-opening and pre-closing phases respectively. 114 (Steries Conmlsn, halal sad Seer Intute eatin Al, $977Topic 1: Overview of the Derivatives Market A market-on-opening order is matched at the opening price at the opening auction and a market-on-closing order is matched at the closing price at the closing auction. Any remaining unexecuted quantity of the market-on-opening order and market-on-closing order is converted into a limit order at the opening and closing price respectively, of the particular contract. Market-To-Limit Orders An order with no price stipulation. A buy market-to-limit order is matched immediately at the lowest sell price and a sell market-to-limit order is matched immediately at the highest buy price. Any remaining unexecuged quantity of the market-to-limit order is converted into a limit order at the matched price. ‘A market-to-limit order which cannot be matched immediately upon its entry into the trading system, whether in part or in full, shall be cancelled by the trading system. Market-to-limit orders may be entered during the main trading phase only. Order Matching Each order is matched electronically according to priority of price and then time.In determining price or time priority, we need to look at the following: Best price: A buy order at the highest price and a sell order at the lowest price has priority over other orders entered for the same contract. Earliest Time-Stamp Each order receives a time stamp upon entry into the system. In the event that there are competing orders, or identical prices entered for the orders, the orders are matched in the order of time in which the orders are entered into the system. Time stamp given to an order entered into the system shall be changed in any of the following circumstances: (i) where the quantity of the order fs increased (ii) where a change is made to the price of the order (tii) where a change is made to the trigger price of the stop order Market orders are given priority over other types of orders. 2 Series Commis, nays ar Sees tue dunt asa, 1999 1-45Topic 1: Overview of the Derivatives Market Trade Confirmation ‘As soon as a trade has been concluded (ie, a match has been found in the system) both Participants receive a printed trade confirmation. Trades are then submitted for registration to the clearing house. 1-16 «secures Commision, aay ard Secu tt Eeston ta,198Topic 1: Overview of the Derivatives Market 3 The Clearing House ‘A prerequisite for the successful operation of any futures/options market, is the existence of an efficient and financially sound, clearing house. Clearing houses provide the fundamental financial integrity to futures and options markets by allowing participants to deal freely with each other without credit risk constraints. How they do this is explained in this section. 3.1 Functions of the Clearing House The basic functions of the clearing house can be summarised as follows: Register all Trades Whenever a trade is concluded, a record is passed to the clearing house. The trade is processed by the clearing house and later that same day, a statement Is issued to the clearing participant describing the trades registered in its name. Novation ‘After the futures contract is registered by the clearing house (in the names of the two clearing participants), the nexus between the two original contracting parties is broken. The clearing house then becomes the buyer to the clearing participant acting as seller, and the seller to the clearing participant acting as buyer. Thus, the identity of the other party to a futures contract is no longer of importance, nor in fact, are parties to an original contract obliged to return to each other to complete or unwind the contract. This function, termed novation, is one of the distinguishing features of exchange-traded futures and options markets. Through novation, the clearing house becomes the seller to every buyer and the buyer to every seller. The clearing house eliminates credit risk between clearing participants since it is able to guarantee the performance of all contracts. The process of novation is demonstrated by the following diagrams: Figure 3: Transacting a Trade on the Futures Exchange Buyer 1-18 seers Comm, alas and Scut ette eton Aa 99Topic 1: Overview of the Derivatives Market Figure 4: Novation — The Clearing House is interposed between Buyer and Seller Clearing Participant, Clearing seller Participant Appoint of note here is that the clearing house does not guarantee the clients of the clearing participants. As mentioned earlier, contracts that are traded by a participant on behalf of a client are registered by the clearing house in the participant’s name and not in the client’s name. 3.2. Risk Management The role of the clearing house is to provide efficient settlement and risk management facilities which protect the interest of clearing participants and their clients. To ensure that the clearing house can assume the risk of its participants if they default, the clearing house must effectively measure, monitor and manage risk so that it can protect its participants in the event of uncertain market conditions. ‘The clearing house protects financial integrity through its risk management policies and procedures. These include: * ensuring that the clearing participant has the capability and meets the minimum. standard of participantship ‘* daily margining requirements and settlement systems ‘financial monitoring * security deposit and clearing fund. Participantship Standards ‘The initial step in the process of safeguarding financial integrity is to assess the creditworthiness and competence of each potential clearing participant. The clearing house imposes stringent financial and operational requirements on its clearing participants. Each prospective clearing participant is subject to an assessment of its operational efficiency, in particular, the accurate and prompt accounting of its transactions. It must have within its organisation experienced management and adequate and qualified staff to perform its functions. Clearing participants must also comply with (6 Scare Contin, Ma ane Securities ses Esato ua, 159 faaTopic 1: Overview of the Derivatives Market the minimum financial requirements relating to their assets, capital and participantship payments. Margining and Settlement For every futures or options trade in the market, a margin, or deposit, is required to be paid to the clearing house. The collection of margins on all positions held by a clearing participants is fundamental to the operation of the clearing house in protecting itself against losses arising from a clearing participant’s default. The margin level is monitored daily and may be adjusted to reflect changes in price volatility, movements in prices of underlying assets and other factors. The margin is returned at the time the contract is settled, whether by delivery, or by an opposite transaction on the futures/options market. The margin is more of a performance bond than a down payment on the contract being traded. In addition to the initial margins required to open contracts, any price movements in the market must be covered daily by further margins called variation gains/ losses or daily settlement. If a trader has bought a contract and the price subsequently falls, the trader will be required to pay additional funds to cover the current unrealised loss. The trader will be in a similar position if a contract has been sold on the futures market and the price rises. The clearing house’s exposure to risk is theoretically limited to a maximum one day's price movement. The system of variation margins, where the seller or buyer progressively pays this debit amount, effectively maintains the participants at current market values. This ensures that the buyer or seller is fully paid up or settled-to-market. Financial Monitoring Programme As part of its risk management procedures, the clearing house operates a programme of financial monitoring. The programme includes: * monthly financial reporting by clearing participants * audits and examinations by the clearing house «information sharing between the clearing house and the futures exchange ‘+ monitoring of the positions of clearing participants against intra-day price movements and economic events. Security Deposit and Clearing Fund The clearing house has recourse to contingency funds maintained by it in the form of security deposits and contributions made to the clearing fund. Security deposits and clearing fund contributions may be used in the event of margins being insufficient to the clearing house against losses sustained by its participants. 1-20 ce ecules Coen yaa Scns eta aves aa, 199Topic 1: Overview of the Derivatives Market 4 Intermediaries in the Futures and Options Market Intermediaries in the futures and options market are the people who trade or provide advice on trading to the investing public. They are the ‘middlemen’ between the futures ‘exchange and the users of the futures exchange’s products. Under the CMSA, intermediaries primarily involved in the futures and options market fall under the following categories of licences: + Holders of a Capital Markets Services Licence (CMSL) who carry on the business of trading in futures contracts + Holders of a CMSL who carry on the business of fund management * Holders of a CMSL who carry on the business of investment advice + Holders of a Capital Markets Services Representative’s Licence (CMSRL) who carry on the business of trading in futures contracts + Holders of a CMSRL who carry on the business of fund management + Holders of a CMSRL who carry on the business of investment advice In this section, we give a brief overview of all six. Note that under the CMSA, the definition of the term futures contract refers to both futures and options, Hence, alt references below to futures, also include options. 4.1 Holders of a CMSL who Carry on the Business of Trading in Futures Contracts Holders of a CMSL who carry on the business of trading in futures contracts refer to companies that are participants of a futures exchange in that they trade in the futures exchange and agree to be bound by its business rules. These CMSL holders can trade on behalf of other persons. Their basic functions are: ‘+ representing their clients in placing orders in the market + collecting margins from the clients + provide basic accounting records and transaction documents to their clients + advising and making recommendations to clients for their trading programs By nature of the development of the futures and options market, these CMSL holders must. ‘execute all orders for trading in futures and options contracts on the futures exchange. This means that, in addition to being licensed under CMSA, they must be participants of a 1-22 (2 Sacer Comin asa and Secs itt ction Aa, 199res yon ust. Fa Topic 1: Overview of the Derivatives Market futures exchange and accordingly, its business and activities are also regulated by the business rules of the futures exchange. 4.2 Holders of a CMSL who Carry on the Business of Fund Management. Holders of a CMSL who carry on the business of fund management are companies that manage a portfolio of securities and/or futures contracts. The funds operate very much like unit trusts and enable small investors to.pool their resources for management by these CMSL holders. Holders of a CMSL who carry on the business of fund management must be companies, and their employees or agents who deal directly with their clients are known as holders of a CMSRL who carry on the business of fund management. 4.3 Holders of a CMSL who Carry on the Business of investment Advice Holders of a CMSL. who carry on the business of investment advice provide advice and analysis to clients who are interested in participating in the securities and futures market. Holders of a CMSL who carry on the business of investment advice who do not engage in the business of futures trading are subject to less strict obligations than holders of a CMSL who carry on the business of trading in futures contracts. The main reason for this is that they do not deal with clients’ money and property in connection with trading in futures contracts. Accordingly, they do not have to maintain segregated clients’ accounts and, unless the Securities Commission otherwise prescribes, they do not have to keep statutory accounting records under the CMSA (except that they have to adhere to the provision of s.92). They do, however, have the statutory obligation under the Companies Act 1965 to maintain accounting records. 4.4 Representatives The person who deals directly with the client of a holder of a CMSL who carries on the business of trading in futures contracts, a holder of a CMSL who carries on the business of fund management or a holder of a CMSL who carries on the business of investment advice are known as representatives. A representative essentially acts on behalf of his or her principal in connection with the principal’s business. As representatives or holders of a CMSRL, they are required to know their clients well. They need to be aware of the clients’: + reputation for integrity + financial capacity 7 trading objectives ‘9 Sees Comm lyn and Sree et eration Ase, 99 1:23Topic 1: Overview of the Derivatives Market In particular, the holders of a CMSRL who carry on the business of trading in futures contracts will often have to: + supply the proper documents for new accounts + explain trading rules and procedures to clients + keep clients informed of prices and market conditions + __enter orders received from clients . report executions + explain the risk involved in futures and options trading As the work of representatives involves personal skills, the most important criterion for licensing individuals as representatives is the possession of the appropriate knowledge and personal qualifications. As they represent their respective holders of a CMSL, they are also subject to the obligations relating to the conduct of the business of trading in futures contracts, the business of a fund management company and an adviser as outlined in the CMSA. ‘As representatives, they are primarily responsible for the professional image and reputation of the entity whom they represent. 1-24 Secures Corte, Halas nd Snares bitte cation Acta, 197Topic 1: Overview of the Derivatives Market 5 Users of Futures and Options — the Clients Participants in the futures and options markets can be generally categorised as either hedgers, speculators or arbitrageurs. They are the users of futures and/or options contracts and the clients of the intermediaries discussed in the previous section. However, as this next section will show, these three categories of users have very different reasons for entering the futures and options market. 5.1 Hedgers Hedgers deal in the underlying instrument and use futures and/or options to manage price risk, The derivatives market performs a price-setting function, permitting hedgers to know in advance the price at which they will buy or sell (or the interest rate at which they will borrow or lend). This allows hedgers to plan for known costs and returns and to put their financial budgeting on a sound footing. The futures and options market achieves its purpose of setting a price in advance by providing profits or losses that balance losses and gains in the underlying market. Thus, a more favourable price in the actual market than that agreed on under the futures contract is balanced by futures losses, while an unfavourable price movement in the underlying market is offset by futures profits. 5.2. Speculators Speculators deat with changes in the expected price levels over time, and they do not usually own or use the underlying instrument. They are motivated by the wish to profit on the transaction and assume the price risk of hedgers. Put simply, speculators profit from futures trading by buying contracts at a tow price and selling them at a high price. Speculators are important participants, giving liquidity to the market and opportunities for continuous trading. Trading houses and professional market participants often operate in futures and options markets to benefit from anticipated changes in the prices of the commodities. 5.3. Arbitrageurs Arbitrage is the simultaneous purchase and sale of the same instrument in different markets to profit from price discrepancies. It is the ability to take advantage of different rates, prices and/or conditions between different markets. Arbitrageurs (people who arbitrage) are able to profit from temporary distortions or inconsistencies in price. Like speculators, arbitrageurs play an important role in futures and options markets by providing liquidity and by ensuring the convergence of cash and futures prices towards the expiry date of the contract. 1-26 secures Conn Maat Secs tte Eaton Ata, 199Topic 1: Overview of the Derivatives Market 6 Regulation of the Futures and Options Market Previously, the regulatory framework for the Malaysian futures and options markets was divided into two segments ~ one dealing with commodity futures and the other dealing with financial futures and options. An amendment to the Futures Industry Act in April 1997 saw the Securities Commission take over the role and function of the Commodity Trading Commission as regulator of commodity futures. As a result, both financial and commodity futures and options are now regulated by the Securities Commission pursuant to the Futures Industry (Amendment and Consolidation) Act 1997. In September 2007, the Futures Industry Act 1993 and Securities Industry Act 1983 were consolidated into a single act, the CMSA. We will now look briefly at the role of the Securities Commission and the impact it has on the operation of the market. As we shall see, regulation is aimed at promoting professional conduct among market participants, ensuring fair and transparent trading, and minimising systemic risk (systemic risk fs the risk of default by one institution leading to default in the entire market and/or other markets.) 6.4 Securities Commission The Securities Commission established on 1 March 1993 under the Securities Commission Act 1993 (SCA) is a statutory body whose primary responsibility is the regulation of the Malaysian securities and futures markets. There are nine Commissioners, alt of whom are appointed by the Minister of Finance under the SCA. They comprise: the Executive Chairman; the Deputy Chief Executive; four members representing the government (which have traditionally included representatives from the Ministry of Finance, Ministry of Primary Industries and Bank Negara); and three others traditionally representing various professions in the private sector. The management of the Securities Commission, on the other hand, comprises full-time employees. ‘The Securities Commission’s functions which are relevant to the futures industry include to: + advise the Minister on all matters relating to the futures industry 1-28 2 sects emis, aly ad Sear tat vain Auta, 199| Topic 1: Overview of the Derivatives Market + regulate all matters relating to futures contracts + supervise and monitor the activities of any exchange holding company, exchange and clearing house + take all reasonable measures to maintain the confidence of investors in the futures market by ensuring adequate protection for such investors + promote and encourage proper conduct amongst participants, depository participants and all licensed or registered persons of an exchange and clearing house + suppress illegal, dishonourable and improper practices in trading in futures contracts + encourage and promote self-regulation by professional associations or market bodies in the futures industry id + license and supervise all licensed persons under the CMSA + promote and maintain the integrity of all licensed persons in the futures industry. Co-Regulation . The scheme of regulation in the Malaysian futures and options industry is one of co- regulation between the: + Securities Commission, which administers the CMSA + futures exchange, which each establishes and administers a set of business rules relating to the trading of products offered on its markets + clearing house,'which establishes and administers its own business rules. Because the futures and options industry is an area that is at the forefront of financial ‘innovation, the regulatory framework has to be flexible enough to accommodate rapid changes to business practices and economic utility of participants, and yet still be able to address regulatory concerns. For this reason, the primary emphasis of the CMSA is on matters concerning investor protection and systemic stability. In contrast, the business rules of the futures exchange and clearing house (though stilt regulatory in nature) have a more commercial emphasis. Business rules are more flexible in that they can be amended with the approval of the Securities Commission, In principle, it may be said that the Securities Commission concerns itself with general policy formulation, licensing, product and market approval, and prosecution, while leaving day-to-day supervision of markets, approval of entry into the industry, prudential controls and participantship regulatory responsibility to the futures exchange and the clearing house. Placing the primary responsibilities for the proper regulation of futures activities on futures exchange and the clearing house (commonly known as frontline regulatory organisations) ensures that futures markets are free to operate with only as (9 Scat Commi, lata and Seti etane Ect ara, 199 1-29Topic 2: Regulation of Futures and Options 1 Overview of Futures Industry Regulation 1.1 Aim of Regulation Public confidence in the soundness of the futures and options market is essential for its continued existence. As trading in futures and options involves a high degree of risk, if people do not trust derivatives market participants, including companies and their employees, they will not be prepared to-participate in the derivatives market, which will hinder the development of the Malaysian capital market. Effective regulation of the futures market promotes domestic and international investor confidence, protects investors, ensures that potential investors have all the information they need to make their own informed assessment of the risks involved, and provides a deterrent to fraudulent behaviour by market participants via the Possibility of enforcement action (e.g. prosecution), Hence, there are three broad aims of regulation: + to promote professional conduct among intermediaries + toensure fair and transparent markets + to minimise the likelihood of systemic disruptions/failures, Each of these aims is described in more detail below. Professional Conduct High professional standards among market intermediaries ensure fair and efficient markets. Fair and Transparent Markets AA second aim of regulation is to ensure that markets are fair and transparent. By fairness, we mean that market participants are able to compete on a level playing field, i.e. no one group of individuals or corporations is advantaged at the expense of another, and there are equat trading opportunities for everyone. The existence of a level playing field is a prerequisite for promoting competitiveness between market participants, in particular, intermediaries. The expression fairness is sometimes also taken to encompass the notion of investor protection (such as the elimination of fraud and manipulation, and the protection of uninformed investors against exploitation by insiders). Regulation of markets also seeks to enhance its transparency, which not only connotes a market that is efficient (where market information is disseminated on a timely basis) but also one in which there exists legal certainty. 22 (© Secres Cons, aay nd Secu tute dean Ace, 998Topic 2: Regulation of Futures and Options Minimise Systemic Risk Regulation is aimed at minimising the risk of default by one institution leading to defaults in the entire market or other markets or both. This risk is known as systemic risk, which has been defined by the Bank of International Settlements as: the risk that a disruption, whether at a firm, a market segment or across markets, will cause widespread difficulties at other firms, in other market segments or in the financial system as a whole. 1.2 Regulatory Framework ‘The futures and options industry is now governed by the CMSA. The CMSA consolidates the Futures Industry Act 1993 and the Securities Industry Act 1983. ‘The CMSA is administered primarily by the Securities Commission. Certain powers under the CMSA, however, have been reserved for the Minister of Finance. Responsibility for the day-to-day supervision of futures markets, approval of entry into the futures industry, prudential controls and participantship regulatory responsibility are placed with the futures exchange and clearing house. The futures exchange and clearing house, known as front-line regulatory organisations, each performs its regulatory functions by establishing and enforcing a body of rules and policies known as business rules. The scheme of regulation in the futures industry in Malaysia is, therefore, one of co-regulation, between the Securities Commission, as the public authority, and the futures exchange and clearing house as the front-line regulators. Sources of Obligations Arising from this co-regulatory structure are four sources of obligations imposed on participants in the futures industry: + Capital Markets and Services Act 2007 (CMSA) + Capital Markets and Services Regulations 2007 + orders and directions given by the Securities Commission under the CMSA. + guidelines and practice notes issued by the Securities Commission + the business rules of the futures exchange and the clearing house. a Secutes Commision ayaa an Saute ate Eaton el, 1 23Topic 2: Regulation of Futures and Options Together, these laws, orders, directions, guidelines, practice notes and business rules, make up the regulatory regime of the futures industry. It should be noted that the nature of these sources of obligations are different, The CMSA, regulations made under the CMSA and orders and directions of the Securities Commission under the CMSA, derive their authority from statute — they may, therefore, be said to have the force of law. In contrast, the business rules of the futures exchange and the clearing house are ‘contractual in nature ~ the Rules of Bursa Malaysia Derivatives Bertiad, for example, are a contract between Bursa Malaysia Derivatives Berhad and its participants. This is significant because contracts cannot be enfdrced by, or be enforced upon, somebody who is not a party to the contract. Therefore, as a general rule, the business rules of a front-line regulatory organisation are only binding on its participants. However, the CMSA provides for certain circumstances where the business rules may be enforced by ‘outsiders’ (see section 2.2 below). Figure 1 outlines the supervisory roles of the Securities Commission, futures exchange and clearing house, over participants, holders of a CMSL who carry on the business of fund management and holders of a CMSL who carry on the business of investment advice, and other traders. 24 2 Sears Cmts, nai and Sects nit dct Ata, 1989Topic 2: Regulation of Futures and Options Figure 1: Regulatory Framework in the Futures Market Minister of Finance Securities Commission ‘HSA 2007 Bursa Malaysia Berhad I Futures Exchange Clearing House Bursa Malaysia = Bursa Malaysia Derivatives Derivatives Berhad Clearing Berhad Businose Rulos Business Rules Holder of OMSL Holder of OMSL ical no (Fund (tavestment Advice) at Management) Partelpants . ‘redo through | Helder ofa CMSRL Holder of @ CMSRL Holder of CMSRL (Fund (rvastrent Advice) (Trading in Futres Management) Contracts) CuENTS - hedgers + speculators = atbitrageurs From the foregoing diagram, we can see that there are three types of institutions that regulate the futures industry in Malaysia: + the Securities Commission — through the enforcement of the CMSA and its regulations, directions, orders, guidelines and practice notes + the futures exchange (Bursa Malaysia Derivatives Berhad) — through the enforcement of its business rules ‘secrites Comin, Hai and Seer Intts Een sl, 199 25Topic 2: Regulation of Futures and Options * the clearing house (Bursa Malaysia Derivatives Clearing Berhad) — through the enforcement of its business rules. The remainder of this topic will focus on the CMSA and the obligations it places on participants in the futures industry. 1.3 The Capital Markets and Services Act 2007 The Capital Markets and Services Act 2007 (CMSA) outlines the powers and duties of the Minister of Finance and the Securities Commission and the rights and obligations of participants in the futures industry, which include the futures exchange, the clearing house, intermediaries and traders. Minister of Finance ‘The Minister of Finance is vested with certain powers under the CMSA, including the power to: + grant and revoke, on recommendation of the Securities Commission, the approvals of stock exchange or futures exchange and clearing houses + the power to prescribe regulations under the CMSA + the power to close futures markets in an emergency + hear appeals against decisions of the Securities Commission in respect of licensing. Role of the Securities Commission The Securities Commission is charged with the administration of the CMSA. The Commission’s role is to ensure the integrity of the futures industry so as to protect public interest and maintain investor confidence. It is responsible for: + licensing futures market participants (holders of a CMSL and their representatives — however, a CMSL to carry on the business of trading in futures contracts can only be issued with the concurrence of the Minister) + approving the business rules of the futures exchange and the clearing house (as well as approving subsequent amendments to them) + enforcement and prosecution + advising the Minister of Finance in matters concerning the futures industry. 26 (Secu Canton, Hays and Sect butte Edenton hasta, 199Topic 2: Regulation of Futures and Options Components of the CMSA The following diagram illustrates the components of the CMSA and is a useful tool for finding your way around this important piece of legislation, It shows that the legislation is divided into 13 main parts. Most parts are then divided into a number of sections (although these are not shown on the diagram) and these sections may then be further divided into a number of sub-sections. Some parts on the other hand, are divided into divisions, followed by sub-divisions, before being divided into sections and subsections. CMSA 2007 Part 3 Pare mt Pat Part vt Part Part I Part xa. Preliminary ‘Captal Market Provisions Copia Market Admiisvative Repeal, Markets Misconduct Aopiable Development ‘cl Actions ‘Savings & Services ‘Other rs Fund Transitional Prohibited Usted Provisions (conduct ‘corporar tons Pate Part PatVi Part VIEL Part x art xt ‘Secures & Compensation |] Issues of ‘Sef-reguatory Disdosure of General Futures Markets | | Fund & Fielty |] Secures & ‘Organizations Information Fund Take-overs & Mergers Remember that under the CMSA, the definition of the term futures contract refers to both futures and options. Hence, all references to futures throughout this topic, also include options. (0 SteriesComtin alsa Sats nt acto ua, 177 27Topic 2: Regulation of Futures and Options 2___Establishment of Futures Markets The CMSA fs concerned with, among others, the regulation of futures (and options) markets, While at its narrowest, futures trading is sometimes regarded as trading that ‘occurs on the floor of a futures exchange or via an automated trading system, this really begs the question as to what is a futures contract and what is a futures market. These issues are covered in Part | and Part Ill of the CMSA. 24 Definition of a Futures Contract The term futures contract is given a precise legal definition under the CMSA. The CNSA divides futures contracts into four categories: + Eligible delivery agreements This category of futures contracts seeks to cover agreements that may give rise to an actual obligation to effect delivery of the underlying instrument. However, ‘it distinguishes such contracts from other contracts in which delivery and settlement occur after the contract has been entered into (e.g. a forward contract) by reference to the feature of futures contracts which allows a party to close out its pasition by taking an offsetting opposite position in the market. If such were not the case, an agreement to buy a car in which delivery is to take place four weeks later will arguably be a futures contract, + Adjustment agreements This refers to futures contracts that are settled, not by delivery of the underlying, but by a payment of the difference between the price at which the contract was bought or sold and the settlement price. Such contracts are also known as cash-settled contracts (an example is the KLCI futures contract). + Eligible exchange-traded options This category refers to options (both deliverable and cash-settled) which are traded on the futures market of an exchange company. Stock index options would come under this category of futures contracts. 28 2 Secures Camis, Haas and ecules esate aan Aastra, 199Topic 2: Regulation of Futures and Options + Futures options These are options over futures contracts, i.e. where exercise of the option will result in the holder of the option owning a futures contract (rather than an underlying instrument like shares of a company). In addition to the above categories, the Minister of Finance has the power to prescribe new types of futures contracts which may not-be covered by the existing categories. 2.2 Futures Exchange A futures market is defined as a market or other place at which, or a facility by means of which, futures contracts are regularly traded. The CMSA requires that all futures markets must be conducted either on an approved futures exchange or on an exempt futures market. + Anapproved futures exchange is defined under subsection 8(2) of the CMSA as a body corporate which has been appraved by the Minister of Finance on the recommendation of the Securities Commission. A body corporate that has been granted such an approval is known as a futures exchange under the CMSA. + Exempt futures markets are markets that have been exempted from having to obtain approval under paragraph 7(3)(a) of the CMSA by the Minister of Finance. This exemptive power is exercised by the Minister to exclude, for example, certain over-the-counter (OTC) markets from some of the provisions of the CMSA, where the relative sophistication of the participants in those markets may render compliance with the provisions to be inappropriate and a cost burden. (Note that exempt futures markets and OTC markets are outside the scope of this course.) Approval of Futures Exchange Before granting approval, the Minister has to be satisfied that the futures exchange has complied with certain prerequisites set out in subsection 8(2) of the CMSA pertaining to, among others, the company’s ability to: + ensure that as far as is reasonably practicable, it will operate an orderly and fair market in relation to securities and futures contracts that are traded through its facilities + manage any risk associated with its business and operations prudently ecw Cotsen, aaa and Secrest Eucaton al, 18 29Topic 2: Regulation of Futures and Options + take appropriate action against its affiliates to whom the rules apply for any breach of its rules In addition, the Minister may impose further conditions when granting the approval. Once a company has been approved by the Minister as a futures exchange, it must meet certain continuing obligations. The continuing obligations of a futures exchange are set out in Part-II of:the CMSA. Functions of the Futures Exchange” The regulatory framework under the CMSA both permits and obliges a futures ‘exchange to perform two important functions: 4. To set up an organised exchange for trading in futures contracts and to develop the market for those contracts 2. To ensure that these markets operate in a fair and efficient manner The second function is performed by the futures exchange in its capacity as a front- line regulatory organisation that: + sets criteria for admission to participantship of the futures exchange + makes business rules to regulate the conduct of participants and other persons who trade on the futures markets conducted by the futures exchange The criteria for admission are designed to ensure that the potential participant is financially sound and possesses personnel of good fame and character who have the requisite skill and expertise. The business rules of a futures exchange deal with matters such as: + duties and responsibilities of holders of a CMSL who carry on the business of trading in futures contracts to clients + requirements aimed at maintaining the financial liquidity of holders of a CMSL who carry on the business of trading in futures contracts ‘+ improper trading practices + — submission of periodic reports on holders of a CMSL who carry on the business of trading in futures contracts’ activities and financial statements to the futures exchange 210 a Secuties Conn Mlysa alScutle neue Futon asta, 19Topic 2: Regulation of Futures and Options audit of holders of a CMSL who carry on the business of trading in futures contracts’ accounts + administration of the fidelity fund Enforcement Powers of the Futures Exchanges To enable the futures exchange to monitor compliance with and enforce the business rules, the futures exchange reviews reports and audit accounts of holders of a CMSL who carry on the business of trading in futures contracts; monitors training activities and practices and carries out investigations into any unusual activities and practices, If an activity involves a contravention of the MSA, the futures exchange makes a report to the Securities Commission. The futures exchange carries on regular dialogue sessions with the Securities Commission in connection with the regulation of the futures markets. ‘A futures exchange (and clearing house) may also apply to court if any of its participants has contravened its business rules (s.360). The court may make such orders as it thinks fit. ‘As we have seen earlier, the business rules are a contract between the futures exchange and its participants. Generally, persons who are not parties to a contract are not bound by the contract; neither can they enforce its terms. However, in the case of business rules of the futures exchange and clearing house, s.355 of the CMSA provides that the Securities Commission may take action against a person who fails to comply with, observe, enforce or give effect to the business rules of a futures exchange or clearing house. It is readily apparent that there is substantial overlap between the provisions of the CMSA and the business rules. Breaches of the business rules are pursued by the futures exchange, and typically result in fines or reprimands on the participants (or in more serious cases, suspension of, or expulsion from, participantship). Because of the overlap, a breach of the business rules may also constitute a contravention of the CMSA, which may result in a criminal conviction. ‘The futures exchange is required to give such assistance to the Securities Commission as it reasonably requires and notify it of disciplinary action taken against a participant. The Securities Commission is entitled to full and free access to the trading facilities. The Securities Commission also has the power to give directions with respect to the operation of the market. Sauter Corie, nla nd Senitesnatats Ceca At, 179 211Topic 2: Regulation of Futures and Options 2.3 Clearing House Section 38 of the CMSA provides for the establishment and operation of a clearing house. Application for approval to establish or operate a clearing house must be accompanied by the rules of the clearing house, which must provide for, among others: + efficient provision of clearing house facilities + rules that cater for quick and fair method of settling disputes between clearing house and its affiliates and between its affiliates and their clients + proper regulation and supervision of its affiliates using its clearing facilities The clearing house is the central risk-taker in the market — because it guarantees the performance of all contracts by becoming the counterparty to all trades. The Bursa Malaysia Derivatives Clearing Berhad, and its participants are regulated by business rules which govern the operation of clearing participants and control the exposure of the clearing house to its participants. It should be emphasised that the Business Rules of Bursa Malaysia Derivatives Clearing Berhad must not be confused with the Business Rules of Bursa Malaysia Derivatives Berhad, which are rules for, among other things, contract specifications and behavioural standards between the futures exchange and its participants and their clients. The clearing house’s business rules include procedures for the acceptance of contracts for registration on behalf of a clearing participant, the method of calculation of the margin and deposit and the cut-off times by which payment must be made, 212 1 secures Commis, alas ard Sects ste Ect Atrl, 192Topic 2: Regulation of Futures and Options 3 Futures Industry Participants Licensing of futures industry participants (intermediaries) is dealt with in Part Ill and Schedule 2 of the CMSA. There are two types of licences issued by the Securities Commission, namely the Capital Markets Services Licence (CMSL) and the Capital Markets Services Representative’s Licence (CMSRL) for the following categories of regulated activities: + Deating in Securities , + Trading in Futures Contracts + Fund Management + Advising on Corporate Finance + Investment Advice + Financial Planning However, this topic will only discuss licences for three of the regulated activities, namely those carrying on the business of trading in futures contracts, fund management, and investment advice, substantial to the futures industry. 3.1 Granting of Licences There are a number of procedures and preconditions that apply to the granting of licences under the CMSA. They are contained within Part Ill, Division | of the CMSA ‘The Securities Commission may refuse to grant a licence if it is not satisfied with any of the following: + the financial resources of the applicant + the skill and experience of the appticant + the reputation of the applicant. Licences must be renewed annually in accordance with procedures set out in s.61. The conditions of renewal are similar to the conditions of initial grant. In addition, the Securities Commission may refuse to renew on the same grounds that it is entitled to revoke a licence. 214 © Secrtes Commision, alas ard Scares atte Eueton tra, 199Topic 2: Regulation of Futures and Options Apart from the CMSA, applicants of licences are also required to observe the requirements stipulated in the SC Licensing Handbook which provides for, among others, the following: + minimum assessment criteria + application procedures and fees + terms and conditions of licence + ongoing obligations of licensed and registered persons + disciplinary action While the lincesing requirements in respect of the above regulated activities are discussed briefly in this topic, reference needs to be made to the SC Licensing Handbook for better understanding of requirements of licensing and obligations of licence holders. 3.2 Holders of a CMSL Who Carry on the Business of Trading in Futures Contracts Holders of the CMSL who carry on the business of trading in futures contracts are the only intermediaries who can trade futures and options contracts on behalf of other persons. The issuance of this CMSL by the Securities Commission can only be made with the approval of the Minister. In order to obtain a CMSL to carry on the business of trading in futures contracts, a person must: + bea corporate entity incorporated in Malaysia + bea participant of a futures exchange + satisfy requirements with respect to representatives Thus, the CMSA endorses the principle of co-regulation by stipulating that to obtain a licence, a holder of a CMSL who carries on the business of trading in futures contracts must also be a participant of a futures exchange with appropriate self-regulatory rules. Not only does this requirement ensure a double check on the suitability of the applicant’s participation in the industry, but it ensures that all holders of a CMSL who carry on the business of trading in futures contracts will be under continuing self- regulatory oversight. Once the CMSL is granted, the holder of the CMSL must comply with a number of continuing obligations — these are described below. «8 scutes Come, tala ard soar intte Eu stra, 1958 215Topic 2: Regulation of Futures and Options Financial Requirements The holder of a CMSL who carries on the business of trading in futures contracts must comply with the financial requirements set by the business rules of the futures exchange and clearing house of which it is a participant. These financial requirements include: “maintenance of a minimum amount of paid-up capital (as defined in the business rules) to support its business + ensure a minimum holding of liquid assets to meet actual and contingent short-term liabilities + posting of margins to the clearing house + monthly and annual reporting of its financial position to the futures exchange/ clearing house. Accounting Records Under the Companies Act 1965, a holder of a CMSL who carries on the business of trading in futures contracts has a duty to keep accounting and other records to. accurately reflect its business. In addition, it has a statutory duty under s.108 of the CMSA, to maintain accounting and other records. Ahholder of a CMSL who carries on the business of trading in futures contracts has an obligation under s. 104 of the CMSA to maintain records in relation to receiving instructions from clients. The records must set out particulars relating to the receiving and carrying out of clients’ instructions. Furthermore, the holder of the CMSL must maintain records relating to its own account trading. These provisions are designed to prevent conflicts between the interest of the client and that of the holder of the CMSL and to ensure there is a clear audit trail of the its own dealings and those of its clients, to ensure that the holders of the CMSL who carry on the business of trading in futures contracts or their employees do not abuse their position. Segregated Funds Aholder of a CMSL who carries on the business of trading in futures contracts must segregate funds or properties that belong to a client from its other properties. The ‘aim of segregation is to: + ensure ease of identification of clients’ funds + facilitate the transfer of clients’ positions by the clearing house in the event of insolvency of a holder of a CMSL who carries on the business of trading in futures contracts 2416 Sects Crain, Hae an Sect rte Eaton fara, 1959Topic fegulation of Futures and Options + protect funds from claims of creditors of an insolvent holder of a CMSL who carries on the business of trading in futures contracts Holders of a CMSL who carry on the business of trading in futures contracts are required to initially place client funds received into a client’s segregated account. There are ceitain limited purposes for which a client’s segregated funds may be used — these are prescribed in s. 118(3) and include making payments in accordance with the written instructions of the client, defraying brokerage and other charges incurred by the holder of the CMSL in making payments to the clearing house and making other authorised payments. It is a serious offence, under the CMSA, for the holder of the CNL to withdraw a client’s segregated funds for any other purposes. Aholder of a CMSL who carries on the business of trading in futures contracts is required to keep separate accounting records with respect to their segregated account, which separately records the deposits and withdrawals with respect to each client. Again, separate records must be kept with respect to property in safe custody. Segregated money or property is not available to pay its general creditors on Liquidation or bankruptcy. Contract Notes Under the Capital Markets and Services Regulations 2007, a holder of a CMSL who carries on the business of trading in futures contracts is required to give a contract note for every transaction that it undertakes on behalf of a client. The contract note must comply with regulation 14 of the Capital Markets and Services Regulations 2007 which requires among other things, that the contract note be given not later than the end of the next market day after the transaction. The contents of the contract note are specified in subregulation 14(3) and include: + name and address of the client + name of the futures exchange on which the holder of a CMSL who carries on the business of trading in futures contracts is an affiliate + date of the transaction + adescription of the futures or option contract + the number of contracts traded + the total amount of commission, trading and other fees charged + the deposit paid or payable + the price at which the transaction was affected ce Sects Conmin, lap and ects inte Econ Axa, 199 27Topic 2: Regulation of Futures and Options This ensures the client is made fully aware of contracts traded for them. Conduct of Futures Business Where the legal relationship between two people is such that one person trusts and places reliance on the abilities of the other person to act for the former’s benefit, the law imposes certain duties on that other person. These fiduciary duties, which are derived from case law, prohibit the person (i.e. the fiduciary) in whom trust is placed, from: + making use of his position to gain a berlefit for himself, or + placing himself in a position where his duty to the beneficiary conflicts with his own interests The CMSA incorporates some of these equitable principles to ensure that holders of a CMSL who carry on the business of trading in futures contracts, on whom clients place reliance, conduct their businesses in a professional manner and with integrity and responsibility. This is essential to generate and maintain investor confidence in the capital markets, Section 99 prohibits a holder of a CMSL who carries on the business of trading in futures contracts from knowingly taking the other side of a client’s order without first obtaining the consent of that client. Thus, the holder of a CMSL that wishes to take Up the buy side of its client’s sell order must first inform its client of its intentions to do so. Failure to do so is an offence that will result in a fine up to a maximum of RM1 million or imprisonment of up to 10 years, or both, Section 92 places a substantial legal duty on the holder of a CMSL when giving advice to clients. This provision, sometimes referred to as the ‘know your client and product’ rule, requires a licence holder to have a reasonable basis for recommendations made to its clients, Section 92 provides that a reasonable basis exists where the licensed person makes recommendations based on the following consideration and investigation: + the licensed person has, for the purpose of ascertaining that the recommendation is appropriate, taken all practicable measures to ascertain that the information possessed and relied upon by the licensed person concerning the investment objectives, financial situation and particular needs of the person is accurate and complete (the ‘know your client’ rule), and + the licensed person has given such consideration to; and conducted such investigation of, the subject matter of the recommendation as may be reasonable in alt the circumstances. 218 (0 Sects Commis, Hints nd Scene Econ Atl, 198Topic 2: Regulation of Futures and Options To illustrate, a licence holder who advises a widow, whose only source of income is her pension, to place her life savings in a highly speculative options strategy will not have a reasonable basis for his recommendation unless he has taken all practicable measures to ascertain that the information he has on the widow, relied upon in making his recommendation is accurate and complete. Equally, a licence holder who advises, without analysing the features of the futures contract or trading strategy that is the subject matter of its recommendation, will not have a reasonable basis for that recommendation, A ticensed person who contravenes the reasonable basis requirement may be liable to pay damages to the client who has suffered loss in reliance on the recommendation. Section 104 governs the sequence in which the holder of a CMSL who carries on the business of trading in futures contracts is to send and carry out instructions of its clients, and in which trades are to be allocated. Generally speaking, where an instruction is received ahead of other instructions, that instruction must be carried ‘out (or sent, as the case may be) first. Equally, trades must be allocated in the sequence in which they were matched and in which the instructions effecting the trades were sent. Section 104 also requires the holders of the CMSL to give priority to a client’s order ahead of its proposed own account trades. In this regard, ‘own account’ includes trades belonging to associates of the holder of the CMSL, e.g. a related company. The penalty for breach of this section is the same as that in s.99. Risk Disclosure Section 100 requires holders of a CMSL who carry on the business of trading in futures contracts to give their clients information that explains the risks associated with trading in futures contracts. in addition, the holders of the CMSL must give the client a copy of the proposed client agreement which contains the minimum terms that are prescribed in the business rules of the futures exchange. These provisions ensure that a.client, and in particular, a speculative client, is fully aware of its obligations in relation to futures trading. Fidelity Fund Section 164 requires that a holder of a CMSL who carries on the business of trading in futures contracts contributes RM30,000 to the fidelity fund upon being licensed. For the next five years, it is required to contribute an additional RM10,000 per year. Nevertheless, the futures exchange may, from time to time with the approval of the Securities Commission, vary the amount and the manner of the contribution. (The purpose and operation of the fidelity fund is explained in more detail later in this topic.) steric Com, ayia a ree that uct Aral, 198 219Topic 2: Regulation of Futures and Options 3.3 Holders of a CMSL Who Carry on the Business of Fund Management. Another category of licence under the CMSA is that of a holder of a CMSL who carries on the business of fund management. These licence holders are companies that undertake the management of a portfolio of securities and/or futures contracts. The funds operate very much like unit trusts and enable small investors to pool their resources for management by licence holders. They must be companies, and their employees or agents who deal directly with clients are known as holders of a CMSRL ‘Who carry on the busiriess of fund management. z Section 58 of the CMSA prohibits any person from carrying on a fund management business or holding itself out as a holder of a CMSL who carries on the business of fund management unless it is duly licensed or registered. Obligations The obligations of holders of a CMSL who carry on the business of fund management are similar to those of the holders of a CMSL who carry on the business of trading in futures contracts. In addition to the statutory obligation to keep accounting records under the Companies Act, these CMSL holders must also comply with the requirements under Division 5 of Part {V of the Companies Act relating to trust deeds and prospectuses, The obligations under the CMSA include: + those relating to the financial affairs of the CMSL holder imposed by the Securities Commission under s.96 + the giving of information to prospective clients + having a reasonable basis for recommendations (s.92) 3.4 Holders of a CMSL Who Carry on the Business of Investment Advice Holders of a CMSL who carry on the business of investment advice are companies who conduct a business of advising other people about securities and/or futures contracts or as part of a business, issues or promulgates analyses or reports on securities or futures contracts. The person that directly deals with clients are representatives of the holders of the CMSL, who are licensed as holders of a CMSRL. Section 58 of the CMSA prohibits any person from carrying on investment advice business or holding itself out as a holder of a CMSL unless it is duly licensed or registered under the CNSA. 4 Sout Commo, Hala ard Sears inthute aca ale, 1958 221Topic 2: Regulation of Futures and Options Obligations Holders of a CMSL who carry on the business of investment advice are not subject to the same stringent duties as holders of a CMSL. who carry on the business of trading in futures contracts because they do not handle clients’ money. As such, they are not required to segregate clients’ funds or to keep statutory accounting records (unless the Securities Commission otherwise prescribes). They are, however, subject to the obligation under s.92 and may also be subject to the common law duties of a fiduciary: 3.5 Holders of a CMSRL Representatives are individuals who hold a CMSRL and act on behalf of their respective holders of a CMSL. They are required to be licensed under Part Ill of the CMSA. However, there are exemptions in the case of individuals who work as clerks, cashiers, and accountants for holders of a CMSL who carry on the business of trading in futures contracts and advisers. As they represent their respective holders of a CMSL, representatives are also subject to the same obligations relating to the conduct of each respective category of licence. Under s.367 of the CMSA, if a representative commits an offence, the holder of the CMSL is also considered to have committed the offence. 22 © Secures Commision, has an seers ltt Eton i, 199Topic 2: Regulation of Futures and Options 4___Trading Offences under the CMSA Part V of the CMSA establishes certain trading offences. These include: + false trading + bucketing ‘+ dissemination of information about false trading + price manipulation and cornering + devices to defraud + false or misleading statements + abuse of information. These offences are designed to deter undesirable or fraudulent practices. They also discourage and prevent unfair use of advantageous positions and price distortions. ‘The integrity and efficiency of the futures market should rely solely on the existence on the natural forces of supply and demand. Failure to comply with the other requirements referred to above are, of course, also subject to penalties, which are, in some cases, substantial. In addition to these offence provisions, there are wide powers for the Securities Commission or the futures exchange to seek orders for the enforcement of its business rules, the restraining of trading in futures contracts and the appointment of receivers to the property of holders of CMSA who carry on the business of trading in futures contracts. 4.1 False Trading Under s.202 of the CMSA, no person is allowed to create, or cause to be created, or do anything that is calculated to create, a false or misleading appearance: + of active trading + with respect to the market + with respect to the price of futures contracts. Section 204 prohibits a person from disseminating information that prices are likely to rise or fall because of the operations of someone who is in contravention of s.202. 224 (2 Sects Comms, yan Sete elie aston Aue, 99Topic 2: Regulation of Futures and Options 4.2 Bucketing Under s.203, no one is permitted to execute or hold himself out to having executed an order for the purchase or sale of a futures contract without having effected a bona fide purchase or sale. 4.3 Manipulation and Cornering Section 205 prohibits anybody from: + manipulating the prices of futures contracts or prices of the underlying instrument + comering the underlying market. 4.4 Devices a Defraud Section 206 prohibits a person from: + employing a device, scheme or artifice to defraud = engaging in any act which operates or is likely to operate as a fraud or deception + making any false statement of material fact or omitting to make a statement of material fact. 4.5 False or Misleading Statements Under s.207, no person is allowed to make a statement for the purpose of inducing the purchase or sale of a futures contract if that statement is: + false, misleading or deceptive + by reason of omission ~ false, misleading or deceptive. 4.6 Abuse of Information The abuse of information obtained in official capacity is prohibited under s.208 of the CMSA. It holds that any person who has information: + that is price sensitive eect Comin, Malayan Secrest Eaton ual, 159 2-25Topic 2: Regulation of Futures and Options + that is obtained by virtue of his official capacity + that is reasonable to expect not to be disclosed except in that official capacity + which he knows is unpublished price sensitive information must not make use of that information to gain an advantage. Vas Ba (a) __ Explain what is meant by bucketing. (b) Why do you think bucketing is prohibited under the CMSA? 226 Secu Conai, Halas and Sct rtane Eaton Atal, 17Topic 2: Regulation of Futures and Options 5 Fidelity Fund Part IV of the CMSA deals with the establishment and maintenance of a fidelity fund by a futures exchange. 5.4 Purpose of a Fidelity Fund The purpose of the fidelity fund is to provide clients with compensation in the event of a dishonest or fraudulent misuse of money or other property by a holder of a CMSL. who carries on the business of trading in futures contracts which causes loss to the client. If, for example, an employee of the holder of the CMSL misappropriated the money of a client and the participant was unable to recompensate the client, the fund would be available. The fund is not available to compensate for losses on the market, whether caused by the negligence of a participant or otherwise. Another characteristic of the fidelity fund is its aim of providing timely compensation, In essence, the fidelity fund allows the futures exchange to pay out to the client first, and then claim against the holder of the CMSL in court in respect of the defalcation (i.e. misappropriation or fraudulent misuse of money), It is for this reason that there is a provision for the subrogation of the futures exchange to the rights of the claimant. This allows clients a quick means of obtaining compensation without resorting to the long drawn-out litigation process which they may not have the funds to finance, 5.2 Administration and Uses The fidelity fund is administered by the futures exchange. Section 159 of the CMSA provides that the assets of the fidelity fund are the property of the futures exchange. ‘The futures exchange shall keep them separate from all its other property and is to hold them in trust for the purposes set out in the regulations. The intention behind this is to prevent any other parties apart from the clients of the particular holder of CMSL, from making any claim against the money contributed to the fund. Under the CMSA, the fidelity fund can be used to pay any claims made by aggrieved clients and all other payments relating to the administration of the fidelity fund by the futures exchange. ‘Any person other than the holder of the CMSL who has suffered monetary loss as a result of the defalcation of the holder of the CMSL is entitled to lodge a claim with the futures exchange. The futures exchange will consider each claim and make such Payment as is appropriate to a claimant, subject to the conditions of claims and (© SecartesConmison, haa and secre tte Eaves sal, 199 2207Topic 2: Regulation of Futures and Options monetary limits outlined in the CMSA, Capital Markets and Services Regulations and business rules of the futures exchange. Em For each of the following, select the best response: (a) Which of the following are requirements that must be met before a company can be approved as a futures exchange? (}) the company must ensure that, as far as is reasonably practicable, it will operate an orderly and fair market in relation to securities and futures contracts that are traded through its facilities (ii) the company must manage any risks associated with its business and operations prudently (iii) the company must take appropriate action against its affitiates to whom the rules apply for any breach of its rules (i) and (ii) only (i) and (iii) onty (ii) and (ii) only All of the above goo> (b) What amount is a holder of a CMSL who carries on the business of trading in futures contracts required to contribute to the fidelity fund upon being licensed? A RM10,000 B — RM30,000 © RM100,000 D__RM1,000,000 228 (9 Seutes Camis, Hag and Serle iste etn ara, 199