Interest and Currency Futures

ADC concurred with the earlier assessment by LCGC that there are inter-connections among the various kinds of financial futures, mentioned in its report [equity, interest rate and currency], because the various financial markets are closely inter-linked. Having a common trading infrastructure and the development of an integrated market will have important advantages. ADC therefore observes in its report that currently, in the country, there is a vibrant currency forward market, and negligible activity in currency options and in interest-rate derivatives. These markets are non-transparent telephone markets.

We now have the institutions and technology at hand, to bring these markets onto the transparent exchange platform. This would bring the advantages of price-time priority, transparency, risk management at a central counterparty, nationwide reach, etc. to these important markets. Hence, SEBI and RBI should move on with trading in futures, options and swaps using a variety of underlyings, such as (a) the INR-USD rate, (b) the short-end interest rate, (c) the long-end interest rate, (d) MIBOR, etc.

The majority view of the Committee is that the member wise position limit should be as follows:

• 20% of the market wide position limit in the stock. where the market wide position limit is less than or equal to Rs 2.5 billion. This would ensure that when the open interest in the scrip is large (close to the market wide limit) it is distributed over at least five members with no member holding more than a fifth of the open interest.

• Rs 0.5 billion plus 7.5% of the excess of the market wide position limit over Rs 2.5 billion where the market wide position limit exceeds Rs 2.5 billion. This would mean that the larger the stock, the larger the number of members over whom a large open interest (close to the market wide limit) would have to be distributed. For example, if a stock has a market wide position limit of Rs 15 billion, each member would be limited to less than one-tenth of this

• The majority view of the Committee is that taken in totality the position limits in single stock futures (modified as above) are more stringent and effective than they were in the carry forward system.

The margins in the derivative market are collected up front. The margin is paid before the trade is executed. This is a level of protection that never existed in the carry forward system and does not exist in the cash market even today. Similarly, the mark to market losses and other margin calls that arise every day have to be paid before trading begins the next day unlike in the cash market where it is paid a day later. Thus in the cash segment, the exchange is exposed to the price risk for twice as long as it is in the derivatives segment. The differences in margin collection dates are the principal reasons for the difference in margin levels between the two segments. If the cash segment could also migrate to the derivative market practices, it should be possible to harmonize the margin levels between the two markets. The speedy collection of margins as well as its high degree of responsiveness to market conditions makes the derivative markets considerably safer than the erstwhile carry forward system.

The ACD believes that the impact cost provides a good measure of liquidity while the quarter-sigma order size is a useful direct measure of the manipulability of the stock. On the basis of this empirical study and on the basis of extensive discussions, the ACD recommends the following broad eligibility criteria:

• The stock should be among the top 500 stocks in terms of market capitalisation and average daily volumes.

• The median quarter-sigma order size over the last six months should be at least Rs 0.5 million.

The stocks that meet the above broad eligibility criteria would include some that are less liquid or more volatile or smaller (in terms of market capitalization) than the current list of 31 stocks on which derivatives are traded. To deal with these stocks, the committee proposes some changes in the risk containment system:

• If a stock is illiquid, the exchange may not able to close out a position on the same day as assumed in the VaR calculations. To deal with close-out risk, the margins need to be adjusted to account for the longer close-out time (say three days). Accordingly if the mean value of the impact cost (for an order size of Rs. 0.5 million) exceeds 1%, the price scanning range would be scaled up by the square root of three ( cube-root of 3 = 1.73 ) to cover the close-out risk. Scaling up the price scanning range scales up the margins for futures by the same ratio, while margins for options are impacted in a non linear fashion.

• As far as volatility is concerned, there is no problem with the VaR computations themselves as they are based on stock specific volatility. The only problem is regarding the second line of defence (the exposure limit) and this problem is easily addressed by linking that also to the volatility of the underlying stock. The second line of defence is currently set at 5%. This would be changed to the higher of 5% or 1.5 standard deviations. Accordingly, the exchanges would be required to ensure that for a particular stock, the higher of 5% or 1.5 standard deviations times the notional value of gross open position in futures and option contracts on that particular stock is collected /adjusted from the liquid net worth of a member on a real time basis.

• As far as small cap stocks are concerned, there are no problems regarding the position limits that are stated in terms of market cap or trading volume. The only problem would have been with the absolute amount of Rs 0.5 billion that is currently used in the definition of the member level position limit. However, the majority view of the committee recommends that this limit be linked to the market wide position limit. The universe of eligible stocks would vary from month to month as the impact cost and the quarter-sigma order size are calculated every month on a rolling basis considering the previous six months. It is therefore necessary to lay down the procedure for introducing and dropping stocks:

• Options and futures contracts may be introduced on new stocks when they meet the eligibility criteria.

The Committee laid down guidelines on the actual computation of impact cost and quarter sigma order size:

• Impact cost and the quarter sigma order size should be calculated by taking four snapshots in a day from the order book in the past six months. These four snapshots should be at times randomly chosen from within four fixed ten-minute windows spread through the day. The Exchanges should work together and use a common methodology for carrying out the calculations. Further, for a stock, lowest impact cost across any exchange in India would be considered.

• The details of calculation methodology and relevant data should be made available to the public at large through the web sites of the exchanges.

The committee feels that when an unlisted company come out with a large initial public offering (IPO), it may be desirable to have derivative contracts trade on these stocks from the very first day of their listing to assist in efficient price discovery. The committee therefore proposes that in such cases if net public offer in the IPO is greater than or equal to Rs 5 billion then the exchanges may consider introducing stock options and stock futures contracts on such stocks at the time of their listing in the cash market. In this regard the exchanges may submit their proposal to SEBI for approval on a case by case basis. As regard the risk containment measures, the price scan range could be a multiple of the volatility indices. Subsequently, after sometime the volatility and the impact cost of the underlying stock could be used when price and order book data is available.

The eligibility criteria laid down above for single stock derivatives can be extended to the case of narrow stock indices as well. A stock index would normally be eligible for derivatives trading if most of the weightage in the index (say 90%) is accounted for by constituent stocks that are themselves eligible for derivatives trading. This would also of course be subject to the right of SEBI to refuse permission in exceptional cases under paragraph 4.10 of the LCGC report.

The ACD also endorsed futures and options on dollar-denominated indexes, which are cash-settled in rupees provided the index meets the above eligibility criteria.

Based on the recommendations of the Standing Committee on Finance of Parliament, SEBI has specified that the value of a derivative contract should not be less than Rs. 0.2 million at the time of introducing the contract in the market. SEBI has been receiving various representations on the issue of minimum contract size. The Committee sees merit in some of these arguments. More importantly, it recognizes that globally the contract size is determined by the exchanges without any intervention from the regulators. The environment under which the Rs 0.2 million limit was introduced has undergone a dramatic change and the time has now come to do away with the minimum contract size in value terms.

At the time of recommending introduction of stock options, SEBI laid down procedures for adjustment in derivative contracts at the time of corporate action in line with international best practices. It was decided that the adjustment for corporate action on the same underlying should be uniform across markets.

On the basis of the experience accumulated so far, the ACD is of the view that the task of deciding on adjustments for corporate action should now be left to the exchanges with the stipulation that

• The basis for any adjustment for corporate action shall be such that the value of the position of the market participants on cum and ex-date for corporate action shall continue to remain the same as far as possible.

• The exchanges should take into account best practices followed internationally.

• The exchanges must act consistent with SEBI's circular on adjustment for corporate actions as well as the decisions of the erstwhile subgroup on corporate actions

• The Exchanges must consider the circumstances of the particular case and the general interest of investors in the market