What’s the probability that NSCC will default?

Internationally, clearing corporations calibrate their risk containment system so that failures are expected to take place roughly once or twice in each fifty years. The track record of futures clearing corporations internationally is impressive. In the 20th century, we have seen just a handful of failures (e.g. Hong Kong in 1987). NSCC has a short track record: it has been doing novation on the “equity spot market” (which is actually a futures market) from 1996 onwards. In these five years, the equity market has experienced high volatility, a high incidence of bankruptcies by NSE brokerage firms, payments problems on other exchanges, etc. NSCC has successfully shouldered the task of doing novation on India’s largest financial market (NSE). While this suggests that NSCC may have fairly sound risk containment systems, we should be cautious since it only has a track record of five years of doing novation.

BSE has no experience with novation. Today, equity trading at BSE takes place without novation. BSE has experienced payments problems fairly recently.

The market impact cost in trading the BSE Sensex is higher, for two reasons: index construction and trading venue. Even if BSE Sensex trades were done on NSE, the impact cost faced in trading the BSE Sensex is higher than that of Nifty. In addition, arbitrageurs working on the BSE Sensex would be forced to trade at the less liquid market, the BSE. The BSE lacks a credit enhancement institution of the credibility of NSCC. These problems imply that arbitrageurs working on the BSE Sensex will demand a higher credit risk premium, and require larger pricing errors in order to compensate for the larger transactions costs. Hence, the BSE Sensex futures are expected to show lower market efficiency and greater basis risk.

There are several kinds of speculation that are possible – forecasting movements of Nifty, forecasting movements in Nifty futures prices, and forecasting interest rates.

Nifty is a well–diversified portfolio of companies that make up 54% of the market capitalisation of India. The diversification inside Nifty serves to “cancel out” influences of individual companies or industries. Hence Nifty, as a whole, reflects the overall prospects of India’s corporate sector and India’s economy. Nifty moves with events that impact India’s economy. These include politics, macroeconomic policy announcements, interest rates, money supply and budgets. shocks from overseas, etc. Shah & Thomas (1999c) offer some time–series econometrics applied to Nifty

If you have a forecast that Nifty will go up, buy Nifty futures. If you have a forecast that Nifty will go down, sell Nifty futures There are several index futures trading at the same time – which one should I use? Sometimes, the forecast horizon generates constraints. If you have a two–month view, then a futures contract that has only a few weeks of life left might be inconvenient. Another major issue is liquidity. Other things being equal, it is always better to use the contract with the tightest bid–ask spread.

Two scenarios are unfriendly to the speculator. The obvious problem is where Nifty fails to rise as forecasted. But sometimes, even if Nifty rises, the futures price may not move in sympathy. A speculator may make a loss, owing to a slight fall in the futures price, even though there was a slight rise in Nifty. This problem is called basis risk. Sometimes, the speculator may be right in essence – and good news about the macroeconomy does appear – but may lose money in practice because the index is badly constructed and does not reflect shocks to the macroeconomy.

Basis risk is minimised by having a well–designed index where the index is highly liquid and the underlying spot market is well thought out and highly liquid. The index accurately tracks the macroeconomy when it is as large as possible while avoiding illiquid stocks, it is regularly maintained, and accurate in terms of data reliability.

If you think the futures price will go up, buy the futures. If you think the futures price will go down, sell the futures.

The speculator who works on movements of the futures price makes calculations for the fair value of the futures, after carefully accounting for interest rates, initial margin requirements and transactions costs faced by arbitrageurs, and dividend forecasts. If, based on this analysis, the speculator feels that arbitrageurs are going to lend money to the market (i.e. buy the spot Nifty and sell the futures), then he has a forecast that the futures price will drop. Such a speculator is front–runing against the arbitrageurs by selling Nifty futures before they do so.

The basis between (say) the spot Nifty and the 1 month Nifty futures reflects the interest rate over the coming month. If interest rates go up, the basis will widen. A buy position on the futures coupled with a sell on the spot Nifty represents a view that the basis will widen. The difference between the two month and three month futures reflects the forward interest rate for 30 days, two months from now. Interest rate views can be expressed using this also.

There are two kinds of brokerage firms on the index futures market: trading members (TMs) and clearing members (CMs). NSCC only deals with clearing members: NSCC bears the full risk of default by a clearing members. Trading members obtain the right to trade through a clearing member; the CM adopts the full credit risk of the TM. If a TM fails, NSCC holds the relevant CM responsible. CMs don’t need to be brokerage firms; entities such as banks or SHCIL are CMs.

There are a few key differences between intermediation on the equity spot market as compared with the derivatives market:

• Certification of employees is mandatory on the derivatives market from the outset. In contrast, certification requirements on the equity spot market are only gradually being phased in. Anyone who actually obtains a password from NSE and trades on the futures market has to have obtained a score of above 60 on the “NCFM F&O” certification examination.

• The equity spot market is primarily focused upon execution. Users of the market generally know what shares they want to buy/sell, and they only look to the broker to do the low–skill job of trade execution. In contrast, for the forseeable future, users in the index futures and options market will turn to the brokerage firm for advice and analytical support in the context of their derivatives trading. It will be typical to see a user who has a buy on HINDLEVER hedging away his Nifty exposure, upon the advice of the stock broker.

• On NSE’s equity market, the broker is both trading member and clearing member. On the futures market, we will see a clear specialisation coming about, where firms with a focus upon customers will become “trading members”, and get their clearing and settlement services from clearing members. Banks will be important in being clearing members.

• On the equity market, the settlement process using physical shares and (to a much lesser extent) using the depository implies that the typical brokerage firm has a large staff which processes settlement activities. Index futures and options are cash settled, so the staffing patterns in the brokerage firm will be quite different.

There are numerous areas where mutual funds benefit from index futures and index options:

• Index funds can directly use index futures in implementing index funds. When funds come in, the index fund can just buy index futures, and gradually unwind the futures position as the spot market trading is done.

• All mutual funds can excel in reverse-cash-and-carry arbitrage, where full Nifty baskets are sold off on the spot market and bought back at future dates.

• Mutual funds can hedge when their index views are adverse. If a fund feels that Nifty will fare poorly, it can sell Nifty futures and reduce its index exposure. Conversely, it can increase its index exposure when it feels that Nifty will do well.

• Income funds and money market funds can invest money into the Nifty futures market.

• Once index options come about, mutual funds can offer “guaranteed return products”, by bundling a Nifty index fund with a Nifty put option. Conversely, funds can be designed by bundling a core investment in government securities with an investment in a Nifty call option: these funds would have a pure upside if equities do well.

In Hong Kong and Singapore, there are cash–settled forwards on the dollar–rupee exchange rate, called “non–deliverable forwards”. The Singapore Monetary Exchange (SIMEX) has chosen Nifty in order to trade products based on an Indian index. This is a significant development, considering the success at SIMEX in competing against the home–country index futures market in Japan and Taiwan. What is the implication of Nifty futures and options trading at SIMEX for India? From an Indian perspective, it helps FDI and FII inflows into India, since investors would have an additional avenue through which “India risk” can be hedged. Trades on SIMEX would be convenient and hassle–free for the international investor, when compared with the operational frictions involved in doing trades in India. From an NSE perspective, SIMEX represents competition. If SIMEX offers a superior market design, more efficient transacting, and a less onerous regulatory structure, it will take order flow away from NSE. SIMEX will also impose stress upon India’s regulatory apparatus. For example, SIMEX will trade Nifty futures and options from the outset, while India’s regulators have not yet permitted options trading. Similarly, if India’s regulators are confused on questions such as margin setting, then many users will have the choice of walking away from NSE to SIMEX.

There be arbitrage opportunities between the two markets. A large buy order going to SIMEX will push up the price of Nifty futures at SIMEX. Then arbitrageurs will step in, selling Nifty futures at SIMEX and buying Nifty futures at NSE. This could, in turn, propagate back to the NSE cash market through normal spot–futures arbitrage in India. Arbitrage involving options at SIMEX be done in two ways. An arbitrageur could choose to do trades between Nifty options (SIMEX) and Nifty futures (SIMEX). Alternatively, if Nifty futures are much more liquid, then the arbitrageur could choose to do trades between Nifty options (SIMEX) directly to Nifty futures (NSE).

If we consider the pure merits of the market, then the great mass of retail traders in India is likely to generate liquidity at NSE in a way that SIMEX cannot access. The international experience is that in countries which have a strong tradition of retail trading on financial markets, offshore trading does not present a major threat to the local market, which dominates price discovery. NSE is dominated by retail trading, and has had peak stock market trading of $2 billion, which is enormous by world standards. The major question mark is about margins and regulation. It took NSE five years to get permissions to do index futures trading. The delay in obtaining permissions for index options has yet to be seen; SIMEX will have a head start on Nifty options. The regulatory posture in India could turn off users, and drive them off to Singapore. This is not just an idle possibility; it was the case with the Japanese Nikkei 225 futures, where stifling regulation in Japan led to a flowering of futures liquidity in Singapore. In summary, as with the Nikkei 225, the success of SIMEX will depend upon a combination of Indian retail dynamism, and the ability of regulators in India to comprehend derivatives and come up with a fair regulatory structure.