Market Survey

By: T. MUTHUKUMARAN DR V.K. SOMASUNDARAM

Financial Derivatives Market: an analysis For the DecaDe

Derivatives trading commenced in india in June 2000 after the securities and exchange Board of india (seBi) granted the final approval in May 2001 on the recommendation of the l.c. Gupta committee. Despite the encouraging growth and developments, industry analysts feel that the derivatives market has not yet realised its full potential.
which have no independent value. Their value depends upon the underlying asset. The underlying asset may be financial or non-financial in nature. Derivative products like futures and options in the Indian stock markets have become important instruments of price discovery, portfolio diversification and risk hedging in recent times. In the last decade, many emerging and transition economies have started introducing derivatives contracts.

role of financial derivatives

Derivatives may be traded for a variety of reasons. Derivatives enable a trader to hedge against risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (that is, taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular

t
14

he global liberalisation and integration of financial markets has created new investment opportunities, which, in turn, require the development of new instruments that are more efficient to deal with the increased risks. Institutional investors who
FACTS FOR YOU

are actively engaged in industrial and emerging markets need to hedge their risks from these internal as well as cross-border transactions. The most desired instruments that allow market participants to manage risks in the modern securities trading are known as derivatives. Derivatives are instruments

MARCh 2011

Market Survey
Table I

A Trace of Derivatives in India

Date December 14, 1995 November 18, 1996 May 11, 1998 July 7, 1999 May 24, 2000 May 25, 2000 June 9, 2000 June 12, 2000 August 31, 2000 June 2001 July 2001 November 9, 2002 June 2003 September 13, 2004 January 1, 2008 January 1, 2008 August 29, 2008 October 2, 2008 November 27, 2008 March 2009 January 8, 2010 March 6, 2010 August 10, 2010 September 20, 2010
Source: BSE & NSE

national electronic commodity exchanges were also set up.

Progress NSE asked SEBI for permission to trade index futures. SEBI set up L.C. Gupta Committee to draft a policy framework for index futures. L.C. Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE. Trading of futures and options on Nifty to commence at SIMEX. Trading of Equity Index Options at NSE Trading of stock options at NSE Trading of single stock futures at BSE Trading of interest rate futures at NSE Weekly options at BSE Trading of chhota (mini) Sensex at BSE Trading of mini index futures and options at NSE Trading of currency futures at NSE Trading of currency futures at BSE A clearing and settlement arrangement on a non-guaranteed basis was put in place for the OTC interest rate derivatives trades 13 members participated in the non-guaranteed settlement of OTC rupee interest-rate derivatives SEBI standardises lot size for equity derivatives SEBI for physical delivery in equity derivatives segment Currency futures opened for NBFCs USE to begin currency futures trading

Derivatives trading in india

Derivatives trading commenced in India in June 2000 after the Securities and Exchange Board of India (SEBI) granted the final approval in May 2001 on the recommendation of the L.C. Gupta Committee. SEBI permitted the derivatives segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Initially, SEBI approved trading in index futures contracts based on various stock market indices such as S&P CNX, Nifty and Sensex. Subsequently, index-based trading was permitted in options as well as individual securities.

regulation of derivatives trading in india

1. The regulatory framework in India is based on the L.C. Gupta Committee Report and the J.R. Varma Committee Report. 2. It is mostly consistent with the International Organisation of Security Commission (IOSCO) principles and addresses the common concerns of investor protection, market efficiency and financial integrity. 3. The L.C. Gupta Committee report provides a perspective on the division of regulatory responsibility between the exchange and SEBI. 4. It recommends that SEBIs role should be restricted to approving rules, bye-laws and regulations of a derivatives exchange. 5. It emphasises the supervisory and advisory role of SEBI with a view to permitting desirable flexibility, maximising regulatory effectiveness and minimising regulatory cost.
MARCh 2011

trade was for hedging or speculation, and active markets require participation of both the hedgers and speculators.

history of derivatives market in india

Derivatives market in India has been in existence in one form or the other for a long time. In commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In 1952, the Government of India banned cash settlement and options trading. De-

rivatives trading shifted to informal forwards markets. In recent years, the government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options in securities. The last decade, beginning the year 2000, saw the ban on futures trading being lifted in many commodities. Around the same period,

FACTS FOR YOU

15

Market Survey
Table II

Total Derivatives Contract and Turnover Since Inception

(Turnover in Rs billion) Year 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10
Source: BSE & NSE

NSE Number of contracts 90,580 4,196,873 46,768,909 56,875,995 77,017,185 160,619,271 216,883,573 425,013,200 657,390,497 679,293,922

Turnover 23.65 1,019.26 4,398.62 21,304.08 25,469.82 48,241.74 73,562.42 130,904.78 107,904.82 176,636.65

BSE Number of contracts 77,743 105,023 138,011 382,288 531,719 203 1,781,217 7,453,371 496,502 9,028

Turnover 16.73 19.26 24.77 120.74 161.13 0.09 590.06 2,423.08 117.75 2.34

Total Number of contracts 168,323 4,301,896 46,906,920 57,258,283 77,548,904 160,619,474 218,664,790 432,466,571 657,886,999 679,302,950

Turnover 40.38 2,088.75 5,803.50 25,247.70 30,948.14 48,243.86 91,964.65 207,861.57 112,987.59 176,729.27

Table III

Product-wise Volume and Turnover in NSE

(Turnover in Rs billion) Year Index futures Number of Turnover contracts 90,580 1,025,588 2,126,763 17,191,668 21,635,449 58,537,886 81,487,424 156,598,579 210,428,103 178,306,889 23.65 214.83 439.52 5,544.46 7,721.47 15,137.55 25,395.74 38,206.67 33,501.11 39,343.89 Stock futures Number of Turnover contracts 1,957,856 40,676,843 32,368,842 47,043,066 80,905,493 104,955,401 203,587,952 221,577,980 145,591,240 515.15 2,865.33 13,059.39 14,840.56 27,916.97 38,309.67 75,485.63 34,796.42 51,952.47 Index options Number of Turnover contracts 175,900 442,241 1,732,414 3,293,558 12,935,116 25,157,438 55,366,038 212,088,444 341,379,523 37.65 92.46 528.16 1,219.43 3,384.69 7,919.06 13,621.11 37,315.02 80,279.64 Stock options Number of Turnover contracts 1,037,529 3,523,062 5,583,071 5,045,112 8,240,776 5,283,310 9,460,631 13,295,970 14,016,270 251.63 1,001.31 2,172.07 1,688.36 1,802.53 1,937.95 3,591.37 2,292.27 5,060.65

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10
Source: NSE

6. Regulatory requirements for authorisation of derivatives brokers or dealers include capital adequacy, net worth, certification requirement and initial registration with SEBI. 7. It also suggests establishment of a separate clearing corporation, maximum exposure limits, mark to market margins, margin collection from clients and segregation of clients funds, regulation of sales 16
FACTS FOR YOU

practice and accounting, and disclosure requirements for derivatives trading. 8. The J.R. Varma Committee suggests a methodology for risk containment measures for index-based futures and options, stock options and single stock futures. The risk containment measures include calculation of margins, position limits, exposure limits, and reporting and disclosure.

Growth of derivatives market in india

Equity derivatives market in India has registered an explosive growth and is expected to continue the same way in the years to come. Introduced in 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. NSE alone accounts for 99

MARCh 2011

Market Survey
Table IV

Product-wise Volume and Turnover in BSE

(Turnover in Rs million)
Year Index futures Number of contracts 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 77,743 79,552 111,324 246,443 449,630 89 1,638,779 7,157,078 495830 3744 Turnover 16,730 12,760 18,110 65,720 136,000 50 554,910 2,346,600 117,570 960 Stock futures Number of contracts 17,951 25,842 128,193 6,725 12 142,433 295,117 299 8 Turnover 4,520 6,440 51,710 2,130 10 35,150 76,090 90 0 Index options Call Put Number of Turnover Number of Turnover contracts contracts 1,139 41 1 48,065 100 2 951 251 5,276 390 10 0 14,710 30 0 310 60 1,380 1,276 2 0 27,210 0 2 210 122 0 450 0 0 8,270 0 0 80 30 0 Stock options Call Put Number of Turnover Number of Turnover contracts contracts 3,605 783 4,391 72 2 0 9 0 0 790 210 1,740 20 0 0 0 0 0 1,500 19 3,260 17 0 1 6 0 0 350 0 1,570 0 0 0 0 0 0

Source: BSE & SEBI

Table V

Top 5 Exchanges by Number of Stock Index Futures Contracts Traded

Exchange CME Group EUREX National Stock Exchange of India Osaka Securities Exchange NYSE Liffe Europe 2010* 373,562,635 211,119,321 79,554,314 71,819,297 49,227,075 2009* 387,676,929 211,855,381 105,431,318 61,849,732 48,120,912 Per cent change 3.6 0.3 24.5 16.1 2.3

Source: World Federation of Exchanges (*1st half 2009 & 2010 market highlights)

per cent of the derivatives trading in Indian markets. If one compares the trading figures of NSE and BSE, performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories. Turnover in the derivatives segment since inception is shown in Table II. During 2000-01, turnover on NSE was Rs 23.65 bllion and during 2009-10, it was Rs 176,636.65 billion. Likewise, during 2000-01 turnover on BSE was Rs 16.73 billion and during 2009-10, it was Rs 2.34 billion. Turnover on BSE increased till 2004-05 but during 2005-06 there was a noticeable decrease in turnover. The turnover

on BSE started increasing since 2006-07. At NSE, during the period 2001 to 2010, turnover was the highest in 2009-10. At BSE, practically, no derivatives trading took place in the period 2005-06. However, since 2006-07 the turnover started increasing. Over the given period, the maximum turnover in NSE was Rs 176,636.65 billion, while in BSE it was Rs 2,423 billion. The index futures trading at NSE commenced on June 12, 2000 on S&P CNX Nifty Index. Index futures at NSE are currently available on indices like S&P CNX Nifty, Nifty Midcap 50, CNX IT and CNX Bank. Among the Index Futures products at NSE, the share of Nifty

Futures is around 94 per cent. This shows that Nifty Futures have been the most prominent and popular product to enable wider participation of retail investors in the derivatives markets. Table III shows the journey of index futures since 2000. Over a period of time many indices have been made available for index futures trading. The index futures turnover at NSE grew from Rs 23.65 billion to Rs 39,343.89 billion in 2009-10. The trading in single stock futures started on November 9, 2001. Table III shows the business growth of stock futures at NSE in terms of number of contracts traded and turnover since inception. Stock futures at NSE grew from Rs 515.15 billion to Rs 51,952.47 billion in 2009-10. As of March 2010, there were 190 stocks available for trading at NSE and the Index options were allowed for trading on S&P CNX Nifty Index on June 4, 2001. Worldwide, options have been the most preferred product in derivatives trading. However, in India, in the beginning the preferred product of derivatives trading was futures. The growth of index options at NSE
MARCh 2011

FACTS FOR YOU

17

Market Survey
Table VI

Top 5 Exchanges by Number of Single Stock Future Contracts Traded

Exchange NYSE Liffe Europe EUREX National Stock Exchange of India Johannesburg SE Korea Exchange 2010* 198,955,076 118,123,693 74,154,830 37,002,890 21,881,547 2009* 115,450,139 93,714,781 80,669,667 47,916,565 22,673,290 Per cent change 72.3 26 8.1 22.8 3.5

Source: World Federation of Exchanges (*1st half 2009 & 2010 market highlights)

Table VII

Top 5 Exchanges by Number of Stock Index Options Contracts Traded

Exchange Korea Exchange National Stock Exchange of India EUREX Chicago Board Options Exchange TAIFEX 2010* 1,671,466,852 221,430,570 173,244,615 147,176,493 48,775,481 2009* 1,375,065,894 146,706,110 204,870,100 106,219,417 40,839,780 Per cent change 21.6 50.9 15.4 38.6 19.4

Source: World Federation of Exchanges (*1st half 2009 & 2010 market highlights)

in terms of turnover has been from Rs 37.65 billion to Rs 80,279.64 billion in 2009-10. The single stock options were allowed for trading on July 2, 2001. Stock options at NSE grew from Rs 251.63 billion to Rs 5,060.65 billion in 2009-10. As of March 2010, there were 190 stocks options available for trading at NSE.

and Israel.

emerging trends
1. Investors are gradually becoming more market-savvy. 2. Information and communication technology (ICT) has started revolutionising financial markets. 3. Electronic trading is replacing pit-trading all over the world at an increasing rate. 4. The need for better cooperation/coordination among regulators is increasing to understand crossborder movements of funds of ambiguous origin and purpose. 5. Emergence of MNC/supranational financial institutions has brought about financial integration.

in the global financial system with the introduction of derivatives. 2. ICT becoming all pervasive, and playing a critical role in minimising information asymmetry in the markets leading to an efficient price-discovery and investor protection. 3. Organised exchanges becoming the institutions that help in achieving efficiencies of scale, transparency in price discovery, orderly conduct of transactions and evolving as one-stop financial shopping malls of the future. 4. Organised exchanges becoming self regulatory in the true sense of word with complete shift to principle-based regulation, away from todays rule-based regulation. 5. Market participants building enough knowledge base so as to shift from compliance-based supervision to risk-based supervision. 6. Operational aspects of the business being given to the organised exchanges. 7. The regulators to play the role of enablers in a true sense, moving away from day-to-day directions to the participants and interventions in the markets.

vibrant market in india

India is one of the most successful developing countries in terms of a vibrant market for exchangetraded derivatives. This reiterates the strengths of the modern development of Indias securities markets which are based on nationwide market access, safe and secure electronic trading, and a predominantly retail market. There is an increasing sense that the equity derivatives market is playing a major role in shaping price discovery. Factors like increased volatility in financial asset prices, growing integration of national financial markets with international markets, development of more sophis-

international markets
The derivatives segment has expanded substantially in recent years both globally as well as in the Indian capital market. The exchanges of the developed markets have shown robust growth and maintained their leadership position. At the same time, developing and emerging market exchanges have gained a position of eminence with strong growth. It is evident from Table V to VIII that the Indian market has emerged stronger along with markets in Korea, Spain 18
FACTS FOR YOU

envisioning the future

1. Indian markets becoming vibrant and achieving a leading status

MARCh 2011

Market Survey
Table VIII

Top 5 Exchanges by Number of Stock Options Contracts Traded

Exchange Chicago Board Options Exchange BM&FBOVESPA International Securities Exchange NASDAQ OMX PHLX EUREX 2010* 463,486,201 424,137,525 398,680,825 262,650,693 143,320,872 2009* 463,756,036 235,338,378 498,252,797 297,065,194 161,303,588 Per cent change 0.1 80.2 20 11.6 11.1

Source: World Federation of Exchanges (*1st half 2009 & 2010 market highlights)

ticated risk management tools, wider choices of risk management strategies to economic agents and innovations in financial engineering have been driving the growth of financial derivatives worldwide and also fueled the growth of derivatives in India. Despite the encouraging growth and developments, industry analysts

feel that the derivatives market has not yet realised its full potential in terms of growth and trading. Analysts point out that the equity derivative markets on the BSE and NSE have been limited to only four productsindex futures, index options and individual stock futures and options, which, in turn, are limited to certain select stocks only. Although

NSE and BSE recently added more products in their derivatives segment (weekly options, currency futures, mini index, etc), their number is still far less than the depth and variety of products prevailing across many developed capital markets. As Indian derivatives markets become more sophisticated, greater investor awareness will become essential. NSE has programmes to inform and educate brokers, dealers, traders and market personnel. In addition, institutions will need to devote more resources to develop the business processes and technology necessary for derivatives trading.
T. Muthukumaran is an assistant professor at Saradha Gangadharan College, Puducherry, and Dr V.K. Somasundaram is head at the post graduate and research department of corporate secretaryship, Bharathidasan Govrnment College for Women (an autonomous institute), Puducherry

MARCh 2011

FACTS FOR YOU

19