In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place.
What are these myths behind derivatives? What is the underlying truth behind such myths? The myths and the realities behind them are:
1. Derivatives increase speculation and do not serve any economic purpose
Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices, or exchange rates.
The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants.
Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options.
By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth.
Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and efficiency and facilitating the flow of trade and finance.
2. Indian Market is not ready for derivative trading
Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the pre-requisites, which are needed for the introduction of derivatives and how Indian market fares:
Large market Capitalization - India is one of the largest market-capitalized countries in Asia with a market capitalization of more than Rs.765000 crores.
High Liquidity in the underlying - The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the country's Market capitalization gets traded. These are clear indicators of high liquidity in the underlying.
Trade guarantee - The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing.
A Strong Depository - National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country.
A Good legal guardian - In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.
3. Disasters prove that derivatives are very risky and highly leveraged instruments
Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters are not necessarily due to dealing in derivatives, but derivatives make headlines. Some of the reasons behind disasters related to derivatives are:
1. Lack of independent risk management
2. Improper internal control mechanisms
3. Problems in external monitoring done by Exchanges and Regulators
4. Trader taking unauthorized positions
5. Lack of transparency in the entire process
4. Derivatives are complex and exotic instruments that Indian investors will have difficulty in understanding
Trading in standard derivatives such as forwards, futures and options is already prevalent in India and has a long history. Reserve Bank of India allows forward trading in Rupee-Dollar forward contracts, which has become a liquid market. Reserve Bank of India also allows Cross Currency options trading.
Forward Markets Commission has allowed trading in Commodity Forwards on Commodities Exchanges, which are, called Futures in international markets. Commodities futures in India are available in turmeric, black pepper, coffee, Gur (jaggery), hessian, castor seed oil etc. There are plans to set up commodities futures exchanges in Soya bean oil as also in Cotton. International markets have also been allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India also allows, the users to hedge their portfolios through derivatives exchanges abroad. Detailed guidelines have been prescribed by the RBI for the purpose of getting approvals to hedge the user's exposure in international markets.
Derivatives in commodities markets have a long history. The first commodity futures exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 1963-68). A clearinghouse for clearing and settlement of these trades was set up in 1918. In oilseeds, a futures market was established in 1900. Wheat futures market began in Hapur in 1913. Futures market in raw jute was set up in Calcutta in 1912. Bullion futures market was set up in Mumbai in 1920.
History and existence of markets along with setting up of new markets prove that the concept of derivatives is not alien to India. In commodity markets, there is no resistance from the users or market participants to trade in commodity futures or foreign exchange markets. Government of India has also been facilitating the setting up and operations of these markets in India by providing approvals and defining appropriate regulatory frameworks for their operations.
Approval for new exchanges in last six months by the Government of India also indicates that Government of India does not consider this type of trading to be harmful albeit within proper regulatory framework.
This amply proves that the concept of options and futures has been well ingrained in the Indian equities market for a long time and is not alien as it is made out to be. Even today, complex strategies of options are being traded in many exchanges which are called teji-mandi, jota-phatak, bhav-bhav at different places in India (Vohra and Bagari, 1998)
In that sense, the derivatives are not new to India and are also currently prevalent in various markets including equities markets.
5. The existing capital market is safer than Derivatives?
World over, the spot markets in equities are operated on a principle of rolling settlement. In this kind of trading, if you trade on a particular day (T), you have to settle these trades on the third working day from the date of trading (T+3).
Futures market allow you to trade for a period of say 1 month or 3 months and allow you to net the transaction taken place during the period for the settlement at the end of the period. In India, most of the stock exchanges allow the participants to trade during one-week period for settlement in the following week. The trades are netted for the settlement for the entire one-week period. In that sense, the Indian markets are already operating the futures style settlement rather than cash markets prevalent internationally.
In this system, additionally, many exchanges also allow the forward trading called badla in Gujarati and Contango in English, which was prevalent in UK. This system is prevalent currently in France in their monthly settlement markets. It allowed one to even further increase the time to settle for almost 3 months under the earlier regulations. This way, a curious mix of futures style settlement with facility to carry the settlement obligations forward creates discrepancies.
The more efficient way from the regulatory perspective will be to separate out the derivatives from the cash market i.e. introduce rolling settlement in all exchanges and at the same time allow futures and options to trade. This way, the regulators will also be able to regulate both the markets easily and it will provide more flexibility to the market participants.
In addition, the existing system although futures style, does not ask for any margins from the clients. Given the volatility of the equities market in India, this system has become quite prone to systemic collapse. This was evident in the MS Shoes scandal. At the time of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri had a position close to Rs.18 crores. However, due to the default, BSE had to stop trading for a period of three days. At the same time, the Barings Bank failed on Singapore Monetary Exchange (SIMEX) for the exposure of more than US $ 20 billion (more than Rs.84,000 crore) with a loss of approximately US $ 900 million ( around Rs.3,800 crore). Although, the exposure was so high and even the loss was also very big compared to the total exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had taken so much margins that they did not stop trading for a single minute.
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