Future and Option Market
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BES’s INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH
REGULATIONS OF FUTURE AND OPTION MARKET
Submitted To:
Prof. Mustafa Sapatwala
Submitted By:
Mr. Kunal Gajanan Malode Roll No: 30 S.Y.M.M.S
Regulations of Future and Option Markets
BES’s INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH
Introduction The term “futures and options” (also known as derivatives) refers to contracts which are traded in financial markets. A futures contract requires delivery of a commodity, bond, currency, stock or index, at a specified price, on a specified future date. The physical delivery of underlying asset may or may not happen. Instead, it may be squared off before its expiry date. For example, if a person is “long” on index future i.e. who bought the contract at the beginning of the month may sell it just two days prior to its expiry. The difference in the value of contract will be paid to him as profit (or deducted from his account as loss) as the case may be. Similar to trading stocks, a certain percentage of the traded value will be levied as commission (brokerage), a service tax (to the brokerage amount) and a securities transaction tax (STT). The brokerage may vary for different brokers. Some may charge a fixed brokerage; some may charge based on traded value. There are 1 month, 2 month and 3 month futures contracts available in India. The contracts are settled on the last Thursday of every month. If this happens to be a trading holiday, the previous day would be the expiry date. The risk involved in trading a futures contract is equal for both buyer and seller or “symmetrical”. Futures trading also come under the purview of Securities and Exchange Board of India (SEBI). In case of short selling equity shares (selling a share one doesn’t possess) the trade needs to be squared off on the same day; otherwise the short sold equity shares will be sold in auction. The short seller will be penalized by the exchange for not squaring it off. But in case of futures no such thing happens; a person can carry a “short” position overnight. He can continue to do so till the expiry date. However, the minimum margin requirements need to be maintained. Margin money is defined as the amount, based on which the broker may allow purchase or sale of a stock or future; this margin also varies from broker to broker. In case of equity share purchases using margin trading, the buyer needs to pay the outstanding amount to the broker before a fixed date i.e. before he receives delivery of shares. In case of futures, stocks in possession can be used as margin for trading in futures; however, market to market obligations (such as losses) need to be met in cash. Futures contract prices also have the same structure like the cash market prices. But there is no price band for futures or options; to avoid errors in entering orders the exchange may fix the price range. Prices in excess of the range will need to be reviewed by the exchange. In
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addition, if the “open interest” or the maximum number of outstanding contracts exceeds a certain value, no fresh positions will be allowed for the particular scrip. An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a specified date. In the case of a stock option, its value is based on the underlying stock (equity). For an index option, its value is based on the underlying index. Options are traded in the same way like stocks. They can be bought and sold just like any other security. In case of options, the buyer pays the premium amount only; not the value of the entire contract. The commission for the Options, however, will be based on the value (strike price) of the underlying assets. There are two option types; Call and Put. A Call option is an option to buy a stock or index at a specific price on or before an expiry date. Call options usually increases in value as the value of the underlying asset increases. The premium amount is paid by the buyer to secure the right to buy the underlying asset. In case, if one does not want to buy the underlying asset, he will lose the option premium paid; no other obligation exists between him and the option seller. Put option is an option to sell a stock or index at a specific price on or before a expiry date. Similar to the call option, a premium amount is paid by the buyer of the put option. In case if he does not want to sell the underlying asset, as in the case of call option, he will lose the option premium. There are two types of expiration; European style in which options cannot be exercised until expiry date; American style in which options can be exercised anytime before expiry. In India all stock options are American style and index options are European style. Option contracts should never be short sold. If the market turns the other way around, the buyer or seller may want to exercise the option. In this case loss resulting from shorting the option will be huge; so short selling options is very risky. “Strike Price” is defined as the price at which the underlying security can be bought or sold as specified in the option contract. “Spot price” refers to the market price of the underlying security. An option writer is defined as the one who sells the option to the option holder. Futures Contracts have symmetric risk profile for both buyers as well as sellers, whereas options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits
Regulations of Future and Option Markets
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may be unlimited, depending upon the spot price and whether he wants to exercise the option or not. In India, at the NSE, an index future trading was introduced in the year 2000. Index Options trading was also made available in 2001. Stock futures were introduced a little later. F & O index contracts are available in Nifty, Junior Nifty, Bank Nifty, CNX – IT (IT sector index) and CNX 100 (diversified 100 stock index accounting for 35 sectors of the economy). For individual securities, F & O contracts are available in one hundred and eighty seven scrip’s, starting from Aban Offshore to Zee Entertainment Enterprises Limited. The contracts are traded as “lots” meaning a contract will have certain fixed number of instruments. For example, the nifty shall have 50 instruments and it is called lot size. When a buyer places an order for a contract he has to bid for 50 or multiples of 50. Stock futures are available for most of the Nifty and Junior Nifty stocks. The stocks are chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six months on a rolling basis. The market wide position limit in the stock shall not be less than Rs. 50 crore. The market wide position limit (number of shares) shall be valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in the month. The market wide position limit of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock shall be 20% of the number of shares held by non-promoters in the relevant underlying security i.e. free-float holding. Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset.
Regulation in Indian derivative market
Development of exchange-traded derivatives Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been
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around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. The need for a derivatives market The derivatives market performs a number of economic functions: 1. They help in transferring risks from risk averse people to risk oriented people 2. They help in the discovery of future as well as current prices 3. They catalyze entrepreneurial activity 4. They increase the volume traded in markets because of participation of risk averse people in greater numbers 5. They increase savings and investment in the long run The participants in a derivatives market • Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. • Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. • Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. Types of Derivatives Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
Regulations of Future and Option Markets
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Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. • Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating. Factors driving the growth of financial derivatives 1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international markets, 3. Marked improvement in communication facilities and sharp decline in their costs, 4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets. Development of derivatives market in India
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The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24–member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real–time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three– decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single
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stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): • Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system. • On relative terms, a volume in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. • Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. • Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent. Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums. Commodity Derivatives Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity
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exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernization programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. The Government of India has constituted a committee to explore and evaluate issues pertinent to the establishment and funding of the proposed national commodity exchange for the nationwide trading of commodity futures contracts, and the other institutions and institutional processes such as warehousing and clearinghouses. With commodity futures, delivery is best affected using warehouse receipts (which are like dematerialized securities). Warehousing functions have enabled viable exchanges to augment their strengths in contract design and trading. The viability of the national commodity exchange is predicated on the reliability of the warehousing functions. The programme for establishing a system of warehouse receipts is in progress. The Coffee Futures Exchange India (COFEI) has operated a system of warehouse receipts since 1998 Exchange-traded vs. OTC (Over the Counter) derivatives markets The OTC derivatives markets have witnessed rather sharp growth over the last few years, which have accompanied the modernization of commercial and investment banking and globalization of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized limits on individual positions, leverage, or margining,
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3. There are no formal rules for risk and burden-sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.
Accounting of Derivatives: The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on accounting of index futures contracts from the view point of parties who enter into such futures contracts as buyers or sellers. For other parties involved in the trading process, like brokers, trading members, clearing members and clearing corporations, a trade in equity index futures is similar to a trade in, say shares, and does not pose any peculiar accounting problems Taxation The income-tax Act does not have any specific provision regarding taxability from derivatives. The only provisions which have an indirect bearing on derivative transactions are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a speculative business carried on by the assessee, shall not be set off except against profits and gains, if any, of speculative business. In the absence of a specific provision, it is apprehended that the derivatives contracts, particularly the index futures which are essentially cash-settled, may be construed as speculative transactions and therefore the losses, if any, will not be eligible for set off against other income of the assessee and will be carried forward and set off against speculative income only up to a maximum of eight years .As a result an investor’s losses or profits out of derivatives even though they are of hedging nature in real sense, are treated as speculative and can be set off only against speculative income. REGULATION FOR DERIVATIVES TRADING SEBI set up a 24- member committee under the Chairmanship of Dr. L. C.Gupta to develop the appropriate regulatory framework for derivatives trading in India. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures. The provisions in the SC(R)A
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and the regulatory framework developed there under govern trading in securities. The amendment of the SC(R)A to include derivatives within the ambit of ‘securities’ in the SC(R)A made trading in derivatives possible within the framework of that Act. 1. Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta committee report can apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange would have to regulate the sales practices of its members and would have to obtain prior approval of SEBI before start of trading in any derivative contract. 2. The Exchange should have minimum 50 members. 3. The members of an existing segment of the exchange would not automatically become the members of derivative segment. The members of the derivative segment would need to fulfill the eligibility conditions as laid down by the L. C. Gupta committee. 4. The clearing and settlement of derivatives trades would be through a SEBI approved clearing corporation/house. Clearing corporations/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval. 5. Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges. The minimum net worth for clearing members of the derivatives clearing corporation/house shall be Rs.300 Lakh. The net worth of the member shall be computed as follows: • • Capital + Free reserves ď€ Less non-allowable assets viz.,
(a) Fixed assets (b) Pledged securities (c) Member’s card (d) Non-allowable securities (unlisted securities) (e) Bad deliveries (f) Doubtful debts and advances (g) Prepaid expenses (h) Intangible assets (i) 30% marketable securities
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6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to submit details of the futures contract they propose to introduce. 7. The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position will be prescribed by SEBI/Exchange from time to time. 8. The L. C. Gupta committee report requires strict enforcement of “Know your customer” rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client. 9. The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI. Forms of collateral’s acceptable at NSCCL Members and dealer authorized dealer have to fulfill certain requirements and provide collateral deposits to become members of the F&O segment. All collateral deposits are segregated into cash component and non-cash component. Cash component means cash, bank guarantee, fixed deposit receipts, T-bills and dated government securities. Non-cash component mean all other forms of collateral deposits like deposit of approved demat securities. Requirements to become F&O segment member The eligibility criteria for membership on the F&O segment is as given in Table
1 . Table.2 gives the requirements for professional clearing membership. Anybody
interested in taking membership of F&O segment is required to take membership of “CM and F&O segment” or “CM, WDM and F&O segment”. An existing member of CM segment can also take membership of F&O segment. A trading member can also be a clearing member by meeting additional requirements. There can also be only clearing members. Eligibility criteria for membership on F&O segment Particulars (all values in Rs. Lakh) CM and F&O segment CM, WDM and F&O segment
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Net worth Interest free security deposit (IFSD) Collateral security deposit (CSD) Annual subscription
100 125
200 275
25
25
1
2
Requirements for professional clearing membership Particulars (all values in Rs. Lakh) Eligibility Trading members of NSE/SEBI registered custodians/recognized banks Net worth Interest free security deposit (IFSD) Collateral security deposit Annual subscription 25 nil 50 2.5 300 25 Trading NSE/SEBI registered custodians/recognized banks 300 34 members of F&O segment CM & F&O segment
Requirements to become authorized / approved user Trading members and participants are entitled to appoint, with the approval of the F&O segment of the exchange authorized persons and approved users to operate the trading workstation(s). These authorized users can be individuals, registered partnership firms or corporate bodies. Authorized persons cannot collect any commission or any amount directly
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from the clients he introduces to the trading member who appointed him. However he can receive a commission or any such amount from the trading member who appointed him as provided under regulation. Approved users on the F&O segment have to pass a certification program which has been approved by SEBI. Each approved user is given a unique identification number through which he will have access to the NEAT system. The approved user can access the NEAT system through a password and can change such password from time to time.
Regulation in United States derivative market
The word "derivative" outside of a narrow circle of Wall Street and Chicago traders and other market participants, and you’re likely to get one or several of the following reactions: fear, anger, or disinterest. Warren Buffett has famously analogized derivatives – financial instruments whose value depends on and thus is “derived” from the value of some other underlying security, such as a stock or a bond or the current price of a commodity – as "financial weapons of mass destruction." Who wouldn’t be afraid of such things? Or, if the widespread condemnation of derivatives for causing or helping to cause the recent financial crisis is accurate, who wouldn’t be angry at them? Meanwhile, those who might not care about the word or the complex issues it raises can be forgiven. After all, derivatives are difficult for non-experts to understand and seem unrelated to every day things most people really care about in times like these – such as their jobs and how they will be able to pay for their children’s education or their own retirement. But whether you know it or not (or care), derivatives have become crucial parts of the financial and economic system not only in this country but elsewhere around the world. Derivatives such as futures and options contracts, and various kinds of “swap” arrangements (involving interest rates, foreign currencies, and loan defaults), provide efficient ways for both financial and non-financial users to hedge against a variety of financial risks. The numbers involved run into the hundreds of trillions of dollars in “notional” amounts, though the amounts actually at risk are substantially lower. Moreover, when properly used and backed by sufficient collateral, derivatives have become a valuable financial tool for banks and wide variety of end-users: corporations and private companies, state and local governmental entities, and so-called “buy-side” non-bank financial institutions.
Derivatives got their bad reputation during the financial panic in September 2008, when the
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world learned that if the parties to both sides of the transactions are large, financially connected with many other parties, and do not have the financial means to make good on their promises, derivatives that are traded “over the counter” (OTC) and not centrally cleared can pose dangers to entire economies. The dangers are especially great for one kind of derivative contract on which I concentrate primarily here – “credit default swaps” (CDS). With CDS, non-defaulting parties (the buyers of this particular kind of insurance against loan or bond default) are likely, especially in an economy-wide crisis, to find it more expensive to replace their contracts with the defaulting party (the seller) than are non-defaulting parties in other OTC swap arrangements. Indeed, mainly for this reason, unless otherwise indicated, when I refer in this essay to “derivatives” I mean specifically CDS, although many of the arguments or claims I advance refer to other OTC derivatives as well.
Fortunately, there is a growing consensus among financial regulators and academic experts about what to do at least with respect to “standardized” derivatives, or those that resemble readily traded stocks or futures contracts, and thus how to help keep financial actors who are heavily engaged in derivatives activities and also run into financial trouble from infecting other institutions and conceivably entire markets. I will outline this consensus shortly, which may be enacted in some form by Congress this year as part of comprehensive financial reform. I have written this essay primarily to call attention to the main impediments to meaningful reform: the private actors who now control the trading of derivatives and all key elements of the infrastructure of derivatives trading, the major dealer banks. The importance of this “Derivatives Dealers’ Club” cannot be overstated. All end-users who want derivatives products, CDS in particular, must transact with dealer banks. The dealer banks, in turn, transact heavily with each other, to hedge the risks from their customer trades and somewhat less frequently, to trade for their own accounts.
I will argue that the major dealer banks have strong financial incentives and the ability to delay or impede changes from the status quo - even if the legislative reforms that are now being widely discussed are adopted - that would make the CDS and eventually other derivatives markets safer and more transparent for all concerned. At the end of this essay, I
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will outline a number of steps that regulators and possibly the antitrust authorities may be able to take to overcome any dealer resistance to constructive change. Wall Street Reform and Consumer Protection Act affect the derivatives market in a variety of areas. It provides for mandatory central clearing and exchange trading of certain swaps, realtime reporting of trades, registration and regulatory oversight for swap dealers and other entities maintaining substantial positions in swaps (called "major swap participants"), registration and oversight for derivative clearing organizations and swap execution facilities, position limits and rules prohibiting manipulation of commodity markets. "Swap" is defined to include a broad variety of derivatives products, with certain exclusions including for physically-settled commodity forwards, commodity and securities futures and instruments based on securities already regulated by the SEC. Over-the-counter foreign exchange swaps and forwards are covered by the Act as "swaps," but the Secretary of the Treasury is given the authority to exempt them from regulation under the Act. Allocation of Jurisdiction Generally, the Act gives the CFTC the authority to regulate swaps other than security-based swaps, while the SEC will regulate security-based swaps. Both the CFTC and the SEC (the "Commissions") may regulate mixed swaps—derivatives that have characteristics of both these types of swaps. The Act generally requires the Commissions to treat economically similar products and entities in a similar manner, but it does not require the Commissions to issue joint regulations for economically similar products and entities. Additionally, the Act creates the framework that the Commissions will operate under to determine the jurisdictional status of novel derivative products that may have elements of both securities and contracts of sale of a commodity for future delivery (or options on such contracts or options on commodities). Under the framework, each Commission must notify the other when it receives a request to trade or list this type of novel product. From there, each Commission may request that the other Commission determine whether the product falls under that Commission's jurisdiction. Each Commission may also ask the other Commission to exempt the product from its regulations. Either Commission may petition the United States District Court for the District of Columbia if it disagrees with the other Commission's determination as to whether the novel derivative product falls under its jurisdiction. Clearing and Reporting
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Mandatory clearing and Trade execution. The Act generally gives the Commissions the power to determine which swaps will be subject to mandatory central-counterparty clearing. Generally, the Commissions will determine which swaps are subject to mandatory clearing by considering, among other factors, the level of outstanding notional exposure, trading liquidity, and adequate pricing data, the availability of operational clearing expertise and infrastructure, and the likely effect that clearing will have on systemic risk and competition. If a swap is within a category of swaps that is cleared by a clearing organization and the applicable Commission determines that swaps in that category are subject to mandatory clearing, then the swap must be submitted to a clearing organization. In addition, if the Commissions do not subject a particular type of swap to mandatory clearing but a clearing organization accepts derivative contracts of that type for clearing, an end-user may elect that the swap be submitted to the clearing organization and cleared accordingly. The Act, subject to grandfathering provisions, provides for extensive regulation of derivatives clearing organizations, including registration, reporting, and minimum capital and margining requirements. It also provides for derivatives clearing organizations to publicly disseminate certain price and volume and other information. Swaps that are subject to mandatory clearing generally must also be executed on a board of trade or a "swap execution facility" if they are made available for trading on a board of trade or swap execution facility. A "swap execution facility" is a newly defined category of swap trading facility for which the Act prescribes registration and regulatory supervision. End-User Exemption. Derivative contracts in which one of the counterparties is a qualified end-user will not be subject to mandatory clearing. An entity qualifies as an end-user for these purposes if it (1) is not a financial entity, a term that includes swap dealers, major swap participants, commodity pools, certain private funds, employee benefit plans, and others predominantly engaged in certain financial activities, excluding, however, certain captive financing companies affiliated with manufacturers, (2) uses the derivative contract to hedge or mitigate commercial risk, and (3) notifies the applicable Commission, in accordance with prescribed procedures, how it generally meets its financial obligations associated with entering into non-cleared swaps. This exemption may allow swap dealers and others to continue to offer over-the-counter hedging products to commercial end-users without running afoul of the mandatory-clearing requirements. An end-user that is a public company
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will qualify for the exemption only if an "appropriate committee" of its board of directors has reviewed and approved its decision to enter into swaps that are subject to the exemption. Non-"Eligible Contract Participants." The Act makes it unlawful for a person that is not an "eligible contract participant" under the Commodity Exchange Act's definition of that term— which is made narrower by the Act—to enter into a swap except on a board of trade. Grandfathering Provisions. Swaps executed before the effectiveness of the mandatory clearing requirements are exempted from mandatory clearing provided that they are reported to a registered swap data repository or the applicable Commission in accordance with the Act's transitional reporting requirements. Additionally, the Act provides that parties to a preenactment swap contract may not, unless specifically provided for in their agreement, treat the enactment of the Act as a basis for early termination of their contract. Real-time Reporting and Public Dissemination of Transaction and Pricing Data. With the stated goal of enhancing price discovery, the Act generally provides for the Commissions to require "real-time public reporting"—that is, making transaction and pricing data publicly available as soon as is technologically practicable after execution of a trade—for swaps, regardless of whether they are centrally cleared or whether the end-user exemption applies. If data concerning a swap transaction of a particular type can be reported to a "swap data repository"—a newly created category of regulated entity to be subject to registration and regulatory supervision—then data regarding the swap is to be reported to such a depository or to the applicable Commission. The new regulations will provide for time delays in publicly disseminating data concerning "large notional swap transactions (block trades)." The regulations will not permit public disclosure of the identity of participants to a transaction. Swap Dealer and Major Swap Participant Registration and Regulation A person that qualifies as a "swap dealer" or a "major swap participant," with respect to swaps or security-based swaps, generally will be required to register with the applicable Commission and will be subjected to requirements to be prescribed by regulations. "Swap dealer" generally means a person that holds itself out as a dealer in swaps, makes a market in swaps, regularly enters into swaps as an ordinary course of business for its own account, or engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps. However, an insured depository institution is not a "swap dealer" to the extent that it "offers to enter into a swap with a customer in connection with originating a loan with that customer." In addition, entities are not "swap dealers" if they
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trade on their own account but not as part of a regular business or engage only in "de minimis" swap dealing. "Major swap participant" generally means a person other than a swap dealer (1) that maintains a substantial position, excluding positions held for hedging or mitigating commercial risk and certain positions held by employee benefit plans, in any major category of swaps to be specified by regulation, (2) whose outstanding swaps create substantial counterparty risk that could have serious adverse effects on the U.S. financial system, or (3) that is a financial entity that is highly leveraged, is not subject to regulatory capital requirements, and maintains a substantial position in swaps in any specified major category of swaps. Certain captive financing companies affiliated with manufacturers are excluded from the definition of "major swap participant." Swap dealers and major participants whose activities extend to both non-security-based and security-based swaps may be subjected to dual registration as dealers or major participants with both the CFTC and the SEC, in addition to any other registration requirements that may apply to them. The Act generally requires the Commissions to regulate swap dealers and major swap participants with regard to the following: capital and initial/variation margin requirements (except for financial institutions whose regulators already impose similar requirements), reporting and record-keeping, general business conduct, business conduct with respect to "special entity" counterparties that include federal and state agencies and certain employee benefit plans and tax-exempt organizations, documentation standards and internal monitoring, management, and disclosure requirements including designating a chief compliance officer. The Act provides factors and guidelines for the Commissions to consider in regulating swap dealers and major swap participants but gives them considerable discretion. In addition, by expanding the definitions of "futures commission merchant" and "introducing broker" under the Commodity Exchange Act to cover persons soliciting and accepting orders for swaps and other products, the Act may subject dealers or other swap participants to registration and regulation under the Commodity Exchange Act as futures commission merchants or introducing brokers. Position Limits
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The Act expands the CFTC's authority to impose position limits to cover certain swaps that "that perform or affect a significant price discovery function with respect to registered entities." The position limits imposed by the CFTC will not apply to a bona fide hedging transaction, a term to be defined by regulation, or to a derivative contract executed before the relevant rule's effective date. Similarly, the SEC is given the authority to implement position limits for security-based swaps. When establishing position limits, the SEC may require security-based swap holders to aggregate their positions in security-based swaps with their positions in other security-based products. Anti-Manipulation Provisions for Commodity Markets The Act makes it unlawful for a person to manipulate commodity markets, including through the delivery of a false, misleading, or inaccurate report concerning crop or market information, in contravention of rules to be promulgated by the CFTC. The Act creates a private right of action for persons injured by such manipulation. Authority to Prohibit Derivatives Trading by Foreign Entities The Act gives the Commissions the authority, in consultation with the Secretary of the Treasury, to prohibit entities domiciled outside the United States from participating in swap or security-based swap activities, if they find that a foreign country's regulation of swaps or security-based swaps undermines the stability of the U.S. financial system. Extraterritorial Reach of the Act The Act generally will not apply to activities outside the United States unless those activities have a direct or significant connection with activities in, or effect on, commerce in the United States or violate regulations issued to prevent evasion of the Act. Federal Preemption The Act contains a preemption provision to the effect that a swap, as defined in the Act, will not be considered insurance and may not be regulated as an insurance contract under state law. Timeline The Act's provisions governing derivatives generally become effective 360 days after the enactment of the Act, or, where implementing rule-making is required, 60 days after the
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publication of a final rule or regulation. Rules are generally required to be issued within 360 days of the Act's enactment. Certain provisions of the Act will become effective earlier, generally under rules to be issued within shorter timeframes.
Bibliography
Web sites:
http://www.faegre.com – timing 23/9/2010 – 4.52 p.m http://seekingalpha.com – timing 23/9/2010 – 5.01 p.m http://www.brookings.edu –timing 24/9/2010 – 8.32 p.m http://www.derivativesindia.com –timing 25/9/2010 – 7.20 p.m http://www.eurojournals.com –timing 25/9/2010 – 7.32 p.m www.sebi.gov.in –timing 25/9/2010 – 8.00 p.m
Book:
Options- pricing, hedging, and trading by A.C.Reddy page. No: 54 to 68
Regulations of Future and Option Markets
REGULATIONS OF FUTURE AND OPTION MARKET
Submitted To:
Prof. Mustafa Sapatwala
Submitted By:
Mr. Kunal Gajanan Malode Roll No: 30 S.Y.M.M.S
Regulations of Future and Option Markets
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Introduction The term “futures and options” (also known as derivatives) refers to contracts which are traded in financial markets. A futures contract requires delivery of a commodity, bond, currency, stock or index, at a specified price, on a specified future date. The physical delivery of underlying asset may or may not happen. Instead, it may be squared off before its expiry date. For example, if a person is “long” on index future i.e. who bought the contract at the beginning of the month may sell it just two days prior to its expiry. The difference in the value of contract will be paid to him as profit (or deducted from his account as loss) as the case may be. Similar to trading stocks, a certain percentage of the traded value will be levied as commission (brokerage), a service tax (to the brokerage amount) and a securities transaction tax (STT). The brokerage may vary for different brokers. Some may charge a fixed brokerage; some may charge based on traded value. There are 1 month, 2 month and 3 month futures contracts available in India. The contracts are settled on the last Thursday of every month. If this happens to be a trading holiday, the previous day would be the expiry date. The risk involved in trading a futures contract is equal for both buyer and seller or “symmetrical”. Futures trading also come under the purview of Securities and Exchange Board of India (SEBI). In case of short selling equity shares (selling a share one doesn’t possess) the trade needs to be squared off on the same day; otherwise the short sold equity shares will be sold in auction. The short seller will be penalized by the exchange for not squaring it off. But in case of futures no such thing happens; a person can carry a “short” position overnight. He can continue to do so till the expiry date. However, the minimum margin requirements need to be maintained. Margin money is defined as the amount, based on which the broker may allow purchase or sale of a stock or future; this margin also varies from broker to broker. In case of equity share purchases using margin trading, the buyer needs to pay the outstanding amount to the broker before a fixed date i.e. before he receives delivery of shares. In case of futures, stocks in possession can be used as margin for trading in futures; however, market to market obligations (such as losses) need to be met in cash. Futures contract prices also have the same structure like the cash market prices. But there is no price band for futures or options; to avoid errors in entering orders the exchange may fix the price range. Prices in excess of the range will need to be reviewed by the exchange. In
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addition, if the “open interest” or the maximum number of outstanding contracts exceeds a certain value, no fresh positions will be allowed for the particular scrip. An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a specified date. In the case of a stock option, its value is based on the underlying stock (equity). For an index option, its value is based on the underlying index. Options are traded in the same way like stocks. They can be bought and sold just like any other security. In case of options, the buyer pays the premium amount only; not the value of the entire contract. The commission for the Options, however, will be based on the value (strike price) of the underlying assets. There are two option types; Call and Put. A Call option is an option to buy a stock or index at a specific price on or before an expiry date. Call options usually increases in value as the value of the underlying asset increases. The premium amount is paid by the buyer to secure the right to buy the underlying asset. In case, if one does not want to buy the underlying asset, he will lose the option premium paid; no other obligation exists between him and the option seller. Put option is an option to sell a stock or index at a specific price on or before a expiry date. Similar to the call option, a premium amount is paid by the buyer of the put option. In case if he does not want to sell the underlying asset, as in the case of call option, he will lose the option premium. There are two types of expiration; European style in which options cannot be exercised until expiry date; American style in which options can be exercised anytime before expiry. In India all stock options are American style and index options are European style. Option contracts should never be short sold. If the market turns the other way around, the buyer or seller may want to exercise the option. In this case loss resulting from shorting the option will be huge; so short selling options is very risky. “Strike Price” is defined as the price at which the underlying security can be bought or sold as specified in the option contract. “Spot price” refers to the market price of the underlying security. An option writer is defined as the one who sells the option to the option holder. Futures Contracts have symmetric risk profile for both buyers as well as sellers, whereas options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits
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may be unlimited, depending upon the spot price and whether he wants to exercise the option or not. In India, at the NSE, an index future trading was introduced in the year 2000. Index Options trading was also made available in 2001. Stock futures were introduced a little later. F & O index contracts are available in Nifty, Junior Nifty, Bank Nifty, CNX – IT (IT sector index) and CNX 100 (diversified 100 stock index accounting for 35 sectors of the economy). For individual securities, F & O contracts are available in one hundred and eighty seven scrip’s, starting from Aban Offshore to Zee Entertainment Enterprises Limited. The contracts are traded as “lots” meaning a contract will have certain fixed number of instruments. For example, the nifty shall have 50 instruments and it is called lot size. When a buyer places an order for a contract he has to bid for 50 or multiples of 50. Stock futures are available for most of the Nifty and Junior Nifty stocks. The stocks are chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six months on a rolling basis. The market wide position limit in the stock shall not be less than Rs. 50 crore. The market wide position limit (number of shares) shall be valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in the month. The market wide position limit of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock shall be 20% of the number of shares held by non-promoters in the relevant underlying security i.e. free-float holding. Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset.
Regulation in Indian derivative market
Development of exchange-traded derivatives Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been
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around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. The need for a derivatives market The derivatives market performs a number of economic functions: 1. They help in transferring risks from risk averse people to risk oriented people 2. They help in the discovery of future as well as current prices 3. They catalyze entrepreneurial activity 4. They increase the volume traded in markets because of participation of risk averse people in greater numbers 5. They increase savings and investment in the long run The participants in a derivatives market • Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. • Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. • Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. Types of Derivatives Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
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Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. • Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating. Factors driving the growth of financial derivatives 1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international markets, 3. Marked improvement in communication facilities and sharp decline in their costs, 4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets. Development of derivatives market in India
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The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24–member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real–time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three– decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single
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stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): • Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system. • On relative terms, a volume in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. • Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. • Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent. Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums. Commodity Derivatives Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity
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exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernization programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. The Government of India has constituted a committee to explore and evaluate issues pertinent to the establishment and funding of the proposed national commodity exchange for the nationwide trading of commodity futures contracts, and the other institutions and institutional processes such as warehousing and clearinghouses. With commodity futures, delivery is best affected using warehouse receipts (which are like dematerialized securities). Warehousing functions have enabled viable exchanges to augment their strengths in contract design and trading. The viability of the national commodity exchange is predicated on the reliability of the warehousing functions. The programme for establishing a system of warehouse receipts is in progress. The Coffee Futures Exchange India (COFEI) has operated a system of warehouse receipts since 1998 Exchange-traded vs. OTC (Over the Counter) derivatives markets The OTC derivatives markets have witnessed rather sharp growth over the last few years, which have accompanied the modernization of commercial and investment banking and globalization of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized limits on individual positions, leverage, or margining,
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3. There are no formal rules for risk and burden-sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.
Accounting of Derivatives: The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on accounting of index futures contracts from the view point of parties who enter into such futures contracts as buyers or sellers. For other parties involved in the trading process, like brokers, trading members, clearing members and clearing corporations, a trade in equity index futures is similar to a trade in, say shares, and does not pose any peculiar accounting problems Taxation The income-tax Act does not have any specific provision regarding taxability from derivatives. The only provisions which have an indirect bearing on derivative transactions are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a speculative business carried on by the assessee, shall not be set off except against profits and gains, if any, of speculative business. In the absence of a specific provision, it is apprehended that the derivatives contracts, particularly the index futures which are essentially cash-settled, may be construed as speculative transactions and therefore the losses, if any, will not be eligible for set off against other income of the assessee and will be carried forward and set off against speculative income only up to a maximum of eight years .As a result an investor’s losses or profits out of derivatives even though they are of hedging nature in real sense, are treated as speculative and can be set off only against speculative income. REGULATION FOR DERIVATIVES TRADING SEBI set up a 24- member committee under the Chairmanship of Dr. L. C.Gupta to develop the appropriate regulatory framework for derivatives trading in India. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with stock index futures. The provisions in the SC(R)A
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and the regulatory framework developed there under govern trading in securities. The amendment of the SC(R)A to include derivatives within the ambit of ‘securities’ in the SC(R)A made trading in derivatives possible within the framework of that Act. 1. Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta committee report can apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange would have to regulate the sales practices of its members and would have to obtain prior approval of SEBI before start of trading in any derivative contract. 2. The Exchange should have minimum 50 members. 3. The members of an existing segment of the exchange would not automatically become the members of derivative segment. The members of the derivative segment would need to fulfill the eligibility conditions as laid down by the L. C. Gupta committee. 4. The clearing and settlement of derivatives trades would be through a SEBI approved clearing corporation/house. Clearing corporations/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval. 5. Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges. The minimum net worth for clearing members of the derivatives clearing corporation/house shall be Rs.300 Lakh. The net worth of the member shall be computed as follows: • • Capital + Free reserves ď€ Less non-allowable assets viz.,
(a) Fixed assets (b) Pledged securities (c) Member’s card (d) Non-allowable securities (unlisted securities) (e) Bad deliveries (f) Doubtful debts and advances (g) Prepaid expenses (h) Intangible assets (i) 30% marketable securities
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6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to submit details of the futures contract they propose to introduce. 7. The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position will be prescribed by SEBI/Exchange from time to time. 8. The L. C. Gupta committee report requires strict enforcement of “Know your customer” rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client. 9. The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI. Forms of collateral’s acceptable at NSCCL Members and dealer authorized dealer have to fulfill certain requirements and provide collateral deposits to become members of the F&O segment. All collateral deposits are segregated into cash component and non-cash component. Cash component means cash, bank guarantee, fixed deposit receipts, T-bills and dated government securities. Non-cash component mean all other forms of collateral deposits like deposit of approved demat securities. Requirements to become F&O segment member The eligibility criteria for membership on the F&O segment is as given in Table
1 . Table.2 gives the requirements for professional clearing membership. Anybody
interested in taking membership of F&O segment is required to take membership of “CM and F&O segment” or “CM, WDM and F&O segment”. An existing member of CM segment can also take membership of F&O segment. A trading member can also be a clearing member by meeting additional requirements. There can also be only clearing members. Eligibility criteria for membership on F&O segment Particulars (all values in Rs. Lakh) CM and F&O segment CM, WDM and F&O segment
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Net worth Interest free security deposit (IFSD) Collateral security deposit (CSD) Annual subscription
100 125
200 275
25
25
1
2
Requirements for professional clearing membership Particulars (all values in Rs. Lakh) Eligibility Trading members of NSE/SEBI registered custodians/recognized banks Net worth Interest free security deposit (IFSD) Collateral security deposit Annual subscription 25 nil 50 2.5 300 25 Trading NSE/SEBI registered custodians/recognized banks 300 34 members of F&O segment CM & F&O segment
Requirements to become authorized / approved user Trading members and participants are entitled to appoint, with the approval of the F&O segment of the exchange authorized persons and approved users to operate the trading workstation(s). These authorized users can be individuals, registered partnership firms or corporate bodies. Authorized persons cannot collect any commission or any amount directly
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from the clients he introduces to the trading member who appointed him. However he can receive a commission or any such amount from the trading member who appointed him as provided under regulation. Approved users on the F&O segment have to pass a certification program which has been approved by SEBI. Each approved user is given a unique identification number through which he will have access to the NEAT system. The approved user can access the NEAT system through a password and can change such password from time to time.
Regulation in United States derivative market
The word "derivative" outside of a narrow circle of Wall Street and Chicago traders and other market participants, and you’re likely to get one or several of the following reactions: fear, anger, or disinterest. Warren Buffett has famously analogized derivatives – financial instruments whose value depends on and thus is “derived” from the value of some other underlying security, such as a stock or a bond or the current price of a commodity – as "financial weapons of mass destruction." Who wouldn’t be afraid of such things? Or, if the widespread condemnation of derivatives for causing or helping to cause the recent financial crisis is accurate, who wouldn’t be angry at them? Meanwhile, those who might not care about the word or the complex issues it raises can be forgiven. After all, derivatives are difficult for non-experts to understand and seem unrelated to every day things most people really care about in times like these – such as their jobs and how they will be able to pay for their children’s education or their own retirement. But whether you know it or not (or care), derivatives have become crucial parts of the financial and economic system not only in this country but elsewhere around the world. Derivatives such as futures and options contracts, and various kinds of “swap” arrangements (involving interest rates, foreign currencies, and loan defaults), provide efficient ways for both financial and non-financial users to hedge against a variety of financial risks. The numbers involved run into the hundreds of trillions of dollars in “notional” amounts, though the amounts actually at risk are substantially lower. Moreover, when properly used and backed by sufficient collateral, derivatives have become a valuable financial tool for banks and wide variety of end-users: corporations and private companies, state and local governmental entities, and so-called “buy-side” non-bank financial institutions.
Derivatives got their bad reputation during the financial panic in September 2008, when the
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world learned that if the parties to both sides of the transactions are large, financially connected with many other parties, and do not have the financial means to make good on their promises, derivatives that are traded “over the counter” (OTC) and not centrally cleared can pose dangers to entire economies. The dangers are especially great for one kind of derivative contract on which I concentrate primarily here – “credit default swaps” (CDS). With CDS, non-defaulting parties (the buyers of this particular kind of insurance against loan or bond default) are likely, especially in an economy-wide crisis, to find it more expensive to replace their contracts with the defaulting party (the seller) than are non-defaulting parties in other OTC swap arrangements. Indeed, mainly for this reason, unless otherwise indicated, when I refer in this essay to “derivatives” I mean specifically CDS, although many of the arguments or claims I advance refer to other OTC derivatives as well.
Fortunately, there is a growing consensus among financial regulators and academic experts about what to do at least with respect to “standardized” derivatives, or those that resemble readily traded stocks or futures contracts, and thus how to help keep financial actors who are heavily engaged in derivatives activities and also run into financial trouble from infecting other institutions and conceivably entire markets. I will outline this consensus shortly, which may be enacted in some form by Congress this year as part of comprehensive financial reform. I have written this essay primarily to call attention to the main impediments to meaningful reform: the private actors who now control the trading of derivatives and all key elements of the infrastructure of derivatives trading, the major dealer banks. The importance of this “Derivatives Dealers’ Club” cannot be overstated. All end-users who want derivatives products, CDS in particular, must transact with dealer banks. The dealer banks, in turn, transact heavily with each other, to hedge the risks from their customer trades and somewhat less frequently, to trade for their own accounts.
I will argue that the major dealer banks have strong financial incentives and the ability to delay or impede changes from the status quo - even if the legislative reforms that are now being widely discussed are adopted - that would make the CDS and eventually other derivatives markets safer and more transparent for all concerned. At the end of this essay, I
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will outline a number of steps that regulators and possibly the antitrust authorities may be able to take to overcome any dealer resistance to constructive change. Wall Street Reform and Consumer Protection Act affect the derivatives market in a variety of areas. It provides for mandatory central clearing and exchange trading of certain swaps, realtime reporting of trades, registration and regulatory oversight for swap dealers and other entities maintaining substantial positions in swaps (called "major swap participants"), registration and oversight for derivative clearing organizations and swap execution facilities, position limits and rules prohibiting manipulation of commodity markets. "Swap" is defined to include a broad variety of derivatives products, with certain exclusions including for physically-settled commodity forwards, commodity and securities futures and instruments based on securities already regulated by the SEC. Over-the-counter foreign exchange swaps and forwards are covered by the Act as "swaps," but the Secretary of the Treasury is given the authority to exempt them from regulation under the Act. Allocation of Jurisdiction Generally, the Act gives the CFTC the authority to regulate swaps other than security-based swaps, while the SEC will regulate security-based swaps. Both the CFTC and the SEC (the "Commissions") may regulate mixed swaps—derivatives that have characteristics of both these types of swaps. The Act generally requires the Commissions to treat economically similar products and entities in a similar manner, but it does not require the Commissions to issue joint regulations for economically similar products and entities. Additionally, the Act creates the framework that the Commissions will operate under to determine the jurisdictional status of novel derivative products that may have elements of both securities and contracts of sale of a commodity for future delivery (or options on such contracts or options on commodities). Under the framework, each Commission must notify the other when it receives a request to trade or list this type of novel product. From there, each Commission may request that the other Commission determine whether the product falls under that Commission's jurisdiction. Each Commission may also ask the other Commission to exempt the product from its regulations. Either Commission may petition the United States District Court for the District of Columbia if it disagrees with the other Commission's determination as to whether the novel derivative product falls under its jurisdiction. Clearing and Reporting
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Mandatory clearing and Trade execution. The Act generally gives the Commissions the power to determine which swaps will be subject to mandatory central-counterparty clearing. Generally, the Commissions will determine which swaps are subject to mandatory clearing by considering, among other factors, the level of outstanding notional exposure, trading liquidity, and adequate pricing data, the availability of operational clearing expertise and infrastructure, and the likely effect that clearing will have on systemic risk and competition. If a swap is within a category of swaps that is cleared by a clearing organization and the applicable Commission determines that swaps in that category are subject to mandatory clearing, then the swap must be submitted to a clearing organization. In addition, if the Commissions do not subject a particular type of swap to mandatory clearing but a clearing organization accepts derivative contracts of that type for clearing, an end-user may elect that the swap be submitted to the clearing organization and cleared accordingly. The Act, subject to grandfathering provisions, provides for extensive regulation of derivatives clearing organizations, including registration, reporting, and minimum capital and margining requirements. It also provides for derivatives clearing organizations to publicly disseminate certain price and volume and other information. Swaps that are subject to mandatory clearing generally must also be executed on a board of trade or a "swap execution facility" if they are made available for trading on a board of trade or swap execution facility. A "swap execution facility" is a newly defined category of swap trading facility for which the Act prescribes registration and regulatory supervision. End-User Exemption. Derivative contracts in which one of the counterparties is a qualified end-user will not be subject to mandatory clearing. An entity qualifies as an end-user for these purposes if it (1) is not a financial entity, a term that includes swap dealers, major swap participants, commodity pools, certain private funds, employee benefit plans, and others predominantly engaged in certain financial activities, excluding, however, certain captive financing companies affiliated with manufacturers, (2) uses the derivative contract to hedge or mitigate commercial risk, and (3) notifies the applicable Commission, in accordance with prescribed procedures, how it generally meets its financial obligations associated with entering into non-cleared swaps. This exemption may allow swap dealers and others to continue to offer over-the-counter hedging products to commercial end-users without running afoul of the mandatory-clearing requirements. An end-user that is a public company
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will qualify for the exemption only if an "appropriate committee" of its board of directors has reviewed and approved its decision to enter into swaps that are subject to the exemption. Non-"Eligible Contract Participants." The Act makes it unlawful for a person that is not an "eligible contract participant" under the Commodity Exchange Act's definition of that term— which is made narrower by the Act—to enter into a swap except on a board of trade. Grandfathering Provisions. Swaps executed before the effectiveness of the mandatory clearing requirements are exempted from mandatory clearing provided that they are reported to a registered swap data repository or the applicable Commission in accordance with the Act's transitional reporting requirements. Additionally, the Act provides that parties to a preenactment swap contract may not, unless specifically provided for in their agreement, treat the enactment of the Act as a basis for early termination of their contract. Real-time Reporting and Public Dissemination of Transaction and Pricing Data. With the stated goal of enhancing price discovery, the Act generally provides for the Commissions to require "real-time public reporting"—that is, making transaction and pricing data publicly available as soon as is technologically practicable after execution of a trade—for swaps, regardless of whether they are centrally cleared or whether the end-user exemption applies. If data concerning a swap transaction of a particular type can be reported to a "swap data repository"—a newly created category of regulated entity to be subject to registration and regulatory supervision—then data regarding the swap is to be reported to such a depository or to the applicable Commission. The new regulations will provide for time delays in publicly disseminating data concerning "large notional swap transactions (block trades)." The regulations will not permit public disclosure of the identity of participants to a transaction. Swap Dealer and Major Swap Participant Registration and Regulation A person that qualifies as a "swap dealer" or a "major swap participant," with respect to swaps or security-based swaps, generally will be required to register with the applicable Commission and will be subjected to requirements to be prescribed by regulations. "Swap dealer" generally means a person that holds itself out as a dealer in swaps, makes a market in swaps, regularly enters into swaps as an ordinary course of business for its own account, or engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps. However, an insured depository institution is not a "swap dealer" to the extent that it "offers to enter into a swap with a customer in connection with originating a loan with that customer." In addition, entities are not "swap dealers" if they
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trade on their own account but not as part of a regular business or engage only in "de minimis" swap dealing. "Major swap participant" generally means a person other than a swap dealer (1) that maintains a substantial position, excluding positions held for hedging or mitigating commercial risk and certain positions held by employee benefit plans, in any major category of swaps to be specified by regulation, (2) whose outstanding swaps create substantial counterparty risk that could have serious adverse effects on the U.S. financial system, or (3) that is a financial entity that is highly leveraged, is not subject to regulatory capital requirements, and maintains a substantial position in swaps in any specified major category of swaps. Certain captive financing companies affiliated with manufacturers are excluded from the definition of "major swap participant." Swap dealers and major participants whose activities extend to both non-security-based and security-based swaps may be subjected to dual registration as dealers or major participants with both the CFTC and the SEC, in addition to any other registration requirements that may apply to them. The Act generally requires the Commissions to regulate swap dealers and major swap participants with regard to the following: capital and initial/variation margin requirements (except for financial institutions whose regulators already impose similar requirements), reporting and record-keeping, general business conduct, business conduct with respect to "special entity" counterparties that include federal and state agencies and certain employee benefit plans and tax-exempt organizations, documentation standards and internal monitoring, management, and disclosure requirements including designating a chief compliance officer. The Act provides factors and guidelines for the Commissions to consider in regulating swap dealers and major swap participants but gives them considerable discretion. In addition, by expanding the definitions of "futures commission merchant" and "introducing broker" under the Commodity Exchange Act to cover persons soliciting and accepting orders for swaps and other products, the Act may subject dealers or other swap participants to registration and regulation under the Commodity Exchange Act as futures commission merchants or introducing brokers. Position Limits
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The Act expands the CFTC's authority to impose position limits to cover certain swaps that "that perform or affect a significant price discovery function with respect to registered entities." The position limits imposed by the CFTC will not apply to a bona fide hedging transaction, a term to be defined by regulation, or to a derivative contract executed before the relevant rule's effective date. Similarly, the SEC is given the authority to implement position limits for security-based swaps. When establishing position limits, the SEC may require security-based swap holders to aggregate their positions in security-based swaps with their positions in other security-based products. Anti-Manipulation Provisions for Commodity Markets The Act makes it unlawful for a person to manipulate commodity markets, including through the delivery of a false, misleading, or inaccurate report concerning crop or market information, in contravention of rules to be promulgated by the CFTC. The Act creates a private right of action for persons injured by such manipulation. Authority to Prohibit Derivatives Trading by Foreign Entities The Act gives the Commissions the authority, in consultation with the Secretary of the Treasury, to prohibit entities domiciled outside the United States from participating in swap or security-based swap activities, if they find that a foreign country's regulation of swaps or security-based swaps undermines the stability of the U.S. financial system. Extraterritorial Reach of the Act The Act generally will not apply to activities outside the United States unless those activities have a direct or significant connection with activities in, or effect on, commerce in the United States or violate regulations issued to prevent evasion of the Act. Federal Preemption The Act contains a preemption provision to the effect that a swap, as defined in the Act, will not be considered insurance and may not be regulated as an insurance contract under state law. Timeline The Act's provisions governing derivatives generally become effective 360 days after the enactment of the Act, or, where implementing rule-making is required, 60 days after the
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publication of a final rule or regulation. Rules are generally required to be issued within 360 days of the Act's enactment. Certain provisions of the Act will become effective earlier, generally under rules to be issued within shorter timeframes.
Bibliography
Web sites:
http://www.faegre.com – timing 23/9/2010 – 4.52 p.m http://seekingalpha.com – timing 23/9/2010 – 5.01 p.m http://www.brookings.edu –timing 24/9/2010 – 8.32 p.m http://www.derivativesindia.com –timing 25/9/2010 – 7.20 p.m http://www.eurojournals.com –timing 25/9/2010 – 7.32 p.m www.sebi.gov.in –timing 25/9/2010 – 8.00 p.m
Book:
Options- pricing, hedging, and trading by A.C.Reddy page. No: 54 to 68
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