indian derivative market : a regulatory and contextual perspective

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Table of contents

S.No. contents Page no.1. introduction 1

2. Financial derivative market 1

3. Development of exchange traded derivatives 3

4. Types of derivatives 4

5. Development of derivative market in india 5

6. Recent Indian derivative market 7

7. Instruments available in india 10

8. Accounting of derivatives and taxation 129. Current regulatory framework 13

i. Forex derivative 15

ii. Rupee interest rate derivatives 17

10. Concluding thoughts 24

11. conclusion 28



Introduction:

The restructuring of the world economy and a universal acceptance of

Liberalization and deregulation of the financial markets including

international finance has helped International trade to move from an Increasing

sum Game to a Zero-Sum-Game, which can create a win-win situation for all

concerned. Derivatives are prime instruments of this transition. Derivatives can

be defined in broad terms as instruments that primarily derive their value from

the performance of an underlying asset class. In other words a derivative is an

agreement between two parties by which one party shifts its risk to another, the

value being derived from the value of an underlying asset.

The esoteric world of derivatives has come into sharp focus in recent times

precisely on account of their complexity and recent events have triggered a

debate on their impact on the financial system stability.

The financial markets, including derivative markets, in India have been through a

reform process over the last decade and a half, witnessed in its growth in terms of

size, product profile, nature of participants and the development of marketinfrastructure across all segments - equity markets, debt markets and forex

markets.

Financial derivative market:

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.

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 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 todays 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 givenprice 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.

Warrants: Options generally have lives of upto 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 upto 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 cashflows 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: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 24member 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 preconditions forintroduction 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 realtime 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 BSE30(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 onNSE 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 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 InstitutionalInvestors (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, volumes 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.



Recent Indian derivative market:

Derivative markets worldwide have witnessed explosive growth in recent past.

According to the BIS Triennial Central Bank Survey of Foreign Exchange and

Derivatives Market Activity as of April 2007 was released recently and the OTC

derivatives segment, the average daily turnover of interest rate and non-

traditional foreign exchange contracts increased by 71 per cent to US $ 2.1 trillion

in April 2007 over April 2004, maintaining an annual compound growth of 20 per

cent witnessed since 1995. Turnover of foreign exchange options and cross-

currency swaps more than doubled to US $ 0.3 trillion per day, thus outpacing the

growth in traditional instruments such as spot trades, forwards or plain foreign

exchange swaps. The traditional instruments also show an unprecedented rise in

activity in traditional foreign exchange markets compared to 2004. Average daily

turnover rose to US $ 3.2 trillion in April 2007, an increase of 71 per cent at

current exchange rates and 65 per cent at constant exchange rates. Relatively

moderate growth was recorded in the much larger interest rate segment, where

average daily turnover While the dollar and euro clearly dominate activity in OTCinterest rate derivatives, their combined share has fallen by nearly 10 percentage

points since the 2004 survey, to 70 per cent in April 2007, as turnover growth in

several non-core markets outstripped that in the two leading currencies.

Indian forex and derivative markets have also developed significantly over the

years. As per the BIS global survey the percentage share of the rupee in total

turnover covering all currencies increased from 0.3 per cent in 2004 to 0.7 per

cent in 2007. As per geographical distribution of foreign exchange market

turnover, the share of India at US $ 34 billion per day increased from 0.4 per cent

in 2004 to 0.9 per cent in 2007. The activity in the forex derivative markets can

also be assessed from the positions outstanding in the books of the banking

system. As of August end, 2007, total forex contracts outstanding in the banks



Instruments available in India:Financial derivative instruments:

The National stock Exchange (NSE) has the following derivative products:



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 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 modernisation 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 effected using warehouse receipts

(which are like dematerialised 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 has accompanied the modernization of commercial and

investment banking and globalisation 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 OTCderivative 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,

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

exchanges 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 investors 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.

Current Regulatory Framework:

In the light of increasing use of structured products and to ensure that customers

understand the nature of the risk in these complex instruments, the Reserve Bank

after extensive consultations with market participants issued comprehensive

guidelines on derivatives in April 2007, which cover the following aspects:

y Participants have been generically classified into two functional categories,namely, market-makers and users, which would be specific to the position

taken by the participant in a transaction. This categorisation was felt

important from the perspective of ensuring suitability & appropriateness

compliance by market makers on users.

y The guidelines also define the purpose for undertaking derivative

transactions by various participants. While Market- makers can undertake

derivative transactions to act as counterparties in derivative transactions

with users and also amongst themselves, Users can undertake derivative

transactions to hedge - specifically reduce or extinguish an existing

identified risk on an ongoing basis during the life of the derivative

transaction - or for transformation of risk exposure, as specifically

permitted by the Reserve Bank.

y The guidelines clearly enunciate the broad principles for undertaking

derivative transactions.



Any derivative structure is permitted as long as it is a combination of

two or more of the generic instruments permitted by the Reserve

Bank and

Market-makers should be in a position to mark to market or

demonstrate valuation of these products based on observable

market prices.

Further, it is to be ensured that structured products do not contain

derivative(s) which is/ are not allowed on a stand alone basis. This

will also apply in case the structure contains cash instrument(s).

All permitted derivative transactions shall be contracted only at

prevailing market rates.

y The guidelines set out the basic principles of a prudent system to control

the risks in derivatives activities. It is required that all risks arising from

derivatives exposures should be analysed and documented and the

management of derivative activities should be integrated into the banks

overall risk management system using a conceptual framework common to

the banks other activities.

y The critical importance of suitability and appropriateness policies withinbanks for derivative products being offered to customers (users) have been

underlined. It is imperative that market- makers offer derivative products in

general, and structured products, in particular only to those users who

understand the nature of the risks inherent in these transactions and

further that products being offered are consistent with users internal

policies as well as risk appetite.

Within the above broad framework, the specifics of the forex and interest rate

derivatives permitted are explained below:

I. Forex derivatives:



Economic entities in India currently have a menu of OTC products, such as

forwards, swaps and options, for hedging their currency risk and the markets for

the same are fairly deep and liquid, as reflected in the volumes and bid-offer

spreads. The origin of the forex market development in India could be traced back

to 1978 when banks were permitted to undertake intra-day trades. However, the

market witnessed major activities only in the 1990s with the floating of the

currency in March 1993, following the recommendations of the Report of the

High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan).

In respect of forex derivatives involving rupee, residents have access to foreign

exchange forward contracts, foreign currency-rupee swap instruments and

currency options both cross currency as well as foreign currency-rupee. In the

case of derivatives involving only foreign currency, a range of products such as

IRS, FRAs, option are allowed. While these products can be used for a variety of

purposes, the fundamental requirement is the existence of an underlying

exposure to foreign exchange risk whether on current or capital account. While

initially the forward contracts could not be rebooked once cancelled, greater

flexibility has now been given for booking cancellation and rebooking of forward

contracts. In the case of exporters and importers, they are also allowed to bookforward contracts based on past performance and the delivery condition has also

been gradually liberalised.

In order to simplify procedural requirements for Small and Medium Enterprises

(SME) sector, the Reserve Bank has recently granted flexibility for hedging both

underlying as well as anticipated and economic exposures without going through

the rigours of complex documentation formalities. In order to ensure that SMEs

understand the risks of these products, only banks with whom they have creditrelationship are allowed to offer such facilities. These facilities should also have

some relationship with the turnover of the entity. Similarly, individuals have been

permitted to hedge upto US $ 100,000 on self declaration basis.



AD banks may also enter into forward contracts with residents in respect of

transactions denominated in foreign currency but settled in Indian Rupees

including hedging the currency indexed exposure of importers in respect of

customs duty payable on imports. ADs have been delegated powers to allow

residents engaged in import and export trade to hedge the price risk on all

commodities in international commodity exchanges, with few exceptions like

gold, silver, and petroleum. Domestic producers/users are allowed to hedge their

price risk on aluminium, copper, lead, nickel and zinc as well as aviation turbine

fuel in international commodity exchanges based on their underlying economic

exposures.

Facilities for Non-residents

Foreign Institutional Investors (FII), persons resident outside India having Foreign

Direct Investment (FDI) in India and Non-resident Indians (NRI) are allowed access

to the forwards market to the extent of their exposure in the cash market. FIIs are

permitted to hedge currency risk on the market value of entire investment in

equity and/or debt in India as on a particular date using forwards. For FDI

investors, forwards are permitted to (i) hedge exchange rate risk on the marketvalue of investments made in India since January 1, 1993 (ii) hedge exchange rate

risk on dividend receivable on the investments in Indian companies and (iii) hedge

exchange rate risk on proposed investment in India. NRIs can hedge

balances/amounts in NRE accounts using forwards and FCNR (B) accounts using

rupee forwards as well as cross currency forwards.

Currency Futures

In the context of growing integration of the Indian economy with the rest of the

world, as also the continued development of financial markets, there is a need to



interest rate; or, rupee interest rate implied in the forward foreign exchange

rates, as permitted in respect of MIFOR swaps. While both banks and PDs are

allowed as market makers in the swap market, all business entities (including

banks and PDs) are permitted to hedge their underlying exposures using these

instruments. PDs have been also permitted to hold trading position in IRF, subject

to internal guidelines in this regard. The interest rate swap market has grown

rapidly with participation from banks and corporate. The market is liquid and bid-

offer spreads are narrow.

Transparency and Reporting

In order to have a mechanism for transparent capture and dissemination of trade

information, the Clearing Corporation of India, at the instance of the Reserve

Bank, has recently developed a reporting system for OTC interest rate swaps. The

reported deals are processed by CCIL which also offers certain post trade

processing services like resetting interest rates, providing settlement values i.e.,

to the reporting members. Information in regard to traded rates and volumes are

made available through CCILs website. Once things stabilize, the next phase could

be development of post-trade processing infrastructure to address some of theattendant risks.

Interest rate futures

While FRA/IRS markets have shown phenomenal growth, the interest rate

futures, first introduced on NSE in 2003, have not picked up on account of certain

structural factors. A sub-group of the Reserve Bank Technical Advisory Committee

on Markets having representatives from the industry and academia, has been

constituted to examine the issues, including the following:



(i) Review the experience with the Interest Rate Futures so far, with particular

reference to product design issues and make recommendations for activating the

Interest Rate Futures

(ii) Examine whether regulatory guidelines for banks for interest rate futures need to

be aligned with those for their participation in Interest Rate Swaps.

(iii) Examine the scope and extent of the participation of non-residents,

including Foreign Institutional Investors (FIIs), in Interest Rate Futures, consistent

with the policy applicable to the underlying cash bond market.

The draft report of the group would be placed in the public domain for

comments.

Structured Credit and Credit derivatives

The structured credit market internationally has grown phenomenally into a

distinct asset class, encompassing a slew of complex products which have

facilitated risk transfer across multiple chains of investors, leveraging several

times on the original loan amount. The downside of this model has beeneloquently demonstrated in the US sub-prime related fallout globally, which I will

discuss later. In India, the structured credit market is still in its infancy, primarily

constituting securitisation products, and the lessons of recent events can hold

important lessons for the future development of this market here.

Securitisation in India has been in existence for over a decade confined mainly to

a few banks and non-banking finance companies. Both mortgage backed

securities and asset-backed securities are in vogue. The securitisation market hasmatured over the last few years and there is now an established investor

community and regular issuers. As per ICRAs estimates, the structured issuance

volumes have grown from Rs. 77 billion in 2003 to Rs. 369 billion in 2006-07. The

growth in 2006-07 has been primarily on account of securitisation of single

corporate loans, which accounted for nearly a third of the total volume. However,



ABS is the largest product class at more than60 per cent, with securitisation of

retail loans remaining popular. The growth of ABS market can be attributed to a

number of factors such as the growing retail loan the portfolios held by banks and

other financial institutions, investors familiarity with the underlying assets class

the relatively short tenor of such issues. Growth of the MBS market has been

slower despite the growth in the underlying housing finance market mainly due to

the relatively long tenor, lack of secondary market liquidity and the risk arising

from prepayment/repricing of the underlying loans.

In the light of the differing practices followed by banks in India and certain

concerns on accounting, valuation and capital treatment, the Reserve Bank issued

formal guidelines in February 2006 after extensive consultation with market

participants. The guidelines are largely in line with those issued by other

supervisors internationally and envisage the following:

y Detailed set of guidelines to ensure arms length relationship between the

originator and the SPV

y Credit enhancements provided by the originator for first as well as second

losses to be deducted from the capital. For the first loss facility, the

deduction is capped at the amount of capital that the bank would have

been required to hold for the full value of assets. Thus a disincentive is

created for an originator trying to provide second loss facility also.

(However, the proposed Basel II guidelines envisage risk weight for

securitised exposures, depending upon rating, will range from 20 per cent

to 400 per cent or even deduction from capital)

y Any profit/premium arising on account of sale not allowed to be booked

upfront and is to be amortized over the life of the securities issued or to be

issued by the SPV.

y Provision of liquidity facility to be treated as an off- balance sheet item and

attract 100 per cent credit conversion factor as well as 100 per cent risk

weight



y Disclosure by the originator, as notes to accounts, presenting a comparative

position for two years:

total number and book value of loan assets securitised;

sale consideration received for the securitized assets and gain/loss

on sale on account of securitisation;

form and quantum (outstanding value) of services provided by way

of credit enhancement, liquidity support, post-securitisation asset

servicing, etc.

In the context of recent global events, the above guidelines will go a long way in

laying the foundation of a healthy structured credit market..

In respect of distressed assets, the legal framework was provided by the

Securitisation and Reconstruction of Financial Assets and Enforcement of Security

Interests Act, 2002", more commonly called SARFAESI Act. This led to the

constitution of asset reconstruction companies specializing in securitising

distressed assets purchased from banks. The issuance of security receipts has

since grown significantly, though the secondary market activity has not been largeenough. To encourage proper market valuation, securitisation companies have

been advised to take into account rating of instruments by SEBI registered rating

agencies, based on recovery ratings for declaring the NAV of the issued security

receipts.

Recently, The Securities Contracts (Regulation) Amendment Act, 2007 has

amended Securities Contract (Regulation) Act to include securitised instruments

in the definition of securities as defined in Securities Contract (Regulation) Act.

The amendment is made to allow listing of securitised debt on stock exchangesand therefore, make the market more liquid.

Credit Derivatives:



The issue of allowing credit derivatives in India is under consideration for some

time now. The draft guidelines for introduction of credit default swaps were put

in public domain this year and feedback from various quarters have since been

received. These basically envisaged introduction of single entity CDS instruments,

allowing protection selling and buying to resident financial entities (banks, PDs

and other entities as permitted by respective regulators) under the overall ISDA

framework. Special Investment Vehicles (SIV) and conduits are not envisaged.

Banks that are active in the credit derivative market are required to have in place

internal limits on the gross amount of protection sold by them on a single entity

as well as the aggregate of such individual gross positions. These limits shall be set

in relation to the banks capital funds. Banks shall also periodically assess the

likely stress that these gross positions of protection sold, may pose on their

liquidity position and their options / ability to raise funds, at short notice. Banks

have to determine an appropriate liquidity reserve to be held against revaluation

of these positions. This is important especially where the reference asset is illiquid

like a loan.

Learning from the global experience in this regard, it will be of utmost importance

that proper disclosure and reporting framework, accounting and valuation

policies and clearing & settlement system for these OTC transactions develops

concomitantly with the market. This would go a long way in addressing some of the associated concerns.

Concluding Thoughts:



The recent episode of financial turbulence has provoked debate about the

measurement, pricing and allocation of risk by way of derivatives, which can have

important lessons for India. I wish to conclude by flagging some of these issues:

(i) Credit Risk Transfer:

Over the past decade or so, the business models of global banks have evolved

from a buy-and-hold to an originate-to-distribute model. Instruments to

transfer risks from the balance sheets of the originating institution have

developed in size and in complexity. Risks have been repackaged and spread

throughout the economy. The greater part of these risks is sold to other banks

and to leveraged investors, very often the originating bank itself funding theinvestors. Small and regional banks, in particular, were significant buyers of

subprime and other structured products. Insurance companies are also

increasingly using such instruments to securitise their liabilities. This wider

distribution of credit risks within the global financial system should in principle

limit risk concentrations and reduce the risk of a systemic shock.

Recent events, however, suggest some reservations about this positive

assessment. One reservation is that banks have become increasingly able to sellquickly even the equity tranches of their loan portfolios (retaining no exposures).

This means they have fewer incentives to effectively screen and monitor

borrowers. A systematic deterioration in lending and collateral standards would

of course entail losses greater than historical experience of default and loss-given-

default rates would indicate, and it is not clear that current risk management

practices make enough allowance for this. Further the gap between the original

borrower and the ultimate investors widened with a number of vehicles in

between.

Secondly, events may force banks to re-assume risks they had assumed

transferred to other parties either to preserve a banks reputation (eg., related

to investment funds sponsored by a bank) or to honour contingency



liquidity/credit lines. In a crisis, major banks could therefore end up holding a

larger share of exposures that they had planned to securitise.

(ii) Ratings for Structured Products

Ratings on structured finance products provide investors with an independent

assessment of risks embedded in them. Given the complexity of such products,

some form of expert assessment is desirable. Nevertheless, some investors failed

to appreciate that ratings did not purport to cover market risk. And the use of

ratings in investment mandates may have tempted some fund managers to

reach for yield without altering their measured risk exposures. The investment

grade status given to tranches of highly leveraged structures (such as CPDOs) hasalso raised questions. Some have argued that ratings should put more emphasis

on the uncertainty associated with the rating of a given structured product

especially those involving the leveraged exposure to market and liquidity risk.

Others argue that ratings should cover more than just the dimension of the

probability of default.

(iii) Valuation of Financial Assets

A growing share of the assets of financial firms has now to be measured at fair-

value. This fosters more active risk management but also makes reported

earnings and capital more sensitive to the volatility of asset prices. In the absence

of traded prices, fair-value estimates are determined using a chosen pricing

model. An intrinsic problem is that the parameter values used in all such models

(especially default correlations and recovery rates) are inevitably matters of

judgment given limited historical data. This can bias conclusions as default

correlations inevitably rise during periods of market stress, when confidence in

mark-to-model prices is undermined. As uncertainty about the true market value

of securities with model-driven prices rose, trading in these securities almost

ground to a halt.



A final aspect is that historical data available before recent events may not have

been representative of a full credit cycle. The recent experience may go some way

to correcting this shortcoming, and make model-driven estimates more reliable in

the future. This could in turn induce a significant change in the behaviour of

investors for some time.

(iv) Value at Risk (VaR)

Most financial firms use VaR and stress tests to measure market risks and assign

position limits. Despite declining financial market volatility during recent years,

most large banks have nevertheless reported a trend rise in the aggregate VaR of

their trading book. This presumably implies that they have taken larger positions.This is not necessarily a matter of concern because trading profits and capital

increased broadly in line with higher VaRs.

Yet the marked movements in the absolute VaRs of large firms over time do raise

questions. These changes could reflect:

(a) Underlying market volatility;

(b) Frequent changes in the firms positioning; or

(c) Changes in various aspects of methodology.

If firms, conscious of methodological shortcomings, frequently modify how they

compute their VaRs, changes over time may not be a good guide to changes in

underlying risk exposures. This would also make it harder for counterparties to

keep accurate track of how underlying risks are evolving.

(v) Stress tests:



Stress tests used by banks probably do not adequately reflect their substantial

reliance on liquid capital and money markets for managing, distributing and

hedging risks. Some of the problems (eg., difficulties in the leveraged loan market,

the valuation of complex products) are not typically incorporated in stress tests.

Stress tests at many banks also may fail to adequately capture the potentially

significant growth in balance sheet exposures resulting from contingent credit

and liquidity facilities to ABCP conduits. Moreover, stress tests tend to focus on a

few risks and thus often fail to capture the potential interactions between many

different risk factors. And in such stress tests, banks frequently assume an ability

to unwind positions across a wide range of asset classes including structured

credit and other complex products that may not be feasible in stressed

conditions. In addition, attempts to reduce risk exposures during a credit event

can further impair market liquidity.

This failure to take into consideration the likelihood that leveraged firms (during a

period of market stress) would attempt to reduce exposures in virtually identical

ways might explain why large financial shocks have been more frequent during

the past 10 years than models predicted even as underlying macroeconomic

conditions have become more stable.

It is thus clear that recent bouts of market uncertainty have been aggravated by

the lack of information about the distribution of risks in the global financial

system and the risk profiles of individual institutions. New, complex financial

instruments have increased linkages across financial institutions and made the

assessment of their exposures more difficult. It has also become harder to update

the valuation of collateral as market developments have unfolded. Incomplete

and differing disclosures also complicate attempts to draw comparisons between

them. This insufficient transparency at the firm level probably undermined exante market discipline. These issues, which have been well-known to the

regulators and the industry for some years, become pressing mainly in a crisis.

Lending institutions find it difficult, if not impossible, to simultaneously review in

a thorough manner a large proportion of their exposures. How effectively ex-post



market discipline is allowed to operate will have a significant impact on the future

conduct of financial firms.

Conclusion:

To conclude, the derivatives market in India has been expanding rapidly and will

continue to grow. While much of the activity is concentrated in foreign and a few

private sector banks, increasingly public sector banks are also participating in this

market as market makers and not just users. Their participation is dependent on

development of skills, adapting technology and developing sound risk

management practices. Corporate are also active in these markets. While

derivatives are very useful for hedging and risk transfer, and hence improve

market efficiency, it is necessary to keep in view the risks of excessive leverage,lack of transparency particularly in complex products, difficulties in valuation, tail

risk exposures, counterparty exposure and hidden systemic risk. Clearly there is

need for greater transparency to capture the market, credit as well as liquidity

risks in off-balance sheet positions and providing capital therefore. From the

corporate point of view, understanding the product and inherent risks over the

life of the product is extremely important. Further development of the market will

also hinge on adoption of international accounting standards and disclosure

practices by all market participants, including corporate.

Reference



y National Stock Exchange website

y Business Line

y Bombay Stock Exchange websitey DSP Merrill Lynch website

y 'Options, Futures, And Other /derivatives' - John C. Hull

y Seminar of De puty governor of R BI

indian derivative market : a regulatory and contextual perspective

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