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8/9/2019 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
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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
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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.
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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.
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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
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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):
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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.
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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
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Instruments available in India:Financial derivative instruments:
The National stock Exchange (NSE) has the following derivative products:
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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.
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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:
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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
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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.
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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:
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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.
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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
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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:
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(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,
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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
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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:
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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:
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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
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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.
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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:
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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
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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
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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