Welcome to Futures Industry
Michael Gorham, Susan Thomas and Ajay Shah
Published 5/1/2005

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Reading the business press, it’s hard to miss the buzz about outsourcing and the amazing growth of India’s software industry. But has anyone noticed the newfound maturity in Indian derivative markets? In the last several years these markets have made a huge jump forward in terms of technology, transparency and trading activity, and it is clear that the potential size of these markets could be enormous. In part one of this article, we look at the fantastic growth in equity derivatives trading in India. In the second part, we look at an even newer trend, the revitalization of physical commodity derivatives after decades of official discouragement.

Creation of the NSE

A little over a decade ago, India’s securities market was absolutely third world. There was little transparency. Most transactions were offset during two-week settlement periods and a real transfer of shares involved clerks pushing around truckloads of paper shares, with a noticeable percentage of the delivered certificates turning out to be counterfeit.

Today, India has a modern securities market that in some aspects actually surpasses the U.S. market. India has 5,644 listed companies, more than any other country in the world. Its leading exchanges are electronic, and its settlement system is a day faster than that of the U.S.—T+2 compared to T+3. The National Stock Exchange, the country’s leading stock market, handled more transactions in 2004 than any other exchange in the world, except the New York Stock Exchange and Nasdaq. The Bombay Stock Exchange, the second-largest market in India and the oldest stock exchange in Asia, ranked fifth on this global list.

How has India pulled off this miracle? The process began just over a decade ago with the government’s frustration in failing to get the BSE, the dominant exchange at the time, to introduce some relatively modest reforms. In 1992 and 1993, the Securities and Exchange Board of India, India’s securities regulator, asked for two things—first, have the BSE brokers register with SEBI and second, unbundle commissions from the prices of securities, instead of embedding the commission in the price of the security the way OTC dealers do.

The brokers reacted by going on strike. Not a smart move. The government countered by creating the NSE in partnership with several state-owned financial institutions. The new exchange was all-electronic and transmitted real-time bids and offers to the remotest parts of the country via satellite.

In strictly volume terms, the NSE has been a smashing success. It began trading in November 1994 and in less than a year it was doing more business than the BSE. Over the last three years, turnover has jumped 69%, thanks to a bull market in Indian stocks, and today the exchange has twice as much volume as the BSE.

More importantly, the NSE’s success has completely changed the nature of the domestic stock market. It forced the BSE to jump on the electronic trading bandwagon and vastly improved the transparency of stock market prices. It also has helped broaden the appeal of equity investing, with the number of stock brokerage accounts growing by 29% last year (that’s 5,400 new accounts being opened each business day) to reach about six million by year’s end.

Equity Derivatives Take Off

SEBI’s main purpose in creating the NSE was to accelerate the process of reform in the stock market, but its success also created the right ingredients for a booming equity derivatives market, which was launched in 2001.

Measured by the number of futures and options traded in 2004, the NSE ranked as the 17th largest derivatives exchange in the world, and the 10th largest in futures-only volume. During the past several months the value of equity derivatives trading has been more than twice the value of trading in the underlying cash equity market.

The vast majority of this trading is conducted by retail participants, a category that includes small brokerages trading for themselves. Only three percent of equity derivatives trading is institutional, and of that small amount, almost all comes from foreign institutional firms.

In the first two months of 2005, the NSE traded 35 times the number of equity futures contracts as were traded on OneChicago, the only U.S. exchange still listing such contracts. Why did Mumbai succeed at single stock futures while they languished in the U.S.? Many would point to a more hostile regulatory environment in the U.S. But a more important factor was that Indian traders had years of practice trading something very akin to equity futures.

Until recently, India’s stock markets had settlement periods that used to be as long as a month, gradually reduced to two weeks and then one week before finally being transformed into the rolling settlement we have in the U.S. For example, a week-long settlement period meant that a trader could buy and sell large numbers of stock from Monday onwards and would only have to deliver or receive delivery on his net position at the close on Friday. If the net position was zero, there was no delivery required and he would simply receive his trading profits or pay his trading losses. In fact India had a peculiar mechanism, called badla, which allowed traders to carry forward large long or short net positions to the next settlement period, so traders could accumulate sizable positions and avoid delivery for many months.

This futures-like practice was eliminated just before single stock futures were introduced, so the familiarity with settlement periods and carry forwards was transformed into a demand for equity futures, ensuring a fabulously successful new product. On the other hand, because Indian traders were not at all accustomed to the idea of trading a broad market index, equity index futures got off to a much slower start and only now are beginning to catch fire.

The Rebirth of Physical Commodity Trading

While exchange-traded equity derivatives are a mere four years old in India, the history of futures exchanges for physical commodities goes back to 1875, about a decade after they started in Chicago. Cotton was the first product to be traded on an organized exchange in India, followed by a group of oilseeds, then jute, then wheat and then many other things. These contracts traded on local exchanges throughout the country, with markets and prices fragmented due to the high cost of moving both goods and information around.

After independence from the U.K. in 1947, however, commodity futures trading came under increasing pressure as the country moved down the socialist path. Prime Minister Nehru had watched from prison as the capitalist countries got mired in the Great Depression of the 1930s while the Soviet Union seemed to be making significant progress. So when Nehru came into power, five-year plans were in and free markets were out. Thus the government in 1952 banned cash settlement and options trading under the Forwards Contract (Regulation) Act, and decided to directly protect farmers by setting minimum support prices for a set of important commodities referred to as "primary commodities." The ban was subsequently extended to all forward trading after several years of drought at the end of the 1990s, when supplies shriveled, prices soared, and a large number of farmers defaulted on their forward contracts, with many of these actually committing suicide. The government resumed permitting trading forwards on a small set of agricultural commodities in the 1970s, but the volumes never reached their pre-ban levels. Trading had moved underground to OTC contracts, which had the additional advantage of avoiding taxes.

All that changed a few years ago when the government began liberalizing the commodity futures sector. SEBI’s authority is limited to financial products, so the lead role went to the Forward Markets Commission, a department of the Ministry of Consumer Affairs, Food and Public Distribution.

In 2002, the FMC decided to encourage the creation of national electronic exchanges to overcome some of the structural impediments to the modernization of commodity futures, which at that point tended to be traded on a large number of small regional exchanges, which typically had active trading in only one or two products. The first exchange out of the box was the National Multi-Commodity Exchange of Ahmedabad (NMCE), which started November 2002. A year later two exchanges opened their doors in Mumbai—the Multi-Commodity Exchange (MCX) and the National Multi-Commodity Derivatives Exchange (NCDEX), which is partially owned by the NSE. A fourth exchange, the National Board of Trade in Indore, is on the FMC’s list to achieve national status, but has not yet converted from floor to screen and actively trades only one product.

These markets are still prohibited from using options or cash settlement, two key components of any modern derivatives market, but in other respects they are making rapid strides. Today, the monthly traded volume in commodity derivatives in India is around Rs 1 trillion (about $22 billion). In comparison, equity derivatives trading, which is almost all at the NSE, is roughly 2.5 times bigger.

The exchanges all list a large number of products, but see active trading in only a handful. For instance, NMCE lists 61, but had trading in only six during the first two weeks of April. MCX traded nine of the 50 listed; NCDEX traded 16 of the 39 listed; and NBOT traded only one of the six listed.

MCX dominates in precious metals and crude oil, while NCDEX dominates in guar (a raw material used to thicken ice cream, puddings and other processed foods) and soy. The much smaller NMCE has found success in jute, pepper and coffee.

While guar seed and guar gum are small products in terms of annual production, their prices are extremely volatile, and not surprisingly, this has resulted in large trading volumes. Gold futures in India is closely tied to gold trading at the New York Mercantile Exchange in New York, and up to 60% of MCX gold trading takes place during evening hours when the New York market is open.

This active and sustained competition among the commodity exchanges is in contrast with the equity world, where liquidity on the derivatives market has all gravitated to a single exchange. It is not yet clear whether this level of competition will be sustained on the commodity futures side, or whether trading in each commodity will concentrate at a single exchange, as in the U.S.

Can the Rest of Us Play?

Foreign entities can trade in Indian equity or equity derivative markets only if they are registered with SEBI as a Foreign Institutional Investor or as a sub-account of an FII. Who can be an FII? First, the entity must fall within a specified, but reasonably broad, group of financial institutions, including: pension funds, mutual funds, investment trusts, insurance or reinsurance companies, endowment funds, university funds, foundations or charitable trusts, and a few others. Hedge funds and CTAs are not currently on the list and thus do not have direct access.

Second, the FII must meet certain fitness requirements, be appropriately regulated in their home country, and establish relationships with a local custodian and local bank. While corporates and individuals cannot be an FII, they can be a sub-account of an FII. As of the end of 2004, there were 637 FIIs and 1,785 sub accounts of FIIs.

Foreign broker-dealers and futures commission merchants can gain access to India's equity derivatives markets by becoming a locally incorporated broker-dealer. More than a dozen foreign brokers have taken the second route and have set up local subsidiaries and joined the exchange, according to NSE. They include ABN Amro, Citigroup, CLSA, Fortis, HSBC, JP Morgan, Merrill Lynch, Nikko Capital, Refco and UBS. As local brokers, these entities can execute orders for both local customers and FIIs and engage in proprietary trading. Foreign individuals or corporates can gain access by having a sub account with an FII.

There is one other strategy by which interested foreign parties have gained exposure to Indian equity derivatives without becoming an FII or trading through an FII subaccount, and that is through an over-the-counter instrument known as a participatory note or PN. The process is simple. An FII takes a position in the Indian market, then issues a PN with the same economic value to an offshore investor. This type of "back-to-back" transaction accounts for a significant portion of the total foreign investment in India’s equity markets, with estimates ranging from 20% to 25% of total FII activity. In January 2004, SEBI issued an order permitting the sale of PNs only to entities meeting certain criteria related to their financial strength and home-country regulation. In practical terms, almost any major financial institution can use this route to gain exposure to the Indian equity markets, according to brokers active in this business.

It should be noted that the Commodity Futures Trading Commission has not yet provided a Part 30 exemption to any exchange in India. Part 30 exemptions, which greatly facilitate cross-border trading by permitting members of foreign futures exchanges to solicit U.S. customers, have been granted for most of the major market centers, including Australia, Brazil, Canada, France, Germany, Hong Kong, Singapore, Spain and the U.K. (In the case of Japan, the Part 30 exemption applies only to the Tokyo Grain Exchange.) The CFTC will grant a Part 30 exemption only if the foreign regulator meets certain requirements and shows that it exercises "equivalent" regulation.

In the case of futures on physical commodities, neither FIIs nor even domestic financial institutions are currently allowed to participate. But the rebirth of the commodity markets is recent, reforms are being done gradually, and there have been discussions about loosening these restrictions.

Can Indians play in our markets? Until recently, the government imposed severe restrictions on outbound investment because of a shortage of foreign reserves. India now finds itself in a completely different position with $125 billion in foreign reserves, the fifth largest in the world. So last year the Reserve Bank of India, the country’s central bank, raised the amount of funds that Indian citizens could invest abroad to $25,000, which is three times the average middle class salary.

Should we want to get in? In most emerging markets, the international investor finds relatively illiquid and unsophisticated securities markets. Not so in India. Markets in equity derivatives are tight, liquid, and transparent. There are sound clearing and settlement processes, topped off by active markets in a range of modern products like stock futures, stock options, index funds, ETFs, index futures and index options. The spot and derivatives markets have a single regulator, SEBI. And the Indian economy is dynamic. So as barriers continue to fall between the two countries, India should prove an increasingly interesting market in which to participate.

Interpreting Those Strange Indian Numbers
As long as you get your information filtered through the Economist or Financial Times or Wall Street Journal, you will not need to know the following. But if you ever pick up an Indian newspaper, visit an Indian website or try to do fundamental analysis on an Indian stock, take note. Americans grew up with hundreds, thousands, millions, billions and, if we went far enough in school, trillions and some other things I don’t use or remember. But unless we’re talking about astronomy or the national debt, we can get by with the first three names of numbers. And when we write numbers, we separate them with commas into groups of three, starting from the right. Like the earth is 93,000,000 miles from the sun. Indians grew up with lakhs and crores. A lakh is 100,000 and a crore is 100 lakhs, or 10,000,000, though I put the commas in American, not Indian style. They do a different comma thing which grows naturally out of the crore-lakh stuff. Going right to left, Indians group the first three numbers just like we do, but after that, everything is in groups of two. The earth, in India, is 9,30,00,000 miles or 9.3 crore miles from the sun. Quick test. What was global futures and options trading volume last year? If you read this Magazine, you would say 8.9 billion, or 8,900,000,000 contracts. If you asked a guy walking down the street in the financial district of Mumbai, he’d say 890 crore, or 8,90,00,00,000, contracts.

Exploding Volumes: Equity derivatives volume at the National Stock Exchange of India

Source: FIA

Michael Gorham is director of the IIT Center for Financial Markets at the Illinois Institute of Technology. Susan Thomas is professor at the Indira Gandhi Institute for Development Research, and Ajay Shah is consultant to the Indian Ministry of Finance. The authors wish to thank Bikram Chandra, an MS candidate at the IIT Center for Financial Markets, for valuable assistance.
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