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Birth, Death and Rebirth

As in the U.S., the history of derivatives in India goes back to the period after the American Civil War. A cotton futures exchange was started in Bombay in 1875, just a decade after the creation of the Chicago Board of Trade, five years after the creation of the New York Cotton Exchange and five years before the creation of the New Orleans Cotton Exchange. Cotton was hot in that period—cotton futures markets were also set up in Egypt (1861), England (1882) and France (1882). But India continued to add futures, including oilseeds in 1900, gold in 1920 and a host of others in those early years.

Then, less than 70 years after the cotton exchange started, there was a reversal in government policy. During WW II, options on cotton and forwards on oilseeds, food grains, spices, and sugar were banned. Then in 1952 the new Forward Contracts Regulation Act prohibited all commodity options and cash settlement on all commodity forwards. In the midst of the shortages caused by both drought and the Indo-Chinese border clash in the 1960s, farmers defaulted on forward contracts, a few committed suicide, and futures trading was banned for virtually all commodities. The premise was that futures lead to speculation, high prices, and shortages.

Now there still were futures markets during this period in the desert. They were just illegal and underground and small. It is difficult to stay underground and hidden if you get too big. The rebirth started slowly. In the 1970s futures were again allowed on seven non-essential commodities, though trading was still sparse. Finally, between 2000 and 2002 all restrictions on commodity futures trading were lifted and the framework for a set of national-level commodity exchanges was put in place.

Equity Derivatives

The story of modern derivatives in India really starts on the financial side of the aisle. In the second half of the 1990s, the National Stock Exchange of India (aka NSEIL or more commonly NSE) got the notion that the country should have financial futures markets. Its much older, but not necessarily wiser, cousin, the Bombay Stock Exchange, disagreed and argued that India already had a home-grown, tested and true version of stock futures built on a couple of traditional features of Indian equity markets. The first feature was a week-long settlement period which allowed traders to buy and sell all they wanted and deliver or receive only their net position as of the end of the settlement period. Add to this a unique Indian practice referred to as badla, which allowed traders to roll a net position over to the next settlement period and traders could obtain stock market exposure for days, weeks or even months, without ever having to make or take delivery, very much like a futures contract.

The government did what governments are wont to do; they appointed a committee, known as the LC Gupta Committee, to look into the question. Dr. Gupta is a thoughtful, scholarly man who lives in Delhi, but his Committee went on for a long time and the government took even longer and in June 2000, both the BSE and NSE launched stock index futures. Index and stock options were approved a year later in July 2001, followed by stock futures in November 2001. So the whole portfolio of products was rolled out over a 17-month period ending almost five years ago—long enough to see the dust settle.

And what do we see? First, there is only one survivor from the equity derivatives wars—the NSE. The BSE never wanted the products, never had its heart in it, and today has substantially less than a 1% market share (if that's possible). The BSE was hurt even worse by the 2001 government-mandated switch from one-week settlement sessions to the rolling settlement used in the rest of the world and a ban on its beloved badla trading.

Second, futures dominate the scene, accounting for 76% of equity derivatives trading, while options play a weak second fiddle with a 34% share (by value as of July 2006).

Third, despite their poor performance in most the rest of the world, and especially the U.S., individual stock futures are wildly popular and account for almost half (47%) of all equity derivatives trading. The huge success of stock index futures is due partly to the fact that they were launched at about the same time that traders were being deprived of the traditional synthetic futures with the elimination of one-week settlement periods and badla. Index futures is the second most popular instrument, with a 39% share. But this 39% share is essentially in one product, the S&P CNX NIFTY, while individual stock futures is spread over 123 individual issues. So from an individual product point of view, the NIFTY rules. Rounding out the product mix is index options with 11% and stock options with only 3%.

India has futures or options on only four indexes listed at two exchanges. This is good when compared to other emerging markets, but substantially narrower than the U.S. market, which has six exchanges listing 33 index futures contracts and seven exchanges offering 100 index options contracts. Despite the apparent competition in the U.S., one exchange, the Chicago Mercantile Exchange, still accounts for 92% of all index futures trading.

India tried to establish a broader base. The BSE, for example, had listed seven indexes and the NSE another 17. But only one index still hangs on at the BSE with a shred of activity and this is its banner SENSEX index. The SENSEX in India has the same place in the popular imagination as the Dow in the U.S. And the S&P CNX NIFTY appeals to the professional crowd just as the S&P 500 does back here. But looking at the volumes, it is clear that India is really a one-index country, with the S&P CNX NIFTY accounting for over 99% of all index futures volume.

Other Financial Contracts

The United States has the full array of financial derivatives contracts—equity, debt, and foreign exchange, but like the rest of the world, debt futures account for just over half of all futures trading (53% of U.S. trading, 54% of rest of the world trading in 2005).

Indian financial futures is all equities all the time. The NSE attempted an interest rate contract in the summer of 2003, but it traded for only three months—9,768 contracts in June, 963 in July and 50 in August, then nothing. The problem, in part, appears to be due to poor contract design. And the Reserve Bank of India has not yet given the green light for foreign exchange futures, nor have capital controls been adequately liberalized. So there is still a lot of growth potential as contracts are eventually added in the debt and foreign exchange areas.

Physical Commodity Contract Design

In the design of physical commodity contracts, Indian exchanges have taken a very different direction than their U.S. cousins. The U.S. tradition has been that commodity contracts are physically delivered—corn, wheat, soybeans, cattle, coffee, cocoa, etc. There are a few exceptions like feeder cattle and hogs at the CME and all of the new NYMEX swap contracts. But in every case, the contract is designed so that all participants remaining at contract expiration do the same thing—participate in a physical delivery or get settled in cash at a final settlement price determined in the cash market.

In India, contracts were initially designed so that the exchange attempted to match interested buyers and sellers and cash settled the rest. The problem was that few people had similar interests and most got cash settled. Another method tried was to give the seller the option to cash settle or deliver. Naturally this created uncertainty for the buyer since he didn't know if he was receiving product or not. In addition, some relatively thin markets seemed to have problems with false reporting of cash market prices in order to benefit futures positions. The result is that there seems to be a strong trend toward the U.S. style of mandatory physical delivery. Currently, of NCDEX's 61 listed products, only eight still have matching of interested buyers and sellers, 26 give the sellers the option, and 27 have mandatory physical delivery.

Measuring Turnover

Making turnover comparisons between India and the U.S. is a bit difficult. Volume data for the U.S. is generally given in number of contracts traded, while Indian turnover is always given in value terms. The reason for the difference is simple. U.S. exchanges and intermediaries quote their fees and commissions based on the number of contracts traded, while Indian exchanges and brokers set fees and commissions as a percentage of value of the transaction. Both brokers and exchanges want to see the number that drives their revenues.

However, to allow a comparison in terms familiar to American readers, we have converted the Indian volume data into number of contracts traded. In the accompanying table we list the top 10 futures contracts on both the financial and physical commodity side for both India and the U.S. Several things jump out. Of course Indian volumes are smaller, but the gap is greater for financials (U.S. is 17 times larger) than for physical commodities (U.S. is 3 times larger). This is not a big surprise given the massive size of the India agriculture sector.

Second, there are not enough Indian financial products to even fill out the Top 10 list. Despite attempts by both the NSE and BSE to create new products, most of them have just not taken hold and we find only four indexes and two groups of stock futures products. In addition, the BSE market share is tiny—.001%.

Third, by switching from Indian-style value to American-style (number of contracts traded), we knock gold and silver out of the top two slots and replace them with Guar seeds and Chana. Indian readers will be quite shocked to see a top 10 list without bullion at the top. What's going on is that there are fewer gold and silver contracts traded, but in the Indian numbers the fact that they are large contracts pushes them to the top of the list.

Incidentally, guar, also called cluster beans in Texas, is used for food in India, for cattle feed in other Asian countries and as a stiffener in soft serve ice cream, cheeses, instant puddings, cloth and paper in the U.S. And chana is a lentil that is split, boiled, pureed and mixed with spices to make one of the many types of dal, a staple of many Indian meals. Finally, urad is another kind of lentil used to make another type of dal, called urad dal.

Fourth, Indian commodity markets are less dominated by energy. Fully half of the top 10 U.S. products are energy products. Only one of the Indian top 10 is an energy product.

Also, though not shown in the table, Indian commodity markets are less diversified. In the U.S. the top 10 physical commodity contracts account for 40% of all physical commodity trading. In India, the top 10 account for 80%, leaving only 20% of the volume to be spread around all the other contracts.

Indian Contracts are Smaller

As can be seen from the table, the top 10 U.S. financial contracts have a single contract value averaging $188,508—almost 30 times the average size of an Indian financial contract. This is misleading given that half the top 10 U.S. contracts are debt contracts, whose nominal value ranges from $100,000 to $1 million. The average of the four stock indexes that made the U.S. top 10 is $56,000, only about eight times the average size of the Indian stock indexes.

U.S. commodity contracts are also larger than their Indian cousins, but only about five times larger. The average top 10 U.S. commodity was worth $45,975 compared to $8,368 in Mumbai. Indian agricultural contracts tend to be quite small $2,000 to $6,400, while Indian precious metal contracts range from $12,000 to over $20,000.

Regulation

Derivative markets in India are overseen by two regulators—the Securities and Exchange Board of India for financial products and the Forward Markets Commission for futures on physical commodities. SEBI is an independent agency created in 1992, while the FMC, created in 1953, is a department in the Ministry of Consumer Affairs Food and Public Distribution. Physical commodity regulation by a department within a larger ministry is actually the same model pursued in the U.S. prior to the creation of the Commodity Futures Trading Commission in 1974. Before that time the Commodity Exchange Authority was a relatively weak department buried in the very large U.S. Department of Agriculture.

Exchanges

How many derivatives exchanges are there in India? There are actually 26 exchanges that list derivatives in India—two for financial products regulated by SEBI and 24 listing physical commodity products and regulated by the Forward Markets Commission. However, in the financial derivatives arena, as mentioned above, the BSE has all but quit the business, leaving the NSE with over a 99.99% market share.

As a way to bring order to the highly fragmented system of regional commodity exchanges, the national government decided that it would be wise to create one or more exchanges that would operate on a national level and list a large number of commodities. The FMC required certain high standards of any entity applying to become a national commodity exchange, including fully transparent electronic trading. Only three exchanges qualified—the National Multi Commodity Exchange of Ahmedabad (NMCE), the Multi Commodity Exchange of India (MCX), and the National Commodity and Derivatives Exchange of India (NCDEX). While most of these names do not trip off the tongue, the exchanges have been hard at work building a large customer base and even offering services such as wide-spread publication of spot prices and improvements in the warehouse receipts system.

Aside from these three exchanges that met the FMC's criteria to be labeled a national commodity exchange, there are another 21 exchanges that act as regional commodity exchanges. According to the most recent two-week figures collected by the FMC (last half of July 2006), 98% of the value of commodity derivatives trading takes place on the three national exchanges, and 92% of the trade takes place on the two exchanges located in Mumbai—MCX and NCDEX. The third is the NMCE located in Ahmedabad, the capital of Gujarat, and despite the fact that Gujaratis have a reputation for being excellent traders, the NMCE has only a 6% market share.

Governance

In India, board composition has a unique feature. The regulator actually has a person sitting in on the board meetings. The law allows the FMC to place its own representative on the board of each exchange and up to three additional directors who represent interests that are not directly represented by exchange members. U.S. exchanges would find it pretty intrusive to have a CFTC or SEC staff member or commissioner sitting in on their board meetings. It also puts the government in the awkward position in that if an exchange does a stupid or illegal thing, the government is at least partly to blame. Initially, the same FMC representative served on the boards of two highly competitive exchanges—MCX and NCDEX—which was a bit awkward, but recently the two leading commodity exchanges have been assigned two separate FMC directors.

Electronic Trading

Let's face it. India was wired (or more accurately wireless) since the early 1990s. Once the NSE came out as a fully transparent electronic exchange, the BSE fell quickly in line and did the same. When the new national commodity exchanges were created in 2003, they came out of the box electronic. So India has lived in a screen-based exchange world for over a decade. The U.S. was brought into it kicking and screaming and it was only the reality of serious foreign competition that got the Chicago exchanges to start seriously converting. The New York exchanges have lagged even further behind.

When India started, it had a much worse land line infrastructure than did the U.S. So it went to the sky. The NSE was able to connect all over India in very short order. Today the NSE is in 296 cities with 2740 VSATS (very small aperture terminals). A VSAT consists of a transceiver which sits outdoors in direct line of sight with the satellite transponder and is connected to inside equipment that brings the market to the trader's screen. The three national commodity exchanges also use satellite technology to reach remote agricultural areas.

There is a problem, however. Satellites are slow. From a given location, it might take 700 to 800 milliseconds to send an order to the exchange. A land line could handle the task in 35 to 50 milliseconds. Even the internet is faster at 300 to 350 milliseconds. Now while satellite speeds are still fine for hedgers and the occasional trader, serious traders are starting to use landlines and the internet to connect to the exchanges, though these alternatives are much more expensive.

Conclusion

In a relatively short period of time, barely more than a decade, Indian derivatives have burst on to the international scene. They offer an interesting array of trading opportunities. Unfortunately it is still awkward for international entities to gain access to Indian financial derivates and impossible for them to gain access to physical commodity products. Recently, the FMC has indicated its willingness to allow international futures brokers to broker only domestically originated transactions in India. While we on the outside may be impatient to be invited to participate, the Indian authorities have many considerations to balance. During the past spring and summer, commodity prices in India rose very dramatically, and many people including Congress Party leader, Sonia Gandhi, pointed fingers at the futures exchanges. It appears as though reason has ruled, the messengers have not been shot and commodity futures will continue to operate unfettered, though the regulator, the FMC, will end up being strengthened, which is a good thing, but this incident reminds us that politics in India is never far away from the action.

Monthly Derivatives Trading at the NSE June 2000 - June 2006 Includes index futures, stock futures, interstate futures, index options and stock options Source: National Stock Exchange

Top 10 Contracts in U.S. and India Number of Contracts Jan-July, 2006 Sources: NSE, NCDEX, MCX and FIA

Size of Top 10 Contracts in U.S. and India Source: Contract sizes calculated using information from relevant exchanges, Forward Markets Commission and FIA.